APPL: Feb 14


Executive Summary

Apples (AAPL) shares have collapsed by 35% in the last five months. The company is over-dependent on the iPhone which accounts for 56% of revenues and 70% of profits. Investors have five main concerns:

  • Product pipeline: Has the company gone ex-growth with no new blockbuster product cycles to replace the iPhone and iPad?
  • Management team: Is the leadership style of Steve Cook conducive to creativity? Or is there a lack of vision at the top, prompting in-fighting that might result in more of a brain drain?
  • Sustainability of profits: Will Apple’s margins decline as its products get cloned and rivals challenge its lead on innovation?
  • Regulation: Is Apple big enough to be the target of anti-trust suits and will regulators pry open its lucrative but closed ecosystem that has been the foundation of its success?

No consumer electronics company in history has managed to maintain super-normal operating profit margins of 35% forever – not least in a hardware industry where 10% operating margins are above the norm. Ultimately, Apple’s margins will fall. But that day is unlikely to be any time soon.

In the medium term, Apple’s shares are set to rise

Apple remains a unique technology company without a competitor. On a 12 month investment horizon, we believe its shares are undervalued because:

  • Apple has substantial room for growth in its six existing product markets: smartphones, tablets, MP3 players, digital music, apps and laptops
  • More importantly, it is well-positioned to expand into five new growth markets: internet TV, smart watches, mobile payments, mobile advertising and enterprise software
  • Its iOS ecosystem creates customer lock-in across a broader range of consumer products and internet services than any of its competitors
  • Its two closest rivals have major deficiencies in their product arsenal: Samsung’s (SSNLF.PK) weakness is its lack of software whilst Google’s (GOOG) weakness is its lack of home-made hardware.
  • Our discounted cash flow model implies that Apple is undervalued even if revenues grow at a mere 2% per annum ad infinitum and EBITDA margins fall from 37.4% in 2012 to 25% by 2022
  • Our Technology Scorecard ranks Apple as the most attractive of the top 15 global technology players – it has an established lead in six of our top ten high-growth technology investment themes

How does Apple make money today?

The string of new products that has fuelled Apple’s envious five-year growth curve has also dramatically changed the composition of its revenue and profit base. In 2007, Mac computers accounted for over half of Apple’s revenues, but by 2012 Mac desktops and laptops barely made up a tenth of its revenue base. Similarly, back in 2007, Macs comprised the bulk of Apple’s gross profits, but by 2012 iPhones probably accounted for 68% of Apple’s profits.

In the year ended 30 Sept. 2012, iPhones accounted for 53% of Apple revenues and 68% of profits

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Source: Company data, CM Research estimates

The iPhone is critical to Apple’s success

By Q1 2013 (the quarter ended 31 December 2012), Apple’s dependence on the iPhone had become even more stark. During that quarter, the iPhone generated 56% of revenues and probably 70% of profits. Apple’s future profitability is therefore very highly geared towards the iPhone’s fortunes.

In the quarter ended 31 Dec. 2012, iPhones accounted for 56% of revenues and 70% of profits
Revenue analysis for quarter ended 31 Dec 2012 Gross Profit analysis for quarter ended 31 Dec 2012

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Source: Company data, CM Research estimates

Almost all of Apple’s recent product launches have strengthened iOS’s pull

In the quarter ended 31 December 2012, Apple sold 48m iPhones, 23m iPads, 13m iPods, and 4m Macs. By the end of the quarter the number of cumulative app downloads from the App Store had reached 40bn. Apple’s phenomenal ascent took place over a relatively short time frame. While the company’s initial turnaround can be traced back to the 2001 launch of iTunes, it is only over the last five year period that things have really come together for Apple: the iPhone was only launched in 2007, the App Store in 2008 and the iPad in 2010.

But rather than merely being new stand-alone products, each product has been another cog in Apple’s ecosystem, creating a level of brand loyalty not seen in a consumer electronics company since Sony’s Walkman era back in the eighties.

On the back of this successful run of new product launches, Apple’s share price rose fivefold in the five year period to 21 September 2012.

Source: Company data, Yahoo! Finance, CM Research

How will Apple make money tomorrow?

As the timeline above illustrates, Apple’s five year growth curve is founded on the continued development of the iOS ecosystem. There is still significant room for growth in that ecosystem, both in the five product markets that Apple is already in (iPhones, iPads, iPods, Macs and App Store), as well as five new growth markets Apple could potentially enter (internet TV, smart watches, mobile payments, mobile advertising and enterprise software).

Apple is well positioned in its existing five product markets…

Of the 1.7bn mobile handsets shipped in 2012, about 712m were smartphones. Smartphone shipments are growing at about 42% per annum. In the smartphone market, Apple has a 19% global market share by unit sales. This is despite an average selling price (ASP) of $643 – well over double the industry average.

Apple is well positioned in its four most important product markets
1. Smartphones: Apple has a 19% market share (by vol.) 2. Tablets: Apple has a 67% market share (by volume)

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3. Computers: Macs have a 6% market share (by volume) and that share has been rising for the last three years 4. Recorded music: iTunes has a 29% market share (by value) of the total (physical and digital) music market

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Source: Company data, IDC, Gartner, PwC, CM Research

In the tablet market, Apple accounted for 67% of the global market by volume last year. Tablet sales grew by 70% in 2012 and are expected to grow by 45% this year.

In the computer market, Apple Macs accounted for 5.5% of shipments in 2012, but that share is growing rapidly, especially in the U.S.

In the music and video markets, Apple is a dominant player with its iTunes platform. iTunes music sales, for example account for around 70% of all legal digital music sales and 29% of the entire recorded music market, including physical sales.

In the apps market, Apple remains the market leader. The company’s App Store accounts for 6bn app downloads per quarter. This beats its nearest rival Google Play, despite the fact that Android mobile devices outsell iOS devices by a ratio of almost four to one.

5. Apple remains the apps market leader despite the fact that Android outsells iOS four times over

App downloads per quarter (in billions)

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Source: Company data, CM Research

… and poised to enter five new growth markets

Apple’s latest quarterly results showed that as sales of iPods declined, those of iPhone and iPads went from strength to strength. But what will happen when iPhone and iPad sales start to fade?

Apple has a strong product pipeline. The table below shows five potential blockbuster revenue streams from new and existing product lines. New products over the next 12 months are likely to include iTV, iWatch and Apple’s home-grown mobile payment system. Mobile advertising and enterprise software are also areas where Apple is likely to grab significant market share.

Apple’s product pipeline is a closely guarded secret … but future growth will likely come from these products
New product Estimated launch date Potential market size Comments
iTV Mid-2013 In 2012, 237m TV units were shipped with a value of $110bn. In 2013, unit shipments are expected to rise to 239m but with a value of only $107bn.
  1. Strengthens iOS ecosystem lock-in
  2. Potential bolt-on service to iTunes
  3. Unleashes $190bn TV advertising market
  4. iPhone/iPad provides “dual screen”
iWatch Late 2013 In 2012, the global watch market was worth $41bn, growing at around 3% per annum.
  1. Pioneer territory – market for smart watches does not yet exist
  2. Technologically possible
  3. But demand uncertain
Mobile payments 2014 IDC forecasts that the transaction value of payments through a mobile device could exceed $1 trillion by 2017.
  1. Unleashes m-commerce market
  2. Several payment apps already on App Store
  3. Apple only vendor to shun NFC technology
  4. Apple already has 450m iTunes accounts
Mobile advertising Apple already a small player in this market In 2012, the mobile ads market was worth $7.7bn. It is expected to grow by 45% in 2013.
  1. Controls iAd platform
  2. Leader in mobile web traffic with 25% global market share
  3. Reportedly paid $1bn p.a. by Google for access to iOS customer data
Enterprise software Apple already a small player in this market In 2012, the enterprise software market was worth $290bn and is expected to grow by at least 10% in 2013.
  1. As a consumer-facing company, Apple has traditionally been weak in enterprise space
  2. Poor suite of enterprise tools
  3. But investing heavily in marketing its products to corporate IT departments
Source: CM Research

What is worrying investors?

In the last four months or so Apple shares have fallen 35% to $467 from a peak of $705 on 21 September 2012. The shares have fallen on a combination of rumours and facts.

One of the rumours was started by a Wall Street Journal (WSJ) article published on Sunday 13 January 2013 which wrongly asserted that Apple had halved its component orders for the iPhone from some suppliers. The WSJ later withdrew the story, fuelling a conspiracy theory on Macworld that a group of fund managers were spreading these false stories in an attempt to manipulate Apple’s stock price so that call options they had reportedly written on Apple’s stock at a strike price of $550 would be in the money.

Then there are the facts. On 23 January 2013, Apple missed analysts’ profit expectations. Apple’s gross margin for its Q1 2013 quarter was 38.6% compared to 44.7% a year earlier. Apart from the fear of rising costs, investors are also concerned that iPhone sales in overseas markets are showing signs of slowing down. Outside the US and Japan – where the iPhone comprises over half of all smartphone sales – the iPhone did not sell as well as many had expected. In China, many iPhones are jail broken, increasing reputational risk for Apple. And most importantly, new entrants are piling into the smartphone sector. Huawei’s market share of the global smartphone market by unit sales has increased from virtually nothing in 2009 to over 5.3% in the last quarter.

Going forward, investors’ concerns can be grouped into four main categories: the management team, the sustainability of profit margins, cash hoarding and regulatory issues.

Management team

Roger Faxon, former CFO of EMI, once remarked, “How do you maintain [corporate] discipline in a way that doesn’t stifle the creativity? That’s the secret of running a creative business.” Steve Jobs knew the secret; Yahoo (YHOO), Microsoft (MSFT), MySpace, Sony (SNE) and Nokia (NOK) once had it too, but subsequently lost it.

Is the leadership style of Steve Cook conducive to such creativity? Or is there a lack of vision at the top, prompting in-fighting that might result in more of a brain drain?

Sustainability of profit margins

As the charts below illustrate, Apple has the highest operating profit of any major consumer electronics company. At 33%, its operating margins for 2012 are almost five times the industry average of 6.7% and double that of its closest rival, Samsung.

How long can Apple sustain super-normal profits?
Quarterly operating margins (handset makers) 2012 operating margins (consumer electronics makers)

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Source: company data, S&P Capital IQ, CM Research

No consumer electronics company in history has sustained super-normal profits for more than a decade. Indeed, Apple’s may already be on the slide. In the quarter ended 31 December 2012, Apple’s gross margins fell from 44.7% to 38.6% year on year.

But profitability comparisons are meaningless because Apple has no competitor

Whilst 90.5% of Apple’s 2012 revenues comprised consumer electronics hardware, Apple cannot meaningfully be compared to other hardware manufacturers, because none of them have an ecosystem of software, apps and content that locks users into their hardware products. Once you buy one Apple product, you’re hooked to buy more because they all feed off the same ecosystem; if you own an iPhone, you will be drawn to purchase Apple’s iTV when it is released, because the iPhone is likely to work seamlessly as a remote control and dual screen for Apple’s television product. By contrast, there is no such soft link between a Samsung television and a Samsung Galaxy phone because they do not share an operating system.

Apple products are sticky

As a result, brand loyalty for Apple products is at levels unheard of for a consumer electronics company. That means that Apple can afford to release one or two weak products without seeing its customer base fall off a cliff. Samsung, LG (LG), HTC (HTCCY.OB), BlackBerry (BBRY) or Sony cannot, because they lack ownership of a digital ecosystem that locks their customers into a walled garden.

Cash hoarding

Activist Apple shareholders such as Greenlight Capital’s David Einhorn are demanding that Apple returns cash to investors. At $137bn, the company’s current cash pile represents 31% of its market capitalisation.

Most of this cash is reportedly held overseas. A cash distribution to shareholders would involve repatriating the cash, triggering a tax charge. Assuming 70% of Apple’s $137bn cash pile is overseas and that the additional tax on repatriation would be at least 25% (being the U.S. corporate tax rate less any allowable offsets), the tax charge would equate to $24bn.

Steve Jobs resisted calls to return cash to investors for a very good reason. As Microsoft’s ten-year share price chart will tell you, once a technology company announces a dividend policy, it is no longer perceived as a growth company. And the market will value it on multiples fit only for the utility sector.


There is something about being the world’s largest technology company that tends to attract anti-competition authorities. IBM and Microsoft have been there. Their share prices went nowhere when they were subjected to anti-trust cases. Apple is now a market leader in several inter-related technology markets. Depending on how the anti-competition authorities define these markets, Apple could be a candidate for a number of competition issues.

In the worst case scenario, regulators in the U.S. or Europe could break up Apple’s closed ecosystem as they did with Microsoft a decade ago, forcing Apple to offer competitors’ products to its customers. That would be a big blow to Apple’s business model.

What does our valuation model say?

Apple’s revenues grew by 66% in 2011 and by 45% in 2012. For the company’s Q1 2013 reporting period, quarterly revenues grew by 18% year on year, but gross margins fell from 44.7% to 38.6% as manufacturing costs rose.

To justify Apple’s current market valuation of $439.4bn, our discounted cash flow model implies that Apple needs to grow revenues by just 2% per annum and can afford to see its EBITDA margin slip from 37.4% in 2012 to 25% by 2022.

The problem with DCF models is that they tend to assume that revenues and profit margins will change gradually over the next decade. In the real world, things tend to be far more volatile, of course. Nonetheless, our DCF model shows that Apple is priced for a steady decline in margins and virtually no top line growth.

What does our Technology Scorecard say?

Our top ten investment themes for the technology sector are smartphones/tablets, apps/software, internet TV, cloud, big data, mobile payments, social networks, games, software defined networks and 3D printing.

Apple is well-positioned in six of our top ten technology growth cycles

Our technology scorecard below ranks the world’s 15 largest technology companies on a combination of current valuation and their market position with respect to each of these investment themes. A green light indicates companies that are well-positioned to profit from these product cycles; a red light indicates they are unlikely to profit from them and an amber light indicates they have entered this product market but are not certain to profit from it.

CM Research’s technology scorecard

The world’s top 15 technology companies ranked by their competitive position in the top 10 tech growth cycles

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Source: Bloomberg, S&P Capital IQ, CM Research

By valuation, Microsoft which is currently trading at 9.8 times this year’s earnings is the most attractively priced. Google, however, ranks top in terms of its market positioning – it is firmly entrenched in eight out our top ten technology product cycles. Apple by contrast is only well-positioned in six of our top ten investment themes, but trades at a more attractive P/E multiple of 10.5.

Combine these two metrics on an equal weighting and we find that Apple is ranked number one. Put another way, Apple is very attractively priced given its growth prospects in six of our top ten technology product cycles.



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