Apple (AAPL) stock is still reeling after last week's news of lower iPhone sales as a result of macroeconomic weakness in China. I already own the stock and will soon be adding to my position. I view this as a tremendous buy opportunity for the following reasons:
- Apple's cash war chest remains underappreciated and undervalued. Historically, cash reserves have been used for share repurchases, but the operating flexibility this gives the company in the future is compelling.
- Apple produces at least twice the amount of free cash flow relative to any other company on the market, yet you can buy the stock at virtually the same value as Amazon (AMZN), Microsoft (MSFT) or Google (GOOG) (in terms of enterprise value). This free cash flow allows an incredible amount of capital to be returned to shareholders.
- The stock price has shown a pattern based on major iPhone releases. We are now in a trough between major releases, and that's precisely the time to buy.
- Apple trades at rock-bottom valuations no matter what perspective you take. I expect 47% upside based on a peer analysis and 18% upside based on a conservative, two-stage, discounted cash flow model.
- Despite a lot of recent negative comments from Wall Street last week, the price targets tell a different story.
1. Apple Still Gets No Credit For Its Cash War Chest
- Data Source: Apple's SEC Filings
Apple's strong free cash flow has enabled it to amass more cash than any other company in the world, which is currently at $237.1 billion as of its most recent quarter. The more important number is its net cash balance (cash less debt), which is at $122.6 billion. This basically gives Apple nearly unlimited potential, whether through acquisitions or internal research & development. Here are a couple examples of what the company could use this capital for:
- Enter the auto industry, which has long been speculated given cars are now just like one giant computer. Apple could do this either from the ground up or by purchasing a company like Tesla (TSLA)
- Enter the entertainment industry, which Netflix (NFLX) could be a potential acquisition target for. (I especially like this should Netflix ever falter and see its valuation decrease.)
- Enter the telecommunications market.
- Branch out and enter other industries like energy or banking.
There are two important things to note here. First, I've believed for a long time that Apple gets no credit for its cash reserves. The stock should trade at a premium, but it simply doesn't. It makes no sense that Apple trades at the cheapest valuations (see analysis below) and has the most cash reserves. Second, the company is valued on the trajectory of its existing business. I view all of the possibilities I mention above as pure upside to the stock.
2. History Repeats Itself
Apple's performance is reliant on iPhone demand, there's no arguing that point. Historically, more iPhones are sold in the twelve months after major releases. There have been dozens of models released, so when I say "major releases", I'm referring to a new line with new hardware and major upgraded features (i.e., iPhone 5, 6, 8 & X, etc.). For example, 2015 was a record year based on the iPhone 6, which was released in September 2014 (basically the beginning of fiscal year 2015). There was no major release during fiscal year 2016, which is why there was a decrease in both unit sales and average selling price. 2018 was strong because of the iPhone 8 & iPhone X release along with record-setting average selling prices.
As we look at the stock price performance, you can see the same pattern as I mention above. New stock highs were reached in 2013, early 2016, and 2018 as a result of the iPhone 5, iPhone 6, and iPhone 8/X releases. The periods in between saw the stock price fall dramatically as iPhone demand weakened and investor sentiment deteriorated. We are now in a similar "in-between" period, and the stock is behaving similarly. The last major line releases were over a year ago (iPhone 8 and iPhone X), and the next major release won't be until mid-to-late 2019. This is the time to buy the stock. We are currently in a trough, and just as before, I expect the stock to pick up momentum in 2019 as anticipation builds for the next major release.
3. Peer Valuation Analysis: 47% Upside Expected
Relative to other large-cap tech giants, Apple trades cheap across the board. Only IBM Corp. (IBM) trades cheaper, and that's a result of a negative, long-standing revenue growth trend. When comparing Apple to Amazon, Google, and Microsoft (all of which have a similar enterprise value), you get at least twice the amount of free cash flow with Apple (see chart below). I'll take that deal every day of the week. Based on an average of Forward P/E, EV/FCF, and PEG Ratio, I expect 47% upside potential in the stock.
- Enterprise Value, Forward P/E, Price/Sales, and PEG Ratio provided by Yahoo Finance.
- EV/FCF provided by YCharts.
- LT Growth Rate derived from Forward P/E and PEG Ratio.
- Note - Outliers removed from averages (Amazon for Forward P/E and EV/FCF; IBM for PEG Ratio).
4. Worst-Case Scenario: 18% Upside Potential
In the following two-stage model, I assume Apple's free cash flow deteriorates over the next five years as a result of the trade war, lower smartphone volume, and compressing margins. At the end of a 5-year period, the company will reach a steady state of $200 billion in revenue and then grow by 3% thereafter.
- Risk-Free Rate - I used the yield on a 30-year Treasury bond.
- Equity Risk Premium - This figure is calculated every month by Aswath Damodaran, a Stern Business School professor.
- Beta - This model is quite sensitive to beta, and statistics from different sources use different measurement time periods and thus vary widely, so I used a beta of 1.
- Required Rate of Return - Calculated by multiplying the Equity Risk Premium by Beta and then adding the Risk-Free Rate.
Wall Street's expectations are similar to my free cash flow model above. In the wake of Apple's disappointing announcement last week, many Wall Street firms cut price targets, and some downgraded the stock from "buy" to "hold" (you can read each analyst's comments here). However, the consensus price target is still at $184.18, which represents 24% upside potential.
5. Apple Returns Tons of Capital Back To Shareholders
I've already established that Apple has more cash and produces more free cash flow than any other company on the market. This capital has primarily been going back to shareholders through dividends and share repurchases. The company's dividend yield is currently at 2%, and with a payout ratio of only 21%, there's plenty of room for growth.
Apple purchased $72 billion worth of stock during 2018, an astounding figure. Over the last 5 years, the company has repurchased $213 billion, which has had a significant effect on earnings per share. As long as it doesn't make any large acquisitions, I'd expect shares to continue being purchased in a flurry.
The general direction of the market, along with bad news, has pushed Apple stock well below what I consider as a fair value. This is demonstrated with a Forward P/E of 10x, EV/FCF of 11.7x, and a PEG of 0.91x. These are rock-bottom levels and a perfect time to open a position. It might take some time for the stock price to recover, but I expect the following catalysts to give Apple significant upside over the next year:
- As we move closer to the next major iPhone release, anticipation will build and expectations for improving iPhone demand will push the stock higher.
- Once the negative news flow subsides, valuations will trend back towards Apple's historical and peer average multiples.
- Strong free cash flow will continue to support dividend increases and share repurchases. Even with stagnant revenue growth, this will enhance returns and increase earnings per share.
Disclosure: I am/we are long AAPL. 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.