Monthly Archives: April 2013

Is AAPL undervalued or overvalued at $400?

Following on from my initial post on Apple’s past, I have spent some time reading up on bull and bear views of its future. Oh my, there really is a massive amount of opinion out there! I knew that Apple was the most analysed stock in the world but I didn’t fully realise the extent of the chatter. The level of discussion was particularly strong last week as AAPL traded below $400. The focus now is the Q2 results due on Tuesday and the gross margins it will report and what can be assumed about Apple’s short term trajectory. There is a lot of noise about Apple at the moment but I am more interested with the medium term and the implied valuation from looking beyond the noise.

From past experience, I am very aware that when any stock falls from grace or reaches maturity, there is the danger that an attachment to the “glory days” can colour judgement on future prospects and capture sets in. As I am not an Apple user and have never directly owned Apple stock previously, I hope my perception is somewhat unbiased. The emotional capture trap that’s so dangerous in investing is something that I have fell for before and one I am very wary of.

I am in big believer in the wisdom of George Box’s quote that “all models are wrong, but some are useful”. In attempting to do a discounted cash flow analysis of a technology company like Apple, you have to make numerous assumptions, most of which will likely turn out to be way off the mark. The purpose here is not to predict the future but to get an idea of Apple’s valuation given the views prevalent today. Before detailing the assumptions for the three scenarios I selected, I have a number of observations:

1)      The importance of the smartphone market (or whatever smartphones evolves into) to Apple will likely not decrease if its financial success is to be maintained. No foreseen new markets, such as TV or watches alone, can ever, in my opinion, match the size and profitability of the iPhone. iPhones and iPads are likely to evolve & merge into a variety of portable products – mini iPads, low cost iPhones, portable iTVs – of differing sizes and capabilities. Whatever they turn out to be, they will remain critical to Apple. There is of course the possibility of an unforeseen killer product or market for Apple in the future. However, as they say, “hope is not a strategy”. Simply relying on Apple to innovate successfully on a scale similar to the iPhone in the future is, in my opinion, naive and not refective of the maturing nature of the market.

2)      It is increasingly likely that Apple will not be able to maintain the gross or net margins that it has achieved in recent years, both for its existing products and for new products. My projections assume varying levels of gross margin reduction and revenue per product reductions. Apple now has strong competitors and maintaining high margins and high prices in a competitive and increasing commoditised market (even at the high end) that is reaching maturity in the core developed jurisdictions is not, in my opinion, realistic.

3)      Initially I did think one scenario would reflect a Nokia/Motorola type implosion for Apple. However, just as my analysis concludes that Apple’s rapid revenue growth years are behind it, Apple’s uniqueness, its unflinching focus on quality, its core loyal customer base, and its ecosystem make a rapid decline equally unlikely. Its DNA, driven by its past, and its cash pile also make such a decline improbable in my view.

So, with the understanding that the analysis below is rough and ready, and has been done by somebody with a partial knowledge of the underlying subject, the following is presented here purely to stimulate consideration of Apple’s current valuation.

Scenario 1 – Apple Loses Its Cool

This scenario assumes the global mobile phone market grows at 2% annually and the Smartphone market grows from the currently approximate 50% of the mobile market to 70% by 2017. The iPhone sales are assumed to peak in 2013 at 137 million units and decrease thereafter at an average of 12% per year with the decrease peaking in 2015 at 20%. This represents a peak market share of 18% in 2012 to 3% by 2020 and a 3% share thereafter. Average revenue drops from $620 in 2012 to $450 by 2016 (as a result of the introduction of lower cost iPhones and a wider model range) and by 4% per year thereafter. Gross margins drop from the current mid 50% to below 50% by 2015 and by 2% a year thereafter until it reaches 40%. Revenues peak at $82 billion in 2013 falling to $30 billion by 2017 and to $15 billion by 2022.

iPad sales are assumed to peak in 2014 at just over 70 million units falling steadily to 27 million by 2022. Revenue per unit falls dramatically from $530 in 2012 to $330 by 2015 and $230 by 2022. Gross margins fall from 30% in 2013 to 25% in 2022.

Mac desktop & laptop products fall from approximately 18 million units in 2013 to 10 million by 2020. iPods also fall from 4 million in 2013 to below a million by 2021. Average revenue falls for each product steadily and gross margins fall modestly.

It is assumed that two new products – the iWatch and the iTV – are introduced with limited success. Both products start with 5 million of sales each. The iWatch reaches a peak of 23 million by 2018 before falling off to 15 million by 2022. Average revenue of $200 for the iWatch is assumed with a gross margin of 30% falling by 1% a year thereafter. The iTV reaches a peak of 13.5 units by 2018 before falling off to less than 7 million by 2022. The average revenue starts at $2,000 and falls by 4% annually. The gross margin starts at 30% and falls by 1% a year until it reaches 25%. Based upon an approximate global market of 250 units annually, Apple only manages to reach a peak of 5% market share by 2017 (assuming constant annual sales of 250 units). This scenario assumes that the iWatch is a niche product and the iTV only has limited success with core Apple users.

No other products are assumed to be introduced after 2014. This scenario therefore could reflect the situation where, after unsuccessful product launches and a drop in core markets, Apple essentially becomes a fallen company where management (likely to be new management) simply runs off the company to maximise cash-flow.

Overall revenue falls from over $150 billion in 2013 to under $50 billion by 2022. Gross margins fall from 41% in 2013 to 30% by 2019. Diluted EPS of above $42 in 2013 fall steadily to $5 by 2022.

(click to enlarge)AAPL Loses Its Cool Projections Forecasts

Scenario 2 – Apple Matures Gracefully

This scenario assumes the iPhone sales peak in 2015 at 155 million units and decrease thereafter by approximately 5 million annually to 125 million by 2022. This represents a peak market share of 18% in 2012 to a steady 9%-8% by 2018 and thereafter (assuming 2% average annual mobile market growth and 70% Smartphone share by 2017). Average revenue and gross margin drops as per scenario 1. Revenues peak at $81 billion in 2013 falling to $50 billion by 2022.

iPad sales are assumed to peak in 2016 at 83 million units falling steadily to 70 million by 2022. Revenue per unit and gross margin falls dramatically from $530 in 2012 to $250 by 2016 and $220 by 2022. Gross margins fall as per scenario 1.

Mac products as per scenario 1.

It is assumed that two new products – the iWatch and the iTV – are introduced with relative success. The iWatch is introduced in 2014 and sells 7 million units in its first year with steady annual grow, reaching over 30 million by 2020. Average revenue of $200 for the iWatch is assumed with a gross margin of 30% falling by 1% a year thereafter. The iTV is also introduced in 2014 reaching 5 million sales in its first year. It grows steadily to just under 30 million units by 2020. The average revenue starts at $2,000 and falls by 2% annually. The gross margin starts at 30% and falls by 1% a year until it reaches 25%. Based upon an approximate global market of 250 units annually (and 2% annual growth), Apple reaches a 10% market share by 2019 and retains it thereafter.

This scenario also assumes a new unknown product is launched in 2018 – $500 unit price, 35% gross margin, 6 million sales in first year growing to 24 million by 2022.

Overall revenue oscillates from 2014 to 2022 in a range between $150 billion to $160 billion – with a peak of $164 billion in 2019. Gross margins fall from 41% in 2013 to 34% by 2019 & thereafter. Diluted EPS of above $42 in 2013 fall steadily to $25 by 2022.

(click to enlarge)AAPL Matures Gracefully Projections Forecasts

Scenario 3 – Apple Keeps on Rockin’

This scenario assumes the iPhone sales peak in 2017 at just over 180 million units and decreases gently thereafter to 140 million by 2022. This represents a peak market share of 18% in 2012 to a steady 10%-9% by 2018 and thereafter (assuming 3% average annual mobile market growth and 70% Smartphone share by 2017). Average revenue and gross margin drops as per scenario 1. Revenues peak at $91 billion in 2013 falling to over $70 billion by 2021.

iPad sales are assumed to peak in 2017 at 94 million units falling steadily to 70 million by 2022. Revenue per unit as per scenario 2 with gross margins constant at 30%.

Mac products as per scenario 1 with a steeper fall to approximately 7 million units by 2020 (given the strength of other products assumed move to hand held devices more extreme for PCs & laptops.

It is assumed that two new products – the iWatch and the iTV – are introduced with good success. The iWatch is introduced in 2014 and sells 10 million units in its first year with steady annual grow, reaching over 60 million by 2020. Average revenue of $200 for the iWatch is assumed with a gross margin of 30% falling by 1% a year thereafter. The iTV is also introduced in 2014 reaching 7.5 million sales in its first year. It grows steadily to just under 40 million units by 2019. The average revenue starts at $2,000 and falls by 2% annually. The gross margin remains at a very solid 40% throughout. Based upon an approximate global market of 250 units annually (and assuming 3% growth), Apple reaches a 14% market share by 2019 and retains it thereafter.

This scenario also assumes a new unknown product is launched in 2018 – $500 unit price, 35% gross margin, 10 million sales in first year growing to 40 million by 2022.

Overall revenue grows to $207 billion by 2017 before dropping back to $190 billion by 2022. Gross margins remain strong at 42% for 2013, 41% in 2014, 40% for 2015 to 2018, and 39% thereafter. Diluted EPS range between $40 to $43 from 2013 to 2022.

(click to enlarge)AAPL Keeps on rockin Projections Forecasts

Valuation & Projections

Cash-flows are projected over 10 years for 2013 to 2022 with a termination multiple applied to the discounted 2022 cash-flow. In any cash flow analysis, two key inputs are the discount rate and the termination value. The discount rate is normally tied to the weighted average cost of capital of a company. However, given the current reality detached risk premia in capital markets, I have simply used a variety of rates from 2.5% to 10%. For a company like Apple, given the rapidly changing nature of its market, my instinct says a rate higher than 5% and below 10% is a suitable range for Apple. Similarly, I have simply selected termination multiples based upon the characteristics of each scenario and what I believe is sensible. The results of the discounted cash flow analysis are below (click items to enlarge).Apple valuation projections & scenarios April 2013

Apple graph valuation analysis April 2013

Conclusion

As stated above, the purpose of this analysis is to get a range of possible
valuations for Apple. I like to focus on downside and somewhere around a 30%
downside looks realistic here from $400 per share. One thing is clear, that as Apple enters a phase of reduced growth compared to recent years, the stock price will be volatile. The jitters concerning the Q2 results is simply a symptom of the market trying to figure out the new trajectory for Apple. If Q2 results show a gross margin below 40% and revenues just around expected, I can see the stock price dropping further. Until there is some visibility into the new product line, gross margins and average product revenue, I don’t expect to see any massive upside in AAPL (assuming the market doesn’t go off on one). That visibility is not likely until the latter half of 2013. My initial focus is on the upside and downside dynamics using the 7.5% discount rate which also suggests that there is no need for urgency in jumping into AAPL now. I am tempted to put a small position, between 10%-20% of my possible overall allocation, to average into any position although the analysis herein suggest that many of the current issues surrounding AAPL will remain unanswered come Wednesday.

Does financial innovation always end in reduced risk premia?

Quarterly reports from Willis Re and Aon Benfield highlight the impact on US catastrophe pricing from the new capital flowing into the insurance sector through insurance linked securities (ILS) and collaterised covers. Aon Benfield stated that “clients renewing significant capacity in the ILS market saw their risk adjusted pricing decrease by 25 to 70 percent for peak U.S. hurricane and earthquake exposed transactions” and that “if the financial management of severe catastrophe outcomes can be attained at multiple year terms well inside the cost of equity capital, then at the extreme, primary property growth in active zones could resume for companies previously restricting supply”.

This represents a worrying shift in the sector. Previously, ILS capacity was provided at rates at least equal to and often higher than that offered by the traditional market. The rationale for a higher price made sense as the cover provided was fully collaterized and offered insurers large slices of non-concentrated capacity on higher layers in their reinsurance programmes. The source of the shift is significant new capacity being provided by yield seeking investors lured in by uncorrelated returns. The Economist’s Buttonwood had an article recently entitled “Desperately seeking yield” highlighting that spreads on US investment grade corporate bonds have halved in the past 5 years to about 300bps currently. Buttonwood’s article included Bill Gross’s comment that “corporate credit and high-yield bonds are somewhat exuberantly and irrationally priced”. As a result, money managers are searching for asset classes with higher yields and, by magic, ILS offers a non-correlating asset class with superior yield.  Returns as per those from Eurekahedge on the artemis.bm website in the exhibit below highlight the attraction.

ILS Returns EurekahedgeSuch returns have been achieved on a limited capacity base with rationale CAT risk pricing. The influx of new capital means a larger base, now estimated at $35 billion of capacity up from approximately $5 billion in 2005, which is contributing to the downward risk pricing pressures under way. The impact is particularly been felt in US CAT risks as these are the exposures offering the highest rate on lines (ROL) globally and essential risks for any new ILS fund to own if returns in excess of 500 bps are to be achieved. The short term beneficiaries of the new capacity are firms like Citizens and Allstate who are getting collaterised cover at a reduced risk premium.

The irony in this situation is that these same money managers have in recent years shunned traditional wholesale insurers, including professional CAT focussed firms such as Montpelier Re, which traded at or below tangible book value. The increase in ILS capacity and the resulting reduction of risk premia will have a destabilising impact upon the risk diversification and therefore the risk profile of traditional insurers. Money managers, particularly pension funds, may have to pay for this new higher yielding uncorrelated asset class by taking a hit on their insurance equities down the road!

Financial innovation, yet again, may not result in an increase in the size of the pie, as originally envisaged, but rather mean more people chasing a smaller “mispriced” pie. Sound familiar? When thinking of the vast under-pricing of risk that the theoretical maths driven securitisation innovations led to in the mortgage market, the wise words of the Buffet come to mind – “If you have bad mortgages….they do not become better by repackaging them”. Hopefully the insurance sector will avoid those mistakes!

To Apple, or not to Apple (AAPL)

My household may be somewhat unusual in that we do not own any Apple products. It’s not that we do not understand the attraction; we have family and friends that are Apple fanatics. It has more being a case of not wanting to get sucked into the Apple eco-system and the contrarian in me going against the hype (plus no teenagers in the house!). We have laptops, smart-phones, MP3 players – you name it – all excellent products with brand names across the spectrum but no Apple.

That said, the recent drop in Apple’s share price has got my attention. I recently asked a friend who manages a fund whether Apple was worth considering. An Apple bear, he said that no electronics consumer firm could maintain operating margins in excess of 20% for ever and that Apple’s time had come. Although that made sense to me, Apple is hardly any consumer electronics company. I decided Apple was worth a closer look.

The first thing to highlight is that given Apple is the most analysed company in the world, this post may seem naive to many who are familiar with the company. Monthly sales, component orders, consumer surveys and the like are all analysed by legions of analysts and commentators prior to each quarter’s results. This post simply illustrates what I saw when I had a little dig around into AAPL’s historical results and is likely all old news to AAPL followers. As the graph below shows, a quick look at the past 10 years shows just what an impressive story AAPL has been. Impressive may become an overused word in this post!

From net margins of 1% in 2003, AAPL had an incredible net margin of 27% in 2012 with gross margins over 40%.  Revenues grew from $6.2B in 2003 to $156.5B in 2012. The P/E ratio, using market values in early November (AAPL’s year end is end September) & the trailing annual EPS, which have been adjusted for AAPL’s cash & liquid assets (at approx $110 per share at year end 2012) has decreased from 60 in 2003 to just below 10, at 9.88, for 2012 (a figure not seen since the depths of the financial crisis). To say that AAPL’s balance sheet is a fortress with net assets consistently over 60% of total assets is an understatement!

AAPL 2003 to 2004 Revenue & Net Income

Switching over to the quarterly results from Q1 2009 to Q1 2013, AAPL’s revenue by region (and retail unit) are in the graph below. Its strength in the Americas, Europe and China (as of Q1 2013, its 2nd largest market) can be clearly seen. What is also interesting is that the operating margins across each region, with the exception of the retail unit at 25%, are all over 40% for the 2012 year (with Japan at an astonishing 56%!). It will be interesting to see the exact China margins in future AAPL reports although the 2012 figures suggest that AAPL is maintaining pricing discipline in each of its major markets.

One of the reasons for the drop in AAPL’s share price is the uncertainty over its next block buster product. The iPod was introduced in 2001, the iTunes store in 2003, the Apple retail store in 2004, the iPhone in 2007 and the iPad in 2010.  Fierce competition in the smartphone market from players such as Samsung has led to commentators fretting over Apple’s next move. The graph below, showing revenue by major product line, shows the importance of the iPhone to Apple.

Revenue Split by Product 2009 to Q1 2013

The graph below of average revenue by product also shows how the iPad is under pressure, with the introduction of the iPad mini likely to continue the trend. The relative consistency from the other main products should be highlighted as yet another strength.

AAPL Average Revenue by Product 2009 to Q12013

Recent concerns about AAPL include the lack of success of the iPhone 5, the price declines in the iPad range, and the possibility of new launches later in 2013 of a low cost iPhone impacting average revenues of their core product. Speculation about a 2013 launch 0f the iWatch (with a retail price around $220) or the long awaited iTV keeps the hope of a new blockbuster product. Other press reports speculate on what Apple’ recent hiring of robotic expertise could mean and on the next steps in its ongoing battle with Samsung as both a supplier and a competitor. Some reports even conclude that Apple has lost its cool amongst the younger generation and is now a brand associated with thirty somethings and above. Blasphemy to any self respecting Apple worshipper!

All of these concerns have led to AAPL’s current valuation. The graph below shows the quarterly PE ratio from Q4 2009 to Q1 2013 (Q2 2013 on the graph represents the position as at the 2nd of April). The market values are taken a month after quarter end (i.e. after quarterly results) with the cash value deducted. The blue line shows the trailing four quarters EPS whereas the red line shows the current quarter and the following 3 quarters (for Q2 to Q4 2013, I have used average analysts estimates). The graph illustrates how much the market is worried about future growth at Apple with both metrics for Q1 2013 in a 8.0 to 8.30 range. My estimates as of end Q2 2013 (assuming EPS of 10.15, 9.38 and 9.0 for Q2 to Q4) put that multiple around 7.0 (that’s even below the relative valuation seen at the depths of the financial crisis!).

AAPL Valuation Multiples April 2013

So, in conclusion, is Apple undervalued? I don’t know because I don’t know if Apple has peaked. But I do know that this incredible company is at an attractive valuation if the concerns about it’s future growth path can be addressed. I will play with some projections and give the issue further thought (and hopefully post any enlightenments!). One thing is certain though, AAPL trades on current sentiment rather than on its incredible history. My gut tells me that they deserve much more respect than they are currently getting.