The Allure of Apple

Long AAPL @ $110 –

  • Market expectations are far too brearish.
  • Apple currently offers a 10+% FCF yield – which has historically represented a good entry point.
  • After adjusting for net cash, Apple trades at just 10x 2015 earnings, providing an exceptional opportunity for a new money investment.

Quality at a bargain price

Apple’s track record of success speaks for itself. Over the past decade, its growth and operational performance has been remarkable.

  • Revenues, earnings and OCF have grown over the last 5 years at 29%, 30% and 36% respectively;
  • ROIC has averaged 30% over the last 10 years;
  • It boasts superior margins – GPM 40%, NPM 22%, FCFM 30%;
  • Generates huge amounts of free cash flow – OCF yield 12%, FCF yield 10%; and
  • It has an A-grade balance sheet – company currently holds $150bn in net cash.

Considering these impressive numbers, it’s hard to believe that after adjusting for net cash, Apple is trading at just 10x E2015 earnings (keeping in mind that the S&P 500 currently trades on an average PE of 18x).

The stocks cash flow metrics also paint a similar picture. Apple’s FCF margins are ~30%, which is outstanding given FCF/S greater than 15% are considered superior. Despite increasing competition, Apple has been able to maintain its margins and continually grow its free cash flow. Apple currently has a FCF yield of ~10%. Looking back over the past decade (see chart below), there have only been two other occasions where Apple has traded with a FCF yield of 10+% – December 2008 and March 2013. Both instances proved to be great entry points for long term investors.

AAPL FCF

The above argument is the obvious case for going long Apple – an exceptional company at a bargain price. However, the more pertinent question becomes what growth can investors realistically expect going forward?

Growth prospects

Back solving a DCF, we can determine that the current market price implies flat to slightly negative growth – an expectation that I believe is far too bearish. Whilst I concede it’s unlikely Apple will be able to maintain the exponential growth rates experienced over the last decade (if not least due to the law of large numbers), I still expect iPhone sales will continue to grow. Future growth will come from both the addition of new customers to iOS (EM and US) and the retention of Apple’s existing premium iPhone customers, where the company’s moat will play an increasingly vital role.

Critics claim that as a ‘typical’ hardware company Apple’s competitive advantage is built on shaky ground. However, I would argue that Apple is much more than a ‘typical’ hardware company. Apple’s strength lies in its experience and expertise in integrating hardware, software, services, and third-party applications into differentiated devices. Additionally, Apple has devoted considerable time and resources to develop its ecosystem, which effectively creates a tangible switching cost after Apple has locked consumers in. This creates a loyal and self-sustaining customer base – a very important aspect of Apple’s business model which leads to recurring revenues. Apple has very high retention rates (churn of ~7%) and an average upgrade cycle of approximately 29 months. The upshot being that roughly two thirds of Apples annual iPhone sales currently come from its exiting installed base of 400 million (of which only 27% have upgraded).

Furthermore, a recent development that received little attention was Apple’s new direct sale and phone lease program. For $32/month, a customer can now lease an iPhone 6s, with AppleCare, and upgrade within 12 months. This has the propensity to materially shorten the upgrade cycle and drive sales. If the upgrade plan is successful and produces an incremental 20% in total iPhone sales for North America, I estimate that EPS would increase by ~$1. So whilst it will take some time for this new upgrade plan to play out, there is potential for earnings to receive a material boost from a shorter upgrade cycle.

Apple also continues to have success in gaining market share from its competitors. In Q3 2015, Samsung’s market share declined 0.8% to 23.7%, while Apples market share rose 1.4% to 13.6%. Despite all the negative headlines and speculation, Apples sales in the greater China region grew 99% year over year to $12.5bn. A remarkable feat, especially considering that China’s smartphone market struggled over the period.

Between first-time smartphone buyers, people switching away from Android and repeat sales to current customers, Apple’s iPhone business still has potential for future revenue growth. As the global smartphone market continues to grow at ~10% per year, I believe Apple can realistically achieve mid-to-high single digit revenue growth in the medium term. This will deliver modest earnings growth in the vicinity of 5-10% (assisted by share buybacks), which is materially higher than what the current market price implies. Given high retention rates, a superior ecosystem, and a multi-product advantage, I believe that earnings power of $10+ and FCF of around $70bn pa is sustainable in the long term. That is to say, I anticipate Apple will trade well above current all-time highs in the years to come.

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