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Apple (AAPL US Equity) Apple is no longer a growth darling – but a value

Apple (AAPL US Equity)

Apple is no longer a growth darling but a value play

BUY

Target price: 600 USD Return potential: > 50%

Contents

Investment thesis summary

Company description

Key figures

Why the bear case is most likely wrong

Apple’s strong and growing moats

Valuation – what’s in the price today?

Peers

Multiples

Reverse DCF

EPV

DCF

EBIT multiple analysis

Conclusions

EPV – DCF – EBIT multiple analysis – Conclusions • Apple’s cash and potential uses •

Apple’s cash and potential uses

Pre-mortem: a summary of risks and negatives

Appendix: Analyst consensus and target price revisions, sales

by quarter, product and geography

Klarmanite 2013 www.klarmanite.com

Nobody can know all the facts. Instead, one must rely on shreds of evidence, kernels of truth, and what one suspects to be true but cannot prove.

One must also balance one’s own perception of the truth with one’s best assessment of what others believe. In investing, other people’s perception of reality influences price more than any underlying truth; your own assessment, even if correct, is valueless if it is already reflected in the market price.

Seth Klarman

Investment thesis

Apple is quickly becoming unsustainably cheap

My chosen valuation methods on average yield a minimum fair value of 557 USD with very (perhaps too) conservative assumptions.

With a required margin of safety of 25%, this means the stock is a buy below 418 USD. Hopefully, it will go even lower on the upcoming quarterly numbers.

The bear case for AAPL is poorly constructed and built on a misunderstanding

Apple is not the hardware company it’s made out to be. Samsung has the phone with the hottest specs? It doesn’t matter that much. The long term value in AAPL is not predicated upon constantly making the most advanced or best selling phone, but rather lies in the providing the most user/developer friendly digital ecosystem overall.

That’s what Apple is building, which not only sustains but increases the substantial

economic moats of the company. Apple is the best human-machine interface company

in its industry and its position will grow even stronger with time.

Klarmanite 2013 www.klarmanite.com

Investment thesis

The growth case is dead, but the value opportunity is here

The transition from hyped-up growth darling to attractive value play will soon have run its full course. The volatility that this adjustment is causing is the reason Apple is currently mispriced analysts are forced to reevaluate their too aggressive growth projections, and consequently the market is temporarily confused.

The time to buy is close at hand. At the current price Apple’s slow demise is discounted and

no growth is priced in, and I believe Apple will prove that this is premature over the next few

years (at which point the opportunity to invest in Apple at a discount to intrinsic value will probably be gone).

Cash really is king if used correctly. I think it will be

In addition to the low valuation, the company boasts a stellar, cash rich balance sheet with no debt, which reduces investment risk and also makes shareholder friendly actions likely in the near future, whether through increased dividends, preferreds or buybacks (most likely).

This should act as a major catalyst for the share price and move it above and beyond my conservative intrinsic value estimate. A reasonable price target appears to be about 600 USD.

Klarmanite 2013 www.klarmanite.com

Company profile

Company profile Klarmanite 2013 www.klarmanite.com

Klarmanite 2013 www.klarmanite.com

Key figuresfundamental ratios

Key Ratios

2011

2012

TTM

P/E

13.17

14.63

8.89

P/E (cash adjusted)

12.17

13.93

7.93

EV/EBITDA

8.86

9.94

5.60

EV/Free Cash Flow

10.49

14.03

7.16

P/S

3.15

3.90

2.25

P/BV

4.46

5.17

2.92

P/Tang BV

4.67

5.36

3.02

P/CF

10.46

12.01

7.14

P/FCF

11.35

14.73

8.02

ROE

33.8%

35.3%

32.8%

ROA

22.3%

23.7%

21.3%

ROIC

41.0%

38.1%

37.6%

CROIC

48.2%

38.2%

42.3%

Current Ratio

1.61

1.50

1.54

Total Debt/Equity Ratio

0.00

0.00

0.00

Inventory Turnover

70.53

112.12

65.75

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Piotroski F Scores

Piotroski 1: Net Income

Piotroski

2: Operating Cash Flow

Piotroski 3: Return on Assets

Piotroski 4: Quality of Earnings

Piotroski 5: LT Debt vs Assets

Piotroski 6: Current Ratio

Piotroski 7: Shares Outstanding

Piotroski 8: Gross Margin

Piotroski 9: Asset Turnover

Piotroski 8: Gross Margin Piotroski 9: Asset Turnover 2003 2004 Key figures - Quality Piotroski Score

2003 2004

Key figures - Quality

Piotroski Score

2005

2006

2007

2008

2009

2010

2011

2012

TTM

5

6

7

4

6

5

7

4

6

5

5

1

1

1

1

1

1

1

1

1

1

1

1

1 1 1 1 1 1 1 1 1 1 1

1

1 1 1 1 1 1 1 1 1 1 1

1

1 1 1 1 1 1 1 1 1 1 1

1

1 1 1 1 1 1 1 1 1 1 1

1

1

1

1

1

1

1

1

1

1

1

1

0

1

1

1

1

0

1

1

1

1

1

1

1

1

1

1

1

0

0

0

0

0

0

0

0

0

0

0

1

1

1

0

1

1

1

0

0

0

1

0

0

0

0

0

0

0

0

0

0

1

0

0

1

0

1

1

1

0

1

1

0

0

1

1

0

0

0

1

0

1

0

0

Altman Z Score

Annual

MRQ

 

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Q1

Working Capital

$

3,530.0

$

4,375.0

$

6,816.0

$

8,038.0

$

12,657.0

$

20,598.0

$

20,049.0

$

20,956.0

$

17,018.0

$

19,111.0

$

25,469.0

Total Assets

$

6,815.0

$

8,050.0

$

11,551.0

$

17,205.0

$

25,347.0

$

39,572.0

$

47,501.0

$

75,183.0

$ 116,371.0

$ 176,064.0

$ 196,088.0

Total Liabilities

$

2,592.0

$

2,974.0

$

4,085.0

$

7,221.0

$

10,815.0

$

18,542.0

$

15,861.0

$

27,392.0

$

39,756.0

$

57,854.0

$

68,742.0

Retained Earnings

$

2,394.0

$

2,670.0

$

4,005.0

$

5,607.0

$

9,101.0

$

13,845.0

$

23,353.0

$

37,169.0

$

62,841.0

$ 101,289.0

$ 109,567.0

EBITDA

$

92.0

$

383.0

$

1,815.0

$

2,818.0

$

5,008.0

$

6,895.0

$

12,066.0

$

18,540.0

$

34,205.0

$

55,763.0

$

17,672.0

Market Value of Equity

$

8,483.3

$

14,911.5

$

43,310.2

$

64,182.3

$ 141,486.4

$

86,055.0

$ 170,244.8

$ 267,972.3

$ 341,332.2

$ 610,567.0

$ 368,158.5

Net Sales

$

6,207.0

$

8,279.0

$

13,931.0

$

19,315.0

$

24,006.0

$

32,479.0

$

42,905.0

$

65,225.0

$ 108,249.0

$ 156,508.0

$

54,512.0

Normal Altman Z Score

4.03

5.31

9.28

8.01

10.55

5.29

9.38

8.58

7.98

9.20

4.73

Revised Altman Z Score

8.07

10.23

17.19

14.56

19.51

10.60

17.35

15.37

13.71

15.80

8.90

Klarmanite 2013 www.klarmanite.com

The bear case and why it’s most likely wrong

The most common bear arguments

1. Apple is a one product hardware company (the iPhone is 50% of revenues and 65% of gross profit), which makes it too risky to touch.

2. The smartphone and tablet competition is intensifying, and Samsung and others

are grabbing market share. Once the cool factor dies down, Apple has no competitive advantages. Samsung already makes a more advanced phone.

3. Since Android products have larger market share, software developers will

choose Android, and Apple will lose the software war again as they did in the 80’s

and 90’s and become a marginal player in smartphones and tablets.

4. Steve Jobs is dead. Apple as a creative company will die with him.

5. Apple is maturing, and will go the way of Microsoft (and by implication be a terrible investment over say the next ten years).

Klarmanite 2013 www.klarmanite.com

The bear case and why it’s most likely wrong

1. The quoted numbers are correct, but is that such a bad thing?

You could have said the same thing back in the heydays of the iPod, which the iPhone displaced. This was a deliberate cannibalization tactic from Apple. The smartphone is however, a much more essential tool than the iPod was. Besides, the iPad is also

growing in importance as the tablet increasingly replaces the desktop and laptop for

«non-productive» uses. (So strictly speaking, it’s de facto a two product company).

The biggest flaw in the one-product argument is however, that the iPhone/iPad products are just another set of hardware products. They are not, because they are

built on a unique, closed OS architecture. This means that the Apple ecosystem (voice,

message, music, pictures, tv, desktop) is not accessible without an Apple device. The iOS is Apple’s real strength, as it is more attractive for software suppliers and also increases customer captivity/stickiness. It is not without reason that David Einhorn calls Apple a misunderstood software company. More on this later.

2. So what if Samsung makes the most advanced phone?

It doesn’t matter much to most consumers of Apple products. They want the most intuitive and smooth user experience in a nice looking package. This is what Mac has been about too, if you think about it. The addictive part of an Apple device is not primarily its sleek design, it is the elegant user experience that produces the loyal

Apple customer. Apple’s competition is other operating systems (in reality, only Android), not other hardware. Klarmanite 2013

www.klarmanite.com

The bear case and why it is most likely wrong:

the iPhone was a gamechanger for AAPL. It has now sold over 250 million units

 the iPhone was a gamechanger for AAPL. It has now sold over 250 million units

Klarmanite 2013 www.klarmanite.com

The bear case and why it’s most likely wrong

3. Another iOS advantage – it’s much more attractive for app developers

The personal computer wars of the past was won by MSFT instead of Apple primarily because more attractive software was available for the Windows system. Today, iOS actually offers more apps (850k vs 700k for Android), and iOS has a large and growing installed base. But so has Android, the bears argue, their base is even larger than Apples.

Yes, but unlike Android, iOS has a homogenized architecture, making it attractive for developers (develop something for one Apple product and it is workable on all devices with little customization necessary. Android is not identical across devices, making development more customized by definition, and also more expensive. iOS customers also tend to spend much more

money when using their devices. Since Android is an open OS , piracy and malware is also more

common (mobile cybercrime was up 80% y-o-y according to Symantec). A larger base is worthless if your efforts are pirated, and/or your customers arent’t spending any money.

As a result of all this, iOS has so far been the first choice for developers of apps. There are also other iOs advantages, which can be read up on here:

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It’s iOS vs Android the other players are marginal

It’s iOS vs Android – the other players are marginal Klarmanite 2013 www.klarmanite.com

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The bear case and why it’s most likely wrong

Device market share is misleading look at the underlying economics

Despite the aforementioned points, the stock market is looking at market share by

device and concluding that Apple is losing the war as Samsung et al sell more smartphones and tablets than Apple. This is wrong, in my opinion.

Instead, we must look at the economics of the respective market shares, and if we do,

we find that the iOS crowd is a more active, profitable bunch:

iOS users accounted for an overwhelming majority of the shopping traffic of smartphone and tablet users in 2012 (see next slide).

iOS users also have a higher level of in-App purchases and use their devices more

(web traffic measurements).

This is also an effect of being in the premium segment, but the numbers do seem to indicate that the Apple user experince is more satisfying and engaging: the fact that

iOS users spend more time and money on/through their devices indicates that Apple

makes the most user friendly and addictive consumer products in the market place.

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iOS users are more engaged and more profitable

iOS users are more engaged – and more profitable Klarmanite 2013 www.klarmanite.com

Klarmanite 2013

www.klarmanite.com

iOS users are more profitable

Platform market share handheld devices

% market share

13.1 34.3 52.6
13.1
34.3
52.6

iOSshare handheld devices % market share 13.1 34.3 52.6 Android Other Total operating profit mobile industry

Androidshare handheld devices % market share 13.1 34.3 52.6 iOS Other Total operating profit mobile industry

Otherhandheld devices % market share 13.1 34.3 52.6 iOS Android Total operating profit mobile industry %

Total operating profit mobile industry

% total industry profits

-8 37 71
-8
37
71

iOSprofit mobile industry % total industry profits -8 37 71 Android Other Sources: Comstat, Canaccord K

Androidmobile industry % total industry profits -8 37 71 iOS Other Sources: Comstat, Canaccord K l

Otherindustry % total industry profits -8 37 71 iOS Android Sources: Comstat, Canaccord K l a

Sources: Comstat, Canaccord

Klarmanite 2013 www.klarmanite.com

The bear case and why it’s most likely wrong

4. Steve Jobs is dead a brief management discussion

Yes. Hard to argue on that one. He is quite dead. And I would have greatly preferred it

if he was still living. However, I don’t think that means the end of apple as a creative, customer satisfaction focused company, even though Jobs was undoubtedly a creative genius. It should be noted that he was also a tyrannical leader, and that his management practices were far from recipes for success.

In fact, I think Tim Cook is likely an underestimated leader, and that Apple will continue to thrive even in Jobs’ absence. Cook is known for sharing Jobs’ passion for customer satisfaction and has said and done nothing to indicate that Apple fall into the trap of sacrificing quality or margins for market share, quite the opposite. The same can be said for Jony Ives, the uniquely talented head of Apples design team (not

dead, not leaving).

Apple obviously employs more than one brilliant individual, and Jobs’ spirit of innovation has fostered a corporate culture that will probably die hard. With the exception of Scott Forstall, the major players from the jobs era are still employed at

Apple, and very well taken care of compensation-wise. The team that made AAPL

what it is today is still mostly intact.

Klarmanite 2013 www.klarmanite.com

The bear case and why it’s most likely wrong

5. Apple will stagnate and go the way of Microsoft

As Apple is becoming a more mature company, it will naturally be more concerned with protecting its franchise, aggressively protecting its intellectual property and perhaps sacrifice risk-taking and innovation to some degree. This is natural, and not necessarily negative. If Apple goes the way of Microsoft, it will become less of an

innovator and more of a cash cow.

Does this have to be a negative? No. As value investors, we should primarily be concerned with the price we pay for an existing franchise and the durability of that franchise and not focus too much on the growth potential. (Going back to my earlier

point of the true nature of Apple as a company, I believe this is in fact a durable

franchise and not a soon-to-be obsolete hardware producer).Microsoft is often cited as an awful investment since 2000. But that is only true from the perspective of a

shareholder that bought in at peak valuations (MSFT traded at an EV/EBITDA multiple of 50 at peak levels).

The problem for a person buying MSFT in 1999 was not that the company stopped

growing. EPS actually grew by a CAGR of 8% between 1999 2013 and shareholder equity doubled. The problem was the initial price paid for that future growth. As I will show in the valuation section, Apple’s valuation is not at all elevated, but rather

low, and literally no growth is priced

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in.

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Apples strong moats

Apple has several important economic moats that protect the franchise and help

reduce investment risk. Very few companies in the world have moats in all these categories. The nature of several of Apple’s moats is also such that they grow in strength over time, an added benefit. These moats are central to my investment thesis and in my opinion confirm that Apple is not merely a hardware company.

Switching costs: Apple’s ecosystem creates customer captivity

Major hassle to move music, pictures, documents etc sticky customers

Network effects: Apple’s services increase in value as more people use them

Direct network effects: iMessage, Facetime, Game Center

Two-sided network effects: the App store (developers   consumers)

Intra-personal network effects (devices communicate: AirPlay, Apple TV, iCloud)

Cost advantages

Economies of scale

Intangible assets

Brand value

Intellectual property (patents, code etc)

Klarmanite 2013 www.klarmanite.com

Apple’s strong moats

Apple’s moats are reflected in its numbers:

High ROE/ROA/ROIC/CROIC

Fiscal year

2006

2007

2008

2009

2010

2011

2012

TTM

ROE

19.9%

ROA

11.6%

ROIC

277.5%

 
 
ROE 19.9% ROA 11.6% ROIC 277.5%  
 

464.9%

CROIC

250.5%

677.3%

GPA (Gross Profitability t

32.5%

32.2%

277.5%     464.9% CROIC 250.5% 677.3% GPA (Gross Profitability t 32.5% 32.2%

24.1%

13.8%

23.0%

12.2%

444.4%

26.0%

17.3%

29.3%

18.6%

33.8%

22.3%

35.3%

23.7%

 

63.9%

48.2%

41.0%

38.1%

37.6%

848.2%

71.4%

57.1%

48.2%

38.2%

42.3%

28.2%

36.3%

34.2%

37.7%

39.0%

35.2%

32.8%

21.3%

High margins

Margins

35.2% 32.8% 21.3% • High margins Margins Gross Margin 29.0% 34.0% 34.3% 40.1% 39.4%

Gross Margin

29.0%

34.0%

34.3%

40.1%

39.4%

40.5%

43.9%

41.9%

Operating Margin

12.7%

18.4%

19.3%

27.4%

28.2%

31.2%

35.3%

33.5%

Net Margin

10.3%

14.6%

14.9%

19.2%

21.5%

23.9%

26.7%

25.3%

Klarmanite 2013 www.klarmanite.com

Valuation: what’s in the price today?

In order to establish what the market

thinks of Apple’s future, let’s start with

a

ratio analysis:

If

we assume that my hypothesis on

the company’s moats is more or less accurate, should Apple be trading at:

a cash adj. P/E of 8?

8 x FCF?

5,6 x EV/EBITDA?

I think that’s way too cheap. That’s the sort of valuation you give to a business in serious decline. And as I’ve said, I think that’s the wrong diagnosis here.

Fundamental Ratios

2011

2012

TTM

P/E

13.17

14.63

8.89

P/E (cash adjusted)

12.17

13.93

7.93

EV/EBITDA

8.86

9.94

5.60

EV/Free Cash Flow

10.49

14.03

7.16

P/S

3.15

3.90

2.25

P/BV

4.46

5.17

2.92

P/Tang BV

4.67

5.36

3.02

P/CF

10.46

12.01

7.14

P/FCF

11.35

14.73

8.02

Klarmanite 2013 www.klarmanite.com

AAPL trades at a massive discount to comparables

Comparables analysis aapl orcl csco ibm msft goog qcom P/E 9.04 15.13 11.83 12.95 15.89
Comparables analysis
aapl
orcl
csco
ibm
msft
goog
qcom
P/E
9.04
15.13
11.83
12.95
15.89
23.82
19.39
Forward P/E
8.16
11.10
9.80
10.20
10.04
15.00
13.15
PEG
0.44
1.42
1.43
1.23
1.86
1.53
1.31
P/S
2.27
4.12
2.32
2.02
3.39
4.95
5.42
P/B
2.94
3.54
1.98
11.00
3.36
3.51
3.14
P/Cash
9.40
4.59
2.37
17.39
3.46
5.29
8.36
P/Free Cash Flow
8.55
13.55
13.07
0.00
12.68
20.87
32.37
Dividend Yield
2.66 %
0.74 %
3.30 %
1.81 %
2.98 %
0.00
%
2.17 %
Payout Ratio
11.98 %
16.26 %
33.14 %
17.39 %
45.44 %
0.00
%
28.78 %

On a cash adjusted basis, AAPLs earnings yield is 15,8%

does

that seem a little high

to anyone else? The average comp trades at an EY of 8,8%.

For AAPL to be valued in-line with comparable listed companies on a cash-adjusted basis, the price would have to be 69% higher 660 USD.

Klarmanite 2013 www.klarmanite.com

Valuation: what’s in the price today?

Negative growth.

Taking this a step further:

If AAPL is judged by the market to be in terminal decline that would mean the market is pricing in very little in terms of future growth. By reverse-engineering a DCF, one can check the implicit growth in AAPL’s stock price today. At the point where the DCF value equals today’s stock price, one will have found the market price implied growth inputs.

Using last years FCF as our starting point, a 10% discount rate, a forecast period growth rate of - 1% and a terminal growth rate of 0%, the DCF outputs today’s stock price…so the market is

currently saying that AAPL will never see positive growth again.

This sounds unlikely to me at this point. At some point, it must inevitably occur, but I cannot see why that would be the case today because saturation is not that high yet in AAPLs target markets, which should still see several years of decent growth.

Sensitivity Matrix: Growth vs Discount Rate

Growth Rates

Discount Rates

8 % 9 % 10 % 11 % 12 % -1 % 449 421 396
8 %
9 %
10 %
11 %
12 %
-1 %
449
421
396
373
353
1 %
505
472
442
416
392
3 %
570
531
496
465
437
5
%
645
599
558
521
488
7
%
732
677
628
585
547

Klarmanite 2013 www.klarmanite.com

Earnings Power Value (EPV) aka no growth valuation:

Confirms reverse DCF valuation

EPV Valuation Section

EPV Valuation Section
EPV Valuation Section
EPV Valuation Section

Values for Normalized Income

EPV > Net Repro Value = Moat exists

TTM Free Cash Flow

$ 46,300.0

Med Normalized Income

Med Normalized Income

$

$

23,195.4

Avg Normalized Income

24,461.5

Avg Adj. Income 5 yrs

TTM Adjusted Income

$ 20,756.2

$ 45,171.6

Data: EPV

Cost of Capital

 

10.0%

Normalized Adjusted Income

$

31,977.0

Average Maintenance Capex

$

(3,128.4)

Interest Bearing Debt

$

-

1% of sales

$

1,646.9

Cash & Equiv

$

39,820.0

39,820.0

Cash - Debt

$

38,173.1

Shares

 

939.06

EPV = Net Repro Value = No Moat

EPV < Net Repro Value = Value Destroyer $450 $400 $350 $300 $250 $200 $150
EPV < Net Repro Value = Value Destroyer
$450
$400
$350
$300
$250
$200
$150
$100
$50
$0
Book Value
Net Repro
EPV

Value

Calculation: EPV

An EPV measures the earnings power value of the company

with no growth.

The EPV estimate roughly confirms my conclusions from DCF valuation:

no growth is priced in today.

Cost of Capital Rates 8 %

EPV

Per Share

+ Cash - Debt

Per Share

 

399,712

 

426

437,885

 

466

9 %

 

355,300

 

378

393,473

 

419

10 %

319,770

 

341

357,943

381

11 %

 

290,700

 

310

328,873

 

350

12 %

 

266,475

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324

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IDC: smartphone market forecast 2012-2016

IDC: smartphone market forecast 2012-2016 Klarmanite 2013 www.klarmanite.com

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A quick look at the smartphone market and growth rates:

The «smartdevice» is the fastest adapted new technology in history

The rate of iOS and Android device

adoption has surpassed that of any

consumer technology in history. Compared to recent technologies, smart device adoption is being adopted 10X faster than that of the 80s PC revolution, 2X faster than that of 90s Internet Boom and 3X faster

than that of recent social network

adoption.

Five years into the smart device growth curve, expansion of this new technology is rapidly expanding beyond early adopter markets such as such as North America and Western Europe, creating a true worldwide addressable market. Overall, Flurry estimates that there were over 640 million iOS and Android devices in use during the

month of July 2012.

Peter Farago, Flurry Analytics

Android devices in use during the month of July 2012. Peter Farago, Flurry Analytics Klarmanite 2013

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Global Apple iPhone sales trend

Global Apple iPhone sales trend Klarmanite 2013 www.klarmanite.com

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What’s the ultimate size of the market for smartphones/tablets?

Kulbinder Garcha, a Credit Suisse IT hardware analyst, said in a report recently that only about 24 percent of the people in the world who could potentially afford a smartphone have one. Current estimates of the size of the smartphone market fail to properly account for so-called white-label phones that don't carry big brand names, he said.

By analyzing the total cost of owning a smartphone, including a data plan, Garcha estimates the number of people potentially in the market for a device could rise to just shy of 5 billion by 2017. Right now, only 1.2 billion people worldwide have one.

"You've got to have a 6,000 US dollar income level," Garcha said. "There are about 4.95 billion people in the world that have that income level, and so we think that's the addressable market for smartphones long term."

Fast growing market:

According to Apple, the size of the annual smartphone market will double by 2016, to 1,4 Bn units sold per year (meaning AAPL will sell 20% * 1,4 Bn = 210 phones per year by 2016).

The tablet market will grow even faster, and reach 375m units per year

Klarmanite 2013 www.klarmanite.com

The iPhone market

If AAPL is right, and the global smartphone market grows to 1,4 bn units per year in 2016 and

we assume they keep at least 15% market share from 2013 to 2016 (they had 18% in 2012),

then iPhone sales should look roughly like this, assuming a smooth sales growth trajectory:

Smartphone market

2011

2012

2013

2014

2015

2016

iPhones Sales growth rate Market share Total market

 

72.3

125

128

150

178

210

N/A

72.9 %

2.2 %

17.2 %

18.8 %

18.0 %

 

15.32 %

17.31 %

15.00 %

15.00 %

15.00 %

15.00 %

472

722

852

1005

1186

1400

Note that judging by the quarterly sales rate at AAPL, they are doing better than this (37m in

the latest quarter (FQ2 2013) estimate for 2013, a run rate of 148m iPhones sold this year.

Klarmanite 2013 www.klarmanite.com

According to Apple, iPhone sales CAGR between now and 2016E would then be:

125*(1,14^4 =210). 14%. This is well below IDC’s forecast of 19% CAGR, but still high.

This realization is of course a huge disappointment if you have modelled in a 25% growth rate…but as I will show, this is actually more than enough to justify saying that AAPL is probably undervalued. And AAPL does have more products than the iPhone to lean on going forward, notably iPad sales, increased revenues from other services as its installed

base grows as well as any growth from new products they may launch.

as its installed base grows as well as any growth from new products they may launch.

Klarmanite 2013 www.klarmanite.com

Valuation and fair value estimates

If we assume the following:

Margins stay more or less in-line with historical numbers

A 10% discount rate*

A 3% growth rate in FCF over a forecast period of 10 years

A 10 yr terminal growth rate of 2%

The discounted value of Apple’s future cash flows is roughly 510 USD.

I think it’s unlikely that AAPL will grow slower than this or see negative growth, rather it seems to me that the biggest risk is on the upside. People talk about margin pressure becoming a problem. I don’t see it yet in the numbers, and company strategy has historically never been to sacrifice margins for market share for example.

The matrix on the next page shows the growth/discount rate sensitivity, and illustrates the upside potential should growth rates surprise positively.

* Strictly speaking, the calculated WACC for AAPL is 9,6%, but I don’t trust WACCs and usually stick with a 10% discount rate

Klarmanite 2013 www.klarmanite.com

Discount rate / growth sensitivity matrix

Sensitivity Matrix: Growth vs Discount Rate

Growth Rates

Discount Rates

Matrix: Growth vs Discount Rate Growth Rates Discount Rates   8 % 9 % 10 %
 

8 %

9 %

10 %

11 %

12 %

 
   
 

-1 %

461

432

405

382

360

1

%

521

485

454

426

401

3 %

589

547

510

3 % 589 547 510 477 447

477

447

5

%

668

619

575

536

501

7

%

760

701

649

603

562

Even at -1% growth, the DCF value is above today’s price of 390 USD…

Klarmanite 2013 www.klarmanite.com

EBIT multiple valuation

EBIT Multiple Valuation

Bearish

Base

Bullish

Normalized revenue projection

 

116,250.0

155,000.0

193,750.0

Projected normalized Op margin

25 %

30 %

35 %

Operating Income (EBIT) est

34,875.0

46,500.0

67,812.5

Valuation Multiple

11

11

11

Value estimate operating segm

 

383,625.0

511,500.0

745,937.5

Plus cash and marketable secs

 

103,000

103,000

103,000

Less total debt

0

0

0

Less

off balance sheet obl

0

0

0

Fair value of equity estimate

 

486,625

614,500

848,938

Shares outstanding

939

939

939

Fair value per share

 

518.2

654.4

904.1

Multiple & scenario sensitivity

Bearish

Base

Bullish

9 x EBIT

 

444

555.4

759

10 x EBIT

481.1

 

604.9

831.9

11 x EBIT

518.2

654.4

904.1

At 10 x EBIT (+ cash debt) AAPL is worth 605 USD.

Peers trade at an avg / median multiple of 11,4 / 9,4 while AAPL is currently trading at 5,8 x last years EBIT. Way too low!

Klarmanite 2013 www.klarmanite.com

Conclusions Heads: I win, tails: I don’t lose much

DCF value:

510

EBIT value:

605

Average:

557,5

Requiring a 25% margin of safety, this implies a buy below price of 418 USD.

Given the conservative assumptions that went into this analysis, this estimate of fair value is likely on the very conservative side, and I have no problem seeing AAPL above 600 or even 700 USD again in a slighty more bullish scenario (a 15 x

multiple on last years EPS yields a 662 USD stock price, e.g). I don’t like relative

valuation methods, but as mentioned earlier, if AAPL were to trade in line with comps, it should be at over 660 USD.

All in all, I think it is reasonable to expect AAPL to trade at 600 USD (target).

Klarmanite 2013 www.klarmanite.com

The downside scenario

Conclusions

First of all, the downside should be limited given today’s low expectations, the substantial moats of the company and its rock solid balance sheet which invites shareholder friendly activities like increasing the dividend or buying back stock.

Let’s say the bears are right and margins compress from 25% to 19% on a 2012 revenue base (implying no growth). If investors value the company at just 10 x this margin-compressed EPS despite AAPLs brand value, cash position and capital return programme, the result is a share price of 297 USD, which is 24% below the current price of 390.

All in all, the realistic upside is at least 50%, while the downside is 24%.

Conclusion: AAPL should be bought at todays prices and below.

With a 600 USD target, the return potential in terms of capital gains alone is > 50%.

Klarmanite 2013 www.klarmanite.com

Apple’s cash and its potential uses

AAPL’s distributable cash:

Assuming full repatriation taxes are paid on foreign cash holdings, AAPL currently has about 104 Billion USD in cash. Subtracting e.g. 14 Bn, which should be more than enough to run the business and invest in new products given its prolific cash flow, one is left with about 90 Bn in distributable cash.

AAPL could pay a special dividend:

This is the equivalent of a dividend of 89,5 USD per share

AAPL could buy back stock on a massive scale

About 24% of the current stock outstanding at today’s price

Update: AAPL announced an increase in buybacks of 50 Bn by 2015 on April 23rd

AAPL could crush any competitor, buy almost anyone, and enter any market it wishes (though

thankfully, this would be out of character).

I think the most likely scenario is a big stock tender offer, or large buybacks over time.

A company that buys back large amounts of stock at a large discount to intrinsic value is actively creating value for shareholders. This should help realize some of the dormant value in AAPL stock right now.

Klarmanite 2013 www.klarmanite.com

Apple offshore cash & securities, total cash and investments

Apple offshore cash & securities, total cash and investments Source: zerohedge.com Klarmanite 2013 www.klarmanite.com
Apple offshore cash & securities, total cash and investments Source: zerohedge.com Klarmanite 2013 www.klarmanite.com

Source: zerohedge.com

Klarmanite 2013 www.klarmanite.com

Pre-mortem risks and negatives

Q: If your hypothesis doesn’t play out like you think: what caused this to happen?

A: One of the following seems most likely:

This is an analysis based on a central postulate: that Apple is not merely a hardware company. If this turns out to be incorrect, my investment thesis does not hold. (What Donald Rumsfeld might refer to as a known unknown in his vastly underestimated and much abused quote as Defense Secretary)

New disruptive technology renders AAPL technology obsolete (a so far unknown unknown)

Major product launch fiasco (would take more than one) destroys value

Android becomes the preferred developer platform (as we have seen, this is unlikely, as iOS offers far better economics and less piracy and malware problems)

Margin pressure and brand value loss if AAPL chooses to compete in lower-end markets (no indication of this happening anytime soon).

Loss of key employees / upper management (yes, I know, Steve is dead)

Long-term and severe macroeconomic pressures which favor AAPLs low-end competitors and marginalizes iOS as

an operating system

Dumb-ass acquisition spree on a massive scale wastes cash and erodes market confidence

Klarmanite 2013 www.klarmanite.com

Appendix: analyst consensus and target price adjustments

Appendix: analyst consensus and target price adjustments Klarmanite 2013 www.klarmanite.com

Klarmanite 2013 www.klarmanite.com

Appendix: Sales trends

Appendix: Sales trends Source: zerohedge.com Klarmanite 2013 www.klarmanite.com

Source: zerohedge.com

Klarmanite 2013 www.klarmanite.com

Sales trends by product

Sales trends by product Source: zerohedge.com Klarmanite 2013 www.klarmanite.com

Source: zerohedge.com

Klarmanite 2013 www.klarmanite.com

Sales trends by geography

Sales trends by geography Source: zerohedge.com Klarmanite 2013 www.klarmanite.com

Source: zerohedge.com

Klarmanite 2013 www.klarmanite.com

Margin trends

Margin trends Source: zerohedge.com Klarmanite 2013 www.klarmanite.com

Source: zerohedge.com

Klarmanite 2013 www.klarmanite.com

Sources

Gartner

IDC

Comstat

Canaccord

www.apple.com, company reports and presentations

www.oldschoolvalue.com; «Apple is not worth 460 USD» by Jae Jun

Flurry Analytics

Reuters

Zerohedge

Statista