AAPL is a Bargain

TL/DR version:

AAPL's market cap is so low ($413B) that even if they plateau and have zero growth, then the company is on pace to have more assets than market cap (share price x outstanding shares) in seven years. If Apple is really "over-valued" then their stock price will go down and their stock buy-backs will decrease outstanding shares (both factors which would reduce market cap). However, assuming market cap stays constant and Apple just earns $40B per year (which they are on pace to do this year again) then Apple will have enough cash to private in seven years: $150B current assets + (7 years x $40) = $430B. Additionally, Apple's use of the iPhone 5C / 5S combo this quarter has huge potential up-sides for profit margin and supply availability, coupled with increased number of addressable markets in this quarter versus last year (China and Japan). Last year Apple only sold 5M units on launch weekend for iPhone 5 due to supply constraints, and those constraints should not be there for iPhone 5C even if they are there for the 5S. Apple stands to see growth in 2013 over 2012 even if that growth is not at the same pace of past years.

Full Version:

I keep hearing this AAPL is over-valued rhetoric. I keep seeing these downgrades on AAPL. I keep asking myself: are people really that stupid? I don't think people are really that stupid, but that they are being short-sighted. The basic argument goes like this:

"If the current stock price reflects what AAPL is worth today based on expectations of analysts and Apple does something that falls short of those expectations, then AAPL must be worth less tomorrow."

That seems pretty sound logic -- especially in the short term. You can certainly predict interim peaks and valleys based on hype versus reality. However, there are some pretty big "ifs" in that premise when looking at the longer term.

Apple Insider did a great piece on the recent trend and you should go read it, but I especially like the way they pointed out how analysts like Peter Misek make predictions for Apple revenue and sales based on assumptions and when those assumptions are wrong, they downgrade those predictions, sending the stock falling, and then when Apple meets the original predictions despite not doing it the way the analyst predicted, the stock does not rise to its original level. Indeed, investors put more faith in analysts who are continually wrong than in a company that is making decisions that are constantly driving revenue, unit sales, and profits. Maybe, just maybe, Apple's strategic plans are working as planned. The bit on Peter Misek is quoted below as an example:

Misek's predictions based on cuts in Samsung's Austin wafer starts could be as off the mark as his outline of Apple's plans from last December, as detailed in a report by Philip Elmer-Dewitt, writing for Fortune Apple 2.0.

Misek described the iPhone 5s as having "new super HD camera/screen, a better battery and near field communications." He also wrote that Apple was building a new iPad for release in June, a new television set and a cheap new iPhone model.

"Our checks indicate a low-cost model would be a retooled iPhone 4 with a scaled-down modem, apps processor, etc," Misek reported, further warning that this predicted new cheap iPhone's gross margin "would be impinged in order to reach the desired $200-$250 price point."

In February, Misek predicted that Apple would hold an Apple TV-related event in March.

But when March arrived with no Apple TV event, Misek issued a steep $80 downgrade on Apple's stock and cut his estimates for the quarter's iPhone sales from 37.5 million to 35 million, while predicting revenues of $41 billion. He also shifted his price expectation for the cheap iPhone to cost between $350 and $450.

Apple's actual revenues for the quarter were $43.6 billion, and the company sold 37.4 million iPhones. However, fears that the predicted new cheap iPhone model would erode Apple's profits in the future continued to be repeated through the year, and were eventually overshadowed only by new concerns that the iPhone 5c model that Apple actually unveiled last week didn't turn out to be cheap at all.

Investors were so worried about the iPhone 5s not being as cheap as some analysts speculated that they ignored the news that Apple was in fact selling a new, broader range of iPhones in China and other key markets, anchored at the low end by an iPhone 4 without either "a scaled-down modem or apps processor," but selling for around $420, the very price target a variety of analysts thought Apple needed to reach to expand its market share in China.

On top of this, keep in mind that Apple is a company that earned $41B last year in profit. So far this fiscal year, Apple has earned $31.6B. Their fourth fiscal quarter (which closes in September) showed $8.2B in profit with the launch of the iPhone 5 last year. Of course, iPhone 5 launch was seriously supply constrained and sold 5M units opening weekend with sales slowing to a trickle thereafter as shipping dates slipped and Apple spent weeks furiously producing more iPhones that were sold before they were assembled. On top of that, the margins on iPhone 5 were lower than normal because of the new hardware and manufacturing investment. This year Apple is selling the iPhone 5C and the iPhone 5S. Apple's fingerprint sensor may or may not be in short supply, but we know the LCD panel is not and Apple has had a year figuring out how to make the aluminum case of the iPhone 5 (this year with new finishes which should be more scuff resistant). On top of that, the iPhone 5C has virtually zero new components except for the plastic case which can be manufactured in huge quantities and a new face-time camera which should not be in short supply. Profit margins should be up on both phones, but on top of that, the available supply (especially on iPhone 5C) should not be nearly as restricted as last year. If Apple does just $8.4B in earnings the same quarter this year then they are going to post another $40B earnings year. I'm guessing that Apple is going to post closer to $9B or $10B, based on increased margins compared to last year, increased markets (China), and increased supply availability.

Assume, for a moment, that Apple does nothing disruptive in the next 7 years. They simply campout in the premium smartphone niche and make iteratively better iPads which are consuming the PC market today. Assume that these evolutionary improvements just playing to Apple strengths allow Apple to maintain these $40B per year earnings averages. That would play right into the bear argument of "zero growth" or "plateau". Assuming that is right, then in three (3) years, Apple will have $270B in cash assets. In seven (7) years, Apple would have $430B in cash assets.

Apple's current market cap (stock price multiplied by number of shares) is sitting at $414B. Now, we have already seen the number of outstanding shares drop from 940M to 908M as Apple has bought back shares. And we know Apple has already announced plans to buy back more shares, which will in turn further reduce the market cap. If you believe Apple's stock price is overvalued at this point then you are saying that in seven short years Apple will have more cash assets than the company is actually worth. That Apple is worth less than the trouble it would take to buy it and liquidate its assets. Now, that simply does not make any sense and it only takes extrapolating the company's performance for seven years, ignoring their historic annual growth and imposing a zero-growth constraint to those projections.

Of course AAPL must go up. No company can earn $40B per year (or potentially more) without seeing its market cap adjust accordingly. The only way AAPL is overvalued is if you believe their earnings is going to significantly fall within the next seven (7) years (not just plateau). Let's imagine a scenario where Apple's revenue falls 25% over the next seven years. Can you imagine what that would do to the stock price? It would mean a decreasing market cap. However, in such a scenario, Apple would still earn $30B per year or $210B to add to their existing $150B cash hoard, for a total of $360B in cash assets. At a stock price of $400 per share and 900M outstanding shares (assuming some buy-backs), Apple would still have a market cap of $360B and have cash assets equal to its market cap in seven years. In either scenario, you are looking at Apple going private based on an undervalued stock price in seven years time. I will remind you that Apple has already booked $31.6B in earnings this year and are on pace to about $40B and possibly more. So any such "25% decline" in earnings would likely have to start with fiscal 2014 and assuming that Apple's platform and ecosystem have lost their stickiness and customer satisfaction has gone way down (something that all surveys and indicators seem to disagree with, just ask JD Power & Associates).

This is why I believe that Apple is a huge value at the moment. If Apple does anything positive in the next seven years that trigger even half the level of growth they have seen in past years then the stock is sure to explode as profits soar. Unless you are the most bearish of Apple detractors, its hard to miss the fact that Apple is undervalued.

Disclosure: I am long AAPL (and this is why)