Let me start with a disclaimer. I am not a typical Apple fan*. First and foremost, I am a software engineer with some corporate finance and accounting knowledge, through a certificate in quantitative finance. I recently bought Apple shares; then sold them, after thinking about going short. But I will not be shorting Apple. And here is why.
The reason I was going to go short was because of size. Apple is huge. So huge that I could not see how Apple could continue to grow. Four years ago, I refused to buy Apple at $100. But now it has proven itself, it is hard to short. I walked into a small business specializing in 3D printing software, whom we work with occasionally. To my surprise, they had an Apple mini server. Currently, it runs Mac OS with Intel chips; therefore, only Microsoft (MSFT), from the PC world, has been cut out of this small business server.
It got me thinking. Could Apple be the one to provide the servers of the future? It sure can be the missing link for ARM (ARMH) in taking off in the server sector. Apple can excel at what Applied Micro (AMCC) is trying to do with its 64 bit ARM servers. Given Apples' wealth, brand and software prowess, as well as its' need for growth, it seems palpable. 15% of the server market is expected to be low power servers. This is all Apple needs, in order to break the $1000 barrier and send ARM astronomically higher, taking market share from Intel and AMD. Could this be why Apple is hiring former AMD chip designers? The Mac line is only 10.6% of Apple's revenue. And optimizing the cost slightly by replacing Intel with Apple's own ARM chips is not worth the gamble on the costs of creating exclusive, high speed desktop/laptop ARM processors. Unless there is a bigger plan. As a first and foremost consumer brand, moving into data centers with a big push, might be unlike Apple. But then again, Apple already sells servers, which currently only pay a small part in generating revenue.
Certainly, servers and data centers can do with the cost and power savings of ARM. For Apple, it sure can provide massive further growth opportunity, in adding to its' many vertically integrated markets. Speculation that the MacBook line might use ARM cpus' is rampant. However, we don't think that provides sufficient justification for the massive investment needed to produce ARM desktop and laptop processors. Looking at the evidence, according to the annual report, we can point that R&D in Apple is increasing, nearly 40% per quarter. This could be an alternative explanation that many analysts have missed.
Furthermore, Apple can kick start the ball rolling through an acquisition of distressed PC chipmakers (AMD?). Or it can continue to invest in chip design talent. Apple can also purchase parts of ailing businesses, like buying SeaMicro from AMD. Imagine the server world being flooded with Apple iPUs (as compared to AMD's APUs, which incorporate a GPU and CPU). Apple's A6 is fantastically power efficient; with a 64-bit extension, in conjunction with the SeaMicro fabric, it can make bigger waves. Apple has the brand, money and power to succeed, where as AMD and AMCC might fail.
How much can Apple grow with potentially larger shares of servers added to Apple's incredible profile of consumer goods, App store sales, iTunes and high attach rates? And how much growth is implied by its current pricing? These are not easy questions to answer. But in terms of software sales, we can say that via the Apple store, we bought more Apple Apps in the first 24 hours of using our iPad than we bought in two years owning an Android phone. In our week-old tradition, let's also take a quantitative look at the growth prospects.
The Apple Growth Simulation
We created an inflation-adjusted (assumed to be 2%) Gordon growth simulation for Apple. This simple chart can predict what Apple should be trading at today using a discounted dividend model. Obviously, this is a simplification, but it's a useful way of providing numerical backup to verbal reasoning. It's a way of evaluating the value at risk when you go long without chart extrapolation. The methodology used relies on CAPM and the related WACC, allowing for growth and discounting dividends. Assuming an expected market return of 5%, Apple's WACC is 4.52%, or 3.6% with a market return of 4%; this is generally lower than Intel. We used the WACC to discount future income, resulting in the growth vs share price chart shown below:
Given Apple has easily been growing 20-50% per annum, a long term growth of 5% above inflation is possible. Therefore, we agree with the professional analysts. This would mean that they are currently undervalued in my books ($632 vs ~$700 target). However, if Apple stops growing, and its' current sales and profit remain flat, the shares are only worth about $200 (See 0-0.0025 on the curve). That downside risk is something to consider when putting your stop-loss. When or if the tide turns, depending on the model you subscribe to, the price could be much lower. For the short-term, reaching $700 or $800 seems within reason and not a fairy tale. At 6% long-term growth, and above inflation, it could easily reach $1000. Or it could go even further, if our suspicions regarding entry into data center servers prove to be correct.
How does Apple compare with Intel?
In order to understand the growth model relative to another company, we also analyzed expected returns relative to Intel, the dominant PC and MacBook CPU manufacturer. We found that low growth favors Intel (INTC) as an investment, and high growth favors Apple. This is also common sense, as Apple is vertically integrated; it benefits more from total sale prices when sales grow rapidly. Intel only benefits from some components. Furthermore, Intel's margins are threatened in the mid-term future from ARM-based competitors.
The Microsoft Threat
As there are plenty of Google versus Apple articles on SeekingAlpha at this moment, for the sake of this argument, we will ignore Google. As far as threats go, Microsoft also has all the pieces of a good ecosystem, brand, capital, operating system, browser, software, game console, phone, search engine, and upcoming Surface tablet. Yet, I am sad to say, it never seems to come together in any cohesive manner. Apple is all about having a cohesive system, something not even Google has understood. Microsoft OS, if anything, just keeps getting more complicated. Windows 8, Windows 8 RT, Windows 7, Windows 7 Phone, Windows 8 Phone (not backwards compatible), Windows CE (includes former Window Mobile OS), Xbox OS; and the list can go on. From a consumer viewpoint, none of them are compatible; while from a developer viewpoint, they are somewhat compatible. Xbox is a minor success. Bing has until now, failed to dent Google, in as much as Google displacing Internet Explorer as the top browser. Microsoft is still a distant second in search.
Given this background, can they threaten Apple? Google can fine tune their applications, making them faster than the built-in Windows browser on an OS they do not control. That tells us something about Microsoft. Microsoft doesn't always hold the attention to detail and cohesiveness to overtake Apple in the mobile game. It has yet to prove that it can with the Surface RT. On the other hand, Google has the openness problem. Where is Google headed if it tries to copy Apple with its' Motorola purchase? It is inconvenient to have two instruction sets running Android (Intel Atom x86 and ARM). What will Samsung do with Android if Google starts competing with it?
In short, without going into these off-topic questions, we see nothing that could fundamentally threaten Apple over the short-term. As covered by numerous other articles, there are plenty of mid-term risks from Android, Google and Microsoft.
Apple products keep selling, as a result forcing the competition to join the eco-system. Even Microsoft Office division fought hard to be able to release Skydrive as well as Office 2013 on the iOS. We were thrilled; we do not need a Windows Phone to use Skydrive. Clearly, Microsoft cannot sacrifice Office and its' cloud services to prop up Windows. Apple is really strong.
The iPad Mini - Will Apple drop margins?
The market sometimes seems to fear a margin drop for Apple, more than it fears the competition. Given the current state of things, it might make sense. On the other hand, I think Apple is making the right move, even with a significant margin drop. It is preventing an Intel style wakeup by removing price umbrellas, otherwise known as pockets of profitable business, left for competitors. If Intel had spent just $500 million (peanuts in Intel's R&D budget) to make Atom competitive for phones, pricing it to undermine competition much earlier, ARM would not have such explosive growth. Apple's reasoning is compelling: if you bought a Nexus because it was less than half the price of the big iPad, you will now buy the iPad-Mini. If you were rich enough to buy the 10" Apple, you will still buy it. 10" is way better than 7". That's smart, and will help to keep Microsoft at bay. Just one more thing. The Surface RT is priced to compete with the iPad price range, not the new iPad-Mini. How convenient, though the surface has an advantage in having Office preinstalled.
As everyone knows, Apple's killer strength is its' focus on "well-designed" products with a slightly larger margin as compared to the high end of the competition, but not large enough to feel prohibitively more expensive. Power Books were prohibitively more expensive as compared to similar PC notebooks. That was an era where Apple was on the verge of death. This has not been the case since Apple dropped the PowerPc and moved to Intel CPUs. Apple's dominance in the top end is also important. In the high-end notebook space, the best value for one's money is a base model MacBook Pro Retina. The top range Samsung (GM:SSNLF) ultrabook 9 series is more expensive and has lower specifications. This, along with the new cloud opportunities, coupled with Apple's iron-clad ecosystem, indicates a good deal of further upside.
Woe onto the Apple doomsayers. Our time has not come. In the short-term, we believe Apple is a good investment; we back it up with numerical evidence. In the long-term, it depends on Apple delivering consistent returns, even if they are single digit. Those returns have to be significantly above inflation to justify Apple's price. So, I would advise for caution if you intend to keep Apple for the long-term (more than 1 year). As Keynes once said, "in the long run we are all dead". But, for the short-term, buy Apple. It is looking like good value.
Additional disclosure: May start a long position on Apple
* About me: I build my own PCs, I over-clock them, I write algorithms in C++, C# for a financial IT firm Technoor Consulting. I also program in OpenCL on Nvidia and ATI (AMD) platforms. Oh, and I hate one button mice. At home, I also have an AMD FX 8 core desktop running at 5Ghz with Microsoft Windows 7, running Oracle Linux inside VirtualBox, on a three monitor ATI Eye-Finity setup. I am not the typical Apple fan.