Apple Is An Outstanding Company At A Reasonable Price

2012 was an extraordinary year for Apple (AAPL, Financial) so 2013 comparisons are difficult. Margins were very high compared to most public companies - they had room to drop. Per the April 23rd Earnings Call, the worldwide smartphone market will double by 2016. The tablet market will grow even faster. It is not a zero sum game between Apple and Samsung - a company can lose market share and still grow. Apple is an outstanding company known for making quality products. Consumers remain very loyal once they join the Apple ecosystem.


Apple is an outstanding company and the April 23, 2013 Earnings Call showed that they are also smart about capital allocation. Announcing 60b worth of buybacks when the stock is near 52 week lows creates value for shareholders. Many other companies choose to do the opposite - announcing buybacks near 52 week highs.


The 10-Q and 10-K sec filings are the primary source for this article - especially when it comes to the graphs.


Apple's CEO Discusses F2Q13 Results - Earnings Call Transcript from Seeking Alpha is another key source.


Buybacks


Quiz: What should long-term shareholders want Apple's stock price to do in the short run?


Sure, human nature is to try to buy the stock near the bottom and hope it goes up quickly so one can immediately brag about it. However, if we're going to be long term owners of this company then we want to be patient. We want the company to buy back shares while they're not too expensive.


Apple recently announced stock buybacks of 60b between now and 2015. Long-term shareholders should think twice about whether they want the stock price to go up or down while this happens. Warren Buffett does a nice job explaining a similar situation at IBM in his 2011 letter to shareholders.

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Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?


I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years.


Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.


If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the "disappointing" scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1 1â„2 billion more than if the "high-price" repurchase scenario had taken place.


The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.


Charlie and I don't expect to win many of you over to our way of thinking - we've observed enough human behavior to know the futility of that - but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham's The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.


In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity.

Margins


Analysts keep talking about falling margins at Apple. The latest quarter came in with a gross margin of 37.5 which was at the low end of Apple's guidance. Still, Apple's gross margins and net profit margins are consistently higher than competitors like Samsung. Samsung makes commodity type products like televisions so they continually have a harder time with margins. Many other companies would be happy to have margins like Apple's.


During the April 23rd 2013 Q2 Earnings Call, Tim Cook and Peter Oppenheimer said margins are only part of the big picture. Margins by product line aren't disclosed but it is well known that products like ipods and ipad minis have lower margins. Still, Apple is happy to include them in the mix - they bring new people into the Apple ecosystem.


2008 to 2012 Gross Margins & Net Profit Margins




Graph Sources:

AAPL Financials

SSNLF Financials


AAPL Gross Margin

2008: 34.3

2009: 40.1

2010: 39.4

2011: 40.5

2012: 43.9


AAPL Net Margin

2008: 14.9

2009: 19.2

2010: 21.5

2011: 23.9

2012: 26.7


SSNLF Gross Margin

2008: 24.1

2009: 23.8

2010: 30.5

2011: 25.2

2012: 29.6


SSNLF Net Margin

2008: 7.6

2009: 10.7

2010: 11.8

2011: 8.3

2012: 12.3


Here is what Peter Oppenheimer said about margins during the April 23rd Earnings Call:

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So while we don't want to make a forecast beyond June, let me tell you how we think about gross margin and hopefully this will help. We are managing the business for the long-term and are willing to trade off short-term profit where we see long-term potential. The iPod is a great example of this. When we launched it in 2001, its margins were significantly below the margins of Apple at that time.


Four years later, the iPod and the iTunes Music Store comprised half of Apple's revenues and inspired us to build the iPhone. The iPad mini is another great example. We have priced it aggressively and its margins are significantly below the corporate average. However, we believe deeply in the long-term potential of the tablet market and think that we've made a great strategic decision. We'll only make great products and this precludes us from making cheap products that don't deliver a great experience.


We believe deeply that there are people in every part of the world that want great products. Looking back over the last several years, we've made very good business decisions balancing units, revenues, and the bottom line. We think about all three and as I said, we're willing to make short-term trade-offs and profits, where we see long-term potential.


And we're managing Apple with a very long-term horizon. Some of our revenues and profits occur after we ship our products. We were thrilled to exceed this quarter $4 billion in revenue for our services for the first time. And as Tim mentioned, we will augment our very strong ecosystem with new services and make the current ones even, even better. So we remain very confident in our strategy and we will use our world-class skills in engineering and operations to manage our business well in the future.

Six Months Net Sales by Product


Apple doesn't provide operating income nor margins by product. However, they do provide net sales. We're in the middle of the fiscal year so we'll look at net sales for the first six months of each fiscal year from 2010 to 2013.


2010 Six Months Sales (in millions $)



2011 Six Months Sales (in millions $)



2012 Six Months Sales (in millions $)



2013 Six Months Sales (in millions $)



Source Data from 10-Q filings


2010

iPhone: 11,023

iPad: 0

Mac: 8,210

iPod: 5,252

iTunes/Other: 3,756 (Other Music: 2,491 + Software: 1,265)

Peripherals: 941

Total: 29,182


2011

iPhone: 22,766

iPad: 7,444

Mac: 10,406

iPod: 5,025

iTunes/Other 4,594 (Other Music: 3,065 + Software: 1,529)

Peripherals: 1,173

Total: 51,408


2012

iPhone: 46,226

iPad: 15,033

Mac: 11,671

iPod: 3,735

iTunes, Software & Services: 6,191

Accessories: 2,663

Total: 85,519


2013

iPhone: 53,615

iPad: 19,420

Mac: 10,966

iPod: 3,105

iTunes, Software & Services: 7,801

Accessories: 3,208

Total: 98,115


*Used 2013 filing for 2012 numbers.


Analysts sometimes panic when iPod sales drop or when Mac sales drop. The pie charts look a little more stable when we group the iPod and iPhone slices together (people listen to music on their phones). This combination is typically more than half the pie. I also like to look at iPads and Macs together. Combined, they typically make up about 1/4th to 1/3rd of the pie.


Operating Income


Operating Income by Geographic Segment (in millions $)



*These segment operating income numbers exclude share-based compensation expense and other corporate expenses.


Americas

2010

Q1: 1,811

Q2: 1,674

Q3: 1,997

Q4: 2,108 (7,590 - 5,482)

2011

Q1: 2,899

Q2: 3,755

Q3: 3,596

Q4: 3,288 (13,538 - 10,250)

2012

Q1: 7,233

Q2: 5,688

Q3: 5,202

Q4: 5,664 (23,733 - 18,069)

2013

Q1: 7,349

Q2: 5,148


Europe

2010

Q1: 2,165

Q2: 1,661

Q3: 1,631

Q4: 2,067 (7,524 - 5,457)

2011

Q1: 2,756

Q2: 2,551

Q3: 3,107

Q4: 3,114 (11,528 - 8,414)

2012

Q1: 4,663

Q2: 3,942

Q3: 3,261

Q4: 3,199 (15,015 - 11,816)

2013

Q1: 4,409

Q2: 3,449


Japan

2010

Q1: 354

Q2: 441

Q3: 390

Q4: 661 (1,846 - 1,185)

2011

Q1: 572

Q2: 689

Q3: 735

Q4: 485 (2,481 - 1,996)

2012

Q1: 1,989

Q2: 1,543

Q3: 1,073

Q4: 1,318 (5,915 - 4,597)

2013

Q1: 2,260

Q2: 1,555


Asia-Pacific & China

2010

Q1: 820

Q2: 892

Q3: 841

Q4: 1,094 (3,647 - 2,553)

2011

Q1: 2,042

Q2: 2,045

Q3: 2,782

Q4: 2,718 (9,587 - 6,869)

2012

Q1: 3,299 (1,706 + 1,593)

Q2: 4,859 (3,781 + 1,078)

Q3: 3,374

Q4: 2,782 (14,234 - 11,452)

2013

Q1: 3,879 (2,544 + 1,335)

Q2: 3,821 (2,787 + 1,034)


Retail

2010

Q1: 481

Q2: 373

Q3: 593

Q4: 917 (2,364 - 1,447)

2011

Q1: 1,006

Q2: 782

Q3: 802

Q4: 652 (3,242 - 2,590)

2012

Q1: 1,851

Q2: 1,154

Q3: 868

Q4: 848 (4,719 - 3,871)

2013

Q1: 1,557

Q2: 1,092


*We used the 2011 Retail numbers from the 2012 filings.

*We used the 2012 Q1 and Q2 numbers from the 2013 Q1 and Q2 filings.


As you can see, Apple is a global company. For example, sometimes analysts seem to put too much focus on Apple's dependence on carrier subsidies in the US market.


Loyalty


KANTAR talks about Apple's Unshakeable Loyalty

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Apple has managed to reach near cult-level status with its keen following and it is this unshakeable loyalty which has driven the brand's consistent performance. When Apple releases a new device, around 80% of its existing customers in Britain will buy it.

Ecosystem


Unlike competitors, Apple is not fragmented. During the April 23rd, 2013 Earnings Call, Tim Cook said that payment processing is in its infancy. If Apple moves forward in this area or in other new areas like tv then their ecosystem and brand loyalty give them a huge advantage over competitors.


Security


CFO Peter Oppenheimer talked about security in the April 23rd Earnings Conference Call. Specifically, he cited mcafee.com saying 95% of mobile malware is on android. The Mobile Malware Growth Continuing in 2013 article from February 21, 2013 talks about this:

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The Android platform continues to make up the bulk of malware targets, representing 97% of total mobile malware.

Symantec's Volume 18 Internet Security Report from April 2013 also talks about the fact that most mobile malware is on android:

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Vulnerabilities likely will become a factor in mobile malware, but today Android's market share, the openness of the platform, and the multiple distribution methods available to applications embedded with malware make it the go-to platform of malware authors.

[page 5]


In contrast to vulnerabilities, Android was by far the most commonly targeted mobile platform in 2012, comprising 103 out of 108 unique threats.

[page 34]


In the last year, we have seen a further increase in mobile malware. This correlates with increasing numbers of Internetconnected mobile devices. Android has a 72 percent market share with Apple® iOS a distant second with 14 percent, according to Gartner.18 As a result of its market share and more open development environment, Android is the main target for mobile threats.

[page 37]

Usage


Chitika noted how they were cited in Apple's April 23rd Earnings Call:Apple CFO Cites Chitika Data on Earnings Call

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In one of the most highly anticipated earnings calls of 2013, Apple SVP and CFO Peter Oppenheimer cited Chitika Insights data, using stats from our most recent Tablet Market Share Study.


Oppenheimer stated, "And in the enterprise, iOS devices have a strong lead over Android. In its most recently published quarterly enterprise device activations report, good technologies found that iOS devices accounted for 77% of all activations by its corporate customers. And thanks to careful App Store curation for the quality of apps, the iOS platform offers a much more secure environment...But perhaps the most important measure of the success of our ecosystem is how engaged our customers are with our products and services. In its most recently published update, Chitika found that iPad accounted for 82% of all North American tablet-led traffic in March."


This further highlights the importance of data looking at web usage in addition to sales and shipment figures when determining success of a device on the market.

Phone Size


The market has spoken and consumers want the option of bigger phone sizes. Apple won't release a bigger version if it sacrifices things like battery life, brightness and resolution. Hopefully they'll work these issues out quickly and give consumers what they want.


Steve Jobs did a nice job limiting the amount of products Apple produced. Current management recognizes this fact and they will not release too many screen sizes if this diminishes quality in any way.


Here is a phone size question and answer from the April 23rd Earnings Call:

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Ben A. Reitzes - Barclays Capital, Inc.


All right, thanks. And Tim, my follow-up just for you, just maybe asking you this every quarter in different ways. But I just wanted to get your reaction to what you thought of the 5-inch phone market at this time versus three months ago? And if anything has changed in your view as to that market and its place in the smartphone world versus your 4-inch product? And that's it from me.


Tim Cook


Yeah Ben, that's a good question. My view continues to be that iPhone 5 has the absolute best display in the industry. And we always strive to create the very best display for our customers. And some customers value large screen size, others value also other factors such as resolution, color quality, white balance, brightness, reflectivity, screen longevity, power consumption, portability, compatibility with apps and many things.


Our competitors had made some significant trade-offs in many of these areas in order to ship a larger display, we would not ship a larger display iPhone while these trade-offs exist.

Brand


Interbrand's Best Global Brands 2012 report has Apple as the #2 brand in the world with a value of 76,568m.



A lot of cars have Apple stickers on them but one doesn't see many car stickers for competitors like Samsung.


Valuation


It is important to look at Apple's cash when talking about valuation. Per the April 23rd Earnings Call, Apple ended 2013 Q2 with 144.7b in cash plus short-term and long-term marketable securities. As of the close of trading on April 29, 2013, market cap was a little over 400b. This puts cash/securities at over 35% of the market cap! If interbrand.com is correct and the brand is worth over 75b then over half the market cap is made up of the brand and the cash/securities. The company had net income of 41,733b in 2012 so the p/e ratio is very low.


Conclusion


I always used to be a windows guy but my iPhone, iPad and Mac have changed the ways I see things. Apple makes great products and their consumers help sell more products by word of mouth. They take things like security seriously such that their consumers waste less time running things like anti virus software.


2012 was a phenomenal year so 2013 comparisons have a hard time measuring up. Still, this is an amazing company with more innovations yet to come and it is reasonably priced at this time.



Disclosure


I am long AAPL, IBM, BRK.A, BRK.B AND MSFT. I wrote this article myself, and it expresses my own opinions. Any material in this article should not be relied on as a formal investment recommendation.