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Third Mile
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Previously, I worked in the buy-side investment industry. Currently, I manage my family investment. My investment style is primarily long-only, bottom-up, high-conviction. Additional strategies include event-driven and macro trading.
  • Apple: The Best, Base And Worst Case 0 comments
    Apr 21, 2013 4:40 PM | about stocks: AAPL

    The success of Apple (NASDAQ:AAPL) can be primarily attributed to three factors, i.e. excellent technology, superb design of ease of use and astute marketing. Steve Jobs was credited to the visionary who could pull together these three drivers leading to all the successful blockbuster products from Apple. The loss of Steve Jobs and the evidently slowing earnings momentum of the aging product lines lead a sharp drop in share price. Having read the numerous articles on Apple, we realize there is little room to add value to what we already know about the stock. Here we will attempt to add value by presenting the upsides and downsides of the stock. We shall start with the most optimistic case.

    The best of best case

    Apple has been great at launching innovative, blockbuster products, so far. We shall not make a fool of ourselves to predict the specific products that will rival the success of iPod and iPhone. We shall make a reasonable assumption that Steve Jobs would have had left behind a pipeline of exciting products. Of course, as time passes and technology rapidly changes, the product ideas left behind by Steve Jobs will most likely deteriorate in terms of relevance. Nevertheless, if a blockbuster product is indeed successfully launched and earnings are increased by 100%, then the PE will easily expand to 15x. With that, the return will easily exceed 200%.

    The best case

    Currently, Apple is paying quarterly dividends of USD2.65 per share, translating into 2.7% dividend yield. In addition, the Company's Board of Directors authorized a program to repurchase up to USD10 billion of the Company's common stock beginning in 2013 through 2015, potentially adding another 0.9% yield. Overall, the management indicated to return USD45 billion to shareholders over the next three years for a total yield of 4% or 36% payout ratio.

    We will next speculate the potential upside in distribution to shareholders. At the current share price of USD391, market capitalization is USD367 billion. With a net cash of USD137 billion, about 37% of market capitalization is cash. Conservatively assuming that Apple keeps a third of the cash in the balance sheet and distributes the remaining two third of the cash to shareholders over the next five years, the additional yield will be another 4.9%.

    If Apple indeed distributes the two third of the cash as speculated above, the total yield will add up to be 8.9%. With such a high yield, we shall use dividend yield as the valuation model. As a tech stock, Apple is widely and correctly perceived to be carrying a higher risk than the traditional dividend stocks. We will demand a higher target yield of 5%, still, yielding a whopping 80% return.

    The base case

    In the immediate future of the next 6 months, it is highly likely Apple does not release any new blockbuster products. In other words, Apple will be subject to intense competition in the existing product categories. The optimistic projection will be made by extrapolating from the recent trends. The revenue growth is running at about 25% for both iPhone and iPad, offset by about 15% decline in revenue from Mac and iPod, yielding a 15% overall revenue growth. Under the assumption of intensifying competition, we will see a decline in margin, primarily arising from declining selling prices, either from outright price reduction of existing product lines or introduction of new product lines of lower selling prices. Furthermore, the sale and marketing cost will rise as percentage of revenue. All in all, the earnings will grow slower than revenue growth, ranging from zero to 10%. The PE will stay flat at the current range of 9-10x, therefore yielding a return of 5-10%, from the earnings growth, dividend and share repurchase.

    The worst case

    In the medium term of 12 to 18 months, we shall expect Apple to release some new product category, of which Apple hopes to be a blockbuster product. If the products unfortunately turn out to be a disaster, the confidence in the management of the post-Steve Jobs era will plunge to the bottom. The PE and therefore share price will drop, perhaps for another 20%. By now, the smartphone and tablet space will be highly competitive. Earnings growth probably ranges from a negative 10% to a positive 5%. Concurrently, the valuation will gradually decline by perhaps another 10%. The return for the worst case will be a negative 20%.

    Ranking by probability

    We shall now qualitatively rank each case by the probability of occurrence over the next 18 months. The base case carries the highest probability to occur because it is extrapolated from the recent history. The next highest probability will be the worst case, which is essentially an extrapolation from the base case. The third most possible event will be the best case, which deserves a higher time value since it could occur at the impending result release. To be conservative, the best of best case will be considered as the least possible event.

    In short, the event with the highest probability is the base case, followed by the worst case, the best case and lastly the best of best case.

    Conclusion

    At the current share price of USD391, the upside is tilted over the downside. However, to minimize the drawdown, a better entry point will be after the impending result release. It is very likely for Apple to post a weak result for 2Q2013 given the very high base of 2Q2012.

    Disclaimer: Third Mile is not a registered investment advisor or broker/dealer. All information contained herein is for general information purposes only and does not constitute any investment advice. Third Mile does not guarantee the accuracy or completeness of the information contained herein. Readers are solely responsible for their own investment decisions.

    Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Themes: long-ideas Stocks: AAPL
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