Today's Buy Opportunity: Apple

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After years of skepticism, I'm ready to give in: I think Apple's (Nasdaq: AAPL  ) a buy. Maybe it's a case of something akin to Stockholm Syndrome. I work with articles about Apple every day and can barely avoid a slew of conversations about the company. Can a company worth $250 billion keep growing at outsized rates? Does the iPhone have a sustainable competitive advantage that investors can bank on? Does Google's (Nasdaq: GOOG  ) Android threaten to disrupt Apple the same way Microsoft (Nasdaq: MSFT  ) did in the 1980s?

However, for reasons outlined below, I'm comfortable with the risks we're taking on to buy Apple at today's prices.

Fast facts on Apple

Market capitalization

$247 billion

Industry

iEverything

Revenue (TTM)

$57.1 billion

Free Cash Flow (TTM)

$13.5 billion

Cash / Debt

$45.8 billion / $0

Source: Capital IQ, a division of Standard & Poor's, and company filing. TTM = trailing 12 months. Free cash flow excludes stock-based compensation. Cash includes long-term investments.

Last week, I published an article outlining four reasons why Apple should continue outperforming expectations. It's worth reviewing these four factors, as I believe they address several of the threats and concerns surrounding the company:

  1. iOS Scales: Some people like to say that Apple needs to keep reinventing new hit products to justify its current valuation. However, as the iPad has shown, Apple can scale its operating system across several devices. Look no further than Apple TV. The newly updated version may be underwhelming, but future models of Apple TV could easily incorporate iOS to provide better media, gaming, and other apps right into consumers' televisions. The point is that even though iOS started on smartphones, it's now a dominant platform on tablets, and it could make further inroads into the home. Not only that, but iOS provides an enclosed platform where Apple can eventually unleash its iAD creative agency to generate additional high-margin revenue streams.
  2. Software is the new kingmaker: Remember when Motorola (NYSE: MOT  ) was the ascendant can't-miss mobile phone company? Well, it fell, and fell hard. However, Motorola's advantage was built upon hardware. Large carriers like Verizon (NYSE: VZ  ) and AT&T (NYSE: T  ) controlled the software experience inside phones; the only way phone companies could differentiate was slick hardware designs that were easily copied. While Apple currently has some of the best hardware design expertise, the real value of its phones is the software. That includes both external software like iTunes that connects the iPhone to a larger media ecosystem, the iOS interface, and the hundreds of thousands of apps being designed specifically for Apple's gadgets. Building up a strong software platform with superior developer support is a much better competitive position than mobile companies of the past. Plus, as users organize their media around iTunes and purchase a collection of apps, their chance of switching platforms declines. Currently, 89% of iPhone users plan on upgrading to an iPhone once again for their next phone.
  3. Consumer behavior: We like to think we're all rational people, but at heart, humans are prone to making the same puzzling decisions over and over. Smartphones play on humans irrationality by offering up a tantalizingly low subsidized price, while the real costs (an extra $30 month for data, etc.) are back-loaded over time. This allows for a much larger total addressable market than other non-subsidized consumer products of a similar price range (Apple collects around $600 for every iPhone sold).
  4. Underrated smartphone growth: Researcher Gartner sees smartphones growing by 28% annually over the next four years. That's a stunning growth rate, but what's even more stunning is that as a leader in this field, Apple trades for only 12 times next year's earnings after netting out cash. There seems to be continuing skepticism about the future of smartphones, but with penetration rates hovering between 10% and 30% across the world, there's still large untapped markets. Also, the nature of smartphone contracts often encourages relatively rapid upgrade cycles. In the U.S., users see massive discounts after two years. Compare that to the average age of a PC, which stands at 4.4 years. The subsidized nature of smartphones and rapid upgrade cycle make them a truly underappreciated trend.

The valuation
Few people would argue that Apple has innovative products that should keep delivering; the greater concern is the company's lofty valuation. However, I believe valuation concerns for the company are exaggerated. While Apple's trailing P/E is around 20, its forward P/E is about 15. However, even that 15 number is likely exaggerated, it's based on analyst estimates, and Apple has outperformed analyst estimates every quarter since at least 2004. Finally, as mentioned above, if you want to further give the company credit for the cash on its balance sheet, the P/E after netting out cash drops to 12.

In my prior write-up on why Apple looks ready to surpass Exxon as the most valuable company in the world, I described a scenario where Apple merely performs in line with expected smartphone growth rates. Using the assumptions below:

Metric

Today

2014

iPhone Gross Margins

Estimates vary between 55% and 65%

50%

Apple R&D and SG&A

11.7% of sales

15% of sales

Apple Effective Tax Rate

27.2%

35%

Source: Capital IQ, a division of Standard & Poor's, and company filings. Gross margin estimates come from researcher iSupply and industry analysts.

And growing Apple at the industry growth rates, Apple would generate $15 billion in post-tax profits from the iPhone alone (more than it currently generates as a whole business).

To arrive at the company's current valuation, you need to assume Apple grows at about 15% over the next five years, 5% in years 6-10, and has a 2% growth rate after year 10. While that 15% growth rate would be lofty for most companies, remember that it's only half the assumed smartphone growth rate, and that Apple's smartphone sales drive a virtuous cycle of other product sales. Take the Mac: Despite controlling around 90% of the market share of computers costing more than $1,000, last quarter, the Mac unit grew an enviable 31%.

Also, remember that the company is growing off results with only one quarter of iPad sales. Apple is now reportedly gearing up to ship 2 million iPads a month. At that run rate, the iPad alone would be around a quarter of Apple's current revenue. Not bad for a brand-new product that many (myself included) doubted.

Final thoughts
Apple is the king today, and I don't see it being displaced. During the next two or three years, I have little doubt that it will keep soaring. However, longer term, there are still concerns.

Google has to be the first concern that comes to mind. If the next couple of years see a reduction in the relevance and use of apps, Apple could get burned while Google's model of free distribution continues growing like wildfire.

However, even within the parallel of seeing Google playing out the same role as Microsoft in the 1980s, I think there's still room for Apple. If the company controls a smaller, but still differentiated platform, it will continue to see strong developer support, especially if its users are from a stronger demographic that spends more money on applications.

Also, as smartphones gain increasing penetration rates in developed countries, much of the growth will come from emerging markets. Even if smartphones grow at the stunning 28% rate I mentioned earlier, Apple might not be able to keep pace as consumers reach for lower-end offerings. The natural beneficiary of this? Google. Because Android can scale down to extremely inexpensive phones, it should do well in these markets.

All things considered, though, as mind-boggling as this is for a nearly $250 billion company, there appears to be some pretty good upside left in Apple. Long term, you'll need to watch the risks closely, but over the next couple of years, the Cupertino juggernaut will keep surprising.

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Eric Bleeker owns shares of no companies listed above. Google and Microsoft are Motley Fool Inside Value picks. Google is a Motley Fool Rule Breakers recommendation. Apple is a Motley Fool Stock Advisor selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Google and Microsoft. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 16, 2010, at 11:39 AM, rbtrader wrote:

    I sold my Apple options yesterday. I guess that's what makes a market. I sold for two reasons, first reason: technical

    Apple has been trading in a range since May and the price is at the top of the range. The price movement over the past two and a half weeks has been on light volume.

    Second reason: more fundamental

    Apple does not have a single competitor that is now cleaning their clock, rather they have a crowd of competitors that blur the lines. There are now many smart phone makers that all have some feature or other that appeals to someone buying a smart phone. This will soon also be true for the iPad, everyone will soon have one on the market. Sony is now outselling iPods in Japan for the same reason, they now have a product that appeals to a certain audience.

    So, I think your late to the party. I may be selling early, but if your an active trader, you know you rarely sell on the top, but I think you are buying too near there.

  • Report this Comment On September 16, 2010, at 11:52 AM, wordlaw1 wrote:

    Eric,

    Two questions come to mind...

    1. Assuming Apple will continue to grow as you state, does AT&T with their exclusive rights to the iPhone stand to gain more market share?

    2. Having been on Sprint for the past 10 years and now on AT&T, I'm experincing a large amount of dropped calls. My understanding is that AT&T has as many cell sites as VZ or Sprint but since they are all GSM which has a much narrower bandwidth dispersement, it results in more drops. What's AT&T's plan for addressing this?

    Your opinion?

  • Report this Comment On September 16, 2010, at 12:47 PM, Henry3Dogg wrote:

    If Google weren't there with Android, then the biggest threat to iPhone would be Windows Phone 7, because the makers without their own OS would use it. MS knows how to play that game, and if the OS is any good then it could be a real threat.

    But with Android there, there is no place for WP7 to exist.

    At the same time Google seem clueless how to play this game. OK lots of makers are using it because they had no real choice. (HP saw a choice and went for it).

    But Google do not understand how to manage the thing, and are just using it to prop up their advertising grip. It will splinter and fester and in a few years we will talk about Android, like we now talk about Symbian. I. e. As the OS that a number of phones use, but not as a single entity. Most of us will have forgotten that Google were ever involved.

    So I don't question listing Google/Android as a threat. But nobody ever gets a market that size to themselves. Google is the ideal competitor for Apple to have in that space.

  • Report this Comment On September 16, 2010, at 1:04 PM, millsbob wrote:

    some people -- actually, Most people -- just don't get it...

    10 years ago, Apple made Macs, and everyone was projecting AAPL's future based on that.

    5 years ago, Apple made iPods, and everyone said AAPL was all about music devices and delivery.

    then Apple brought out the iPhone, and now all anyone can see is smart phones.

    hello? are Any of you awake?

    mills (long AAPL stock & options)

  • Report this Comment On September 16, 2010, at 1:57 PM, rbtrader wrote:

    Good Afternoon Eric,

    I find it interesting that with the number of companies now making smart phones, and the number of companies that will have tablet computers and ereaders on the market in the next couple of months, you are now willing to buy Apple stock at a near all time high. I don't see any one company as a smart phone standout to compete with the iPhone (but then I don't use a smartphone), but I see so many smart phones to choose from that no one phone is going to keep a large share of the market (each has some feature to offer a potential buyer). An article at Fortune's on line site shows the iPhone has had a reduction in market share for the first time. Another article published within the past week lists no less than 20 tablet/ereaders scheduled to be in the market in the next 30-60 days.

    With the shear volume of competition coming to market for Apples largest revenue producers, why would you be willing to "take the leap" and buy now?

  • Report this Comment On September 16, 2010, at 3:53 PM, cdubonmf wrote:

    Mills nailed it. Apple is an innovator. Everyone seems to forget that all these other smartphones came out after the iphone- they are simply copycats following Apple's lead. THAT is what makes Apple a great company. That and they understand the value of image and style in conjunction with their revolutionary technology.

  • Report this Comment On September 16, 2010, at 3:54 PM, joe951 wrote:

    once apple gets a multi carrier strategy going on in the US, they will grow their market share by about 50%, but not much more. Afterwards I expect apples marketshare in smartphones, and tablets to remain about the same over the next 5-10 years. however both markets will be growing a lot in that time frame as well.

    i expect their marketshare in PCs to grow slightly in this time frame as well.

    i also expect their market share for music playing devices to fall by a few percentage points during this time period due to iphone sales taking away some ipod sales and apple not focusing as hard on this devision because it does not offer as much upside.

    I sold about half of my apple stake 2 months ago for a nice profit. I am looking to buy in again sometime, but I am not sure if now is a good time.

  • Report this Comment On September 16, 2010, at 3:57 PM, paddlinfaster wrote:

    I succumbed a month ago. Ater a brief dip below my buy-in price, I am currently up 12%. Not bad for a month...

    The only problem is that I had PLANNED on buying a little more when I had more money & was expecting the "historically worst stock month" to keep the price stable. Joke's on me, I guess.

  • Report this Comment On September 16, 2010, at 4:27 PM, emptygestures wrote:

    More like "Today's Sell Opportunity".. Apple is technically a sell.

    One their computers: I really like Windows 7 which is very user friendly compared to older OS's created by Microsoft. I think gradually people will start moving away from Apple because of the high price of their computers.

    Phones: Competition from Google which the new Droid is superior in performance to Iphone 4. Spring is making some good leaps with their new touch screens.

    Long term buy maybe but short term I would wait for a pull back to enter

  • Report this Comment On September 16, 2010, at 5:24 PM, Emperor2 wrote:

    People that worry Apple competitors products will really hurt Apples sales miss the entire point of the way Apple does business. They sell you an entire "ecosystem", not just one product. Every product they sell you will inter-act and inter-relate with all of your other Apple products. Competitor A has more features on their smart phone. Competitor B has more features on their "pad". Competitor C has more features on their computer. But these competitors are only selling a "product". They are not selling an entire "ecosystem" that pulls you in like quicksand, albeit quicksand that offers a wonderful experience. Once people are in the Apple quicksand, they realize that this is one quicksand they don't want to struggle to leave. Apple makes their products easy to use and makes information easy to share across multiple Apple products. Those investors that cannot understand the big picture, and focus instead on the minutia of the features of competitor's products, will miss out on a great investing opportunity. Buy more Apple now while you can still get it at a reasonable price.

  • Report this Comment On September 16, 2010, at 5:47 PM, iinsic412 wrote:

    When I first joined MDP, Apple was not a "buy first" or even a "buy" stock. It was trading around $194 earlier this year, give or take. But I had a client whose employer was an innovator with wireless music download platforms and they were doing some q.t. work with Apple. He told me if he had $100,000, he'd put every cent in Apple, in spite of the almost $200 share price.

    I'm not a rich man, but I did put five grand into Apple at a dip of $193. In only seven months, that investment has appreciated 43%!

    Now Eric is suggesting - as are many other analysts looking at Apple's undeniable innovation juggernaut - buying in at the current $276.

    I'm happy with where I bought in and I doubt I'll buy more. But, based on Eric's recommendation, I'm sure I'll hang on to it for at least the next couple of years.

    And why not? In the last two years, I've replaced my PC and phone with Apple products - and now can't live without them. When the print utility is added to the iPad OS in November, I'll buy one of those. And I'm seriously thinking about snagging one of the new $99 Apple TV boxes to make my Netflix membership more fruitful.

    My mother - God rest her soul - was one of those "buy stock in companies whose products you love" investors. And she passed away with a pretty hefty portfolio. If she was alive today, she'd own more Apple stock than I do.

    Fool on!

  • Report this Comment On September 17, 2010, at 5:22 AM, jsnodgrass wrote:

    iinsic412,

    Your mother - God rest her soul - whose oversimplified investment advise was "right on" is the reason everyone I know who rides--rides Harleys. Someday in the not too distant future, this market is going to really take off. More folks will be working and disposable income will grow to the point where both young and old will be investing more and more in the kind of toys that offer freedom and excitment. I love my wife, my dogs, and Harley Davidson--I could care less about which smart phone or computer I own, they all get the job done--but there's nothing like being on a Harley, and I've been on a lot of other brands. Thanks, iinsic412, for your Mom's "heads up", think I'll buy more HOG when the market opens.

  • Report this Comment On September 17, 2010, at 3:57 PM, alon2k5 wrote:

    millsbob got it right to the point.

    Everybody is sleeping when it comes to understanding Apple & Steve Jobs.

    If Apple was about chasing the market with a nice looking 'me too' product every year, I'd sell all my shares today (for a nice 115 % profit).

    Apple (with Jobs as the visionary) is inventing the future each and every time.

    And as investors and traders are concerned with the smartphone competition and how it will affect Apple, you can bet your best money that in 3-4 years we will all be talking about something completely different, well almost..... it will still carry the apple logo.

    As long as Apple continues to lead and invent ahead of the rest, no competition can hurt them.

  • Report this Comment On September 23, 2010, at 11:41 AM, tomtomtomtom wrote:

    ...and what happens when Steve Jobs dies?

  • Report this Comment On September 24, 2010, at 2:16 PM, Andru16 wrote:

    Everybody dies in the end, but I see at least another 20 great years ahead with Steve. For crying out loaned, he's only in his 50s.

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