Apple (NASDAQ:AAPL) stock is the biggest position in my portfolio, and also one of the most profitable ones, since it has gained over 250% in the last five years. But investment decisions need to be based on forward-looking considerations, not past performance, and it's important to always keep looking ahead and maintain an up-to-date investment thesis.
With this in mind, let's take a look at the three main reasons I bought Apple in the first place, and whether these arguments are still valid.
1. Competitive strength
According to multiple sources, Apple is the most valuable brand in the world. Different publications and rankings such as Forbes, Interbrand, Brand Finance, and Brand Value consider Apple the most valuable brand in the planet. These kinds of rankings are always subjective to some degree; however, it's hard to argue against the idea that the Apple brand is major source of competitive advantage for the company.
Brand strength creates product differentiation and pricing power, which enables Apple to deliver above-average profitability for investors. Most competitors in the smartphone industry are aggressively cutting prices to sustain market share, while Apple delivered a $62 increase in the average selling price in its iPhone segment during the last quarter, to $659 per unit.
It takes a very special business to sustain growing prices in times when the rest of the industry is moving in the opposite direction, and this has powerful implications from a financial point of view. According to Strategy Analytics, Apple retained a gargantuan 89% of all smartphone industry operating profit during the fourth quarter of 2014.
2. Rock-solid financial performance
Apple has an immaculate balance sheet with nearly $194 billion in cash and investments, and only $44 billion in financial debt. This means the company has a gargantuan net cash position of $150 billion. The business is also generating tons of cash on a recurrent basis: Apple produced $52.8 billion in operating cash flow during the six-month period ending on March 28. After deducting $5.6 billion in capital expenditures, this leaves $47.2 billion in free cash flows during the period.
Sales jumped 27% year over year during the last quarter, and gross profit margin expanded from 39.3% of sales to 40.8% of revenue. The company is repurchasing stock at an impressive rate, from the inception of its capital-return program in August 2012 through this March, Apple has returned more than $80 billion to shareholders in the form of buybacks.
Earnings per share grew by a staggering 40% year over year during the last quarter; this was achieved on the back of strong sales growth, increasing profit margins, and share buybacks that reduce the amount of shares in circulation. Even assuming that growth will most likely slow down in the future, Apple's performance is nothing short of breathtaking considering the size of the business.
3. Convenient valuation
All this comes for a very reasonable price, Apple stock trades at a forward price to earnings ratio of nearly 13, a significant discount versus the average company in the S&P 500 index, and its forward price to earnings ratio is in the neighborhood of 18.
The main reason Apple trades at such a discount is arguably because the market is expecting a slowdown in iPhone sales as the industry matures over time. Almost 70% of Apple's total revenue came from the iPhone segment in the last quarter, and product concentration is a considerable source of risk to keep in mind.
iPhone unit sales grew by a vigorous 40% in the March quarter, with sales more than doubling in high-growth emerging markets such as Korea, Singapore, Taiwan, and Vietnam. Demand looks healthy across the board, and emerging markets should offer considerable room for growth in the years ahead. However, it's hard to tell for how long Apple can sustain this kind of performance through booming iPhone sales.
For this reason, new products and services such as Apple Music, Apple Pay, Apple Watch, and the revamped Apple TV are remarkably important to monitor. If Apple can diversify its revenue base and open new growth venues with these ventures, this could be a major plus in terms of reducing risks and providing more visibility to investors. Under such a scenario, Apple stock could deliver substantial gains and expand valuation levels. Meanwhile, the company could reduce its dependency on the iPhone.
Apple is priced for a considerable slowdown in growth. If this happens, it's already reflected in current valuation levels. On the other hand, if the company surprises with better-than forecast performance from the iPhone and successful new products in the coming years, this could drive big gains for investors.