Apple: Too Big To Grow?
Apple (NASDAQ:AAPL) has been strengthening its position as the world’s most valuable company, with its stock price rising by more than 40% over the last 12 months. The company’s $750 billion market cap stands at about twice as much as the next biggest company, and accounts for about 4% of the S&P 500. The enormous valuation is certainly not without reason: Apple’s high-margin flagship product, the iPhone, has been seeing unprecedented demand, allowing for solid sales and earnings growth. Apple’s track record of execution and beating expectations has been so good that few analysts and commentators want to bet against the company. For instance, when Apple became the world’s most valuable company back in 2011, with a market cap of about $340 billion, overtaking Exxon Mobil, there was a lot of skepticism whether the winning streak would continue. However, it went on to more than double its market cap to current levels of about $750 billion. Many in the market believe that Apple stock has a lot more room to run, with prominent activist-investor Carl Icahn valuing the stock at $240, a premium of over 70% above the current market price.
Our $144 price estimate for Apple is about 10% ahead of the current market price.
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However, despite the heady growth and track record of beating expectations, the markets assign Apple stock an earnings multiple of just 14.5x FY 2015 earnings (still lower ex-cash), making the stock look like a complete bargain in the current market. The S&P 500 trades at about 18x projected earnings. However, there could be two good reasons behind this, namely growth prospects and risk. The law of large numbers – which implies that financial growth begins to slow for very large companies as it becomes difficult to find new markets to expand into – is likely to be something that is on the back of investors’ minds. The increasing concentration of revenues around the iPhone could also be of concern. The iPhone accounts for about 60% of Apple’s revenues. Additionally, while iPhone revenues grew at rates more than 50% year-over-year over the last two quarters, all other product lines combined actually saw revenues decline. So that brings us to an important question – how much more valuable can Apple really get, or is the company peaking? In this note, we examine the company’s growth trajectory thus far, and take a look at the prospects for Apple’s current product lines and potential future products.
Apple’s Growth Trajectory So Far
Since the iPhone was launched in 2007, Apple’s stock price has grown at about 33% CAGR, while average revenue growth rates have also come in at similar levels. However, the increase hasn’t been consistent. While Apple’s sales grew at an average rate of 39% during FY2007 and FY2008, riding on demand for the original iPhone and the iPhone 3G, growth rates moderated to about 14% in 2009 – a year in which the company had no major product launches. However, revenue growth averaged 54% between 2010 and 2012, driven by the introduction of the iPad and due to an important redesign of the iPhone line-up with the iPhone 4. Revenue growth slowed down considerably over FY2013 and FY2014, averaging about 8% a year as the company’s product upgrades largely remained evolutionary. Apple looks set for another growth spurt this financial year, with revenue growth expected to come in at about 25% (based on consensus revenues), owing to demand for the new big-screen iPhones and the introduction of Apple Watch. In summary, as the above chart shows, the law of large numbers is certainly kicking in, with overall revenue growth rates falling from levels of over 40% (2007-2012) to about 14% (2013-2015E). That said, growth rates do see a spurt every time a major new product is launched, or when existing products see a significant upgrade. So rather than applying the law of large numbers abstractly, let’s also take a look at the outlook for Apple’s major product lines and some potential new markets that the company could tap into to gauge its growth prospects going forward.
Existing Product Lines Should Remain Key Levers Of Apple’s Valuation
iPhone Has Some More Room For Growth: The iPhone is the single-largest driver of Apple stock and we estimate that it accounts for about 59% of the company’s market cap and over 70% of its gross profits. It’s safe to say that the iPhone will continue to be the primary lever of Apple’s valuation in the medium term, and possibly the longer term. iPhone revenues soared by over 57% and 55% respectively, year-over-year for Q1 and Q2 FY2015, driven by demand for the iPhone 6 and iPhone 6 Plus, which offered the larger screens that Apple resisted adopting for nearly three years. Apple commanded 18.3% of the smartphone market during Q1 2015, up from about 15.2% a year ago, according to IDC and the near-term outlook remains solid. [1] For example, Apple estimates that just about 20% of its active iPhone users have upgraded to the latest iPhone 6 and 6 Plus units, leaving room for growth. Apple has also been seeing strong momentum in China, emerging as the country’s top smartphone vendor during Q1 2015, according to IDC. While the broader Chinese smartphone market is saturating, demand for premium smartphones should remain strong as customers upgrade to more capable and premium devices, and Apple is likely to be a big beneficiary of this trend. Apple has also invested considerably in building on its already robust iPhone ecosystem – with products such as Apple Watch, Apple Pay, and the upcoming streaming music service – which could increase switching costs for the platform.
However, there are risks. The smartphone paradigm has been largely set, and gaining an edge in terms of feature-based differentiation appears increasingly difficult. The recent evolution of the iPhone (from the iPhone 4 in 2010 to the iPhone 6 in 2014) is a testament to this, with upgrades largely related to better software/services, spec upgrades, and larger screens. Additionally, competition is only likely to heat up further as the market matures. Design and user experience on Android phones is getting better and more vendors are beginning to focus on the high end of the market in a quest for greater profits. Strategy Analytics estimates that Android vendors together accounted for just 11% of global smartphone profits, or $2.4 billion during Q4 2014, compared to the roughly $19 billion in profits commanded by the iPhone. By the nature of innovation and disruption, it only seems likely that these above-normal rates of return that the company is realizing could mean revert over time. [2]
Watch Has Potential, But Don’t Expect It To Be A Blockbuster: The Apple Watch went on sale late last month. Although early reviews of the device have been mixed owing to weak battery life and the lack of a true-killer application, we still think it will sell very well owing to Apple’s brand cachet and pent-up demand for an Apple wearable. That said, we don’t expect the Apple Watch to be a major driver of Apple’s future sales or valuation. Unlike the smartphone, which has become a modern day necessity, smartwatches remain something of a nice-to-have accessory rather than a must have device, due to their limited use-cases. Apple has been managing investor expectations of the Apple Watch as well, given that it hasn’t disclosed early sales numbers as it often does with new products. It will not be breaking out Watch sales under the segment information in its earnings releases either. Margins for the device were also guided to be below the company average for FY Q3.
Enterprise Market Could Provide Incremental Upside For iPad and Mac: Apple’s iOS devices have been dominating the enterprise mobility space for some time now. For instance, activation data from Good Technology, a mobile security solutions provider, indicates that as of Q1 2015, iOS accounted for about 72% of all mobile device activations in the quarter. Although Good gathers information only from its customers and excludes BlackBerry devices, it should be a reasonable proxy for the broader enterprise market. We believe that Apple may have some room for growth particularly as tablet penetration improves in the enterprise space. Enterprise tablet penetration stands at just about 20% (notebook penetration is more than 60%) and we believe that the wide ranging deal that Apple signed with IBM last year could help to make the iPad a more integral part of enterprise computing infrastructure. An iPad equipped with quality enterprise-focused software could possibly supplant PCs for several typical business use-cases. Under the deal reached by the two companies last year, IBM will develop industry-specific apps and solutions for iOS devices, optimize its cloud services for the iOS platform, and help with marketing Apple devices to enterprises.
Future Pipeline: Why Apple Car, Apple TV, Home Automation Are Likely To Be Overshadowed By iDevices
Products such as the iPhone and iPad proved to be a game changer for Apple, enabling the company to upend several high-value industries and markets – ranging from mobile phones to photography to the gaming and media industries – by leveraging its core strength of software development and hardware engineering. However, finding similarly large and profitable markets to exploit may be challenging. Companies typically prioritize projects that they believe can provide the greatest rates of return and Apple’s recent launches and product rumors seem to indicate that it may not be easy for the company to keep the new product momentum going. For instance, the Apple Watch, Apple’s first new product category in over 4 years, is unlikely to break into the mainstream in the near-term or really move the earnings needle. Separately, according to reports from The Wall Street Journal, Apple has abandoned plans to introduce a high-definition TV set after many years of development, after reasoning that the new features it was experimenting with were not compelling enough to make a dent in the competitive TV market. Other rumored products (that all lie in Apple’s hardware/software domain) such as home automation, Web-based subscription TV services are only likely to provide some incremental upside, in our view.
However, one big area that Apple is reportedly very interested in is the automotive space (related: Thoughts On An Apple Car). The Wall Street Journal reported that Apple was working on building its own electric car, assembling a team of several hundred employees to work on the initiative. Although automotive technology isn’t Apple’s core competency, this is unlikely to be a major issue. Tesla Motors has proven that it is entirely possible to build an innovative automobile from the ground up by combining strong leadership, the right talent, and a reasonable amount of capital. Tesla’s success provides a level of confidence that Apple should also be able to build an automobile business of its own. Additionally, the Apple brand is likely to have significant cachet among the next generation of car buyers, which could make it easier for the company to compete against the established order in the automobile industry. However, there are many concerns as well.
Firstly, volumes and margins will be major concerns. Unlike Apple’s consumer electronics business, which is a high-volume, high-margins affair, the company will face a major trade-off in the auto market. Battery technology is evolving very slowly and battery costs account for a bulk of an electric car’s cost base. Given these constraints, it’s likely that Apple will focus on the low-volume, high-end of the electric vehicle market, since this would allow enough headroom to make a truly innovative, high-margin product, without being constrained by high battery prices. Although it’s hard to gauge the impact of the launch of a high-end electric car on Apple’s valuation, it’s unlikely to be very large in percentage terms. For perspective, BMW, the world’s largest luxury car maker, currently has a market cap of under $70 billion, and if Apple’s car business were to be valued at similar levels it would add just about 9% to its market cap. Secondly, entering the mainstream auto market will likely require in-house manufacturing which isn’t exactly in the company’s DNA. Thirdly, Apple has a reputation for being notoriously patient with its product development cycles (iPhone and Apple Watch reportedly took roughly three years to build) and the timeframe to develop and bring to market a truly innovative car could be much longer. Finally, there’s no real dearth of premium brands or innovation (Tesla, BMW) in the auto market, and it’s difficult to see a niche that Apple could carve for itself, if it were to make an electric car.
Bottom Line
We remain bullish on Apple stock with a $144 price estimate, which stands at about 16x FY2015 earnings. However, we are of the view that driving double-digit growth rates over the medium-term will be challenging. Most of Apple’s current success is attributable to the iOS juggernaut, which has already disrupted several high-value industries. Finding other similarly large and profitable markets for expansion within Apple’s core domain won’t be easy. While rumors of Apple’s expansion beyond the consumer electronics/computer industry with products such as an Apple Car seem exciting, we wouldn’t assign a large probability to such products actually materializing or factor them into our valuation models, since they lie outside Apple’s domain of expertise, and might require a cultural shift for a company that has been as razor-focused as Apple. In the interim, we believe that a valuation upside could come from the equity markets assigning a higher earnings multiple to the company, as it proves that it can sustain sales and margins (particularly for iPhone) over the longer term, while driving some incremental upside from other products. For example, if Apple were to be valued at an 18x forward multiple (at par with the broader S&P 500), this would translate to a price of $164/share, or a 25% upside from the current market price.
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- Smartphone OS Market Share, Q1 2015, IDC, May 2015 [↩]
- Android Captures Tiny 11% Share of Global Smartphone Profit in Q4 2014, Strategy Analytics, February 2015 [↩]