After months of underperformance, Apple’s (NASDAQ:AAPL) shares have received a fresh infusion of life lately. Rising from a low of about $400, Apple’s stock has appreciated more than 25% in less than two months. It has now decisively shot past the $500 mark – a level that was last seen in January this year. Most of the recent run-up (more than 10% in the last week alone) has however happened on the back of a couple of tweets by legendary investor Carl Icahn, who said that he has taken a large position in Apple. A number of recent filings by noted hedge funds, such as those run by George Soros and Leon Cooperman, also showed that institutional interest in Apple’s shares has been picking up amid growing speculation about Apple’s future product launches.
While most of the exuberance seems to be driven not by a change in fundamentals but investor sentiment, it doesn’t change the fact that Apple’s shares were extremely undervalued for a long time. Even at $500, we estimate that the stock is trading at a discount of about 20% to our $600 fair price estimate. Moreover, our price estimate doesn’t take into account any new product categories such as the iWatch and iTV, which may be launched in the coming months and could add even more value. Considering just the iPhone, on which rides almost half of Apple’s value by our estimates, there is immense value to be captured in the emerging markets where Apple is still a fringe player but has a very high brand strength. The introduction of a low-cost iPhone and a possible subsidy deal with China Mobile (NYSE:CHL) for the same could help Apple realize a lot of that potential in the coming years.
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Emerging Market Focus Essential
Apple’s recent quarterly results show that it has started increasing its focus on the emerging markets. Last quarter, the company took an ASP hit to sell more of the older and discounted iPhone models into sales channels in the emerging markets. Bucking the seasonal trend, Apple shipped as many as 31.2 million iPhones during Q3 and posted a y-o-y growth of 20% but a higher sales mix of lower-priced iPhone models caused ASPs (average selling prices) to decline by 4% over the same period last year.
What is a good sign for Apple here is that despite selling cheaper iPhone models, gross margins held up pretty well and came in at the higher end of Apple’s guidance at about 37%. Not only does this mitigate concerns about Apple’s ability to generate good profits at the mid-end but also shows that the iPhone remains the more popular choice when pitted against Android at similar price points. The latter can be seen not only from the increased emerging market demand for the discounted models last quarter but also that half the smartphone buyers at AT&T and Verizon chose to buy an iPhone at a time when Samsung had just launched its latest generation Galaxy S4.
It is here that coming up with a cheaper iPhone will prove value-accretive to Apple. Not only will such a move help Apple take on Android in emerging markets but also target first-time buyers who are likely to contribute the most to smartphone growth in the future. This is true not just for the emerging markets but also developed ones such as the U.S. as well. According to a recent UBS report, almost 68 million people in the U.S. upgraded their smartphones last year, down by about 9% over 2011.
Apple’s China story has been floundering of late in the absence of an iPhone deal with the largest carrier, China Mobile, which accounts for about 65% of the country’s wireless subscribers. Revenues from China last quarter declined about 43% sequentially and 14% y-o-y. With subsidy concerns likely to be the main factor holding up talks between the two, we believe offering a cheaper iPhone will also help Apple decrease the per-phone subsidy costs and potentially bring China Mobile aboard. China Mobile, for its part, will be looking for a ‘hero’ device to promote its LTE network in the coming years as it looks to wrest back some of the market share advantage it had lost to rivals in the recent years.
A big trigger exists in China Mobile
A deal with China Mobile could alone add billions to Apple’s value. Considering that China Mobile had been adding iPhone users at the rate of 1.25 million per month in 2011-12 in the absence of a compatible 3G network, we can expect the carrier to add an additional 1.5 million when it initially launches a low-cost iPhone on its network. Going forward, the carrier could sell as many as 200 million iPhones by 2020 if we take AT&T’s 27% iPhone penetration of its user base in 2012 as a benchmark. If we take a more conservative figure of 100 million and account for the ASP and margin hit as a result of the increasing mix of low-cost smartphones, we arrive at a fair price estimate of $650 for Apple – about 10% ahead of our current $600 price estimate. (see Apple Has A $45 Billion Opportunity If China Mobile Deal Materializes)
Our assumptions are contingent on China Mobile actually leading the 3G race in the same way as it has dominated 2G. The current 2G scenario is heavily biased in favor of China Mobile, but its 3G advantage is not so significant. If China Mobile is unable to leverage its huge 2G lead and turn it into a 3G advantage, the scenario may not play out as described above. Having China Unicom and China Telecom in the bag may help Apple cover a bit of lost opportunity in China Mobile, but for the China story to play out, its largest wireless carrier must deliver.