For my investing purposes, going long Apple Inc. (AAPL) is not a question of revenue growth, iPhone models, or units shipped, rather it's a question of margin of safety. We all know the company will grow, but how much reward can I get for the potential risk? Well, the answer to that question is the reward far outweighs the potential downside risk. Apple is the rare case where it has a wide moat and limited downside in the next years. I am taking a very conservative approach when determining the downside potential, thus factoring in outlier scenarios. Let's review some of the factors that led me to my outlook.
Net Profit Margins
For my investing horizon of 1-2 years, I've not allocated too much weight to declining margins, since revenue growth far outpaces the downfalls of a pressure on EPS from margin reductions. This is one of the major factors that makes AAPL an investment that is so enticing. I am utilizing analyst guidance with a haircut to quantify the downside potential:
- Average analyst estimate 2013 revenue = $191.8bn
- 1000bp haircut = $172.62bn
- Analyst estimate 2013 net profit margin = 30%
- 500bp haircut = 25%
In this outlier scenario, and using current P/E values for the trailing twelve months, AAPL stock is valued at $619. This margin of safety demonstrates the fact that reward is grossly skewed in the investor's favor as the ultimate downside by December, 2013, is greater than the closing price today - essentially a positive margin of safety. This is mostly unheard of when searching throughout the equity markets. The actual earnings results in 2013 are likely to be far better than my analysis has determined as AAPL's margins have not fallen below the mid-20s in years. Conversely, its margins have trended upward consistently. Moreover, the company's most recent reports missed EPS by approximately 10% and my downside analysis accounts for an EPS miss of 13%. Just meeting guidance would result in a price in the mid $800s come 2014.
The last years have been full of stories asking if we should categorize Apple as a growth stock or a value stock. I believe it is both, yet my analysis utilizes a value stock approach wherein the stock commands a relatively low multiple. Once again, my conservative assumptions come through. AAPL currently trades at 14x trailing P/E, which is well below its long-term average and at a level I believe it will be for some time. I don't foresee a rosier outlook for AAPL than we have seen the past three years so it would be unjust to assume investor sentiment will improve upon where it has been recently. All the better if it does, but what if it doesn't?
Just as it would be unjust of me to assume the multiples to expand, it would be similarly unjust to assume that AAPL will trade at a significant discount to where it is presently. To put this in perspective, utility, material, and telecom companies all trade at a higher P/E than AAPL. Mature companies (ones with far slower growth than AAPL) such as DOW Chemicals (DOW), McDonald's (MCD), and Wal-Mart (WMT) all trade at a multiple in the high teens. This ratio can only compress so much before traders realize how much they are undervaluing the growth of the firm and AAPL's PEG below 1.0 confirms this.
I would be concerned with the downside for AAPL if it currently commanded a high multiple, such as that for AMZN currently, or firms with high flying multiples that turned short winners like Green Mountain Coffee Roasters (GMCR), Netflix (NFLX), and Opentable (OPEN). Given my outlook, I am forecasting for minimal P/E compression with values to be in line with current values in 2013. This will result in higher future EPS being multiplied by a steady P/E, and most importantly, this means a much higher stock price. The downside is a large miss multiplied by a slightly lower multiple putting the stock in the high $500s.
Sentiment Risk and iPhone Risk
I would be acting irresponsibly again were I to assume there are no risks for Apple. The overly positive sentiment for AAPL has diminished slightly over the last year and this could be exacerbated by another earnings miss in the next few quarters. This has the potential to drag on multiples and reduce the willingness for investors to pay a higher premium for future earnings.
Additionally, many are expecting the iPhone 5 to be the largest product launch in Apple's history with pent-up demand driving unit sales. Supplier issues, increasing domestic competition, or another operational problem like an antenna, could dampen sales.
Bringing it All Together
So, as we can see, with an unheard of revenue and EPS miss accompanied by a lower P/E multiple, the value of the Apple stock by the end of 2013 is approximately where it has been the last few months. It is easy to focus on the fact that margins may fall, Samsung may win patent suits that slow iPhone growth, and the iPad mini may not sell as many units as anticipated. It is more difficult with the noise in the markets to focus on the true story that such a wide margin of safety is built into the stock. Look around and I'll challenge you to find a company that has a similarly wide moat, even after three years of tremendous compounded growth.
Disclosure: I am long AAPL.