The Tear Sheet we published on Apple last week gives a summary of our Apple valuation and of an option strategy to exploit its mispricing. We also pubished a detailed ChartBook for Apple this evening which focuses in on our analysis of the company’s valuation drivers. Here are the three things we think an owner of Apple should know.
Apple survives on its first-mover advantage in smartphones and its ecosystem.
The market Apple built for premium-priced, web-enabled time wasting devices is saturated in developed markets. Its imitators’ technology has caught up and, in some ways and some product upgrade cycles, surpassed Apple’s. The imitators are also less reluctant than Apple to compete down market. Apple’s large installed base of loyal customers (whose music libraries are stored on Apple servers) allow it to survive despite its expensive, “walled garden” approach to technology. Long-term revenue growth will depend upon 1) generating robust sales into emerging markets, 2) the development of innovative, winning products.
Apple is unlikely to generate robust sales into emerging markets or develop innovative, winning products.
Apple’s strategy of providing seamless connections between multiple devices is sensible and effective in developed markets. But many emerging market customers have only a single digital device, so switching costs are much less for them. This makes emerging market consumers much less loyal to brands, tending to buy the least expensive, highest functioning brands available at the time. Apple always loses on the “least expensive” metric overseas and lately, sometimes loses on the “highest functioning” metric. This will make it hard for Apple to continue to grow quickly in the most quickly growing markets.
Steve Jobs simplified Apple’s product line and created a big hit with the push into digital entertainment devices with the iPod > iPad > iPhone series. His strategy is the equivalent of a highly-concentrated investment portfolio with only one main holding. The chance that Apple will find another big hit product that has a large potential market and will boost medium-term free cash flow growth very quickly is, judging by the company’s recent investments, extremely unlikely.
Despite all the negatives, Apple appears undervalued.
Even if Apple’s revenues increase at an average of only 1% per year for the next five years, profit margins fall by 33%, and cash flows shrink at a rate of 5% per year six to ten years from now, the company is still worth about $100 / share. If Goldman’s “channel check” showing strong pent-up demand for the iPhone 7 is accurate, our worst-case assumptions will be shown to be significantly too bearish, at least in the short-term.
Apple’s value is highly concentrated in its iPhone franchise. We believe that due to a maturing demand environment for smartphones and the headline risk associated with this maturing market, an income-generating “bond replacement” option investment is more likely to be successful long-term than one that speculates on future capital gains.