Apple Is Valued As If Tariffs Were 105%

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About: Apple Inc. (AAPL)
by: Michael Battat
Summary

A DCF analysis shows that Apple is undervalued.

The stock is currently trading as if Trump threatened to levy a 105% tariff.

Investors should buy the stock despite headline risk.

Perhaps, no company is in the throes of the U.S.-China trade war as Apple (AAPL). Since President Trump's May 5th tweet, shares of Apple have slid 10.90% versus a decline of 3.62% in the broader market. With severe headline risk (aka tweet risk), it is sensible that spooked investors have decided to wait on the sidelines until there exists a semblance of clarity.

Numerous analyses by professionals far above my pay-grade have shown the potential effects of Trump's proposed next round of tariffs. JPMorgan estimates that Apple would have to raise iPhone prices by 14% to offset the costs of the new tariffs. This analysis is agnostic of the decrease in demand as a result of the price increase.

JPMorgan also speculates that the company would instead opt to absorb the increased costs, which would lower Apple's gross margin by 4%. This analysis is the crux of my valuation for the company. At its recent close of $190.92, under my assumptions, Apple is trading as if Trump threatened to impose tariffs of 105%.

I used a discounted cash flow (DCF) analysis to value Apple. The most important assumption is sales, off of which many other assumptions are derived. Apple's sales grew 6.30% in 2017 and 15.86% in 2018. Looking forward, the company's flagship iPhone franchise is maturing, and growth is forecast to slow. In fact, smartphone sales (of which Apple commands a 40% market share) hit a five-year low in Q1 2019.

However, iPhone pressures have been partially offset by products such as AirPods, which are experiencing rapid growth. The product's high price point is dually genius: consumers appear to have no qualms with it, and it makes Apple's ecosystem stickier. The ecosystem is made more viscid by Apple's focus on services (Apple TV, Apple News, and Apple Music) and subscription revenue. In 2020, Apple expects to cross 500 million paid subscribers across its platforms. Perhaps, a 14% price increase could be swallowed by consumers, after all.

With the above crosscurrents in mind, my forecast for 2019 revenue growth is 11.08%, an average of the previous two years. I then decrease this revenue growth rate by 2.20% per year through 2023, at which point, I assume that Apple's sales will grow at 2.28% into perpetuity (the average U.S. real GDP growth rate of the last 25 years). This is not a flawless assumption, as Apple is obviously a global company (hence, the basis of this article), but is reasonable for the purposes of this analysis.

(Hat-tip and a sincere thanks to Dr. Jan Barton for the valuation template)

Other key inputs to the model include net operating profit after taxes (NOPAT) and net operating assets (NOA). The former was calculated by adjusting net income to isolate the company's operating income (using a 37% and 23% tax rate in 2017 and 2018, respectively). NOA was calculated assuming that cash and debt were non-operating items, and marketable securities were deemed operating, given that it is such a large item on Apple's balance sheet.

Net operating profit margin (NOPM) increased from 20.34% in 2017 to 21.83% in 2018. For the horizon and terminal periods, I forecast NOPM of 21.09%, an average of the previous two years. Additionally, the company's net operating asset turnover (NOAT) increased from 1.00x to 1.36x, largely due to fewer net operating assets. Similarly, I forecast NOAT of 1.18x, an average of the previous two years.

To calculate Apple's weighted average cost of capital (WACC), I calculated the company's effective interest rate (cost of debt) and utilized CAPM to determine its cost of equity. Apple's after-tax cost of debt and cost of equity are 2.22% and 7.68%, respectively. With 12% debt capital and 88% equity capital, I calculate Apple's WACC as 7.04%.

AAPL cost of debt Apple (NASDAQ:<a href='https://seekingalpha.com/symbol/AAPL' title='Apple Inc.'>AAPL</a>) cost of equity Apple (<a href='https://seekingalpha.com/symbol/AAPL' title='Apple Inc.'>AAPL</a>) WACC Shown below is my DCF model for Apple. Included in it are mid-year and current-day adjustments. Assumed below are the aforementioned assumptions and no tariffs. As shown, under these assumptions, Apple should be trading at $252.02 per share, or 32.00% higher than its closing price as of May 15, 2019. For context, the stock is currently 18.71% below its all-time high.

The outputs get particularly interesting when sensitized and seem to indicate that the market may be overreacting to the proposed 25% tariff. To explore the impacts of different tariffs, I created a model input called a "tariff factor," which works off the assumption that a 25% tariff would depress Apple's gross margins by 4%. I had to adjust this assumption to fit my model, as mine only looks at NOPAT and not the many line items between it and sales. Without adjusting for taxes, I would be understating the tariff's effect on Apple's NOPAT.

To adjust, I multiplied 4% by (1 + 23%), representing Apple's assumed 23% tax rate (2% state plus 21% federal). Again, not the most airtight assumption, but one nonetheless. 4.92% was subtracted from 1.00 to yield the "tariff factor (0.9508)" for a 25% tariff. 0.9508 was then multiplied by NOPAT to capture the effects of the tariff.

Sensitizing by different WACCs and tariff amounts shows an array of potential valuations for Apple. In my eyes, the takeaway is that even if Trump follows through on his threat to increase tariffs to 25%, Apple still appears undervalued. In fact, Apple's recent close of $190.92 implies that Trump levies a 105% tariff. Effectively reverse-engineering the market's assumptions shows that it appears to be severely overreacting to tariff threats.

The above analysis implies that Trump has the chutzpah to implement tariffs that would be directly felt by 40% of Americans (to use Apple's market share as a proxy). This seems like a sure way to get on American citizens' bad side (as if he was not on yours already) and lose an election. If Trump's May 5th words turn out to be an empty threat, Apple's stock appears to be even more undervalued.

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.