AAPL: Affirmation


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.

Ecosystem: Positive

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.

(click to enlarge)

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.

Margins: Neutral

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.

(click to enlarge)

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.


One thought on “AAPL: Affirmation

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

    As Apple’s (AAPL) stock price continued to slide last quarter, earnings expectations showed confidence from investors that indicated the weakness was temporary. We stated in last quarter’s earnings article that ‘Apple loyalists are not giving up on the company as whisper numbers move away from restrained confidence and move towards strong confidence’. Even when the company reported earnings that topped expectations the stock continued seeing price weakness that started back in October 2012. We’re seeing a similar situation this quarter – a strong whisper number expectation perhaps driven by Apple brand loyalty.

    Apple reports fiscal second quarter earnings on Tuesday, April 23rd, after market close. The whisper number is $10.56, forty-three cents ahead of the analysts estimates. Whisper numbers range from a low of $9.99 to a high of $11.12. Apple has a 73% positive surprise history (having topped the whisper in 43 of the 59 earnings reports for which we have data).

    Trading on an earnings event requires an understanding of post earnings price movement, both after hours and intra-day. We’ll take a look at the average post earnings price movement, when those moves occur, and if Apple presents an earnings trade opportunity.

    Since Apple reports earnings after market close, it’s important to look at after hours trading activity. Over the past four quarters the average price move in after hours trading following their earnings reports is -1.2% (down from +2.4% last quarter), and over the past eight quarters the average price move in after hours trading following their earnings reports is +1.4% (up from +3.0% last quarter). In other words if you took a long position prior to the past four earnings reports you were on the right side of the trade in one out of four trades, and if you took a long position prior to the past eight earnings reports you were on the right side of the trade in four out of eight trades.

    The average price move during next available intra-day trading (market open to market close) for the past four quarters is -1.0%, a limited and negative price move. The average price move within five trading days for the past four quarters following their earnings reports is -0.5%, a limited and negative price move. So Apple gives back some overnight gains in the five trading days following earnings.

    Longer term earnings analysis (last four years of earnings) shows the company tends to see (on average) price movement of -0.8% (intra-day) in one trading day following their earnings report, -0.7% in five trading days, -1.2% in ten trading days, +0.1% in fifteen trading days, and -0.6% in twenty trading days.

    (click to enlarge)

    Apple topped the whisper number in January 2012 by $3.65, topped again in April 2012 by $1.81, and beat the whisper number last quarter by thirteen cents. They fell short of the whisper number in July 2012 by $1.70, and missed in October 2012 by $0.31.

    (click to enlarge)

    October 2011 was the first time Apple reported earnings short of whisper number in five years. Within twenty trading days (from open) of that report the stock dropped 4.2%. Add that to the after hours drop of 4.9%, and the stock was down a total of 9%.

    Apple missed again in July 2012, but the price reaction was much different. Within twenty trading days (from open) of that report the stock gained 16.3%. Take away the after hours drop of 4.3%, and the stock still realized a positive move of 12%.

    When Apple missed the whisper number in October 2012, the stock remained flat in after hours trading. By year end the stock was down 12.7%.

    Last quarter the company topped a very confident whisper number by thirteen cents. After hours saw a 10.5% price drop, and the stock is down 12% to date.

    (click to enlarge)

    When considering all quarters for which we have a whisper number, the best timeframe for positive returns falls at the thirty day mark. The 30-day price reaction for the forty-three quarters that Apple has topped the whisper shows an average price move of +3.8%. And for the 15 quarters it has missed the whisper number, an average price move of +8.0% in thirty trading days following earnings.

    Other factors that may influence post earnings price movement;

    The majority of investors polled are expecting the company to provide a neutral to positive outlook:

    – Positive 50.0%
    – Neutral 33.3%
    – Negative 16.7%

    Compare this to last quarter’s expected outlook:

    – Positive 60.0%
    – Neutral 40.0%
    – Negative 0.0%

    As indicated earlier, Apple has a 73% positive surprise history:

    – Beat whisper: 43 qtrs
    – Met whisper: 1 qtrs
    – Missed whisper: 15 qtrs

    The whisper numbers have proven more accurate than analysts estimates as well. Over the past twenty-five quarters the whisper number has been closer to the actual earnings in 22 of 25 quarters.

    Summary: Over the past four quarters Apple has topped the whisper number twice. The current whisper number is above the analysts estimate, showing confidence from investors. The key to playing Apple earnings, however, is the expected price reaction. Historically the after hours move is positive (but limited) averaging +2.4% to +3.0%. The stock tends to give up ground over the next ten to fifteen trading days, but the move is very limited. The stock then sees strength through thirty days (averaging about 4%). These averages are trending lower due to the recent price weakness. More post earnings price movement and historical data can be found here.

    What are your earnings expectations? Let us know in the comments section below or visit whispernumber.com.

    Since 1998, WhisperNumber.com has been tracking and publishing “crowd sourced estimates” for earnings. We call these earnings expectations whisper numbers. Our whisper numbers are gained from individual investors and traders just like you that have registered with our site. While the whisper number itself is an important part of our analysis, a company’s “price reaction” to beating or missing the whisper number expectation is the key. On average, companies that exceed the whisper are “rewarded,” while companies that miss are “punished” following an earnings report.

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