Analysing Apple

My colleague Alan Kohler, in a recent Eureka weekend briefing, pointed out the attractive qualities of Apple stock – a low P/E ratio, exciting new devices, and the ubiquity and game changing nature of its products. So maybe it’s time to discuss “the elephant in the room” (all $US600 billion of it) and whether Apple should be included in the Eureka International portfolio.

I have been fortunate to have been a holder of Apple stock in the past and it certainly made me money. In October 2001 I visited the company at its Cupertino headquarters with a young analyst in tow just as the company was launching the iPod. After the meeting my analyst was excited about the new product but I was sceptical. I was all too familiar with Apple’s struggles during the 1980s and 1990s when the company underwent a roller coaster ride launching innovative products that never really reached critical mass in the broad market.

There had been a number of management changes; visionary chief executive Steve Jobs was exiled from the company and didn’t return until 1996.I had been an active investor in technology during that period but had preferred Compaq Computer and Dell over Apple with its quirky Macintosh PCs that only seemed to appeal to the education and architectural markets.

However, my analyst convinced me that not only would the iPod be a success but it would create a bit of a “halo” effect for the other parts of Apple’s business – iMac computers and the Apple retail stores which had been established earlier that year.

We bought the stock and enjoyed stellar returns as Apple shares went from $US6 (when adjusted for the recent share split) to over $US80 between 2003 and 2006 on the back of 100 million iPods sold, a resurgent iMac PC business and the new iTunes store.

From 2007 to 2010 Apple developed its iPhone and iPad products and the stock had another great run, increasing six-fold between 2009 and mid-2012. At that point I felt that competition from Korean and Chinese handset manufacturers such as Samsung, LG, HTC, Huawei and Xiaomi might derail the momentum of the iPhone, so I sold the stock and have been out of it ever since. That decision was correct as the shares corrected from their 2012 highs and went sideways in 2013.

Nothing has really changed since then. Apple is still a “hardware” company, competition remains fierce, Android phones are gaining market share and Chinese smartphones just get better and better for a significantly lower price. Consider that Apple’s average selling price globally is over $US600 while other smartphones are averaging $US249.

In spite of that however, Apple seems to be back in favour with the shares up 25% this year – handily beating the S&P500’s 7.5% gain. Apple has just launched a new series of iPhones and the long awaited Apple Watch. Will these products be as transformational as previous product cycles and drive the shares beyond recent highs?

Well, let’s start off by saying the Apple Watch is not an “iPod moment” for me. As a device it’s clever, has a myriad of neat features, and is well designed, but it is entering a crowded market in which no other manufacturer has ever succeeded. Battery life is short and the size of the display suggests that the female half of the population may give it a miss. You also have to tether it to an iPhone.

At any rate it’s not available until 2015 and sales are unlikely to move the needle for a company that had $US170 billion of revenues in 2013. I don’t see a lot of people throwing away their Rolexes, Breguets and Patek Philippes. It will most likely turn out to be a nice “niche” product like Apple TV and being able to use Apple Pay is a practical bonus.

The new iPhones have been announced and, surprise, surprise, they have larger screens, a newish design, faster processors, better cameras and can use the new “Apple Pay” system. Ever heard of the phrase “planned obsolescence”? Newer, bigger, better, but NOT revolutionary. There are existing Android phones that have similar features and the large screen iPhone 6 is clearly a reaction to the larger screen Android phones from Samsung and others.

That being said, most analysts expect strong demand for the product. In fact pre-orders for the iPhone 6 hit four million the other day. That’s double the iPhone 5 pre-orders two years ago. The China launch is delayed either due to a components shortage or a delay in Chinese government approval for new products. At over 50% of total sales the iPhone will remain the major driver for Apple’s 2015 revenues and earnings growth.

Speaking of growth, when analysing any company, one of the first areas I populate in the spreadsheet model are revenues and revenue growth both historical and projected. Starting in 2009 actual and projected revenues for Apple are as follows:

• 2009 = $37B
• 2010 = $65B Increased 76% YOY
• 2011 = $108B Increased 66% YOY
• 2012 = $157B Increased 45% YOY
• 2013 = $171B Increased 9% YOY
• 2014 = $179B {projected} Increase of 4.6%
• 2015 = $199B {projected} Increase of 11%
• 2016 = $204B (projected) Increase of 2.5%

It’s clear that competition is increasing and markets are maturing for handsets. Apple’s 2009-2012 growth is in a word – unrepeatable. According to industry forecaster Gartner Group, iPhone sales in North America, Western Europe, and Japan have plateaued. There is growth in China particularly as Apple gains new partners. Gartner has also flagged Apple market share declines in all markets save China and Japan. iPad sales peaked in 2013 and year to date are down 14%. The larger screen iPhone 6 may further cannibalise iPad sales in 2015.

In fact Apple’s share of the global smartphone market has been on the decline as this graphic from IDC clearly shows: (Apple is IOS)

Apple’s stock has had a strong run over the last five quarters, up some 75% yet it’s not really expensive in absolute or relative terms. At 14.3X 2015 earnings it’s at a small discount to the overall market but that P.E. is at a three-year high. Relative to large cap peers it’s towards the high end with MSFT at 16X, Intel at 15.4X, Oracle at 12.9X, IBM at 9.9X and HP at 9.5X. What do all those peers have in common? They are all EX GROWTH either due to their size, market competition, or industry structure. Is Apple among them? That revenue table is scary!

For Apple’s stock to continue to outperform the new iPhones have to drive earnings per share well ahead of consensus. That really means that the larger iPhone 6 with the 5.5” screen must sell well above market estimates with a high average selling price and better margins. Possible but unlikely in my opinion. Do most consumers really want a phone that big? The blogosphere is rife with comments on “upgrade fatigue”. Still, demand will be pretty good for the iPhone 6 as the consumer seems programmed to trade up, it is a good product, and the Apple Pay option is intriguing. However I don’t believe sales of iPhone 6 will produce the blow out earnings surprise that would drive the stock substantially higher from here.

Conclusion and recommendation

I would not be a buyer of Apple at this time. It is a great company with neat (and expensive) products but I can find other stocks that I think have more upside from here. As a portfolio manager, stocks are either a “buy” or “not buy.” If you own it – congratulations, you’ve had a good return this year. I don’t anticipate a massive correction in the share price. There may be a bit of “marking time” and mild market underperformance, which is not unusual after a major product launch. Given the quality of this company, it’s unlikely you will wake up in the morning to a 20% price correction.

Downside risks

• Inventory management/supply chain will be challenging due to the increased complexity of its products.
• Sales may fall off post-new product surge, front end loading the first half of 2015.
• Due to competitive pressures, Apple might be forced to create a cheaper product; margins would suffer and volumes wouldn’t be enough to meaningfully impact $US200 billion sales base. Going down market is never a good option.
• Apple reports fourth-quarter earnings on October 28, 2014. I will update after the results. Analysts are looking for $US1.28 earnings per share (EPS) for the quarter and the iPhone 6 will not really be a factor. We will have to wait for earnings during the last three months of calendar 2014, which will be released early in 2015, to get a sense of how iPhone 6 is travelling. Analysts are looking for more than $US2.35. That’s a sequential gain of some 60% over the fourth quarter of 2014 so the iPhone 6 and Apple products in general will have to deliver.

Apple’s future opportunities

Although I’m not recommending buying Apple shares here, there is the possibility of a third leg of outperformance in the future and that’s based on the long term potential of Apple Pay and the development of the Apple ecosystem which will essentially keep millions of Apple users “in the system” and is available for any new device, app, software or service the company devises. This third leg will not be hardware driven and it may take time to develop. Its current software and services category, which includes iTunes, the Apple retail stores, warranties, etc., generated $US16 billion in 2013.

Apple Pay is an intriguing service but (like all the other Apple products) someone else pre-empted them – Google. The Google Wallet service allows users to transfer money to each other, make online purchases and use their mobile phones to make payments in physical stores. Nevertheless, Apple Pay represents a new direction for Apple and could turn out to be revolutionary.

Apple’s new phones have an NFC (near-field communication) radio antenna which unsurprisingly only works with Apple Pay, plus secure chips that store payment information. Security is provided through the Touch ID fingerprint scanner, while credit cards are stored in Passbook, Apple’s coupon app. While the payments work at any of the 220,000 merchants that have NFC readers in place, Apple worked with a handful of retailers including Bloomingdale’s, McDonald’s and Whole Foods on deeper integrations. More will be forthcoming.

The payment system can also be used for one-click purchases within mobile apps. Apple receives .15% of every transaction, whether it’s a hamburger or a $US3000 vacation. Revenue impacts vary but some commentators see a $US1.5-2 billion revenue opportunity by 2017. Apple Pay could also raise Apple’s user retention metrics (currently 76%) over time.

To see Apple's financial summary and forecasts, click here.