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Do "New Categories" Make Apple, Inc. Undervalued?

No matter what valuation metrics you use, Apple (NASDAQ: AAPL  ) is significantly cheaper than most stocks in the S&P 500 today. In fact, once you consider the fact that Apple will likely continue to repurchase a meaningful number of its own shares in the coming years, it can be argued that Apple is priced for very little bottom-line growth -- 5% annualized EPS growth at best. Is this conservative outlook for Apple realistic, especially with CEO Tim Cook promising new categories?

Is the market pricing in new categories?
"There will be new categories [in 2014]," Cook reiterated in a recent interview with The Wall Street Journal. As hedge fund guru Carl Icahn (whose fund owns about $4 billion in Apple shares) pointed out in a tweet, Cook's reference to new product lines was plural. Icahn sees the possibility for new categories as a positive catalyst for Apple stock. "Wall Street apparently still not listening," he said in the same tweet.

But even one new category could have major implications for Apple's business. Longtime Apple analyst Katy Huberty from Morgan Stanley estimated that an iWatch, with an average selling price of $300, could add as much as $17.5 billion to the top line in its first year of sales -- that would amount to 10% of Apple's trailing-12-month total revenue. Notably, $17.5 billion in first-year product revenue would mark Apple's most successful product launch in history.

Icahn even played analyst in a recent letter to Apple shareholders and put some estimates on the impact of the rumored Apple television. The scenario he laid out was arguably even more bullish:

With 238 million TVs sold globally in 2012, it would not surprise us if Apple could sell 25 million new Apple ultra high definition televisions at $1,600 per unit, especially when considering both its track record of introducing best in class products and its market share in smartphones and tablets. At a gross margin of 37.7%, which would be consistent with that of the overall company, such a debut would add $40 billion of revenues and $15 billion to operating income annually.

Even if both of these scenarios are overly optimistic, it's easy to see that a new category could provide meaningful upside for investors. Even better, neither product category would likely result in any noticeable cannibalization of Apple's other important products. Sure, a television could cannibalize sales of the company's $99 Apple TV, but that would hardly have a noticeable impact on the business. The rumored iWatch is thought to be an accessory to the iPhone, so it could actually inspire new iPhone purchases.

Apple investors are in the fortunate position to know that new categories are set to be delivered this year, yet the market seems to expect very little from the new product lines.

Of course, as Apple expert Horace Dediu has pointed out recently, estimating the upside from these launches is difficult work:

Markets are effective in anticipating the path of a technology as it ascends into the hands of users, especially if it is destined for ubiquity. But markets are completely incapable of anticipating the emergence of new technologies.

But Dediu also acknowledges that it is important for investors to attempt to recognize that there is potential upside:

The speed with which products are introduced and scaled is phenomenal so it is more important than ever to see beyond the trajectory of existing products into the pattern of the introduction of new product categories.

Is there any downside risk to these new categories?
Given Apple's history of product launches, the chances are slim. For that reason, it's an excellent time to be an Apple shareholder. Not only is the stock cheap relative to the value its current business is delivering, but also new categories largely offer nothing but upside potential at today's conservative valuation.

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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 February 11, 2014, at 10:36 AM, JarJarThomas wrote:

    Market hates Aapl because market wants to dictate.

    Aapl doesn't play the same rules so its easier for them to make money shorting it and hammering the stock down

  • Report this Comment On February 11, 2014, at 12:13 PM, Cintos wrote:

    Icahn stated the scenario exactly as I have been seeing it for monts now:

    "Apple could sell 25 million new Apple ultra high definition televisions at $1,600 per unit, especially when considering both its track record of introducing best in class products "

    I will wait till Apple has a 4K HD TV, as I don't want to invest in a product which has few and fragile viable highways for media provisioning. iTV 4K content will be delivered from "AppleTV" via the internet.

    4K content will cost more that HD, and the DOJ will probably go after Apple for stealing content away from places like Netflix, as the Studios get on board with a higher distribution price. That scenario was seen in the iBooks case, when readers got a richer media presentation, but at a higher cost than Amazon's loss leader pricing. The DOJ failed to acknowledge the enhanced user experience delivered through iBooks. Typical "just as good as" that fails to ask the customer what they think....

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Daniel Sparks

Daniel is a senior technology specialist at The Motley Fool. To get the inside scoop on his coverage of technology companies, follow him on Twitter.

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