Valuing Apple: Now Is The Time To Buy

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About: Apple Inc. (AAPL)
by: Mac Rowan
Summary

Challenges in emerging markets, coupled with slow sales in China, have greatly impacted Apple's revenues, causing a steep drop in the stock price.

The company has great long-term prospects and is currently 25-43% undervalued.

Apple repurchased $72 billion worth of stock in 2018. High free cash flows will push this number higher, along with EPS and share price.

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Investment Thesis

Apple Inc. (NASDAQ:AAPL) is currently a value stock upon which investors need to consider capitalizing before share prices climb higher. While it is understandable that investors are wary due to the inundation of data over recent macroeconomic events, the near future holds economic improvements and a new iPhone release, which will propel the stock price upward. In this article, I walk you through my valuation methods and thoughts to show why I view Apple as a great buy opportunity.

Apple Financial Model and Valuation Methods

The Three-Statement Model

To determine the long-term prospects for Apple, I created a three-statement financial model and a discounted cash flow model for the years 2018 to 2023. I first started with the income statement by forecasting product revenues for the iPhone, Mac, and iPad, three of Apple’s top-selling products, to forecast revenue projections. To find ASPs for these products, I forecasted product unit growth for iPhones by straight-lining a 1.5% growth rate in iPhone sales for the years 2019 to 2023, and assumed 0% growth in Mac and iPad product sale growth (conservative estimates because of macroeconomic conditions). I also forecasted service revenues and other product growth figures based on historical data. I then multiplied units sold by ASPs to find product and service revenue projections. These allowed me to calculate a variety of growth rates and margins (revenue, R&D, SG&A, etc.) that I used throughout the model.

I then turned to the balance sheet, where I forecasted each individual working capital line item to arrive at appropriate projections. To do this, I took the end-of-year balance for each line item and grew it by the revenue growth rate or COGS (depending on the line item). For example, accounts receivable grew with revenue, while accounts payable grew with COGS. I used the same method for other assets and liabilities. For PPE, I took the beginning-of-period balance, added capital expenditures, subtracted depreciation, and then arrived at the end-of-period balance. To forecast debt, I used a weighted average interest rate of future payments of 2.5%. This value was captured by incorporating future Apple interest rates listed on the company's 10-K and averaging them over time. I also assumed 100% of debt would be paid off with cash, and 0% with PIK accrual because of Apple’s massive cash balances. I then took the beginning-of-period balance of debt, added any additional borrowings, subtracted any additional pay-downs, and arrived at end-of-period balance.

To forecast common stock, I assumed a new share issuance of 0 for 2019 to 2023 (companies generally give fair warning before issuing new shares). I then forecasted stock-based compensation (SBC) by taking the sum of COGS, R&D, and SG&A, and multiplying it by the straight-lined value of SBC as a percentage of all operating expenses from 2018 (2.2%). Finally, I took the beginning-of-period balance of common stock, added new share issuances, added any SBC, and arrived at the end-of-period balance. To forecast treasury stock, I first predicted stock repurchases by straight-lining the 2018 stock repurchase value. Then, I took the beginning-of-period balance, subtracted stock repurchases, and arrived at the end-of-period balance. To forecast retained earnings, I first calculated the 2018 dividend payout ratio by dividing common dividends by net income. I then straight-lined this value from 2019 to 2023, and then grew common dividends by this ratio every year. Finally, I took the retained earnings beginning-of-period balance, added net income, subtracted common dividends, and arrived at end-of-period balance. For OCI, I assumed an income/loss of 0. This allowed me to straight-line the 2018 OCI balance from 2019 to 2023. These balance sheet forecasts allowed me to observe important ratios such as net profit margin, ROA, ROE, and asset turnover. I then created the EBITDA reconciliation by adding back D&A and stock-based compensation to operating income.

Modeling the cash flow statement was straightforward - I simply linked each line item to the values I had calculated previously. I included the line item “Revolver” to be thorough in analysis. After completing the cash flow statement, I conducted a revolver-needs analysis (Apple has no need for a revolving line of credit because of its massive cash balances). This allowed me to find the net change in cash during each period. I then revisited all cash and cash-related line items to ensure they were in line with the cash flow statement. From there, I forecasted shares outstanding to look at EPS and projected EPS growth from 2018 to 2023. To find basic share outstanding, I took the beginning-of-period shares, added any new shares, subtracted share repurchases (stock repurchases divided by share price), and arrived at the end-of-period shares. From here, I was able to forecast year-over-year share price changes by using the previous year’s share price and growing it by the percentage change in year-over-year EPS. I also included an EPS sensitivity analysis for 2019 - inputs being revenue growth rates, gross profit margins, iPhone unit growth, and iPad unit growth. This was a security measure to show how negative increases in product revenue could impact EPS.

The Discounted Cash Flow Model

These financial model projections were the ones I used in my DCF. To begin, I looked at the free cash buildup for Apple. I tax-effected EBIT to arrive at EBIAT (unlevered net income). To avoid double-counting the interest expense tax shield in the WACC calculation, I used (1 - tax rate). With EBIAT as a starting point, I added back the following line items to arrive at the unlevered FCF for Apple: D&A, SBC, accounts receivable, inventory, accounts payable, accrued expenses, other current assets, other non-current assets, and other non-current liabilities. This brought me to the unlevered CFO balance per period. From here, I subtracted capital expenditures to get to unlevered FCF. I then used a discount factor to arrive at the present value of this unlevered FCF.

To determine WACC, I used the current 10-year treasury bond yield as the risk-free rate, a beta of .96, and a market risk premium of 5.5% (I had no thesis to calculate beta and the MRP; I used online financial advisory to arrive at these values). I then explored both the perpetuity approach and the exit EBITDA multiple approach in determining enterprise value. With regard to the perpetuity approach, I took the sum of the present value of the terminal value and added the present value of stage 1 capital flows (with a long-term growth rate of 3%) to determine enterprise value. For exit EBITDA, I used the same method, but with a terminal value EBITDA multiple of 8.0x. This yielded an enterprise value of just over $300 billion less than the perpetuity approach. I then calculated equity value by subtracting net debt from enterprise value, and then found equity value per share by dividing the equity value by diluted shares.

The DCF showed an equity value per share between $205.36 and $269.80, suggesting Apple’s current share price is undervalued. Assuming all projection drivers have been appropriately calculated and employed, this DCF advocates the purchase of Apple stock. Qualitatively, we also know that the company historically sells more iPhones in the 12 months following a major release. The next major iPhone release will not occur until late 2019, which further indicates that now is the time to buy the stock (before excitement for a new iPhone mounts). I expect the stock price to increase as we approach the new iPhone launch date.

Apple's Cash Stash and Share Repurchases

The model shows Apple to exit 2019 with over $200 billion in cash, cash equivalents and securities. $72 billion of this was used for share buybacks (an extremely high figure). In fact, $213 billion of shares have been bought back by the company over the past 5 years. Assuming a constant P/E ratio, these buybacks should continue to have a significant effect on EPS for the foreseeable future.

Trade War Provides Uncertainty

News of weak sales in China, coupled with political uncertainty about future trade prospects between the United States and China, make it difficult for Apple to definitively project product and service revenues. The United States is (essentially) in the midst of a trade war. Political leadership in both countries are in difficult positions. On one hand, the Chinese economy took a beating in the back half of 2018, leading to some economic instability in the country. If fear of further instability were to take hold of the Chinese markets, they could see huge economic crashes, forcing Xi Jinping to back down on trade talks. On the other hand, President Trump now has the reality of working with a Democrat-controlled House of Representatives. Considering the amount of pushback the president has received from Democrats (and Republicans) during his first two years in office, he will have a much harder time passing desired legislation during the back half of his term. Couple this with the unfinished Mueller investigation, and any hope of reelection may rest on the state of the economy in 2020. If the economy begins to weaken further, Trump may be forced to concede. With all this uncertainty, Apple can only hope that the Chinese president backs down first. The best way for the stock price to recover is to reassure investors that the Chinese market is intact and ripe for selling.

Future Company Outlook

In the last fiscal year, Apple managed to generate $100 billion in revenue on non-iPhone products. This is an encouraging fact for investors who were disappointed in iPhone sales last quarter. Tim Cook has also stated he wants Apple's service revenue (Apple Music, iTunes, etc.) to double by the end of 2020. If achieved, this would help satisfy investors who feel the company is too reliant on iPhone revenue.

Cook has also been very reassuring when it comes to China-U.S. trade talks. He is confident that the weakness in China (regarding trade) is just temporary and that both countries will be quick to come to an agreement.

"It is a very complex trade agreement and it needs to be updated, but as I've said before, I'm very optimistic that this will happen," he said.

The question still remains: Will Apple retain its luster? Or will it fall into the category of "just another technology company?" With the departure of Steve Jobs, we've seen new innovations from the company, yet not quite at the level of the past. If Apple can find new ways to push the envelope of consumer technology forward, it will have no problem retaining its status as one of the most highly valued technology companies in the world.

Conclusion

The market’s general direction has pushed Apple stock below its true value. While it may take time for the market to correct itself, the aforementioned catalysts will give the stock a significant push as time passes. A high free cash flow will continue to give the company a variety of options for expansion and the ability to continue to repurchase stock. This will boost returns and continue to increase earnings per share.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.