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

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:

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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