It is no secret. Investors are petrified by negative sentiment and rumors about Apple (AAPL). Traders and shareholders continue to digest such rumors about Apple and the recent trend has been typical: dump the shares. For example, a fresh piece from the Wall Street Journal about the future of the next iPhone, an iterative iPhone 5 and a version of the same phone for the China market, cost shareholders $10 billion in market cap within an hour, or the size of BlackBerry (BBRY) and AOL, combined. That market cap disappeared as a speculative – and unconfirmed – report was pushed out by a couple of journalists. Such speculation has been trending for several months now, as journalists and analysts fire speculative shots about Apple’s supply chain, demand, and future products at investors based on their discussions with vendors and third parties.
Though Apple is fundamentally extremely strong with surveys pointing to high product retention rates among existing users and continued growth in emerging markets, many analysts have now updated their models to reflect not the fundamental value of the company they adored only a few months earlier, but a “new mood” among Apple traders. In other words, what we are witnessing here is true market inefficiency at work – led by market participants. A prominent analyst slashing his price target by 53%, or $480 billion, in several months’ time is a clear example of such inefficiency. $480 billion, by the way, is 15% larger than the current Apple market cap and is about the size of Argentina’s GDP. To wipe away such a significant amount within a few months’ time raises serious questions around the analyst’s methodology. Did the fundamentals really change by $480 billion in a few months’ time?
While the competitive risks are high and it’s true that Apple might need to prove to investors their next product cycle’s strength, should we really value the company at a third or even half that of competitor Google (Apple trades at 9.88X TTM and an eye-popping 6.6x P/E if you back out cash; Google (GOOG) trades at 24.34X TTM and a whopping 20+X market cap ex-cash)?
Is Apple then currently priced correctly? Depends on how you value the company or what methodology you use to predict the stock’s next move. But let’s face it. As a market leader, Apple’s strategy was never about responding to analysts’ and pundits’ demands. On the contrary, Apple’s strategy has always been about understanding what consumers want and offering revolutionary products that will change the way they live their lives. Whether you’re using a discounted cash flow model or the comparables method, the fundamental value that drives a stock in the longer term is the company’s product and its proven track record. I will explain why in my view the drivers of Apple’s share price are extremely strong and why that should drive the stock to premium levels in the longer term.
Whether you’re bullish or bearish on Apple, it is hard to deny the company’s most effective tool to driving its success: its ecosystem. Apple’s carefully crafted ecosystem is probably its most undervalued asset and a new future product will without a doubt be built around the same ecosystem that has made every one of its current products successful. A future Apple might unite with credit card companies to allow us to make payments using an iWatch through the cloud. A future Apple might be a cable company that allows us to watch ESPN through an “a la carte” service without paying for Bravo. An Apple TV might also mean that Apple will truly revolutionize the way we use our televisions versus our current methods. Point to some of the millions of iTV apps and play Angry Birds while Skyping with your girlfriend. Yes the technology is there. So was the MP3 player before the iPod was rolled out. The smartphone also existed before the iPhone revolutionized that market. I owned a tablet long before the iPad was introduced (which is why I doubled down on Apple after negative iPad sentiment during days following the release caused the stock to sell off by 10%).
The bottom line is this: an ecosystem is a very important barrier-to-entry and while competitors are catching up by introducing substitutes toproven (key word is proven) Apple products, Apple is building new products around its ecosystem. This is what many market participants who trade Apple have trouble “valuing,” but it is an essential piece.
Emerging Markets: Positive
One of Apple’s strengths I am extremely pleased about in terms of Apple’s strategy is their ability to successfully globalize. They have effectively used their sought-after brand to introduce leading products in markets around the world. While their sales have grown in every major segment, its most important market at the moment is in China. At 67% Y/Y sales growth, it is by far its strongest growing geographic segment. The prospects for this region are even greater. Here is why. Apple’s iPhones, until now, have been available to a select few of China’s population of 1.35 billion as 48% of China’s income share was held by the highest 20% in 2005. However, within that number, there is inequality in itself as 32% of China’s income share was held by the highest 10%. This turns into an extremely fat-tailed income distribution (sorry, image not available). What does this mean? Let’s say until now, the more expensive iPhone was only available to 5% of China. That means the market opportunity was constructed around 68 million people. Let’s say a less expensive iPhone would be available to an additional 45% of China. That means the new market opportunity will be around an additional 608 million people. Below, I built a very simplistic segment forecast to show just how such an upside could affect EPS.
The chart assumes that Apple will enter a price war with competitors by introducing a less expensive product (price is blend of products) at 78% of original price. This would to a degree be subsidized by a carrier (such as China Mobile) and would create a very affordable item for the segment’s population and could potentially create an extra 554% segment upside for Apple or an additional $11.26/share. I would like to caution that this is not a projection, but a way to better view the potential of the China market. This is one of the main reasons I am surprised that any analyst is currently modeling Apple at negative growth and at a discount to comps.
Cash Management: Positive
Should too much cash be treated as a positive or a negative? That of course depends on your market outlook and your opportunity costs. For most passive investors, Apple hoarding 33% of its market cap, or $137+ billion in cash, during such uncertain times should be incredible. For someone like David Einhorn, who has to show investors that he’s taking risks during a booming equity market, Apple hoarding its cash is quite terrible. My belief is that since inflation concerns seem to be muted in the near-term and since the market is entering a late investment cycle(investment cycles were covered in my last submission), Apple is right to hold on to its cash until they find more favorable conditions or investments. What about buying back shares? Although I do believe that buying back shares would spur investor confidence, I’d be more in favor of Apple investing its money in its ecosystem, where I see potentially heavy growth.
Yes Apple’s operating margins have been compressing, but they’ve been settling at normal levels, at or way above comps as can be seen here. Notice that Amazon (AMZN)’s operating margin was a mere 2% in 4Q12, a difference of 3,378 bp.
Below is a chart of Apple’s operating income growth (decline) by region and the corresponding margins. Greater China and Japan have seen outstanding operating income growth on even stronger sales, while margins in lower cost regions and those regions hit by recessions have experienced much margin compression.
While analysts have raised red flags around margins, I don’t believe that Apple’s declining margins should be of huge concern to investors simply because they still have some of the highest margins in the industry and are trading at a deep discount to industry rivals. At the same time, all new products Apple rolls out should and I believe will take into consideration declining margins and therefore will most likely be much higher margin products.
Apple’s revolutionary story, as we know it today, began not at the Mac or the iPod, but at its ecosystem, which is still in its “child” stage. A gifted child I might add. The market opportunity for expanding that ecosystem globally is quite enormous. Because Apple has extremely strong brand recognition, much cash, and loyal consumers, I believe other companies will be willing to “play along” by joining Apple’s ecosystem. That will create billions of dollars of cash flows in the longer term. The stock trades at a deep discount to comparables as is evident above. This should, in my opinion, correct in the future. While I would not recommend timing Apple’s stock for quick surging bounce (through options, for example) for the near term, I do believe that downside risk is not nearly what it is for companies like Amazon, Google, and Facebook. This in my opinion is a longer-term, even greater success story.