Apple's Stock Is Still Worth Retaining

GuruFocus.com
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- By Daniel Seens

Apple (AAPL) continues to be one of the most interesting and challenging companies to analyze. Right now is no exception given the recent flop of the Samsung (005930.KS) 7 phone, the surprise success of the Google Pixel phone and what this means for future sales and earnings.

Professional analyst reports and commentary continue to highlight uncertainty around whether the company is charged for more growth or it has reached a point of satiation and is inevitably headed to become a mature boring tech company like IBM (IBM) or Intel (INTC).


At the end of the day, the question investors must ask themselves is: Would it be so bad if Apple continued its transformation toward becoming one the strongest cash generators the world has ever seen? Or is it more important for Apple to drain its reserves and continue to find new innovations and market defining products at any cost? If you take the view that cash generation is king, this company is stronger than ever.

Apple 's products have become and continue to maintain leadership positions in virtually all of its markets. The firm designs, manufactures and markets personal computers, tablet computers, portable music players, cell phones and related software, peripherals, downloadable content and services.

The company added the digital watch to its portfolio in mid-2015 and is seeing small signs of success. It sells its products through its own retail stores, online stores and third-party sellers. The company also sells digital content through its iTunes store and is becoming a big player in the "digital wallet" mobile payment market. Once the necessary critical mass is reached in this market, the sky is the limit.

Once considered luxury goods, the company's products are slowly becoming necessities. The iPhone, iPod, iPad and MacBook all represent the company's core hardware products. It also sells iTunes, QuickTime, OSX, and the emerging iCloud software-based products that contribute to the company's revenues. Who know's what products are next? An iCar perhaps? iAppliances maybe?

It's hard to foresee major shifts in the current consumer tech landscape, but we all know it happens, and when it does it usually happens quickly. Just witness what happened to BlackBerry (BBRY). Google represents the greatest threat to Apple 's dominance in the phone market as it has been making major inroads. If Apple loses its dominance in this market, it will be in big trouble. As it stands right now, however, Apple is without question the most profitable firm in the industry.

We have serious doubts the firm's growth momentum can be maintained in the absence of major new product innovations -- most recent product innovations are only marginal improvements. While the Apple Watch is showing some potential, without direct connectivity it'll remain largely a novelty product without much true value. Future growth will come from Apple Pay, Apple TV and iCloud services -- and of course whatever else might be waiting in the wings. That being said, the company has built up and continues to build up a huge amount of switching costs. We're not terribly concerned about possible innovative stagnation.

Purchase considerations and reasons for caution

Guess how much cash Apple has generated and returned to shareholders over the last five years? Over $200 billion. Yes you heard that correctly, over $200 billion. This is absolutely insane! We love this result. What we love more is Apple 's business model and marketing excellence. Apple's most well-known product, the iPhone, is becoming synonymous with the words cell phone. This is one incredible feat that 10 years ago no one would have thought possible. You might even be reading this article on one. Almost everyone I know has one (interestingly I'm still using a BlackBerry). They're everywhere!

So is the market saturated? That's difficult to say, but it is certainly looking this way in at least the North American market. Also, many people think that it is priced too high in emerging markets and that lower-priced clones and Android products will command market dominance. But the truth is, the iPhone is doing well, and shipments are continuing to grow.

That being said, Apple 's profitability and cash-flow story is the best in the industry (and just wait how much better Apple will look after Samsung takes its expected $5 billion charge to recall faulty phones). Yes, net profit margins will compress slightly as Apple competes with new products and tries to maintain its market share. Regardless, though, the company's products are far from becoming commoditized and should be able to earn positive residual income for many years to come. Apple is generous with its massive cash hoard and shareholders will continue to benefit.

We are not concerned about Apple's ability to innovate. We do think, however, that innovation will need to be directed out of the consumer market toward the business market in order to find new blockbuster products. Also, as long as it executes effectively, Apple Pay has the potential to be huge. We also foresee the potential for major integration of products and applications into cars and in the health-care space. And other household appliances, too, if you look further down the road. Breakthrough technologies in the TV space have been slow. This is one area where Apple has so far "dropped the ball." If done right, we still see some upside potential.

A major cautionary point is that phones will likely never be as profitable as they were in 2012. Also, the competition is getting better and better at replicating Apple 's user experience --namely through the Android platform. Google's hardware offerings are going to capture significant share in many major markets; it's only a matter of time. We are also concerned about competition and price erosion in the tablet space. Lastly, Apple 's stock price has already impounded most of its success and future opportunity -- fairly. You'll need to choose your entry points carefully.

Estimating sales growth

When assessing the competitive strength and investment merit of any firm, the first thing we like to do is to look at what's going on with sales -- that's really the first level of inquiry that any investor should undertake. Ideally, we are looking to invest in companies whose sales are strong, consistent and generally growing faster than Nominal GDP Growth (that is, Real GDP Growth and Inflation combined). Based on Apple 's historical sales data, you can see that things look pretty steady. The 10-year sales growth has been 33% a year. This compares to nominal GDP Growth of 3% per year over the same period, which is superb growth for any company.

Starting this year, Apple 's sales are forecast to pull back a bit due to intensified competition, industrywide price cutting and broad market saturation. That being said, it appears to be on solid footing, and you can invest in this company if you're looking for moderate but steady growth. Apple 's sales growth has been 29% per year over the last five years and 14% per year over the last three years. Apple 's three-year revenue growth is actually ranked higher than 89% of the 2,023 companies in the Global Consumer Electronics Industry.

Overall, we can see that Apple has an attractive revenue profile and has done a superb job of generating strong, stable and growing revenues. While sales growth is projected to slow significantly in the coming years, we continue to expect good things from this company.

Figure 1: Revenues ($ Millions) and Revenue Growth (%)

The second thing we like to do when assessing sales is to look at consensus market estimates. As reported in Yahoo Finance, the market is projecting -8% annual growth for this year and 5% for next year. These estimates are drawn from the projections of 39 analysts. The sales estimate is $214 billion for 2016, which compares to the year-ago estimate of $233 billion. Note that the company does not provide annual revenue guidance.

A third thing we like to do when assessing sales is to compute the firm's Sustainable Growth Rate. The sustainable growth rate reflects the rate of growth in sales that a firm can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a firm's sustainable growth rate is calculated by multiplying its Return on Equity (ROE) by its Retention Rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the firm's three-year average ROE and three-year average Retention Rate. Apple 's ROE averaged 37% over the last three years while its Retention Rate averaged 74%, giving the firm a sustainable growth rate of 27% per year.

Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next five years could grow at a rate of somewhere between -2% and 33%.

Table 1: Choices for Possible Growth Rates

We're going to select a rate of 1%. With $233.715 billion in sales generated last year, this means that sales will continue to grow in the future and will reach about $243.798 billion in five years. This estimate reflects our understanding of the firm's historical results, the intensity of competition within the industry, changes in buyer preferences and new product/service launches.

Estimating earnings per share

Now that we have generated our sales estimates, we're going to estimate growth in earnings per share. This method applied below takes the sales growth projection -- in this case, 1% per year -- and subtracts the expenses and taxes. What we're left with are the earnings. Then we divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).

A projected growth rate of 1% will result in almost $243.798 billion in sales five years out. Now we need to take a look at the firm's pretax profit margin (what's left over after expenses but before taxes are subtracted). In Figure 2 below, we can see that Apple has been doing a decent job maintaining its profit margin -- 36% in 2012, 29% in 2013, 29% in 2014 and 31% in 2015. The average for the last five years has been 31%, and the average for the last 10 years has been 27%.

Apple 's margins will revert to its long-term mean of 27%. At this rate, projected pretax profits on $243.798 billion in sales would be just over $65.826 billion. This means expenses would amount to $177.973 billion.

Figure 2: Pretax Profit Margins (%)

The next step in our estimation process is to establish the tax rate that will be paid on the company's profits. The most recent year's rate was 26%. Normally we wouldn't play with that number too significantly because in general, it shouldn't change much from year to year. The only time we would make major changes to this number would be in instances where maybe the current rate differed significantly from that of the past or if we had some knowledge about what rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad.

For Apple over the last 10 years, the company's tax rate has been as low as 24% and as high as 32%. Tax rates for most U.S. companies will fluctuate between 35% and 40%. We're going to select a rate of 28%, representing the average rate of the last 10 years, excluding the influence of nonrepresentative years. This would result in a tax expense of $18.431 billion from pretax profits of $65.826 billion in five years. This would leave us with $47.394 billion in projected earnings five years from now.

Our next main consideration is a matter of determining the number of diluted shares that will be outstanding in five years. Apple has significantly decreased the number of shares outstanding over the last decade. There were 6.143 billion shares outstanding in 2006, then the number of shares went up to 6.473 billion in 2010 and then decreased to 5.793 billion in 2015. Currently there is 5.473 billion shares outstanding.

This data suggests that the company has been repurchasing about 67 million shares per year. We're going to rely on the company's historical share repurchase activities to guide our estimation process but will be slightly more aggressive as we think the company is finding fewer high-valued uses of its cash to stimulate growth. As such, we project share repurchases of 75 million per year over the next five years.

With shares estimated at 5.098 billion in five years, EPS is expected to grow at a compound rate of 0.2% over the period. This is slightly lower than our projected five-year revenue growth rate. Note that our revenue growth forecasts are being offset by our estimates of margin compression. Based on this EPS growth forecast, we are expecting EPS of $9.30 five years out. Results of our forecasting procedure are summarized in the table below.

Table 2: Path from Projected Sales to Projected Earnings

Forecasting a target P/E multiple

Now we need to take a look at the price history of the company's stock. From Figure 3, we can see that the spread between the high and low stock prices has widened significantly over the last five years. We have a current price of $116.06, with a high in the past 10 years of $133 and a low of about $40. We want to keep this growing variability in mind when establishing our upper and lower valuation range. Specifically, given the firm's historical stock price behavior, we should expect the stock to fluctuate by at least $31.07 over the course of a year.

Figure 3: Stock Price History: Close, High, Low

Apple 's stock has traded at a declining price-earnings (P/E) multiple over the last decade, averaging 20 over the last 10 years, 14 over the last five years and 13 over the last three years. Currently the firm is trading at 14 times trailing 12-month earnings per share and 13 times expected future earnings.

For determining an estimated target P/E multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal P/Es that are not reflective of the normal operations of the firm, and this could be the result of abnormal growth or significant one-time nonrecurring charges/gains. In the case of Apple , we are going to leave the historical series intact. The next thing we like to do is to run an optimization procedure that reveals what P/E multiple yielded the best forecasting accuracy over the evaluation period. If in our judgment this multiple continues to accurately portray the earnings and cash generating power of the company as well as the growth and risk characteristics of the firm, then we will use this multiple as our target multiple. If not, we will adjust the multiple upward or downward accordingly.

The figure below presents the historical P/E profile for Apple . We will utilize a target P/E multiple of 14x which we believe reasonably characterizes the risk-return attributes of the company's stock. This multiple represents an expansion of 0% relative to the current multiple. It also represents an expansion of 3%, a contraction of 1%, and a contraction of 45%relative to the three-year, five-year and 10-year average P/E multiples.

Figure 4: Historical P/E Multiple and Target Point of Reversion

Setting a target price and valuation range

We selected a target P/E multiple of 14x. To determine a price target five years out, we then multiply this by our EPS estimate. EPS are estimated to reach $9.30 in five years giving us a target price of $126.44. Now, this price is higher than the current price. It's also higher than the price at which it has traded over the last year and is closer to where it traded in mid-2015. Nonetheless, to properly judge to what extent the stock may be under or overvalued, we need to determine a fair-value range within which we expect the stock to trade. To do this we rely on the trend-adjusted average annual trading range for the stock, which from the analysis above we know is $31.07. This means that, given our target price estimate, we expect the stock to trade naturally, and fairly, between $110.91 and $141.97. The result of this is that when the stock is trading below $110.91 it is in the Buy Zone and when the stock trades above $141.97 it is in the Sell Zone. Currently the stock is in the Neutral Zone.

Conclusion

So what return can we expect for holding Apple 's stock? Well, we now know we can expect stock price appreciation of 9%. We can also expect to earn dividend income of about $9.90 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 3%, provided our estimates prove accurate. All-in-all, we are happy with this company and believe that it offers acceptable return potential to retain a position in the stock. If you don't currently hold Apple , wait for the stock to fall to $111 before purchasing.

Disclosure: We do not own any positions in Apple .

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