Apple is undervalued primarily because it’s now the largest publically traded company in the world. Investors believe that there is some limit to its size, and our thinking has been anchored to the size of Exxon Mobile. I believe that as Apple overcomes the “biggest company in the world” speed bump, its market cap will unhinge from the $350 billion limit imposed by XOM and explode up to a more realistic valuation. This will be fueled by strong earnings growth for the numerous reasons discussed below. Furthermore, because the stock has been trading within a fairly narrow range since January, volatility has been low. As a result, options are also undervalued for technical reasons (ATM IV at 35%), making calls an attractive way to get more leverage on the investment thesis.
Before we start looking at actual growth rates, I want to make one quick effort to debunk the “too big to win” myth. The Power Law is a well-documented phenomenon in mathematics, more commonly known as the “80/20 rule”. We can estimate that 80% of web traffic is driven by 20% of websites, 80% of the population lives in 20% of our cities. We find this phenomenon everywhere, both in nature and in man made systems. When we plot these distributions, they look like this example chart from Wikipedia:
Likewise, it shouldn’t be surprising that 80% of profits are earned by 20% of our companies. Plotting the largest companies based on market cap should look like the example of a power-law distribution above. Here is what the distribution looks like for the top 50 companies:
If Apple traded at 25x trailing earnings, a totally reasonable valuation, the chart would look like this:
This isn’t unimaginable to me. It perfectly follows the well-known power law and is natural. To some degree it more accurately reflects reality because Apple is undervalued. The current valuation of Apple has been arbitrarily limited by the market cap of an unrelated company in an unrelated industry simply due to size. This is a common psychological impediment to rational decision-making known as anchoring.
However, these charts prove nothing. All I intended to show was that Apple could expand its valuation without crushing our understanding of economics or the natural order of the universe.
A low-growth scenario is insane
The fact that Apple is a large company does not mean that it cannot grow. I’m not saying that growth prospects are limitless, and I’m not advocating that we simply extrapolate historic growth rates into the future. We need to think about Apple’s growth prospects by understanding its product line and the competitive landscape.
The following chart shows how Apple has generated its revenue for the past few quarters:
Obviously the most important component is the iPhone, a product that barely existed two years ago, followed by the iPad, a product that didn’t exist two years ago. Because of how much growth has been fueled by innovative new products, investors seem to get stuck trying to figure out what the next new product will be. Opportunities exist, and I’ll discuss this at the end. But more importantly, existing products have ample room for growth, and can more than justify a higher valuation. To start, I’ll focus on the iPhone and iPad segments individually, add in some thoughts on the other segments collectively, and then discuss China and some obvious avenues for continued innovation.
The iPhone has been the biggest driver of growth for Apple in recent quarters. Fortunately, the nice folks at Garnter make forecasting easy for us. For starters, they have summarized current market share data. The following two charts from Gartner show Apple’s share of cellphone sales, and the iOS (Apple’s operating system) share of smartphone sales:
We can see that Apple has doubled iPhone sales and increased market share. Also important to note is that market share is still small, indicating that Apple has ample room to run. But this is history, not relevant to current or future Apple shareholders. Fortunately Gartner has also put together some forecasts for us:
Unit sale increases to 190k units in 2015 represents a CAGR of 20.3% over 2011 unit sales of 91k units. Assuming revenue per unit stays flat, this alone translates into 9.1% revenue growth for Apple (when mixed in with all of Apple’s other products). In 2012 alone, forecast unit sales of 119 million represents 71.4% growth over the LTM unit sales of 69 million. This alone translates into Apple top-line growth of 32.0% in 18 months.
This leaves two questions. A) how will revenue per unit change, and B) why is market share declining to 17.2%? Gartner answers both questions with this paragraph:
Gartner predicts that Apple’s iOS will remain the second biggest platform worldwide through 2014 despite its share decreasing slightly after 2011. This reflects Gartner’s underlying assumption that Apple will be interested in maintaining margins rather than pursuing market share by changing its pricing strategy. This will continue to limit adoption in emerging regions. iOS share will peak in 2011, with volume growth well above the market average. This is driven by increased channel reach in key mature markets like the U.S. and Western Europe.
So the forecasts above assume that Apple effectively prices itself out of the market, to some degree, to maintain margins. Why these high prices weren’t a deterrent in recent quarters, I don’t know. Sales in “Asia-Pacific” (ie China) grew by 160% in 2010 and 191% in the first nine months of this year. (These growth rates aren’t specifically for iPhones.) China has a low GDP, and yet consumers are gobbling up Apple goods. If Apple’s pricing strategy “continues to limit adoption in emerging markets” to a sub-200% annual growth rate, investors won’t have much to complain about.
But this growth rate provided by Gartner assumes that Apple’s strategy department doesn’t understand basic economics. Apple generally sells its goods at higher price points than competitors, and I don’t expect this to change. But Apple does not limit its offering to one product at the highest price point. iPods range in price from the Shuffle starting at $49 to the Touch topping out at $399. Computers range from the Mini starting at $599 to the Pro with a top-line model starting at $4,999. Offering one phone at the maximum price point is not a strategy Apple is likely to stick with for its top selling product. This assumption is absurd. So the Gartner forecasts, in my opinion, are really a worst-case scenario and present only a baseline growth rate. Apple clearly has opportunities to continue growing market share in a rapidly growing industry while maintaining margins, and even high price point products are selling in low GDP countries.
Furthermore, I agree and fully comprehend that smart phone prices (as well as PC prices) will generally decline over the long-term. The questions are to what degree will price cuts increase demand and to what degree will component manufacturers take a hit. Modeling this relationship in detail is unlikely to yield an information advantage. But Apple is the market player with the greatest bargaining power with suppliers and the greatest pricing power with consumers. This gives Apple the best protection against shrinking margins and the most opportunity to benefit from growing market size, a recipe for success. Apple is not going to be the one to suffer from this long-term trend.
To summarize, a pessimistic forecast for iPhone growth through 2012 alone is enough to justify analyst estimates for EPS growth. Less pessimistic forecasts are easy to conjure, and Apple has other products that are performing well. And there isn’t one year of growth left, growth is forecast to continue at least till 2015.
The next most relevant product for Apple is the iPad, a product that’s been on the market for just over a year. Credit Suisse estimates 2011 Apple sales of 41.2 million units, compared to 25.5 million in the LTM and 65 million units to be sold industry wide. 2012 sales are forecast at 59.2 million units compared to 116 million units for the industry. Credit Suisse derives these estimates by looking at the distribution of average sales prices for desktop and laptop computers over the past decade, taking note of how prices have dropped, and then working tablet cannibalization into the price point model. Overall this assumes 16% unit growth globally. In 2012, tablet sales are forecast to represent 23% of sales, the vast majority of which will be replacing laptops in the $300-$699 range. In the short-term, these estimates seem reasonable. Credit Suisse models out to 2015, eventually concluding that tablets will represent 42% of PC sales. I intuitively suspect these estimates are too aggressive. But 2012 forecasts for 59.2 million unit sales compared to 25.5 million in the LTM represents 132.2% growth. Growth in the iPad segment should therefore contribute an additional 27.5% of revenue growth for Apple. Adding this to our iPhone sales growth from above, and we’re at 53.4% revenue growth within 18 months.
These forecasts are again conservative compared to Gartner’s forecast of 69 million unit sales for Apple in 2012, an incremental improvement of 16.6%:
The Gartner forecasts represent a 69.0% CAGR from 2011 to 2015 just for Apple. I’ve been focusing on 2012, but this obviously represents sustainable growth well beyond the next year, and it’s a good supplement to iPhone growth.
Part of what makes the iPad so important is its enterprise adoption. It took a few years before businesses were using iPhones. iPads were adopted immediately and in large scale.
If iPads continue to be adopted by businesses, it stands to reason that corporations might eventually begin to adopt other Apple products as well. As this report is being written on a MacBook Pro by someone who does not own an iPhone, iPod, or iPad, I’m admittedly at a loss to explain why computer adoption hasn’t already occurred. Apple computers are easy to use, difficult to break or crash, and secure. I suspect that iPad adoption may be the catalyst to increased Mac use as users become familiar with the operating system, accustomed to the stability, and eventually hooked on the cloud based services that synchronize devices together. If that doesn’t convert users to Mac, a devastating global computer virus eventually will.
I said before that I don’t want to rely on extrapolating trends, but I think in the case of computer sales, historic growth rates provide the fairest estimate of future growth rates. Also, unless Mac sales grow tremendously, sales are almost immaterial compared to the iPhone and iPad. This doesn’t make or break the investment thesis. The chart below shows how computer sales have changed since 2005:
Assuming these growth rates hold steady for another year, we can predict sales growth of just under $5 billion, or an additional 4.9% revenue growth, bringing our total to 58.3% growth in 2012.
iTunes and iPod
I’m labeling “other music related products and services” as iTunes, because that’s effectively what it is, and looking at it alongside the iPod. The same chart above reproduced for these two segments looks like this:
Assuming that iPod sales stay flat and that iTunes continues to grow at its historic rate, these two segments add another 1.3% growth to the top line in 2012, bringing our total growth to 59.6% using conservative forecasts. Assuming Gartner forecasts for iPhone and iPad sales are correct, Mac and iTunes continue to grow at historical rates, and iPod and other revenues stay flat, Apple will generate $225 billion of revenue in CY2015, compared to $100 billion in the LTM.
If 58.3% growth in 2012 materializes, we’re paying 6.9x earnings and 4.2x EV/EBIT (assuming the cash balance doesn’t increase) in 18 months. This seems like a good deal for a company that has dominated its markets. But of course, if we’re then stuck at some lower growth rate beyond 2012, maybe in the 10% range, investors might not be happy and a 7x earnings multiple may seem justifiable. But in the most likely scenarios, growth should continue at a respectable rate at least until 2015 given the strength of Apple’s position. Furthermore, there are clear avenues for Apple to continue innovating and growing.
The biggest opportunity for Apple is to take advantage of its popularity in emerging markets where Apple products are a status symbol. Carrying around an iPhone is a visible sign of wealth, but not something that can be easily copied like a fashion accessory. In the most recent conference call, Tim Cook states:
China was very key to our results. As a reminder, for Greater -- we define Greater China as Mainland China, Hong Kong and Taiwan. Year-over-year it was up over 6 times. And the revenue was approximately $3.8 billion during the quarter, and that makes the year-to-date numbers through the three quarters that we have had thus far around $8.8 billion.
This is party attributed to a retail store presence (although retail sales are counted separately). Apple has stores in the US, UK, Canada, Australia, France, Japan, Germany, Italy, Switzerland, Spain, and China. China is scheduled for the most store openings, but surprisingly it’s the only emerging market location on the list. Both based on GDP and GDP per capita, other countries not on the list seem ripe for store openings. And the lack of capital is obviously not a problem. Expansion to Brazil, Russia, China, Singapore, the UAE, and Hong Kong all seem like a great idea, if for no reason other than to introduce new products to large markets. Other countries are similarly underserved. This isn’t a company that’s nearing saturation, it’s barely scratched the surface.
Aside from the geographic opportunities, technological growth opportunities still exist as well. The two in particular that I find interesting are television and video games. Rumors of an Apple television with iOS installed have been circulating quite a bit, and the concept makes sense. Apple TV has been out for a while, but as a stand-alone streaming content box, it hasn’t done too well. Integrated into a set, it might be a more attractive offering. Another thing that hasn’t done well is $0.99 single TV episode rentals on iTunes. This service was pulled from iTunes recently, in a move that might have surprised some. Perhaps it will be more profitably reintroduced in an integrated hardware offering? The Times summed it up nicely saying:
The slight retreat by Apple comes two days after Tim Cook was named the chief executive of Apple, replacing Steve Jobs, who was named chairman. And it comes at a time when the company is widely believed to have its industry-disrupting sights set on the television industry.
In the meantime, Apple has decided to move towards a cloud-based ownership model. As iTunes in conjunction with iPod was disruptive to the music industry, it’s easy to see how iTunes in conjunction with an Apple TV and some new pricing schemes could be highly disruptive to the broadcasting and network businesses, which have relied on bundling for so long. A-la-carte packaging options transmitted over broadband will appear attractive to many consumers, and as the distribution model matures, it may become more attractive to the likes of HBO and other content producers. A recent report from the Economist states:
In future HBO Go could allow the network to bypass the entire pay-TV system. For now, going “over the top” in this way makes no sense, says Bill Nelson, HBO’s chief executive. There are roughly 105m multichannel TV households in America, of which 77m do not subscribe to HBO. By contrast, he reckons, there are only about 3m households with broadband connections and reasonable amounts of money but no multichannel TV. It makes sense to go after the bigger group. But this may change. “Let’s assume that in ten years’ time there has been a significant shift away from multichannel subscriptions,” says Mr Nelson. “In that environment, HBO may reconsider its position.” If HBO were to try selling its programmes directly via the internet it would have a hugely disruptive effect on the television business—more disruptive than anything Netflix or any other company has yet done.
Apple could also enter the video game market. Buying Nintendo would be a quick shortcut to success, picking up a handful of the most successful franchises of all time, and on the cheap. Nintendo currently trades 2.7x trailing earnings, or $2.7 billion. This is because recent product launches have been failures. While Nintendo’s president has claimed that he doesn’t want to produce games for iOS, the fact of the matter is that Apple already has the functionality using Apple TV that the Wii U (Nintendo’s next system) will have. On the heels of a failing 3DS, Nintendo is launching its next major equipment upgrade into the headwinds of a competing Apple product already in the market for $99. The fact of the matter is that Apple is getting into games, even if not deliberately. Nintendo can defy shareholders for a while, but not forever. And from Apple’s point of view, the IP must be attractive, especially at the current trading price of Nintendo shares. And on September 6th, news surfaced that Apple products would be sold at GameStop…
In both TV and games, Apple could be characteristically disruptive. These two strategies could be combined, with iOS natively running Nintendo games. iTunes would also further benefit from TV content subscriptions, episode downloads, and digital game sales. But most importantly, this is all gravy on top of iPhone and iPad sales, which more than justify Apple’s current share price.
Ignoring all these upside opportunities, how does my model compare to the sell-side? Here is my revenue forecast based almost entirely off of Garnter forecasts:
And this is a revenue forecast from FBR Securities:
2012 total revenue is expected to be $126 billion with $60 and $24 billion coming from iPhone and iPad respectively. My revenue lines should be a bit higher as I’m using the calendar year compared to Apple’s fiscal year ending in September. But one extra quarter of growth doesn’t explain the huge difference with disparities across the board (but most apparent in the iPhone and iPad segments). Unfortunately the report doesn’t really dig into the iPhone market, but it does cite iPad unit sales of 50.9 million units compared to Gartner’s estimate of 68.7 million. At 50.6 million units, FBR is assuming an iPad ASP of $468 compared to $640 in the LTM. The reason for this decrease isn’t made clear, but FBR does reference the Gartner forecasts, and it should be noted that while estimates are lower than Gartner in 2012, they are higher in 2013, so Gartner (and I) seem to be front-loading sales a bit more.
While FBR doesn’t state iPhone unit sales expectations, they do say that market share should decrease from 53% to 50% in 2012, citing the Gartner expectations that a lower-priced phone won’t be released. They leave room for upside if a $200 phone is offered.
Furthermore, this report was published in June 2011, and it was predicting 2011 EPS of $12.93 and $14.39 in 2012. Apple has already reported $25 in the LTM and analysts are now expecting $27 at the fiscal year end. Only 3 months out and this report’s estimates are already antiquated.
Here is the revenue summary from a Credit Suisse report:
Again in 2012 my forecasts are too high with the focus on the iPhone and iPad. Credit Suisse is a little more explicit, stating 112.2 million iPhone unit sales compared to my 118.8 (which can be explained by my extra quarter), and 59.2 million iPad sales compared to my 68.7 million estimate (which probably can’t be explained by an extra quarter). However, these estimates resulted in much lower revenue. Credit Suisse estimates revenue per iPhone unit to be $601 compared to $648 in the LTM, and revenue per iPad to be $578 compared to $640 in the LTM. So perhaps my assumption that ASPs won’t decline in the next 18 months was an aggressive one.
On September 6, Credit Suisse released an updated guidance with iPhone sales in FY2012 of 118 units, the same as the Gartner estimate for the calendar year. It looks like estimates are moving in the right direction.
How well have analysts in general predicted AAPL performance in the past? This chart from Bloomberg shows analyst EPS forecasts and how they change on quarterly basis:
We see from this that analysts have underestimated Apple earnings growth significantly every year. This isn’t surprising, no one could have predicted the iPad’s success, and the iPhone’s success was surprisingly strong as well. That being said, despite the fact that I’m predicting higher revenue in 2012 and the same gross margins as analysts, I’m also assuming higher R&D and SG&A costs, which results in 2012 EPS of $32.62. This is exactly in line with analyst expectations. My model isn’t wacky, and it predicts that shares could be worth north of $1,000 per share if investors are willing to pay 20x 2015 earnings. And this is based only on the projected success of existing products.
Aside from the Apple is “too big to win” argument, I haven’t seen any reason to be pessimistic about Apple. If there weren’t clear paths to greater profitability, I would probably agree with the “too big to win” argument, but the evidence that Apple will continue to grow is overwhelming. It’s well positioned technologically, it has obvious economies of scale, tremendous love from consumers that translate into fat margins, and clear avenues for continued innovation.
Perhaps because share price appreciation has slowed as Apple’s market cap approached the market cap of Exxon Mobile, volatility over the past nine months has been low. This appears to have made options cheap. This chart from Bloomberg shows Apple’s share price and the implied volatility of at-the-money options:
Two possible scenarios exist for the next twelve months. The first is that investors will continue to fret about the “to big to win” argument and shares will continue to trade at low multiples in the 10-15x range, but the company will continue to perform well and will therefore continue to grow its share price by 30-50% annually. The second scenario is that continued growth will push the market cap up to $400 billion, investors will see that Exxon Mobil was and will continue to be irrelevant, and then the share’s will unhinge from the XOM valuation and reset to a reasonable price, probably in the $600-$700 range.
In the first scenario, 30% growth and a 15x earnings multiple at year-end 2012 would translate into a share price of $520. January 2013 stock options at an exercise price of $400 cost $65 today. This would generate an 85% return. In scenario two, the share price more accurately reflects reality and Apple trades up to $700, yielding a 362% return. The options market is simply not factoring in the probability of strong growth for fundamental reasons.
Downside scenarios exist, although I’m having trouble imagining them. Under new leadership, it’s possible that Apple could release a string of junk products. However, even if Steve Jobs was the secret sauce at Apple, he’s still involved in the business, just not running the day-to-day operations. And Apple has released its fair share of flops in the past, it’s just quickly forgotten. A string of bad products seems like a concern investors might face beyond 2015.
It’s also possible that an economic downturn can disrupt Apple. On the upside, at least there isn’t much liquidity risk on this one. The affects of a global recession are difficult to predict, and the impact on Apple’s share price is even more difficult to predict. But call options limit downside risk while maintaining significant upside as long as position sizes are kept reasonable. This should be an easy trade to get comfortable with.
Disclosure: Long AAPL