Apple: Overvalued, But Optimism Warranted

Summary

I am having trouble rationalizing the current price Apple shares are trading at. Essentially, my question is: Is Apple the company, in the best shape it has ever been in?

Apple's valuation is at an all-time high in terms of market capitalization. Yet bulls rationalize this valuation by calling Apple a "consumer staples" company (think P&G or Pepsi) with higher growth.

While these comparable companies are at 20-25X earnings, Apple, because it is higher growth should get a higher valuation. Therein lies the problem, what exactly is Apple?

At 0/share, Apple is valued at .3 trillion. Yet hardware growth is negative. While wearables and services are growing at solid rates, Apple's bread-and-butter is hardware. That being said, Apple has a unique "stickiness" to its brand that other smartphone manufacturers can't seem to replicate.

Rating reiterated at HOLD, PT bumped from 0 to 8. Bear case is 3. Bull case is 5.

What Apple Is Doing Right

While I am moderately bearish on Apple (NASDAQ:AAPL), it is important to take a step back and consider the other side of the story. So, what is Apple doing right? Why would I want to go long the stock?

  • cheap valuation relative to other tech companies
  • returning capital to shareholders (buybacks and dividends)
  • impenetrable hardware+software ecosystem
  • phenomenal brand (AirPods Pro as an example)
  • operates well in China
  • services, wearables, 5G other (AR glasses) growth in the pipeline

Apple's valuation, in comparison to other tech companies, is relatively cheap on both an earnings and a revenue basis. It is the cheapest on an earnings basis, and second cheapest on a revenue basis.

ChartData by YChartsChartData by YCharts

While Apple appears compelling relative to other tech companies, it is important to consider the growth profiles of these companies. After all, growth is the driving force in valuation. Let's look at revenue and EPS growth:

ChartData by YChartsChartData by YCharts

Long term, analysts are anticipating growth rates at Apple to be the slowest out of all the major FAANG type stocks. Looking back at the valuation, sure Apple is the cheapest among major tech stocks, but maybe there is good reason for that. Apple is not, as a whole, a growth company. While they do have fast growing segments (think wearables, services, etc.), the company overall is not a growth business.

Second of all, Apple has been very consistent in terms of returning capital to its shareholders in the form of shareholder returns (dividends and buybacks). This is nearly indisputable, as Apple yields a solid dividend and is committed to repurchasing stock. While the yield is shrinking (only 1.06% as of Dec. 27 prices), a dividend yield makes Apple a hard-to-short stock. In addition, investors have management actively working with them in the form of buybacks, providing a cushion for the stock price and allowing for share price expansion longer term. Basically, management is working in favor of the stock through shareholder returns.

Thirdly, bulls mention Apple's impenetrable hardware+software ecosystem. Bulls, in particular Apple analyst Gene Munster has mentioned the fact that out of the FAANG stocks, Apple is the one that seems to have had a software and hardware business approach that has been successful. Apple has maintained a relatively successful business model in hardware by monetizing a very strong brand. Meanwhile, they are able to monetize the apps you are using on the phone itself. The analogy I like to use is the analogy of the house and the furniture. The house, in this case is the iPhone itself. The furniture and stuff within the house are the applications. There is great value in both the hardware and software aspects of the business. And Apple has so flawlessly integrated the hardware and software components of its business that it has been able to become an ecosystem. This ecosystem is well known and (outside of maybe China) it is very hard for consumers to back out of the Apple ecosystem. This allows for a consistent consumer that keeps the iPhone upgrade cycle alive as well as fueling software subscription revenues (think Apple TV+, News+, Apple Music, etc.).

Somewhat tying into Apple's ecosystem is the idea of Apple's brand being one of the greatest in the world. Case in point of the idea that Apple has a strong brand is their AirPods wireless earphones. The original AirPods were sold at 0. The AirPods Pro sell for 0. This holiday season, AirPods were sold out at major retailers across the country. Since the launch and success of AirPods, competitors have begun to train their sights on creating an AirPods competitor. Amazon (NASDAQ:AMZN), Samsung, Sony, and countless others have raced to produce their own AirPods competitors. They are all cheaper than AirPods, and have similar quality, but fail to really appeal to the market. So why are AirPods so successful? Because it's Apple, and AirPods are associated with the Apple brand. Another story supporting Apple's brand is the iPhone. While we have not seen a meaningfully innovative iPhone since the iPhone X (personal belief), Apple has managed to keep selling iPhones. Why? A large factor is the brand. Apple's brand will continue to propel the company going forward, as Apple seems to be regarded as a premium technology brand.

Despite the recent headwinds Apple has faced in its Chinese operating segment, Apple's China business for the most part has been extremely resilient, being one of the most successful American companies to operate in a significant manner in China. Tim Cook and management's overall ability to navigate trade talks over the last few quarters has been masterful, helping de-risk the story and allow for upside in the stock. Few American companies are able to operate as successfully in China as Apple. That being said, Apple will likely face some risks longer term from the Chinese market.

The last major part of the Apple bull thesis is likely their future growth avenues. These growth avenues are what bulls believe will justify the valuation going forward. These growths avenues are the following:

  • services
  • wearables (Apple Watch, AirPods)
  • augmented reality glasses
  • 5G iPhone sales
  • autonomous driving

Some elements of Apple's future growth are likely less relevant than others, and less likely to come to fruition as a major business (autonomous driving and AR glasses). That being said, Apple is still working on these projects and they may eventually drive growth at the company. That being said, the material catalysts for growth at Apple are really services, wearables, and 5G. In my opinion, the most important of these catalysts is 5G.

When Apple rolls out its 5G iPhones, it would not surprise me if new features are implemented, as 5G will likely allow software developers to do more with the apps they develop as connectivity speeds will be much faster with 5G. This means there may be a technological reason to buy a new iPhone, rather than upgrading your phone for the sake of upgrading it. This could upend worries about elongating replacement cycles, and lead to a demand super cycle.

The second and third most important growth drivers are likely services and wearables. With regards to services, there are few real headwinds to Apple's services business. The only real headwinds to services are Apple Care's reliance on solid iPhone shipments, and an ongoing lawsuit filed by Spotify (NYSE:SPOT) accusing Apple of anti-competitive measures regarding Apple Music. With an iPhone supercycle, AppleCare+ should see growth as iPhone units expand. While the Spotify lawsuit may lead to Apple being fined, I don't believe the lawsuit will structurally adjust Apple's business model.

Wearables is where I see more risk to Apple. As of Q4, wearables saw growth of ~52%. I see this high rate of growth being largely unsustainable. The drivers of this growth are hardware products, the Apple Watch and AirPods. Only ~5% of all iPhone owners also own an Apple Watch, leaving the Apple Watch as a product with quite a bit of room for growth longer term. In addition, there seems to be solid interest in upgrading these devices somewhat frequently. In comparison, we do not know how sustainable the sale of AirPods will be. Is this a one-off product where you buy it and hold onto it, or is there an upgrade cycle. I believe AirPods have a much more limited use case than Apple Watch, and are likely to be a one-off purchase rather than a consistently upgraded device. While I am sure there is still a significant amount of iPhone owners that do not own AirPods yet, I question the long-term growth trajectory of the product. I find it hard to believe that AirPods will be the factor that helps maintain a 52% wearables growth rate. If anything, growth is likely to be driven by the Apple Watch and an AR headset (planned launch in 2022). AirPods just do not seem sustainable, and I would anticipate a drastic tail-off in growth of AirPods over the next couple years.

Base Case Valuation

My base case valuation is also my overall one-year price target for the stock. In the past, I have used different methods in valuing Apple's stock. This includes building a discounted cash flow model and assigning an earnings multiple to the overall business. The problem with using a DCF is that you have to project multiple years into the future. In the case of Apple, iPhone technology and the overall business can change in extremely unexpected ways that are nearly impossible to predict with a serious degree of accuracy. So, I switched to an overall multiple on the business. This is not fair either, as the hardware and software components of Apple are growing at much different rates. Therefore, I am going to try to break down my valuation of Apple into valuing the hardware and the software businesses.

My classification of hardware: iPhone, iPad, Mac, Wearables & Other

My classification of software: Services

Let's start with valuing the hardware business. We will begin with estimating iPhone units and ASPs.

In fiscal 2019, I estimate Apple sold ~184.96 million iPhones. I estimate ASPs for the full year were around at 9.79. In fiscal 2020, I believe a strong consumer (in the U.S. and China), lower price points on the iPhone 11, and easier Y/Y comps. All of these things put together will likely yield higher iPhone units in 2020. ASPs on the other hand are likely to decrease in the first three quarters mostly because of the iPhone 11 price cut. The iPhone 11 is ~7% cheaper than its predecessor, the iPhone XR. That being said, I would expect a sequential increase in ASPs from FQ3 to FQ4'20, when the next generation of iPhones launches. JPMorgan says that they anticipate four new iPhone models. A 5.4" model, two 6.1" models, and a 6.7" model. Two of these phones are anticipated to support mmWave technology, allowing for faster speeds. These are likely the 5G supported models, and will probably carry a higher ASP. This will drive ASPs in the final quarter of the year.

  iPhone Units (in millions) iPhone ASP
2020E 191.18 5.30
2019E 184.96 9.79

Something that could negatively affect ASPs (and gross margins for that matter) is if the 5.4" model sells well into the mix. This phone will likely have a lower attached ASP than anything we've seen so far (I'm thinking 9-9). The more of these phones that are sold, the more likely it is that iPhone ASPs decline. That being said, I would anticipate a majority of the mix would skew towards the 5G enabled models. Let's call those models the iPhone 12 Pro and the iPhone 12 Pro Max. According to Piper Jaffray, 18% of consumers are willing to spend ,200+ on a 5G iPhone. Considering the lack of marketing we have seen for 5G tech, I am surprised that 18% of respondents are willing to put down that much money. Overall, Apple will likely be able to leverage this to their advantage, hiking ASPs and ramping marketing into next holiday season.

  iPad Revenue (in billions) iMac Revenue (in billions)
2020E .248 .276
2019E .28 .74

I am anticipating a decent decline in revenues from both iPad and iMac, both of which have been decently volatile in revenue over the last few years. I do not expect any major moves this year in Mac and iPad. That being said, the rate of technological improvement from both iPad and iMac has drastically slowed.

Finally, let's look at "other" segment. This segment generates the majority of its value from wearables, the Apple Watch and the AirPods. Only 9% of iPhone owners, according to Gene Munster, also own an Apple Watch. As Apple Watch becomes more of a health tracking and improvement platform, then I would anticipate it becomes more of a necessity to iPhone owners. As a result, I believe Apple Watch sales will increase as Apple begins to attack its overall installed base with the new generations of the watch.

  Wearables & Other (in billions of $)
2020E .05
2019A .482

This is a 35% Y/Y growth rate, a deceleration from the current 52% growth rate displayed in Q4. As the year goes on, AirPods comps will likely get tougher and tougher, as comps eventually approach the holiday season. The holiday season saw sold out AirPods, likely an indicator of strong demand.

All of this put together yields a solid overall performance from Apple in terms of the hardware business in FY'2020.

  Hardware Revenue Hardware GM%
2020E 1.973 38.5%
2019A 4.18 39.4% (Q4'19, mrq)

The reason that I am expecting a contraction in hardware gross margins is Apple's ASP cutback. I would've expected a much worse gross margin if wearables wasn't picking up the slack that iPhone is leaving. Overall, I expect an expansion in revenues fueled by strong wearables, and decent iPhone, despite weakening Mac and iPad.

Now, let's take a look at my projection for Apple's software services business.

  Services Revenue Services GM%
2020E .002 65.0%
2019A .291 64.1% (Q4'19, mrq)

Revenue should continue to grow at a solid rate and margins should remain largely unaffected, as there seem to be no headwinds on the immediate horizon to deter services' margin expansion.

Now that we understand my expectations for Apple's hardware and software revenues and margins, let's value the stock. Overall, I am anticipating a combined gross profit of 9.91 billion, 71.26% of which will come from the hardware business. Now, we need to back out my expectations for operating expenses. I anticipate ~.028 billion in OpEx. Backing out this OpEx figure, I anticipate an overall operating profit of .883 billion. Assuming the same 71.26% of this operating profit is then applied to hardware, then the hardware business should see .488 billion in operating profit. The software business should see .395 billion in operating profit.

Factoring in a 16.5%, tax rate, as Apple has guided for, we see net income of .507 billion from hardware and .37 billion from software. Now, let's actually value the business components.

Hardware traditionally trades at 10-15X earnings, well below a market multiple. This is because hardware is much more cyclical than traditional businesses. However, part of hardware is comprised of AirPods and Apple Watch, both of which are fast growing segments. In addition, Apple has a brand factor working in its favor that other traditional tech hardware companies can only dream of. For this reason, I believe Apple should get a multiple closer to the high end of this range. Therefore, I believe an appropriate multiple is 15X, near the market multiple. Based on this multiple, I believe the fair value of Apple's hardware business is 7.605 billion, ~8.73/share.

The software business, because it is a higher growth business segment, should get a higher multiple. In addition to being a higher growth business, services is much more subscription services based, so it is less prone to volatility unlike the hardware business. I'm giving the software business a higher growth multiple of 22X. On 22X, .37 billion in earnings, I have determined the fair value of Apple's software business at 8.14 billion, ~.80/share.

Put together, I believe Apple is worth .205 trillion, ~8.54/share.

My base case price target on Apple is 8.

Bear Case Valuation

When determining my bull and bear cases, I am going to apply a optimistic/pessimistic earnings estimate with an optimistic/pessimistic earnings multiple. Starting with the bear case, I am applying a bearish multiple to bearish software and hardware earnings estimates. We'll start with bearish earnings estimates.

iPhone units and ASPs:

  iPhone Units (in millions) iPhone ASP
2020E 186 1.30
2019E 184.96 9.79

My bear case iPhone estimate is for <1% Y/Y units growth. The ASP estimate comes from an expectation of ~5% Y/Y decrease. iPhone 11 is ~7% cheaper than the iPhone XR. This estimate assumes that the 9 iPhone 11 dominates the sales mix in 2020.

Now onto my bear case for iPad and Mac:

  iPad Revenue (in billions of $) iMac Revenue (in billions of $)
2020E .2
2019E .28 .74

This assumes less traction from Apple's newest generation iPads and Macs, leading to overall revenue declines in both segments. These products traditionally have volatile revenue streams, so a negative year this year for both products wouldn't surprise me.

Finally, let's look at the "wearables and other" business segment.

  Wearables & Other Revenue (in billions of $)
2020E .133
2019A .482

This estimate assumes wearables' growth decelerates closer to the current services growth rate. Why would we see such a great deceleration in wearables? A great part of the acceleration we witnessed in Q4, and will see in Q1'20 came from AirPods. However, once AirPods finally reaches a great portion of the installed base of iPhone owners, it is unlikely that AirPods will be able to continue the growth rate that they are at right now. Eventually, AirPods will decelerate in growth drastically. This bear case is just saying that the deceleration happens this fiscal year.

  Hardware Revenue Hardware GM%
2020E 6.354 37.5%
2019A 4.18 39.4% (mrq)

Now let's look at a bear case for services.

  Services Revenue Service GM%
2020E .398 64.0%
2019A .291 64.1%

This assumes a deceleration in services Y/Y growth to 13%, compared to the most recent quarter's growth rate of 18%.

Combined gross profit in the bear case is 0.859 billion, 69.8% of which will come from Apple's hardware business. Backing out ~.5 billion for operating expenses, we get operating profits of .36 billion. Hardware operating profits should total .601 billion, while software operating profits should total .758 billion. Backing out 16.5% for taxes, Apple's hardware business should see net income of .922 billion. The software business should see .003 billion in net income. Now, for the bear case valuation estimates.

With regards to hardware, I can see hardware earnings getting to the midpoint of that 10-15X range mentioned earlier. So, in the bear case, Apple gets 13X .922 billion in earnings. This yields a valuation of 0.986 billion, ~7.16/share.

The software business, rather than getting the 20X multiple in the base case is more likely to see ~18X in a bear case. Especially if we see the growth deceleration I am projecting in the bear case. On 18X .003 billion in net income, the software services business is valued at 2.054 billion, ~.18/share.

Put together, the Apple bear case yields a market capitalization of 2.95 billion, ~3.32.

My bear case price target is 3.

Bull Case Valuation

Again, I am going to be applying bull case estimates and a bull case valuation on those earnings. Starting with iPhone unit estimates and iPhone ASPs.

  iPhone Units (in millions) iPhone ASP
2020E 196.058 5.94
2019A 184.96 9.79

These estimates assume ~6% Y/Y unit expansion out of iPhone, fueled by a weak comp in 1H, and a strong upside case for 5G units in FQ4. With regards to ASPs, the bull case entails minimal ASP compression. I find it very unrealistic to expect ASPs to expand over the coming year. So, in the bull case I continue to anticipate ASP erosion.

  iPad Revenue iMac Revenue
2020E .131 .77
2019A .28 .74

In the bull case, iPad and iMac see slight expansions on a Y/Y basis.

  Wearables & Other Revenue (in billions)
2020E .499
2019A .482

My bull case entails 45% Y/Y growth, a measured deceleration from the Q4 Y/Y growth rate of 52%. This assumes continued strength out of Apple's AirPods and Apple Watch. This assumes a greater percentage of the total installed base begins to value the Apple Watch as a health product, spurring growth. It also assumes that AirPods growth remains resilient into 2020, despite Apple likely reaching limits in terms of the company's penetration of the installed base.

  Hardware Revenue Hardware GM%
2020E 4.568 39%
2019A 4.18 39.4% (mrq)

Now, let's look at services. My bull case is for a slight acceleration in growth from 18% Y/Y (the number we saw in Q4) to ~20% Y/Y, as more software services come to market this year (Apple TV+, Arcade, News+, etc.).

  Services Revenue Services GM%
2020E .549 65.5%
2019A .291 64.1%

Combined gross profit in the bullish scenario is 7.865 billion, 71.8% of which is coming from Apple's hardware business. Then, backing out a little bit more of a conservative OpEx estimate of .5 billion, we get to an operating income estimate of .365 billion. 71.8% of this operating income goes to hardware, the remainder of which is services related. Assuming the same 16.5% tax rate, hardware should see profits of .975 billion, while software sees profits of .102 billion.

In this bullish scenario, I am willing to put a greater premium on Apple's hardware business. While my base case is 15X earnings, my bull case is closer to 17X, reflecting a better long-term growth profile in 5G and wearables. On 17X, Apple's hardware business is valued at 1.575 billion, ~1.93/share.

With software, I am willing to extend the bullish P/E multiple closer to 25X, on earnings of .102 billion. This brings my valuation of Apple's software services business to 2.55 billion, ~3.06/share.

Put together, this entails a bull case valuation of .504 trillion, 4.99/share.

My bull case price target is 5.

Conclusion

Where is the top with Apple? Well, based on my valuation of Apple, the top is around the bull case, 5. That is, I believe the fundamental top of the company is ~5. Whether the stock gets to 5, or breaks out beyond 5 is a different story. That being said, I would be looking into a short position in the name if it indeed broke above that 5 level. Inversely, if the stock somehow breaks down below the 3 bear case level, I would look to go long. For now though, I believe the safest place is the sidelines.

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TIPRANKS: HOLD

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice. Please do not interpret this as financial advice. Do your own due diligence before investing in any of the securities mentioned.

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