Is Apple a Buy?

By Adam J. Crawford

When the market turns against a stock, watch out. Just ask Apple investors. From its peak just seven months ago, Apple is down over 40%. That's an incredible move for a company of Apple's size.

Several factors have contributed to the decline, including: management departures, low-cost competition, and concerns that Apple's well of innovation may have run dry with the loss of Steve Jobs.

Each of these factors is cause for concern. However, healthy skepticism can quickly give way to a herd mentality, causing an overreaction in share price. Could that be what we're seeing with Apple?

To find out, we decided to take a look at the prospects for each of Apple's major business segments.

Smartphones

Worldwide shipments of smartphones topped 700 million units in 2012, according to tech research firm IDC, an increase of 46% over 2011. Torrid growth is expected to continue; in 2013, IDC expects a 27% increase in smartphone shipments and another 17% in 2014, lifting sales to over 1 billion units annually.

Analysts look for Apple's smartphone growth to stay pretty much in lockstep with the market: fiscal year 2013 iPhone shipments are estimated to increase by about 25% (from 125 million to 156 million units), while a 19% increase is foreseen for FY 2014 (from 156 million to 185 million units).

These estimates look very achievable and possibly even conservative. Here's why:

• Introduction of a low-cost phone. In the US, Apple depends heavily upon a carrier-subsidized business model. Under this model, Verizon, AT&T, and other telecoms buy iPhones from Apple, then resell them to consumers well below their costs. In exchange for the discount received on the phone, the consumer signs a long-term contract (typically two years) with the carrier.
  
  In many regions outside the US, the subsidy model is not utilized. In order to penetrate the market in those regions, Apple needs a low-cost phone. Speculation has it that such a phone is on the way and will be introduced sometime around mid-year.
  
  In addition to driving growth internationally, an iPhone in the $300-$400 price range should help Apple capture share with non-contract (known as prepaid) US carriers.

• Refresh of iPhone 5. The iPhone 5 is due for a refresh. One is expected at mid-year, about the same time as the low-cost phone introduction. If that's the case, it will be just in time for the upgrade cycle, as iPhone 4 customers who bought phones in the fall of 2011 will be coming off their two-year contracts and looking for new subsidized phones.
  
  It's a safe bet that most of these customers will stick with Apple. A recent survey from Morgan Stanley and AlphaWise found that Apple leads the smartphone industry in customer retention. Among those surveyed, 83% of iPhone users said they plan to buy another iPhone.

• Addition of carriers. Currently, Apple has relationships with and supplies about 250 carriers in over 100 countries. However, there is significant potential for growth with telecoms that do not have relationships with Apple. China Mobile - China's largest telecom with over 700 million subscribers - is a prominent example.
  
  We've concluded that adding carriers in emerging markets could provide Apple with an incremental 60 million units of iPhone sales annually. However, carrier expansion will likely be pushed out toward the back half of 2013 and into 2014.

In the following calculation of gross profit for Apple's iPhone segment for 2014, we have assumed a unit volume of 185 million. We've also modeled the impact that a low-cost phone will have on average sales price and gross margins.

Tablets

The tablet computer - a cross between a laptop, a smartphone, and a personal digital assistant - is not a new concept. Computer scientist Alan Kay began advancing ideas about component miniaturization, touchscreens, and WiFi technology way back in 1968. However, not until 2010 did any version of the tablet meet with meaningful commercial success. That's the year that Apple launched the iPad. On launch day, 300,000 iPads were sold. Over the next year, more than 15 million were sold. The era of the tablet had arrived.

Why did it take so long? Well, there were some attendant and powerful circumstances that prevailed in 2010 that either did not exist or were not sufficiently mature during earlier attempts to market tablets. Though inferior to the PC for content creation, the tablet is ideal for content consumption. Thanks to the advent of the Internet and WiFi and the spawning of thousands of apps, there is now a lot of content to consume. In addition, battery life has been extended from three hours on early versions of the tablet to over 12 hours on some current models, making these devices more portable and, therefore, more appealing to consumers.

Those circumstances have driven astonishing adoption rates every year since 2010. In fact, the market for tablets has ramped up faster than any technology in history.

(Click on image to enlarge)

This is not a fad. Rather, it is structural and will prevail for many years. Technology research firm IDC estimates that tablet shipments will reach 191 million units in 2013 and grow at a compounded annual rate of 16.6% for four years thereafter.

Upon reinventing the tablet category in 2010, Apple dominated the market with a whopping 70% share. Since then, several formidable competitors have entered the fray, including Samsung, Amazon, and Microsoft. For the fourth quarter of 2012, Apple's share had dropped to 46%, owing to the increased number of competitors and to Apple's unwillingness to participate in a race to the bottom on pricing. IDC estimates that by 2017, the company's share will drop to 43.5%. Conservatively, we have built our projections on the assumption that its share will be 40% for next fiscal year (September 2014).

For fiscal year 2012, the average sale price of an iPad was about $531. However, in November 2012, Apple released the iPad Mini with a retail price of $329. Estimates are that the Mini will comprise 40% of total iPad sales. We estimate that that will lower the average sale price to about $450.

Gross margin on iPads was 42.7% during fiscal year 2012, but the shift in sales mix to the Mini will put downward pressure on those margins. We estimate margins will fall to 38% for tablets in 2013 and stabilize at that level for 2014.

Putting this all together, here is our projection for tablets down to the gross profit line for 2014:

Personal Computers

Much has been written in recent years about the decline in sales of personal computers (desktops and notebooks). As we all know by now, mobile computing devices are the cause. As consumers shift their time away from their PC to tablets and smartphones, they no longer see their PC as a device that they need to replace on a regular basis.

According to Gartner, PC shipments peaked in 2011 at 364 million units, a 3.7% increase over the prior year. In 2012, year-over-year shipments decreased by 6.3%, and the slide is expected to continue in 2013 and 2014, with decreases of 7.6% and 4.1% respectively.

However, Apple's Mac division has experienced no such letdown; unit sales of Apple personal computers actually increased by 9% for the 2012 fiscal year.

We think Apple is defying the PC trend for two main reasons:

1. Apple serves the high end of the PC market. Because these high-end users are content creators, they are less likely to abandon the Mac for a tablet.

2. High customer satisfaction around other Apple products (iPods, iPhones, and iPads) creates a halo effect, which drives customers to Macs when they are ready to buy a PC.

For these reasons, we think Apple's Mac sales will continue to resist the overall trend, and at worst, remain flat for the next 18 months. We also foresee little change in average sales price and margins. Here's our resulting forecast for the PC segment:

Putting It All Together

In the table below, we aggregate the information for the segments we discussed above. We add in the combined revenues from the iPod, iTunes, and accessories segments with the assumption that the iPod segment will decline at a 25% annual rate, while iTunes and accessories will increase at about a 12% annual rate. And finally, we assume that operating expenses and income taxes, consistent with the last two years, will be 8.5% of sales and 25% of pre-tax profits, respectively.

The case presented above yielded earnings per share of $50.32 for fiscal year 2014.

Currently, Apple's share price multiple is about 10 times, well below the current market multiple of 18. This may seem too low; however, we think this is a good number to apply to our estimate. Multiples are usually a reflection of anticipated growth. Because Apple faces the law of large numbers, the market is apt to be perpetually nervous about its ability to grow, and therefore will continue to assign it a low earnings multiple.

Nevertheless, 10 times our earnings estimate would result in a share price of $503, a return of about 25% in 18 months. This is by no means a spectacular return, but it is based on conservative projections. So it is, in our view, very achievable.

What Will Move Apple

Just as a stationary ball needs a push to provide it initial momentum, the undervalued stock needs a catalyst to fuel its price move.

With Apple, there are a handful of short-term catalysts that could send the stock higher. The ones that immediately come to mind are:

• The successful launch of a new product - such as the long-rumored smart TV and/or the iWatch - that catches fire in the marketplace.
• A deal to distribute iPhones with China Mobile, China's largest mobile network provider with over 700 million subscribers.
• A sizable dividend hike and/or a sizable share buyback.

On the flip side, a disappointing earnings report could send shares lower. But that's probably baked into the cake. And besides, CEO Tim Cook will probably have some good news in his hip pocket (i.e., a big dividend hike) if he thinks earnings will disappoint.

Of course, there's always the possibility of a major market correction. If that happens, almost every stock will get hit. But since Apple is down big over the last few months, it will probably withstand a downturn better than most.

Long story short, Apple possesses the characteristics we look for in a stock. Given its future earnings prospects, it looks undervalued, and it has multiple short-term catalysts. For these reasons, it looks like a decent buy at current levels.