Valuing Apple

Sep. 03, 2012 9:40 AM ETAAPL
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Contributor Since 2012

Equities Research Analyst.

The last few weeks had been a momentous one for Apple and its shareholders. Besides claiming the title of having the largest market capitalisation ever when its market value hit USD$638.2 billion on August 27, the company also won its lawsuit against Samsung on "patent infringement" charges. Samsung will have to pay apple USD$1 billion in damages and it may be required to remove some of its products from the US market as a consequence. Additionally, the iPhone 5 will be released shortly and there is talk of Apple becoming the first trillion dollar company.

Regardless of your views on Apple, I believe we can all agree that Apple's market value is largely dependent on one product, the iPhone. And this is worth taking a closer look at what the value is based upon. Looking at the numbers, there are three key points worth making about the iPhone franchise:

  1. Money Maker: In the last twelve months, about $100 billion in revenues and approximately $21 billion in after-tax profits were attributed to iPhone sales.
  2. Top Dog: The smart phone market grew about 40% last year as cell phone users switched to smart phones. With Apple selling about 30 million out of the 150 million smart phones purchased worldwide, and the premium pricing that iPhones commanded, the market share (by revenue) that Apple had the smart phone market came to about 43%.
  3. Ever Changing: The reason why Apple's earnings disappointed in the last quarter was due customers delaying their phone purchases in anticipation of the iPhone 5. Apple iPhones have an average life cycle of 1 year, and this short life cycle poses two challenges for the company. First, a short product life cycle requires constant innovations in order to retain its customers, and that will require investment in research and development, especially during the later parts of each cycle. Second, even with these innovations, there will be customers who switch to competitors' products due to factors such as pricing, user interface or more attractive innovations.

iPhone Original: June 2007

iPhone 3G: July 2008

iPhone 3Gs: June 2009

iPhone 4: June 2010

iPhone 4s: October 2011

Given the iPhone's profitability and dominance in the growing smartphone market, when assessing the value, the following questions have to be asked.

  1. Profitability: Will Apple be able to maintain its pricing power and after-tax operating margin of 21% on future iPhone sales?
  2. Smartphone market: What will be the CAGR for the smart phone market in the next decade? Note that the CAGR should fade off and revert to the growth rate of the economy in the long run.
  3. Product life cycle: Will the life cycle for a new iPhone continue with its current trend? And how much after tax operating income does Apple have to reinvest in the later part of each life cycle?
  4. Market share: Will Apple fans and iPhone customers continue to be loyal so that the market share of iPhone continues to rise?

There are internal conflicts between considerations 1,3 and 4. Since in order to preserve the high margins of the iPhone requires a price premium and reduction in R&D expenditures, more customers may switch away and reduce the market share of the iPhone.

To sum up, Apple has created an ecosystem of innovative products consisting of the iPod, iMac iPhone, iPad and Apple TV and this has attracted a whole group of loyal fans. With the fan base and by out doing weaker and less innovative competitors, Apple has been able to increasing overall market size. The question that investors must ask now is whether Apple can continue to innovate and inspire. The valuations attached to the company assume that the company can keep on doing what it is right now, that the iPhone 5 will launch successfully, followed by the iPad Mini and so on. The risk is that the link may break down somewhere along the way. Unlike other large market cap companies like Coca Cola or Mcdonalds with long product life cycles or diversified product offerings, Apple's value rests on being able to constantly reinvent itself every few years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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