The Best Apple Christmas Present May Be Its Stock

Screen Shot 2013-04-09 at 5.45.11 PMApple’s stock has taken a beating since reaching all-time highs over $700.  Apple may be down but it’s by no means out.  I believe the stock will finish 2013 with a strong rally somewhere above the $500 mark.  The best Apple present this Christmas may not be an iPad Mini but rather Apple stock.

Analysts are mixed on Apple (AAPL).  Schwab’s Equity Rating is D, Underperform.  Ned Davis is Neutral.  Credit Suisses rates Apple an Outperform.  And the Reuters average rating is Outperform.  So, let’s examine the pro and cons of owning Apple stock.

Apple Cons

Concerns center around pace of innovation, supply problems and structural issues around gross margins.  And, of course, there’s the never-ending grumbling about capital allocation of its $140 billion hoard of cash and whether Apple should issue a dividend.  Many analysts worry Apple cannot sustain its gross margins, which has historically been well above industry competitors.

Other concerns hover around the increased competitive scenario and the fact that Apple no longer enjoys a monopoly.  People are excited about new products from Samsung (SSNLF.PK) which seems determined to continue its onslaught in spite of lawsuit setbacks against Apple.  And let’s not forget new forays into hardware offerings from Google and Facebook.  Apple is very dependent on iPhone for sales — about 70% comes from iPhone.  Plus, Apple has no recurring revenue stream other than iTunes and their revenues are based on what they sell.  We saw this in the 1980s with Sony when Sony was conquering the world of technology innovation.  The world loves Apple.   But people are waiting for a dramatic new product from Apple.  The world owns it.  But haven’t we seen this before with IBM or Cisco?

Apple’s lucrative margins are under attack, forcing it to protect its profits by pressuring its suppliers.  It’s not that Apple is doomed though.  It’s only likely to become less profitable.

Screen Shot 2013-04-09 at 5.44.54 PMApple is going through a transition from a hyper-growth story to a more traditional, high quality branded company.  It grew earnings at +45%+ per year for ten consecutive quarters.  Recently, it has grown earnings a little above 20%.  Apple will have over $200 billion in annual revenue this year.  It’s impossible to keep growing at that rate.  So, it will be a more traditional growth company with a great consumer brand and with great products.

Most of Apple’s cash is offshore – a constraint to returning cash to shareholders in the form of dividends.  Coke trades at a higher multiple than Apple.  People have expectations of growth from Apple that they can’t live up to.

Are Apple’s days of growth over?  Is Apple the new Coke?  Are its days of hyperbolic growth over?  Is Apple now the great new value play?  Or, is it a value trap?

Apple Pros

Apple may well continue a bumpy ride in the near term.  However, Apple’s fundamentals are still fantastic going forward if you take an outlook of more than a quarter or two.  Apple’s second quarter 2013 results are expected to beat expectations.  Credit Suise’s Kulbinder Garcha put an Outperform rating and a price target of $600 on Apple.

New iPhone demand will be strong

Screen Shot 2013-04-09 at 5.44.37 PMWhile 2013 may not have enough new products from Apple to satisfy everyone, the next iPhone will begin production this quarter according to a recent Wall Street Journal report.  Apple is reportedly working on a less expensive version with a plastic case that could be on the market before Christmas.  Regardless of which features are included, the new iPhone will be better than the last one.  The iPhone 5 has sold more than the 4S and Apple sold a record 47.8 million iPhones in the first fiscal quarter of 2013 – up 29% from a year ago.  The first iPhone 4S customers who bought in October, 2011 will be primed for a new phone now that their 2-year contact is about to end.  So, according to Morningstar analyst Brian Collello, the upgrade cycle will likely keep demand strong.  He maintains that the smartphone market is still in the “early-to-middle innings.”

Apple continues to lead in tablets

Apple remains the undisputed leader in the tablet market.  With more iPad and iPad mini models to come, expect tablets to bring in more app revenue for Apple than from smartphones.  iPads are also predicted to show strong sales for the second quarter – an increase of 61% year over year to 19 million units.  iPad minis will account for more than half of that.

Apple Apps remains the heavyweight

Screen Shot 2013-04-09 at 5.44.21 PMiPads are pulling in more revenue from each app than the iPhone, most likely due to higher-priced apps or apps that get more in-app purchases.  It’s also possible that games are playing into this because the iPad’s bigger screen lends itself to more complex games.  According to research by App Annie, app store downloads from iPad users doubled from 100 million in January 2012 to 200 million in January 2013.  More surprising was the amount of revenue the iPads generated from app downloads.  In January 2012, iPad has less than 20% the app downloads of the iPhone, but had nearly 50% the app store revenue.  In January 2013, the gap narrowed with the iPad accounting for 30% less app store revenue than the iPhone.

Canalys issued a report on app downloads at the four major mobile stores:  Apple, Google (GOOG), Microsoft (MSFT) Windows Phone Store and Research in Motion’s (BBRY) BlackBerry World.  Apple’s App Store accounted for the largest share of revenue among the four stores, around 74%.  Google saw the greatest number of downloads (about 51%) with Apple close behind.

Apple trades below intrinsic value

Apple has an attractive valuation and is currently trading well below intrinsic value.  Apple’s revenue growth should continue to be robust in the 20% range and is trading at PE ratio estimated at 9.6 and just 8.38 times next year’s earnings.  Compare that to the S&P 500 PE ratios which Robert Shiller estimates is currently trading at 18.17.

With the shares hovering around $425, there seems to be little downside, especially when you take into account about $100 in net cash per share if Apple were to bring all the overseas cash back and pay U.S. taxes on it.  Apple’s capital allocation is a continuing source of speculation.  With an estimated $140 billion in cash hoard – 75% of which is trapped overseas – a buy back would be viewed very positively.

Other pros for Apple include a potential China upside that has not yet played out, strong cash flow and the “leveragability” of iTunes.

My Take  

If you missed the opportunity to buy Apple before, take a hard look now.   There is little downside at $425.  Even if there is no big new product announcement, iPhones and iPads continue to sell well.  Apple is a well-managed, cash-rich company that’s proven it can juggle the profit margin pressures inherent with the transition to new, lower-priced product innovations.  While Apple may not climb back to it’s record-high levels, I expect it to hit somewhere north of the $500 mark by Christmas.

Smart investors will continue to profit from Apple and might be wise to consider putting Apple stock in their Christmas stockings rather than just another iPhone or iPad upgrade.  Awesome Stock.  Awesome Products.  Awesome Potential.

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