May 02, 2011 - 3:45am EST by
2011 2012
Price: 350.13 EPS $15.15 $27.00
Shares Out. (in M): 925 P/E 23.0x 13.0x
Market Cap (in $M): 324,000 P/FCF 17.3x 10.0x
Net Debt (in $M): -66,000 EBIT 18,385 32,000
TEV (in $M): 258,000 TEV/EBIT 14.0x 8.0x

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It is unlikely that any company receives as much attention these days as Apple, and yet, despite this constant scrutiny, Apple remains largely misunderstood.  Such misunderstanding is currently causing Mr. Market to misprice (perhaps severely) Apple shares.  Indeed, market sentiment is giving little credence to the possibility that Apple's outstanding performance over the past five years might just continue.  I think such sentiment is likely to prove incorrect for the following reasons:  
  • (1) Apple main markets offer considerable headroom for continued growth.
  • (2) Apple possesses sizeable (and growing) scale and demand advantages in these markets.
  • (3) There are many bad arguments and otherwise misleading information in circulation, leaving much misunderstood.
  • (4) I could be wrong about all of the above and AAPL investors are still unlikely to lose much when buying at current market price (given Apple's cash pile and cash generation).


Apple's Markets 

Apple gets well over half (~60% in the most recent quarter) of its revenue - and purportedly a higher percentage of its earnings - from iPhone and iPad sales, and both of these products compete in large, rapidly growing markets.



The smartphone market is clearly on a tear.  It is estimated to have grown by 70% in 2010 alone, and market research firm IDC expects Smartphone shipments to increase another 43.7% in 2011.   Another analyst expects the market to grow at a 20% CAGR through 2016.  (Note:  the worldwide mobile phone market grew by almost 20% in 2010, so these smartphone projections don't sound all that unbelievable.)  Furthermore, Apple's "effective" market size will increase at an even greater rate as it offers the iPhone to more countries and carriers.  Indeed, even the sillier forecasts that predict Windows to be the #2 mobile platform in 2015 expect Apple to have nearly quadrupled iPhone sales by then.


Tablet Computers

Compared to the smartphone market, the tablet market is much newer and growing even faster.  This market didn't really exist a year ago, and in a year's time Apple has sold 20M iPads, adding an incremental $10B+ to its annual revenues, and demand for iPad 2 has been stunning - leading to what Tim Cook calls "the mother of all backlogs."  Interestingly enough, the iPad is gaining significant adoption even beyond Apple's typical consumer market.  Hospitals, Law Firms, and Fortune 100 companies have all been snatching them up because they are seeing gains in productivity.  (Note: I think this looks similar to early adoption of Blackberries in the enterprise.)  Benefits in education are also apparent as some school districts have already made bulk orders and several universities are requiring students to use them for certain courses.  Market forecasters have caught onto this and expect the tablet computer market to grow five-fold (to roughly $50B) by 2015.  However, this could prove conservative given the incredible demand currently seen for the iPad 2.  (In my estimation, the iPad alone should see over $20B in sales in 2011.)  Gartner expects Apple to remain in the lead with nearly 50% market share of a 300M unit market by 2015 - this implies total market unit growth of ~1500% over 2011.  Of course, market forecasts should generally be viewed with healthy skepticism.  However, in this case, I agree because the underlying causal drivers are the benefits people derive from a very portable, extremely versatile computer with a large intuitive interface.  Apple COO Tim Cook expects tablets to one day outnumber PCs, and I have a hard time disagreeing with him.  Anecdotally, everyone I know who has one thinks the iPad is great, and given that these devices will only get better and cheaper with more content over time, the modern tablet computer would seem here to stay.  


Apple's Scale Advantage 

Apple is already the largest mobile device maker in the world by revenue, but more importantly, Apple is a really strange company!  It brings in annual revenues well over $60B (and rising) by selling just a handful of product lines.  In fact, looking under the hood, Apple sells yet a smaller number of configurations.  For example, the iPhone, iPod Touch, iPad and Apple TV have a tremendous amount of commonality in both software and hardware.

Apple's sheer size and extreme product commonality have two major competitive implications.  First, when Apple goes shopping for components, it distorts the global supply base in its favor, and second, Apple can devote more resources toward each product and still achieve lower fixed costs per product.  Together, these mean that Apple can bring the benefits of vertically integrated products to market at prices non-vertical competitors can't match.


Everyone's Best Customer

Whether by luck or by design, Apple's voracious component appetite allows it an unfair advantage in the component marketplace.  As an example, consider how Apple achieved its 70% market share of portable music players: 

When rival music and media players got too close, matching the iPod in both features and price, Apple prepaid $1.25 billion to Hynix, Intel, Micron, Samsung Electronics, and Toshiba, thereby securing long-term NAND flash memory supply.  Rivals were unable to match Apple's orders and therefore remained prone to shortages and price shocks due to seasonal trends and artificial shortages created by the Apple deal.   

Apple has continued this strategy of securing long-term component supply at attractive prices.  The following lists some of Apple's recent supply deals: 

  • Prepaid 1.25B to multiple vendors in 2005 to secured long term supply of NAND flash memory
  • $500M NAND order with Toshiba in 2009
  • $500M LCD contract with LG in 2009
  • Tim Cook announced $3.9B in "strategic long term contracts" in the Q1 2011 call.
  • Purportedly signed contracts with Samsung in early 2011 totaling $7.8B for LCDs, mobile processors, and NAND memory
  • As of March 2011, Apple has outstanding off-balance sheet commitments for manufacturing and component purchases totaling $11B, this is up from $7.9 billion at the end of 2010

 Further recent anecdotal evidence reinforces this point.  One sell-side analyst estimates that Apple has already booked over 60% of available touch panel capacity.  Another analyst says Apple has been "aggressively attacking" the component situation in Japan by offering upfront cash payments, in a move that could block competitors from access to critical components. 

No other OEM has the scale to match Apple in securing component supply, and it is hard to challenge Apple's offerings when you can't get yours to market... or in sufficient quantity... or at comparable prices which offer an acceptable return, and of course, without a reasonable installed base, few developers have any incentive to develop for your platform.  Suffice it to say, I think this is a huge advantage for Apple, and should Apple continue its growth, this advantage will continue to increase.


Economies of Scale

Clearly vendor contracts are one benefit of Apple's scale, but so too are the economies of scale in design, development, marketing, etc.  This is apparent in hardware and software development, and it is further amplified collaboration present in the company.  For instance, its flagship PC operating system, Mac OS X, formed the basis for iOS, which is now shared among the iPod Touch, iPhone, and iPad.  In addition, new breakthroughs from iOS development are making their way back into OS X with the next version to be released this year.  On the hardware side, as mentioned above, the iPod Touch, iPhone, iPad, and even the Apple TV share remarkably similar internals, and hardware work on the iPad has begun to influence the Mac line, which can be seen in the most recent MacBook Air.  Therefore, should equality ever reappear in component prices, Apple's competitors would still face an uphill battle in fixed costs per unit because rival OEMs sell several models with added complexity, while Apple leverages focused investments into industry leading revenues.  Perhaps this helps explain why, in December, the iPhone enjoyed a 22% share of the mobile industry's revenues and accounted for more than half its profits (or 51%).

Unfortunately for Apple's competitors, Apple's scale advantage is even beginning to be seen in Apple's relatively low volume PC market.  Consider the anecdotal evidence of the recently released Samsung Series 9 notebook.  This is Samsung's MacBook Air competitor.  To be fair, it does out-spec the current MacBook Air in some areas, but its base model is also $350 more expensive than the entry level 13-inch Air.  The "Apple Tax" may have dwindled all the way to a negative figure by now...


Demand Advantages 

The Ecosystem

Apple has over 200M customer accounts tied to credit cards.  In its most recent quarter, Apple recorded over $1B in revenues from iTunes, the App Store, and iBooks.  This is significant because, for the most part, the content bought through these channels can only be used on Apple devices.  Over time, this locks customers into Apple's product portfolio for new purchases, or it at least creates an impediment for users wanting to switch brands. 


The Installed Base

This content ecosystem is also partly responsible for what many call the "halo" surrounding Apples products.  For instance, early iPod users were more prone to switch to the Mac, iPod and Mac users were much more likely to purchase the iPhone over competitive offerings, and now the iPad is garnering more attention due to Apple's huge installed base.  As this installed base grows it can be leveraged into more and more product areas.  For example, if Apple were to come out with a TV, it would already have ~100M potential customers with expensive, sophisticated Apple remotes (read:  iPhones or iPod touches) already in their pockets.  Apple's installed base makes it significantly easier for Apple to sell new or existing products.  Furthermore, Apple is "cool."  In addition to customers, Apple has "Fans."  While some might find this weird (if not creepy!), it means that Apple can move the first ~2M units of seemingly any product.  Apple's rivals lack this momentum. 


Free advertising

Apple's events oftentimes make the news - not just the financial news - the LOCAL news!  This is an almost unfair advantage.  Harvard Business School professor David Yoffie has said that the introduction of the iPhone in 2007 resulted in headlines worth $400 million in advertising.  Subsequent product announcements and releases have enjoyed similar, if not larger, advantages.  Further attention is drawn from the large lines queuing up for new products in busy retail centers, and in a way, each success breeds more success as Apple's huge installed base uses their distinctive products out in the wild for others to see. 


Contrarian Arguments to Widely Held Assumptions

Because there is no shortage of information circulating about Apple, there is more than enough false, flawed, or misleading information circulating about Apple.  The result is that Apple's situation is not well-understood and in some cases quite misunderstood.


Wrong Metaphor

Many people are viewing the smartphone market (and probably the tablet market, too) through the wrong lens.  Most expect a repeat of the Windows vs. Mac battle of the 80's and early 90's, and using history as a guide, these folks have already declared that Android will become the dominant platform.  That sounds reasonable enough, but it's actually a flawed argument.  Windows overwhelmingly won out over the Mac mainly because of the Mac wasn't interoperable with the growing Windows installed base.  This all occurred before the internet was very important to everyday computing and at a time when file formats were more or less exclusive to each platform.  Those are the two conditions led to the emergence of a dominant platform in the PC industry.  Those two conditions no longer hold.  As evidence, the Mac has grown its share of the PC market significantly over the past five years.  How was this possible?  Because Mac users access the same internet as Windows PCs users and Mac users can now open, edit, and share MS Word documents.  iPad users can do the same today, and I have yet to learn of an all-important app, that is important to almost everyone, that only Android users can access.  Thus, while certainly possible, it is in no way inevitable that the mobile computing story ends with a single, dominant platform, and therefore, I think it is hard to argue that the iOS platform will see a significant decline in the near future (see competitive advantage discussion above).      


Is Android really winning?

Several recent studies have claimed that Apple's iOS is losing mobile OS share to Android.  This isn't necessarily the case, and even if true, these stories are still quite misleading.  First of all, other recent studies have shown the opposite and most pro-Android studies neglect the impact of iPad and iPod on mobile OS share.  Furthermore, and more importantly, according to smartphone unit data, Apple is actually growing at a faster rate than the overall smartphone market (i.e., gaining market share).  So, perhaps other OEMs are switching from another OS to Android, or maybe Android is taking down Blackberry numbers.  This is hard to say, but as long as the iPhone outgrows the market, it's hard to say that consumers are abandoning it.


iOS remains the developer favorite

Despite all the publicity showing Android's share gains over Apple, Apple remains the top choice among developers.  The reason for this is simple: there is more money in iOS apps.  Apple's App Store had sales of over $1.7B in 2010, representing over 80% of all mobile app sales.  Most iPhone and iPad users regularly buy apps (and many iPad apps are high in value) and can easily transfer them to future Apple devices, while most Android users don't pay for apps and fragmentation makes users less certain they will be able to keep their apps after upgrading to their next device.  


Android platform has a fragmentation issue 

Because Android is available to all, it forces device makers into fiercer competition.  This leads OEMs to take steps to differentiate their product offerings, and this causes Android platform fragmentation.  Most developers consider this a problem.

Uncertainty for developers makes it harder to plan investments.  Unlike the iPhone, for which developers know that each version is the standard for a year and each version will be supported by Apple for at least two years, Android devices can be hit or miss.  Also contributing to the trouble are the non-standard configurations between rival handset makers.  Just knowing how much RAM devices have is a critical factor in order to ensure adequate app performance.  Some Android developers have found themselves trying to forecast which Android devices will be good sellers so they can plan their development activity accordingly.  Android is not Android is not Android.  As some evidence, the head of Angry Birds maker (Rovio Mobile, probably the most successful mobile developer) said last year the he expects Apple to be "the number one platform for a long time from a developer perspective."  Just last November he had to apologize for poor game performance for some Android users and had to promise to develop a dumbed-down solution for lower-end Android devices.  At a conference last week, he said that he still sees "fragmentation of the [Android] ecosystem" as an issue, and that, with some Android devices, mobile carriers are starting to mess with the experience again, which is an unattractive environment to developers.


iPad is more insulated from Android competition than iPhone ever has been

Many industry experts expect Android's smartphone success to translate directly into tablet success.  I do not share this view.  Unlike the smartphone market in which Android devices were able to gain a foothold in uncontested areas, Apple will cede no such breathing room to Android devices in the tablet market (for the record, the iPhone is still on far fewer carriers than Android).  This is because the WiFi version of the iPad can be readily sold to anyone without going through the slow process of individual carrier negotiations.  Furthermore, this slower Android adoption by consumers would cause a significant difference in developer interest.  Also, because moving Apps from older iPads to newer iPads is pretty seamless, users will feel more comfortable purchasing the much higher value apps available for iPad (already evidence of this).  This means developers have a huge incentive to focus on the iPad.     


Vertical Integration and the mobile computing paradigm

When computers consisted of a large plastic box or two and a monitor on a desk, consumers paid scarce attention to a product's size and weight (and obviously battery life hadn't yet entered the picture).  Price and performance were seemingly all that mattered.  However, as products become more mobile and are carried around in pockets, bags and briefcases, a premium is now being placed on the new dimensions of size, weight, and battery life.  This new era plays into the strengths of the vertical integrator because he can tailor the designs of nonstandard components to better optimize the overall system across all dimensions.

Apple's always been an odd duck in the computer industry because of its stubborn insistence on vertical integration.  In addition to developing its own proprietary OS, now Apple design its own mobile chips.  Apple's latest system on a chip, the A5, is designed specifically for use with Apple's iOS software and specifically for use in Apple's mobile products.  As a result, the iPad 2 is able to deliver a combination of graphics performance, size, weight, and battery life that can't presently be matched using commercially available chips.  Furthermore, because Apple can spread the design and production costs over 100M or more units annually, its custom chips aren't much more expensive than generic ones.  As a result, the iPad 2 is able to come to market with the best performance, at the lowest cost, and with the highest margins.  The iPod Touch is in a similar situation - as is the iPhone, although the many carriers and subsidies currently cast a fog over the situation.  In summary, as the only vertically integrated device maker in the "post-PC" market, Apple can make better products than its competitors, and because of its scale advantages, Apple can also do this at lower costs.     


What's AAPL worth? 

As of March 26, 2011, Apple had cash, cash equivalents, and marketable securities amounting to roughly $70 per share and TTM EPS of $21.  Most reputable analysts expect Apple to have $87 per share in the bank and TTM EPS of $27 by the end of its fiscal year in October. 

Bear Case:  Given Apple's dramatic growth prospects, I think a fairly conservative bear case would have Apple seeing no growth.  In such a scenario, AAPL shares might be worth 10x trailing EPS + cash and securities per share, which would correspond to share prices of $280 today or $357 in October.  These prices are ~20% below current share price and roughly equal with it, respectively.  In either case, even without growth, annual cash flows of ~$20B+ would continue to pile up on the balance sheet, increasing AAPL's value with time. 

Neutral Case:  Perhaps with low growth (i.e., that stemming from declining share of a high growth market), AAPL shares might be worth 15x trailing EPS + cash and securities per share, which would correspond to share prices of $385 today or $492 in October.  These prices are roughly 10% and 40% current share price, respectively.   

Bull Case:  What if I am right about both Apple's markets and competitive position?  If that proves to be the case, Apple could reasonably double its revenues and earnings over the next 2-3 years.  This could mean $40-$60 EPS and at least $140 per share in cash and securities in two or three year's time.  Even with a 10x multiple, this would mean $540 to $740 (or more) per share.  This corresponds to gains of at least 55% and potentially over 100%.  Furthermore, should the market begin to better understand Apple's competitive position, Apple's multiple will likely expand.  (I estimate multiple expansion to ~20x would boost AAPL to ~$600 per share yet this year.)  Finally, because Apple's scale and demand advantages come from it selling more and more of its products and subsequently locking customers into its ecosystem, Apple's competitive advantages actually strengthen through each growth year, further extending its lead over competitors.  Thus, this virtuous cycle actually makes Apple's business more predictable, or less risky, as it grows. 

In summary, I think Apple is largely a misunderstood company, and thus, I think AAPL shares currently represent a mispriced bet.   



I am sure there are many.  Clearly, Steve Jobs' leadership will end someday and that could lead to a power struggle that hurts business performance.  Apple could also blow its growing cash hoard on a wasteful acquisition.  Alternatively, Apple's annual product refreshes could slip and allow openings for competitors, or Apple might grow so large that it becomes a target of antitrust litigation. 

All this and more could happen, but even still, considering Apple's current valuation, competitive position in growing markets, etc., I continue to think the risk/reward is acceptable (if not quite attractive).  



I neglected to mention a few things above because the above argument does not depend on them.  However, should operations continue as they seem to at present, the following could account for significant improvements to Apple's future performance.


The Mac Business

I haven't even mentioned Apple's PC business (the Mac computer) because at ~10% of 2011 sales, it's becoming a smaller and smaller portion of Apple's overall business.  However, the Mac is a product line that shares a great deal of product development synergy with Apple's iOS products, and it has been growing much faster than the overall PC market for the past five years.  It also has significant headroom for continued growth because its share of the PC market is only just ~10% in the US and ~5% worldwide.  The Mac continues to see more adoption amongst consumers and small businesses (every quarter Tim Cook happily reports that about 50% of Mac purchasers in Apple retail stores are new to the Mac).   Furthermore, the Mac is even making inroads into the enterprise.  A late 2010 survey by the (albeit slightly biased) Enterprise Desktop Alliance indicates that Mac sales into the enterprise should grow by about 23% in 2011 and "the number of organizations with a measurable proportion of Macs will grow to 70% by the end of 2011."  So, should these trends continue, the Mac could continue to add to Apple's growth. 


Unannounced products

It should be mentioned that neither the iPod nor the iPhone, nor the iPad existed a decade ago, and Apple is supposedly always secretively working away on the "next big thing" and maintains a multi-year product development roadmap.  Thus, it certainly would seem possible for Apple to have a fourth big hit come along over the next few years.  I'm certainly not counting on this, and I think Steve Jobs' continued leadership is extremely important to the success of a completely new product; however, this unquantifiable "plus" is nice to have in an otherwise attractive stock.


Culture and Management

From my experience, the managements of most large companies seem mediocre on average due to a number of factors that result in a complex and far from optimal set of incentives and constraints.  This is evident in numerous examples of collections of very smart people, making very poor decisions over time.  In contrast, I think Apple's recent history stands out.  In fact, a study of Apple's main decisions over the past decade indicates a remarkably deliberate, strategically gifted management.  Perhaps this is just Steve Jobs.  Perhaps this is because Steve Jobs doesn't tolerate BS arguments or office politics.  Perhaps this is the result of Steve Jobs forging what some describe as the "product culture" of Apple.  Whatever the cause, obviously this is a difficult thing to determine as an outsider, and thus, it is very difficult to judge the likelihood of this culture surviving following Steve Jobs' reign.  However, Apple does seem to benefit from above average management (and culture?) at present, and should this continue, one might expect Apple to continue to out-innovate its peers.  



Apple not losing share dramatically in the growing smartphone and tablet markets over the coming quarters.
Market realizing that Apple is more likely to grow than collapse. 
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