Numerous top tier investors continue to hold Apple Inc. (AAPL, Financial) shares including Carl Icahn (Trades, Portfolio), David Einhorn (Trades, Portfolio), Bill Nygren (Trades, Portfolio), and David Tepper (Trades, Portfolio). With the shares trading at what I believe is a low valuation, I thought I would review some of the risks and reasons to own Apple.
Risks
There are a few things that bother me about Apple. First, consumer technology can be very fickle. Whether we are talking about Palm, Blackberry (BBRY, Financial), Motorola (MSI, Financial), etc. preferences change which can lead to large drops in revenue and profitability. Apple is different than most consumer technology companies, which I will explain later, but it is still an important risk of which to be aware.
Second, I went to Trefis to see how they break down the value of Apple. In its analysis 61.2% of the value of Apple is from the iPhone. That means that over half the value of the company comes from one product line. If people started moving away from the iPhone that would be devastating to Apple's results.
Next, how fast can Apple continue to grow when it is the largest company in the world with a market cap over $600 billion? The law of large numbers cannot be defied forever, and Apple's growth will slow and may even decline in the years ahead. Growing from such a large base will continue to become more difficult.
Also, there is likely to be more cyclicality now that Apple is growing more slowly. In the next downturn we will see how cyclical Apple has really become. Competition has also increased and there are several firms building quality smart phones and tablets and introducing wearables.
Finally, there are still questions regarding Apple's ability to replace Steve Jobs. It is impossible to replace Jobs, and that is not Tim Cook's job; Cook's job is to be Tim Cook, not Steve Jobs. Apple continues to produce great products, but can they develop the next big thing?
Apple makes great products
Apple makes very high quality stylish products that people want to buy. They build premium products at a premium price and generate premium margins. I think of Apple as a luxury product, even though the masses are still able to buy it. If you are going to spend that much money on a phone, notebook, or watch what are you going to buy, an Apple or something else? For a high percentage of the population the answer is Apple.
Furthermore, there are millions of diehard Apple fans, almost cultlike in some instances, who buy Apple no matter what. Look at how many people line up outside stores just to be one of the first to own the next Apple product. I expect Apple's new products to have similar quality.
The ecosystem
One way that Apple has tried to avoid the path of Motorola, Palm and Blackberry is to create an ecosystem. As of June there were 1.5 million total apps for Apple products. As of January there were 725,000 iPad apps and as of September there were already 10,000 Watch apps. Google has caught up and there are now has 1.6 million apps in the Google Play store as of July. However, apps are only a part of the ecosystem as Apple has iTunes, iCloud and Apple Pay to keep customers attached to their products.
There is also functionality between the iPhone, Mac and Watch. Add in HomeKit, HealthKit and CarPlay, and it is easy to see that Apple wants you to think of them as a body part; it is a part of who you are and you don't go anywhere without it.
Diversification
Apple is trying to create other products that would diversify its revenue stream somewhat. The products tie in together since they are all part of the Apple ecosystem but could provide protection against a poor iPhone product cycle.
While iPad sales have slowed, it is still a great product that generates about 4% of Apple's value according to Trefis. The Apple Watch has made a small impact and into the future there are likely to be more types of wearables, which could garner higher sales. The new and improved Apple TV could start to make an impact, but future iterations of Apple TV are more likely to generate noticeable revenue streams. Apple also has various other potential new products and services that they could offer in the future which will further diversify the revenue base.
Growth and valuation
The company continues to grow revenues and cash flow from operations despite its size. Although this will slow going forward, Apple is showing that it can still grow. Also, with a current price around $116 it is trading at about 10.6x the trailing 12 months (TTM) adjusted free cash flow (FCF) which I calculated as CFO less CAPEX less Stock Comp. Growth with a cheap multiple doesn't occur very often.
| Fiscal year ends in September. USD in millions. | 2010-09 | 2011-09 | 2012-09 | 2013-09 | 2014-09 | 2015-09 |
| Revenue | 65,225 | 108,249 | 156,508 | 170,910 | 182,795 | 233,715 |
| Revenue Growth | Â | 66.0% | 44.6% | 9.2% | 7.0% | 27.9% |
| Net Income | 14,013 | 25,922 | 41,733 | 37,037 | 39,510 | 53,394 |
| Net Income Growth | Â | 85.0% | 61.0% | -11.3% | 6.7% | 35.1% |
| Cash Flow from Operations | 18,595 | 37,529 | 50,856 | 53,666 | 59,713 | 81,266 |
| CFO Growth | Â | 101.8% | 35.5% | 5.5% | 11.3% | 36.1% |
| Stock based compensation | 879 | 1,168 | 1,740 | 2,253 | 2,863 | 3,586 |
| Investments in property, plant, and equipment | -2,005 | -4,260 | -8,295 | -8,165 | -9,571 | -11,247 |
| Purchases of intangibles | -116 | -3,192 | -1,107 | -911 | -242 | -241 |
| Free Cash Flow | 16,474 | 30,077 | 41,454 | 44,590 | 49,900 | 69,778 |
| Diluted Shares | 6,473 | 6,557 | 6,617 | 6,522 | 6,123 | 5,793 |
| Free Cash Flow/Share | 2.55 | 4.59 | 6.26 | 6.84 | 8.15 | 12.05 |
| FCF adjusted for Stock Comp | 15,595 | 28,909 | 39,714 | 42,337 | 47,037 | 66,192 |
| Basic Shares | 6,366 | 6,470 | 6,544 | 6,477 | 6,086 | 6,086 |
| Adjusted FCF/Basic Shares | 2.45 | 4.47 | 6.07 | 6.54 | 7.73 | 10.88 |
While Mac computer revenues are not growing quickly, they are growing. Macs are taking market share from Microsoft (MSFT, Financial) and sales grew 1.5% in Q3 2015 when the overall PC market declined. Year over year Mac market share in the U.S. increased from 6.9% to 7.6%.
Apple is trying to grow in enterprise and healthcare businesses as well. Its partnership with IBM (IBM, Financial) could lead it to garner more of the business market. IBM and Apple are developing over 100-plus apps and other industry specific solutions, reselling iPhones/Pads with these apps loaded and creating an enterprise focused AppleCare service for business. IBM Watson and Health Cloud are being used in conjunction with Apple's ResearchKit and HealthKit. They are also rewarding shareholders increasing their dividend from $0 in 2011 to 52 cents per quarter currently. This generates a dividend yield nearing 2%, and they repurchased more than $35 billion in stock in fiscal year 2015.
Conclusion
The risks for Apple are well known, and they have already been priced into Apple's valuation. An investor cannot ignore the risks as they are real threats, and these risks should impact the position size. However, this is a great company that is still growing and trades at a low valuation. It is rewarding shareholders, and several well-known investors still own shares in the company.
