With a slew of analyst upgrades a couple of weeks ago, Apple remains the darling of many analysts and investors. Today, Apple is $350 but the median analyst target prognosticates $425. For Apple to be worth $425, presently, what rate of sales growth is required to justify such a valuation? Is that rate reasonable? What are the impediments to achieving such a growth rate?
To approximate implied growth I use a Discounted Free Cash Flow to the Firm model with the following crude assumptions.
- 3% terminal free cash flow growth rate
- Cost of Goods Sold is 60% of sales, now and forever. ( 40% gross margin )
- Selling, General and Administrative expenses are 11.2%
- The tax rate is 30%
- Capital expenditures of $5 billion / year.
- Required Rate of Return is 11.7%
- Intrinsic value of $425
- $5 billion of excess cash.
Solving for the sales growth rate for the next 10 years, I get 17.7%. In other words to achieve its median forecast, Apple has to grow sales by 17.7% each year for the next 10 years and 3% thereafter. Any less, and the stock will not earn earn enough to meet its required rate of return of 11.7%.
In a historical context, this isn't an unlikely rate of sales growth. Over the previous 10 years sales have had a compounded annual growth rate of 23%. Over the last 5 years they have grown at a rate of 45%.
And while growing their sales, they have done excellent work of protecting and growing their gross margins over the last 10 years.
It currently makes roughly 40% profit on its products where its competitors in the PC market make 20%, Handset competitors such as Nokia make a little more at 30% gross margin.
However, Apple has hinted that its gross margins will shrink in the future. From their latest 10-Q:
"The Company expects to experience decreases in its gross margin percentage in future periods, as compared to levels achieved during 2010, largely due to a higher mix of new and innovative products that have higher cost structures and deliver greater value to customers, and expected and potential future component cost and other cost increases. "
HP, Sony and Dell are making competitive PC products, competing in design and quality. Android handsets are growing faster than IPhones. Apple's gross margin advantage is likely to evaporate or become smaller over the long term. It very unlikely is that their gross margins continue to be in the 40% range.
If we change our inputs such that Cost of Goods Sold increase linearly from 60% today to 75% by year 10, sales have to grow faster to compensate for the declining margins. To get to $425, as foretold, my model requires 29.3% sales growth for 10 years and 3% thereafter. Which exceeds the growth rate of the past 10 years of 23%.