Why I'm Doubling Down on Apple Stock

As shares of Apple (NASDAQ: AAPL  ) dropped from more than $700 to less than $400 between September 2012 and April 2013, investors' concerns about the company multiplied rapidly. From a psychological perspective, this is not very surprising. While Apple stock was running up from less than $400 in late 2011 to its peak around $700, it was natural for investors (including me) to gloss over some of the company's weaknesses.

AAPL Chart

Apple Stock Price Chart, Dec. 2011-present. Data by YCharts.

By contrast, during its recent fall, Apple's flaws have come into clearer focus, and many people seem to have forgotten that it is still one of the most profitable companies in the world. A recent article in Fortune tried to take an even-handed approach, but still concluded that Apple has peaked. Author Adam Lashinsky argues that the company is "following" competitors with its new products and services like iTunes Radio, iOS 7 and possibly an iWatch.

In the midst of this chaos, an incredibly simple fact often gets overlooked: Even if investors were overly optimistic about Apple's prospects when they drove the Apple stock price up above $700 in September, isn't it very likely that the company is dramatically undervalued in the low-$400 range? That's what I concluded, which is why I significantly increased my position in Apple late last month.

Has Apple really peaked?
The debate about whether Apple has "peaked" makes for some very interesting theater, but can sometimes obscure more than it reveals, especially from an investing standpoint. There are two key points that investors should keep in mind when considering the future prospects of Apple and its stock.

The first point to consider is that it takes a good deal of hubris for analysts and other bystanders to proclaim that innovation is dead at Apple. While investors have become accustomed to the idea that leaks in the supply chain will give plenty of advance warning regarding Apple's plans, outsiders cannot really be sure of what the company is working on.

At most, one could argue that Apple has not debuted any innovative products since Steve Jobs died. However, there was a gap of more than five years between the iPod's debut in late 2001 and the announcement of the iPhone in early 2007. During that time, the company created lots of variations on the iPod (and iMac), but nothing truly "new."

Somebody who thought in 2005 that Apple had stopped innovating was proven wrong in dramatic fashion. However, the idea that Apple had peaked would never have even come up in 2005, simply because Apple stock traded for less than $40 back then. Apple just wasn't a big deal in 2005, whereas today it is constantly under the microscope.

A second point to consider is what people really mean when they speculate about whether Apple has peaked. If people are measuring the distance between Apple and competitors, then it is probably true that Apple has peaked. Apple was so far ahead of competitors in the smartphone and tablet arenas -- two humongous addressable markets -- by mid-late 2010 that it would be hard to replicate that dominance. For example, Apple had a staggering 71% share of smartphone profits in 2011.

However, if the question is whether Apple's earnings power has peaked -- and this is the key question if you're thinking about whether or not to buy Apple stock -- the answer is "probably not." Indeed, despite all of the pessimism surrounding Apple today, analysts still (on average) expect the company to grow revenue by more than 9% and EPS by more than 10% next year. That would still leave Apple's EPS a little below the record high it achieved in 2012, but any new product lines (or even higher-than-expected share repurchases) could lead to record EPS next year.

The big takeaway is that even if Apple never reopens its lead in the smartphone or tablet markets, and even if it never creates a new product that takes the world by storm, there is still room for the company to resume earnings growth by fully exploiting existing opportunities. One example is the often rumored idea of building a lower-cost iPhone that could be affordable to the middle class in developing countries.

Beyond a bargain
When I stated in the introduction that Apple stock's rapid decline from $700 to less than $400 seemed overdone, that actually underestimated the depth of the company's fall. From an enterprise value standpoint -- which adjusts for debt and excess cash to determine the value of the underlying business -- the drop in Apple's value was much steeper. After deducting Apple's cash, the company's enterprise value peaked at nearly $550 billion last September. As recently as late June, that had fallen nearly 60% to $225 billion.

Moreover, Apple has announced a big increase to its share repurchase program in the interim, raising confidence that excess cash will gradually be returned to shareholders through dividends and repurchases. That means that investors have less reason to discount or ignore the company's cash when determining Apple stock's proper value.

Could the Apple enterprise really be worth just $225 billion? Analysts currently expect Apple to earn over $37 billion for FY13, compared to last year's record earnings of $41.7 billion. Apple's enterprise valuation therefore bottomed at just six times earnings last month, and still sits well below seven times earnings. That represents a discount to the valuation of Hewlett-Packard, a company that has gone through much more turmoil over the last two years, and it represents a significant discount to Dell's current valuation.

In short, the recent Apple stock price only makes sense if you believe that the company's earnings will continue declining. However, it's important to note that while earnings declined this year, revenue growth continued. The earnings decline was entirely driven by lower gross margin. The bulk of the evidence points to this margin contraction being one-time in nature, not a long-term trend.

Foolish conclusion
If you believe that bargains do arise in the stock market, Apple stock today fits the bill. The company may not be as far ahead of competitors as it was two or three years ago, but it still has a unique brand name that provides an enviable moat. Moreover, despite a margin "correction," the company is still on pace to earn net income of approximately $37 billion this year.

Yet for all these advantages, Apple stock can be bought for less than seven times earnings (if you exclude the company's cash). Could something go wrong for Apple investors? It's always possible; the technology landscape can change rapidly. However, Apple provides a generous margin of safety for value investors -- enough to make me feel comfortable upping my holdings.

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Read/Post Comments (13) | Recommend This Article (13)

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 July 10, 2013, at 7:26 PM, p2i wrote:

    I sold Microsoft and bought Apple recently. Sort of a Dogs of Technology play. Better dividend and better upside potential.

  • Report this Comment On July 10, 2013, at 7:34 PM, pebbles444 wrote:

    But, is it safe to buy Apple before its upcoming earnings with all the negative comments about it falling short?

  • Report this Comment On July 10, 2013, at 7:45 PM, tech2guru wrote:

    The key to AAPL's decline in value is that Apple lacks a technology barrier to secure its leading position in consumer electronics. Steven Jobs' contribution was to introduce the novelty of a new product, and his limitation is that he was not technically proficient enough to how to to build up a technical barrier to curb off competitors. Apple filed trivial patents such as rounded square which is not going to save it from the competitor. Not until Apple learns how to differentiate itself from other competitors such as Samsung and HTC that AAPL can find some supporting ground in the trading floor.

  • Report this Comment On July 10, 2013, at 7:50 PM, VegasSmitty wrote:

    The end of Apple is in sight, except for the fanboys.

  • Report this Comment On July 10, 2013, at 7:56 PM, jackflash9999 wrote:

    Whos the fool buying Apple stock now?

    Apple is an eroding company. It's real innovation is gone. Apple has regressed from innovative to coasting and will eventually be an average at best manufacturer of average products with excellent service. Welcome to the future of Apple!!!

    Watch out for the Korean products like Samsung and Hyundai. While we're sleeping here in North America working for the weekend, extending our breaks and waiting to punch out, those companies are up late at night working extra hard to give their clients what they want. Just look back over the last 3-5 years and it's obvious. This is coming from an on-the-fence Apple product owner.

    Cheers!!!

  • Report this Comment On July 10, 2013, at 8:13 PM, TMFGemHunter wrote:

    Thanks for the comments. Is Dell an innovative company? Its trading multiple is about 1.5 times that of Apple if you exclude cash, and Carl Icahn and others are convinced that Dell is worth far more than that.

    Samsung has been following Apple's lead for years with great success. Even if Apple and Samsung are "co-leading" the mobile world for the next few years, I don't think that will slow Apple down very much from an earnings perspective.

    @pebbles444: There's always the possibility of a further decline in the stock price. That shouldn't be a big worry from a long-term investing standpoint; one quarter of earnings (when many customers are waiting for a raft of new product launches) won't make much difference to what Apple stock is worth two or three years from now. One option to mitigate your risk is to buy half of your intended position before earnings and another half after.

    Another way to look at it is that the longer Apple's stock price stays at its recent depressed level, the more shares the company can buy back within its $60 billion repurchase program. That will boost the long-term value of other shares.

    Apple will only be a bad long-term investment from here if earnings continue to decline by 10% a year or more for the foreseeable future. I don't think that's very likely to happen, but that's just one man's opinion.

    Hope that helps.

    Adam

  • Report this Comment On July 10, 2013, at 8:30 PM, ChakaTen wrote:

    Great post.

  • Report this Comment On July 10, 2013, at 10:36 PM, MrSmith210 wrote:

    Well written, to the point and kept simple. This is exactly what makes AAPL compelling. I do expect a Q4 spurt into 2014 but its still a couple months out before I see aapl getting its legs back. 2013 will be virtually dead money the entire year when we look back at it I expect.

  • Report this Comment On July 10, 2013, at 10:58 PM, hankering2buy wrote:

    TMFGemHunter, nice summary. I used MS products from the beginning on the PC until 2007when I switched. APL has exceptional look and feel, a solid Objective-C open source process and loads of cash to keep the technology edge sharp. We just have to watch for its current managers to be confident they are using the $ well for investor's benefit.

    I'd buy more because the price is a steal, except with the appreciation since I've bought I'm at near 10% of my Fool portfolio and do not want to let it go larger except through value growth.

    Look at the long view, as long as it remains technically innovative APPL will do well - even if it pays penalties for jury-rigging the e-book market.

  • Report this Comment On July 11, 2013, at 12:58 AM, pebbles444 wrote:

    Adam...yes, you did help. Thank you.

  • Report this Comment On July 11, 2013, at 6:09 PM, topbeancounter wrote:

    Why not buy gold as well, since that is down too? I'd say you have loser with Apple for none of the reasons you have disclosed. And I just heard that gold is going to $5,000, just not in my lifetime!

  • Report this Comment On July 11, 2013, at 8:22 PM, csqrd55c wrote:

    I traded heavily in the 80's and 90's with tech stocks because that was my field. I held Apple for years in the 90's and told friends they should invest in the company too. However in about 1999 after it sat dormant for several years I sold about 100 shares at about $27/sh, I stopped the day trading I had been doing to travel. I was preoccupied with other things when the ipod was introduced and then again when the iphone came out. You can't imagine how many times I have kicked myself since I decided to start playing the market again! Many of us thought Apple's innovative days were long gone in 1999/2000. I doubt very much that they have quit the game, and that would be the only reason they wouldn't continue to innovate, and in a big way. I see their price drop as a real opportunity for those of us that are trying to get in or back in the game at this late hour.

  • Report this Comment On July 12, 2013, at 12:03 AM, dwatson102 wrote:

    Apple has a 90% customer retention rate on upgrades. For Android it is 50%.

    Do the math as another cycle comes around.

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