By June 16, 2013 Read More →
Apple: A Misunderstood Blue-Chip?

Apple: A Misunderstood Blue-Chip?

Apple’s share price is down more than one third since its peak in 2012. Now, by virtue of having been the most expensive company in the world, or perhaps because almost everyone we know owns an Apple product, it has become increasingly difficult to find somebody who doesn’t have an opinion on where Apple’s stock price is headed in the coming weeks, months and years.

The endless, day-in-day-out speculation on the company’s growth prospects, profit margins, competition, product range, etc. which peppers the mainstream business news has turned sour: lately, Mr. Market has been feeling gloomy about Apple’s prospects.

At first glance, writing up an investment case on Apple may not seem like the smartest way to spend our time. Apple is one of the biggest blue-chips out there, and its stock is followed by analysts the world over.

In other words, apple stock trades – or is supposed to trade – in pretty much the most efficient market out there. What are the chances the market has this one wrong? This makes finding an edge all the more tough. However, all the recent gloom has attracted our attention. To quote the Don: “When everybody is greedy be fearful, and when everybody is fearful be greedy!”

We make the case that at current prices, Apple is a somewhat unusual instance of the market consensus fundamentally misunderstanding a business – chiefly as a result of overly short-term thinking on the part of a large number of market participants.

In fact, upon closer inspection, it seems that misperceptions on Apple abound.

Apple is of particular interest for the following reasons: the company is understood by the market as a hardware company – in need of new blockbuster products to maintain its position and hence priced for decline. To our minds, Apple is more appropriately considered a software company with a wide moat (in the form of its OS ecosystem) embedded in an innovative product range.

Further, its $46bn in annual free Cashflow and its $147bn in cash reserves dwarfs that of the competition, and is likely to flow into shareholders pockets. As a result, we believe Apple doesn’t need to grow at a breakneck 20% to still have an intrinsic value of at least $750 a share.

 

Apple Inc. Stock Price May 2012 – June 2013

 

For people who like ratios, here are some to begin with: It currently has a PE of 10.8 and a P/FCF of 8.8 – both significantly lower than all other tech stocks and miles off the average S&P PE (see the graph above).

Based on current P/E or P/FCF ratios, Apple is the cheapest large cap tech stock on the market. It’s cheaper than Microsoft, Google, Cisco, Oracle or Qualcomm.

As the share price has fallen while the company has continued to grow, the current PE ratio for Apple is approaching its lowest in ten years.

 

Apple Inc. Stock Price Analysis (AAPL)

1: The Risks

We believe the biggest risk Apple faces is increasing competition from Google’s Android – and maybe from Microsoft, Blackberry and Sony. Android offers its own software ecosystem with cloud services / Google Play and is competing with Apple in the premium as well as low-cost segments of the phone market.

Slow growth in the premium smartphone market (5%) and high growth in the cheaper smartphone market (35%) also threaten Apple’s growth potential.

If it reduces prices it endangers its margins (the iPhone is its biggest and highest margin product) and may tarnish its brand.

And a danger all consumer tech companies face: Shifts in consumer preferences can occur very quickly – as Apple itself has showed the world. With Apple’s visionary founder now out of the picture, Apple’s capacity to innovate may no longer be what it once was. The point is underscored by allegations that the company is running out of ideas and hence is starting to distribute its cash prematurely.

Apple Inc. 2008 - 2012 Financial Data

 20082009201020112012
Revenue per share36.8448.0571.72117167
Free cashflow per share9.5210.0218.1132.5446.34
Earnings per share5.489.2215.4128.0544.64
Book value per share23.8535.4352.5582.29126
All figures in US dollars.

Yet one does have to ask: how do you value a company in the fast-changing consumer products market?

Ultimately, we believe that at such an incredibly low price, the risks are more than justified. Joel Greenblatt frequently warns of this, yet has made Apple one of his largest positions.

We will clarify why the above concerns appear to us to be overstated throughout the rest of this analysis. For now, a summary: Apple can compete with Android. It has a powerful product range and has customers captured within its OS.

2: Competitiveness

Apple can compete in the lower priced segment, since it can in fact protect its current net margins and is not considerably more expensive than, for example, the Samsung Galaxy line.

Even without a new revolutionary product, Apple ie promising in terms of growth trajectory and revenue generated in developed and developing markets.

Apple also has the largest cash pile in corporate history, which makes it, as odd as this sounds, one of the world’s largest hedge funds. Management is clearly aware that this makes little strategic sense for the company, and its taking steps to start distributing this cash in the near to medium-term.

Furthermore, Apple continues to innovate and its R&D expenditures are growing fast – by 30% this year alone.

At its current price of around 6-7x free cashflow, a company with such competent management and powerful product range is worth a closer look.

3: What makes Apple different? What the market has likely missed…

There are a number of misconceptions about this tech-giant’s stock price. Growth investors aren’t as happy as they used to be because Apple has become a mature business and is no longer growing exponentially.

The long appreciation of its stock price in recent years, coupled with uncertainty about its future prospects has turned off many value investors.

Moreover, a high nominal price has had a certain psychological effect on many retail investors, who believe they would get less bang for their buck if the stock traded in the hundreds – rest assured if they did a 10-1 stock split or a 1-10 stick split, a 1% change is still a 1% change.

Apple is a software company – not a hardware company

As mentioned earlier, we think Apple is more appropriately understood as a software company – albeit one with the ability to charge high premiums for its hardware. The true value comes from iOS, the App store, iTunes and iCloud – the products which, combined, create the iOS ecosystem.

Apple skeptics often mention the decline of Research in Motion or Motorola to highlight the inevitable fate of Apple. Between September 2006 and March 2009, Motorola’s share price collapsed by 87% from $102 to $14.

This was the result of its faltering mobile division and its outdated product range. As David Einhorn of Greenlight Capital observed: “A Motorola RAZR phone was a one-time winner because when someone else made a phone that was just a little better, RAZR sales stopped. In contrast, a consumer with one AAPL product tends to want more Apple products. Once the user has a second device, AAPL has captured the customer.”

What does this mean? Simply put, the “cost” of switching from an Apple product to another brand is high. For most consumers to move from an iPhone to Android, there usually has to be a significant flaw with the iPhone.

The same applies to switching from an iPad to a Nexus / Microsoft tablet, or switching from a Macbook Pro to an Acer. This results from the ease of use of the Apple OS, the hassle of getting used to a new operating system and Apple’s brand appeal.

Combine that with the way in which these devices are integrated with one other and with iTunes, iCloud and the App Store. The result is that giving up an iPhone with its music, films, contacts, calendar and, of course, data is an alternative many or most consumers will be unwilling to pursue.

All this produces a highly defensible Apple ecosystem capturing its customers.

In comparison to hardware firms like Dell or HP (which have very thin margins as assemblers of third party products), Apple embeds its own operating system, thereby avoiding the costly step of surrendering revenue to firms like Microsoft when it assembles its products. This also protects Apple from piracy, since when the “Chinese want to have Apple they obviously must buy Apple – as opposed to pirate the OS”.

The high degree of interoperability which characterizes Apple’s products likely makes them superior to Microsoft’s or Research in Motion’s mobile / tablet OS and allows them to compete comfortably with Android in the top tier of the market.

There is a tendency among Apple analysts to implicitly factor in blockbuster products in their estimations of the company’s intrinsic value. While resisting the temptation to gaze into the proverbial crystal ball, it is clear that Apple has developed a high quality OS coupled with innovative products. Moreover, this has been achieved with only a third of the annual R&D expenditure of Microsoft ($3.4bn as opposed to around $10bn).

4: The question of growth

Apple has revolutionized at least three industries since 2000: MP3 players, phones and tablet computers. The competition is bound to catch up and as a result, the premiums Apple can charge are likely to fall. Nevertheless, it is worth remembering is that Apple’s net margin remains at an unusually high 27%, in contrast to both Microsoft’s and Google’s ca. 21%.

Is annual growth of 20% sustainable? Annual sales have already reached $180bn – yet Apple still grew at 18% in the last quarter. Growth will inevitably slow down further (to grow at the same rate, Apple would have to push another $36bn more in sales next year!), but the market likely underestimates the potential for Apple’s current product range in developed as well as developing markets.

As Dan Loeb points out:

Perhaps underappreciated is what we describe as Halo Effect 2.0, which addresses the Mac opportunity. Ten years ago, a consumer may have had an iPod, a Windows PC or laptop, a Sony TV, a Nokia phone, and a library of CDs and DVDs. Today, U.S. households increasingly have iPods, iPhones, iPads and an iTunes library.

With consumers deeply invested in their Apple ecosystems and iTunes libraries (now across music, apps, books and video), the living room stands as Apple’s next frontier. In order to sustain its success, Apple will need to drive its ecosystem experience outside of the US, with multiple devices, content libraries and cloud services. 

However, for Apple to expand in developing markets, the company will have to lower its prices to grow market share. This has the potential to damage its brand image as well as lower margins. BUT when one considers that most Apple sales in China are in the iPhone 4 / 4S bracket, Apple’s price premium relative Android phones is not actually that large.

Apple also offers certain intangible but compelling service features on top of its ‘slick’ products. This ranges from the growing presence of retail stores around the world – Apple stores are by far the best performing by sales per square foot globally – to its email customer service and iCloud.

These services, we believe, add a certain value to Apple’s brand which lower prices are unlikely tarnish.

If Apple manages to expand its ecosystem into a lower income countries, its growth figures will likely remain in the higher teens even without a new blockbuster product.

5: Margins

To understand the debate surrounding the potential for declining margins, it is worth appreciating the following: Apple’s R&D and SG&A spending as a percentage of sales has fallen from 7.6% to 2.2% and from 19.5% to 6.4% respectively – while it has increased R&D spending in nominal terms eightfold since 2001 from $471m to $3.4bn today.

As a result net margins rose to 27%. This can mainly be attributed to Tim Cook’s impressive supply chain management, staggering retail presence and finally, highly targeted and effective R&D.

The result of this is that “as long as the company can grow sales, and R&D and SG&A spending increase at the same rate, Apple can keep its 18.5% gain in net margins through operational leverage”. As the first quarter earnings announcement in 2013 proved, even an 18% decline in profits did not blemish the company’s net margins. This impressive supply chain is a further piece in the puzzle of understanding Apple’s wide moat.

6: Valuation

Ultimately though, it’s the current low price that got us interested.

Apple generated ca $46bn in free cash flow last year – around $50 per share. This means that it produces 25% more CF than earnings per share. Until recently, it has had no debt and $147bn in cash on its balance sheet ($160 per share).

It now issued $17bn in 30 year bonds at 2.378% in order to finance its stock repurchase program – mainly to avoid footing a $10bn tax bill. A move we warmly welcome. Even with no growth and its current free cash flow, Apple will still have $300 per share on its balance sheet by 2015.

Apple has a solid track record in capital allocation, which one might not able to say of Microsoft or HP considering their past acquisitions. After subtracting net cash, Apple  has a price to free cashflow ratio of 5-6 and a forward PE of 6-7. Currently trading at approximately half the average PE of the S&P index, Apple appears to be valued as sub-par within its sector.

We believe the opposite,  holding the view that Apple offers a substantial margin of safety. Moreover, both Apple’s free cashflow and cash reserves are greater than those of Microsoft, Google, Facebook and Nokia combined. Yet, with the exception of Nokia, Apple stock trades at a significantly less than all of them with the exception of Nokia.

The gigantic cash-pile will eventually find its way back to shareholders. The dividend yield has just been raised by 15% to $12.30 (2.8% yield), and Tim Cook has announced further $60bn in share buybacks. That takes about 150m shares off the market – around 18% of the float – and will push the current dividend yield to around 3.5%. This still leaves enormous room for the company to increase its spending on shareholders both through share buybacks or a higher dividend.

Based on its net margins, large cash reserve, sticky product ecosystem, powerful brand and innovative, user-oriented products, we consider Apple to be considerably undervalued. In our opinion, Apple’s intrinsic value stands at around $750, a far cry above the current share price of $430.

(Disclosure: we currently hold Apple stock)

Notes:
1. 2012 Shareholder Letter
2. Dan Loeb presentation
3. Vitaly Kastelanson presentation
2012 Shareholder Letter
Dan Loeb presentation
Vitaly Kastelanson presentation

About the Author:

Carl Livie is Nabataeans’ editor for financial markets and value investing. He studied Arabic and Islamic Studies with a focus on the economic development of the Middle East at the School of Oriental and African Studies in London. Carl has been active in the Egyptian start-up scene, where he co-founded the online services provider elmenus.com, but also spent time at UBS’ derivatives sales and structuring desk in London. Carl’s long-standing interest however has been identifying contrarian-minded and value-oriented investment ideas around the globe with a particular focus on the Middle East.

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