What company is almost 40 years old, was worth only $3 billion in 1997, only to see its value grow to beyond $10 billion in 2003 pushing through the dot-com bubble barely scathed? What company then went on to blow past all market expectations over the next decade to become one of the most successful and valuable companies in the world expanding their market value to $646 billion, that is about 1.5-times more valuable than key rival Google Inc (GOOG, Financial)(GOOGL, Financial).
Unless you’ve been living on a deserted island somewhere, it won’t come as a surprise that that company is Apple Inc. (AAPL, Financial). Apple designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications through online and retail stores as well as through itunes. The company’s flagship products and services that have won consumers minds’ as “BEST CHOICE” include the iPhone, iPad, Mac, Apple Watch, and iPod.
Apple also produces Apple TV, a portfolio of consumer and professional software applications, the iOS and OS X operating systems, iCloud, Apple Pay and a variety of accessory, service and support offerings, each which represent important and growing revenue streams for the company. The company sells and delivers digital content and applications to consumers through the iTunes Store, App Store, iBooks Store and Mac App Store. The company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the company sells a variety of third-party iPhone, iPad, Mac and iPod compatible products, including application software, and various accessories, through its online and retail stores. The company’s primary customer base includes household consumers, small and mid-sized businesses and education, enterprise and government customers.
Financial highlights
Apple’s stellar performance continues. AAPL's net sales rose 33% or $12.2 billion during the third quarter of 2015 compared to the same quarter in 2014. Net sales and unit sales increased for iPhone and Mac due to continued strong demand for iPhone 6 and 6 Plus and for Mac portables following the launches of the new MacBook and updated models of MacBook Pro. Net sales were also supported by new sales of Apple watches, licensing revenues and sales of apps. Net sales growth was partially offset by lower net sales and unit sales of iPad and the effect of weakness in most foreign currencies relative to the U.S. dollar. Also, while net sales increased within all operating regions, growth was particularly strong in China (112% year over year).
Gross margins continued to strengthen in Q3 (39.7%) compared to the same period in 2014 (39.4%) driven primarily by a favorable shift in mix to products with higher margins partially offset by higher product cost structures and, to a lesser extent, the effect of weakness in most foreign currencies relative to the U.S. dollar.
Operating costs grew a bit excessively over the last nine months due to an increased head count and related expenses, including share-based compensation costs and higher spending on marketing and advertising. The market expects earnings per share of $9.12 in 2015 and $9.76 in 2016. The company utilized $10.0 billion to repurchase shares of its common stock and paid dividends and dividend equivalents of $3.1 billion during the third quarter of 2015.
Purchase considerations and reasons for caution
Currently, it is hard to imagine a tech landscape that isn’t dominated by Apple, as it has without question the most recognizable, sought after and lucrative cellular and computer brands in the world. It also has one of the most loyal consumer groups among any we have ever seen. Over Apple’s lifetime, it has learned how to walk to the top, fall, and leap back to the top of the tech mountain and, learning from its past mistakes, now knows what it needs to do to remain at the top of the mountain –Â create more and more value, innovate, achieve marketing excellence. That is why it remains targeted on delivering a fairly narrow product/service line, always tries to build in substantial switching costs, and always focuses its efforts on simplifying and optimizing user experiences. Apple has executed so flawlessly in most areas that 90% of consumers that adopt an apple computer or cell phone are uncomfortable with the idea of switching to a competitor’s product. That being said, over the last couple of years the company has had fewer new product ideas come to market and it remains to be seen if the upward momentum in new product/service launches can be maintained.
However, even without revolutionary new product/service launches, you cannot undervalue the switching costs that Apple has built into its product lines, and it looks like a formula for success that will continue to pay dividends moving forward.
Apple’s stock recently touched $134 in May 2015, which is high but not unreasonable given an implied P/E multiple of 13 to 15 with growth projected at around 7%. Not to mention growing margins, operating earnings, free cash-flows and so forth. The company’s cash hoard has grown to almost $35 billion, or about $6 per share, and it has started paying dividends at $1.8 per share and is committed to buying back stock.
Being the biggest and best company, however, coupled with the rapid growth in the company’s stock price over the last decade means that the company cannot trip, or else. If it does, its stock price is likely to be crushed by the market, and this is a good reason to take caution. Any signs that the company sales or earnings are going to grow at a slower clip than that achieved historically, watch out!
Fair value estimation
A company’s fair value estimate can be calculated as the present value of expected future free cash-flows to equity. Free cash-flows to equity represent the amount of cash-flows available to common stockholders after all operating expenses, interest and principal payments to lenders have been paid and necessary investments in capital equipment and working capital have been made to maintain and grow operations.
Here we estimate fair value in five steps:
- we forecast the firm’s free-cash flows to equity for the next 10 years using econometric processes;
- we discount those cash-flows to the present;
- calculate a terminal value for the firm 10 years out based on a long-term expected growth rate and terminal discount rate and discount it to the present;
- add the discounted terminal value to the discounted value of free-cash flows to equity over the next 10 years; and
- divide the present value of all cash-flows by the diluted number of shares outstanding.
Figure 1 presents our free-cash flow estimates. Figure 2 presents valuation results and Monte Carlo Simulation results.
Figure 1: Free Cash-Flow to Equity Projections
Figure 2: Fair-Value Estimation and Monte Carlo Simulation
AAPL’s per share earnings in 2014 were $6.45. Historical earnings per share grew at an annual rate of approximately 45% per year since 2005. AAPL’s sales per share in 2014 were $29.86. We project that sales will grow at a blended rate of about 4% per year between 2015 and 2024. We expect stable operating and net margins. Interest expenses will remain minor. Capital expenditures will remain at recent historical levels in the amount of approximately 5% of sales. Our fair value estimate of AAPL equals $148.83. At a current price of $122.99, this suggest that AAPL is underpriced by about 21%. Also, based on a pure Monte Carlo Simulation, there is a 99% probability that the company's true underlying fair value exceeds the current market price.
Conclusion
The big question everyone has is “What’s Next?” First Apple stormed the market with the ipod, then it was the iphone, then it was the ipad. With virtually every product it launched it gained almost instant market dominance. Without any other major new innovations in the pipeline –Â from what we know –Â how can Apple continue to repeat its past success? Or are we slated to see nothing more moving forward other than refinements and tinkerings of its existing products with a greater emphasis on cost cutting reductions to support earnings growth. We think that successful innovation will continue and that growth will come both from greater absorption rates in Europe, Latin America and Asia as well as through entry into new product markets. In particular, while take-up hasn’t quite been there with Apple TV, Apple Pay or Apple Watch, we do think that Apple TV and Apple Pay have enormous potential and, if traction builds and it is able to redefine tv streaming and payment processing the way it redefined audio listening, the market better watch out.
