We are maintaining our fair value estimate for Apple AAPL
despite a 6% stock decline Wednesday and a bout of recent selling
pressure and stock price volatility. We believe many factors are at play
regarding the stock price decline from an intraday high of $705.07 on
Sept. 21 to an intraday low of $505.75 on Nov. 16. Primarily, we believe
investors have been taking gains in Apple, as the September price of
$705 represented a 74% gain in nine months. We believe that such
profit-taking was exacerbated in early November by U.S. President Barack
Obama's re-election, which appears to have heightened concerns about
the U.S. fiscal cliff and higher tax rates on investment capital gains.
Since Apple was probably the largest investment holding and/or the
biggest 2012 winner for many investors, we suspect the stock has likely
been a casualty of any profit-taking or trimming of holdings by large
investors. More recently, we suspect that technical investors are
steering the Apple boat, as evidenced by the massive recovery in the 12
trading hours following the Nov. 16 low of $505, as the stock catapulted
back to $566 by the end of the following trading day.
Other
nontrading data points have come out in recent days that may have
contributed to Wednesday's slide. Taiwanese trade paper DigiTimes
reported that Apple's component suppliers may expect a 20% drop in
component orders in the March quarter, thereby hinting at a sharp
decline in Apple production and, ultimately, sell through. We aren't
sounding the alarms for Apple on the basis of this report, as DigiTimes'
sources have not always exhibited an accurate record and component
orders are always subject to change based on improving or deteriorating
forecast product demand. Another potential negative catalyst was Nokia's
NOK agreement with China Mobile CHL
to sell the Windows-based Nokia Lumia 920T on the carrier's TD-SCDMA 3G
network. We don't believe that this deal prohibits Apple from someday
selling the iPhone with China Mobile, which is a key catalyst in our
thesis for further iPhone growth in the long term, given China Mobile's
massive subscriber base of more than 700 million people. At the same
time, we are taking a wait-and-see approach toward Nokia and Windows
phones in general, and availability with a given carrier is not a
guarantee of future success.
Finally, at an investor conference Wednesday, the CEO of AT&T Mobility T,
Ralph de la Vega, hinted that the carrier expects to sell 26 million
smartphones in 2012, which implies 9.3 million devices in the fourth
quarter, about equal to smartphones sold in the fourth quarter of 2011.
Given the high proportion of iPhones sold by AT&T as a percentage of
total smartphones, one could interpret this to presume that the iPhone 5
launch is not faring significantly better than the 4S launch in 2011.
We view this data point as a slight negative, as it would imply that
Apple and its loyal base of iPhone customers with AT&T might not
wildly exceed expectations. However, we certainly don't see this news as
a death blow either, as we think these comments still point to solid
iPhone 5 sales with the carrier.
More important, the comparison
with the year-ago quarter at AT&T and Apple is not exactly
apples-to-apples, as the iPhone 5 was launched Sept. 21 and initial
sales were included in AT&T’s third-quarter results, versus the 4S
launch Oct. 14 where opening weekend sales were captured in the fourth
quarter. Additionally, while AT&T is a key iPhone carrier and the
U.S. is Apple's most important iPhone market today, we can see a
scenario where iPhone sales at Verizon VZ or Sprint S
exceed expectations and contribute to an overall strong iPhone 5
launch. We also have not seen enough evidence that Nokia's Windows
phones, Google's GOOG
Nexus 4 phones made by LG, or Samsung's relatively older Galaxy S III
phones are putting a serious dent in Apple's iPhone 5 momentum just yet.
We keep a close eye on the competitive dynamics of the smartphone
market, especially during this important holiday season, but we are
maintaining our fair value estimate for Apple at this time.
Thesis 10/09/12
We
believe Apple's strength lies in its experience and expertise in
integrating hardware, software, services, and third-party applications
into differentiated, premium devices that provide superior functionality
and ease of use for the end customer. Although Apple has a robust
product pipeline and ample opportunity to gain share in its various end
markets, short product life cycles and intense competition will prevent
the firm from resting on its laurels or carving out a wide economic
moat, in our opinion.
Although Apple originated as an innovator in the PC market and rose
from the ashes in the mid-2000s on the heels of its wildly popular
iPods, its fortunes are likely to remain tied to the iPhone and, to a
lesser extent, the iPad for quite some time. We believe the key to
Apple's success has been the firm's ability to seamlessly integrate
hardware and software into easy-to-use devices. Its multiyear head start
in this integration gives the firm an advantage over software providers
(like Google GOOG and Microsoft MSFT) and hardware providers (such as Samsung and Hewlett-Packard HPQ)
alike. Although Apple didn't invent the handset, or even the
smartphone, its elegant iPhone design revolutionized the industry.
Handset makers caught up with their own touchscreen smartphones, and
certain devices have at times outperformed Apple's hardware in terms of
screen size and data speed, but we see Apple remaining at or ahead the
rest of the pack on the hardware front as it continues to add
innovative, differentiated features (like retina display and a devout
focus on battery technology) into its devices.
We believe Apple's bigger battles are in software and services today.
The early iPhone success was driven by easy portability of iTunes media
(leveraged from its dominant position in iPod music players), as well
as a first-mover advantage in the development of its iOS operating
system and third-party app store. Ongoing enhancements, such as FaceTime
and iMessage, help to differentiate Apple from Google's Android and
other operating systems even further. Apple's current goal is to
heighten the switching costs of its products, and we see iCloud, which
allows for online storage and synchronization across iOS devices, as a
key facet of this plan. Customers who own an iPhone and other iOS
products (perhaps an iPad, Mac, iPod, or current and future Apple TV
products) may become more reluctant to buy a new device that doesn't
sync with iCloud and the rest of the ecosystem. Although iCloud and iOS
won't provide Apple users with insurmountable switching costs, the firm
has done a much better job than predecessors (Motorola and Research in
Motion RIMM
come to mind) that failed to lock in customers when they were king of
the hill. Finally, we view Apple's integration of third-party apps into
iOS 6, including Siri, as an interesting, increasingly important part of
its strategy. A Siri search that provides a restaurant review from Yelp
YELP
may enhance the iPhone's ease of use today and, given the complexity of
voice recognition software, may emerge as a clear differentiator that
other OS platforms may be unable to match for years to come.
Ultimately, Apple will have to continually develop superior products
on all fronts (hardware, software, services and third-party apps) while
fending off many strong rivals in end markets highlighted by short
product life cycles and intense competition. We expect Apple to remain a
premium supplier of devices, even though rivals will clearly compete on
price; Amazon AMZN is
essentially selling its hardware at cost in order to profit from higher
online media sales, and Google gives the Android OS to handset makers
for free in order to drive search traffic. Apple may do a better job
than any other phone or tablet maker in raising the switching costs
associated with its devices, but as rivals like Samsung develop products
with similar functionality and others offer serviceable products at
much lower prices, a few missteps from Apple could drive customers to
leave iOS altogether, especially as consumers replace phones every
couple of years. Apple's decision to part ways with Google Maps and
offer an inferior in-house mapping solution might not be a fatal blow or
even a long-term issue, as Apple Maps improves and Google may build an
iOS mapping app, but similar blunders may cause iOS customers to take a
second look at other smartphones. The maps issue highlights that,
despite Apple's size and software expertise, the firm will still have to
develop and maintain partnerships with third parties like Facebook FB and others in order to provide a favorable experience to end users.
We
are raising our fair value estimate to $770 per share from $670, based
on improved long-term growth assumptions. This fair value estimate
implies fiscal 2013 (ending September 2013) price/earnings of 15 times,
enterprise value/EBITDA of 11 times, and a 6.5% free cash flow yield.
Given the success of the iPhone 4S, iPad 2 and "new iPad" to date, we
project 45% revenue growth in fiscal 2012. We expect Apple's momentum to
continue in the near to intermediate term and project 21% sales growth
in fiscal 2013 and 17% in 2014.
Despite the iPhone's huge success thus far, according to Gartner
data, unit sales make up less than 25% of smartphone shipments and less
than 10% of total handsets today, so Apple still has a mammoth
opportunity to recognize strong iPhone growth. We expect the smartphone
market to essentially double over the next five years, and we hold our
forecast of the iPhone's share of the market relatively constant in the
low to mid-20s, as Apple gains share on the high end, but a larger
portion of smartphone growth will likely come from cheaper Android
devices sold in emerging markets. We project 34% unit growth and 27%
revenue growth for the iPhone in fiscal 2013.
We also anticipate robust long-term iPad revenue growth, as this
device both displaces PCs and is purchased as a third device alongside
of PCs and phones. We assume that Apple's line of Mac PCs will see
minimal revenue growth, as Macs gain share in the large but slow-growth
(at best) PC market. IPods should also see lower revenue as Apple
retains majority market share in portable music players but smartphones
continue to cannibalize these products.
Longer term, we think a higher portion of iPhone sales will be in
China and other emerging markets, which will probably cause a mix shift
toward budget iPhones (likely older models) and average selling price
declines on its latest phone models. In turn, Apple's iPhone gross
margins may dip from around an estimated 50% today to the low 40s.
Similarly, iPad gross margins may dip a few percentage points from
current levels, especially if the firm launches an iPad Mini at lower
price points. We project that Apple's total gross margins and operating
margins will peak at 43% and 35% in fiscal 2012, respectively, and will
dip to the high 30s and high 20s by 2016, respectively. Our fair value
uncertainty rating is medium, given the company's size and scale in its
various industries.
We
believe a large, well-diversified company like Apple faces several
risks. Despite its intentions to control as much of the user experience
as possible for its products, the firm still relies on a robust app
developer base and strong partnerships with third parties. Its decision
(and subsequent apology) to use an in-house mapping solution may have
diminished Apple's reputation and its customers' user experience, at
least in the near term, and switching costs around other iOS products
might not be enough to retain unsatisfied customers. We think it is
unlikely that a further split from Google involving search is next, as
we believe Apple's and Google's map differences pertained to specific
creative user interface differences around mapping features, whereas
search has a much simpler user interface (i.e., typing in the search
bar). We also view Facebook as a key third-party apps provider. Although
Apple is on the record as stating that Facebook is a friend and not a
foe, a Facebook-centric phone could lure customers away from iOS in the
unlikely event that the two firms were to end their relationship.
Apple also faces several well-branded, well-capitalized rivals in
software and hardware. It must continually deliver premium products in
order to stave off these hungry competitors. If Apple were to falter and
its exceptional brand be diminished as customers departed iOS in
droves, we don't think its cash cushion could help the firm buy its way
out of any problem. As a premium phone supplier, Apple also runs the
risk that wireless carriers could reduce or eliminate the subsidies that
they provide their customers on the iPhone, in turn raising customers'
up-front costs and perhaps making other smartphones appear to be better
alternatives. Finally, Apple lost cofounder and visionary Steve Jobs in
October 2011, and while we believe that CEO Tim Cook is a
more-than-capable leader, Apple runs the risk that its unique culture
and sense of innovation may diminish over time.
Management & Stewardship
We
view Apple as a good steward of shareholder capital. Tim Cook became
CEO in August 2011 after cofounder, longtime CEO, and visionary Steve
Jobs stepped down from the CEO role before passing away in October 2011.
Cook was considered to be Jobs' right-hand man and served in various
operations roles with Apple before becoming COO in 2005. We believe
Jobs' passing was a blow to the firm, as he was a one-of-a-kind leader
and creative mind. However, we believe Apple is in good hands with Cook.
Apple's formal apology after parting ways with Google Maps in iOS 6 and
launching Apple Maps with a variety of bugs and errors may have put
management in the spotlight. However, we understand the rationale for
such a switch, and we're willing to give the management team the benefit
of the doubt and tend to view the mishap as a one-time misstep. Arthur
Levinson, former chairman and CEO of Genentech, is chairman of Apple's
board of directors.
Apple continues to generate operating margins and cash flow well
above its peers in various hardware industries. Although Apple may have
frustrated investors under Jobs by holding a titanic cash cushion ($117
billion as of June), we applaud the company's recent dividend initiation
and buyback plan under Cook. We also appreciate Apple's frugality by
making smaller strategic acquisitions and developing products in-house,
rather than splashy but questionable deals like Microsoft's purchase of
Skype or Google's foray into hardware by acquiring Motorola Mobility.
Overview
As
of June, Apple held $36 billion in cash and investments in the United
States that can be used for dividend payments, stock repurchases, and
domestic acquisitions. Apple held another $81 billion in overseas cash
and investments that it cannot repatriate to the U.S. without paying
additional taxes. The company has no debt. We are not concerned about
Apple's financial health.
Profile:
Apple
designs consumer electronic devices, including PCs (Mac), tablets
(iPad), phones (iPhone), and portable music players (iPod). Its iTunes
online store is the largest music distributor in the world; it sells and
rents TV shows and movies and sells applications for the iPhone and
iPad. In early 2011, Apple launched the Mac App Store, an online store
that sells first- and third-party applications for Mac desktop and
notebook computers. Apple's products are distributed online as well as
through company-owned stores and third-party retailers.
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