Based on the numbers alone, shares of Apple (NASDAQ:AAPL) look like the bargain of the century. The iPhone maker generated $53.4 billion of net income in fiscal 2015, which ended in September, putting the P/E ratio at just about 10. Backing out the $141 billion of net cash on the balance sheet, and ignoring any potential tax issues with the repatriation of that cash, Apple's P/E ratio drops to just 7.75, a pessimistic valuation, to say the least.
The bull argument for Apple is simple. With the iPhone remaining both wildly popular and wildly profitable for Apple, even nearly nine years after the original was launched, and with other Apple products and services reinforcing the ecosystem, making it difficult for consumers to switch, continued success of the iPhone seems likely. Add in future products like the rumored Apple car, as well as a valuation that's so low that Apple doesn't even need to grow in order to provide solid returns, and you have what looks like a value investor's dream.
Despite Apple stock appearing to be a no-brainer based on valuation, I won't be buying the stock for one simple reason: I can't predict what Apple will look like 10 years from now.
In order to justify buying Apple stock today, investors need to convince themselves that the company's profits will, at worst, decline slowly in the coming years. Two things need to occur for this scenario to play out:
- The iPhone needs to largely maintain its market share and its profitability. During the fiscal fourth quarter, iPhone sales accounted for 62.5% of Apple's revenue, and likely a higher percentage of operating profit.
- New products, some already released, like the Apple Watch, and others only hypothetical, like the Apple Car, need to generate enough revenue and profit to counteract any declines in iPhone sales.
While it's easy to simply extrapolate based on the past and assume that the iPhone will continue to generate outsize profits for Apple, I think that investors are ignoring the full range of possible outcomes. Before buying Apple stock, all investors should consider the following questions:
- Two-year contracts are now mostly dead in the United States, a market where the iPhone enjoys a market share in excess of 40%. With the full cost of high-end smartphones no longer obfuscated by subsidies, how will the high-end smartphone market be affected?
- On the same note, two-year contracts created an incentive for consumers to upgrade phones every two years. The total monthly bill remained the same regardless of whether a new phone was bought, and a steep discount that brought the price of a new iPhone down to $200 made upgrading an affordable proposition. Without contracts, a consumer financing a phone would see their total bill decline once the phone is paid off, creating a disincentive to upgrade, since it would increase their total monthly bill. How will this shift in incentives affect the average time between upgrades?
- The quality of smartphones, particularly mid-range smartphones, has improved dramatically over the past few years. Today, a smartphone that retails for $300-$350, like the Nexus 5X, is likely more than enough for the vast majority of users. What percentage of smartphone users will remain willing to pay twice as much for an iPhone, or any high-end smartphone? And will that be enough for Apple to maintain its market share and profits?
- If a combination of the end of two-year contracts and mid-range smartphones increasing in quality leads to consumers, on average, upgrading their phones less frequently, how will this affect both the smartphone market as a whole and Apple's financial performance?
- Will consumers continue to upgrade to the newest iPhone as the relative improvements between generations get smaller? Have we reached the point where adding more pixels, a better camera, or a faster processor won't be enough to convince the average iPhone user to upgrade? Is there any real innovation left in smartphone hardware?
- The PC market has become increasingly commoditized over the years, with large PC manufacturers generating low-single-digit operating margins at best. The outlier is Apple, which is far more profitable thanks to the premium prices of its Macs and MacBooks. However, this premium strategy limits Apple's PC unit market share, which was just 7.6% globally during the third quarter. Why would the smartphone market look any different than the PC market in the long run?
- The smartphone category barely existed 10 years ago. Ten years from now, will smartphones be supplanted by some other type of device? How likely is it that Apple is the company to develop it?
- How will a slowdown in the Chinese economy affect demand for high-end smartphones in China, one of Apple's most important markets?
A range of possibilities
I don't know the answer to all of these questions, but there seems to be a lot of things that can go wrong for Apple in the coming years. In my opinion, assuming that the company will be able to maintain its current level of profits in the long run seems like a dangerous assumption to make. I think that the most likely scenario is that Apple's profits decline over the next 10 years; the only question is by how much.
There's a chance that Apple's profits completely collapse, driven by a combination of the points I mentioned above, and perhaps some others that no one has yet considered. There's also a chance that Apple's profits rise substantially, with none of the points above mattering much at all, or perhaps driven by the overwhelming success of a new product. The probabilities of these extreme scenarios are small, but they're certainly not zero.
Even if Apple's profits do decline over the next 10 years, investors can still achieve a positive return, driven by a low valuation, huge amounts of cash for share buybacks, and dividend payments. The relevant question, though, is this: Is Apple stock likely to provide a return that is higher than that of the market as a whole over the long run? It's impossible to know the answer to that question, but my best guess is that it won't, all things considered.
Let me be clear: I'm not an Apple doomsayer. I'm not predicting that the company will fall apart, or that iPhone sales will plummet tomorrow. I don't know how iPhone sales will fare in the coming years, or for that matter how the smartphone market will evolve, and that's the main reason why I won't be buying the stock. Investing is a game of probabilities, and buying a stock based strictly on the best-case scenario is a recipe for disappointing results. The range of possible outcomes is vast, and each must be considered, not just the ones that we want to believe.
For me, Apple stock is far from a no-brainer, despite its tantalizing valuation. The chance that Apple's earnings fall substantially over the next decade is simply too high for me to be comfortable buying the stock. I could be wrong; maybe the iPhone will remain a cash cow indefinitely, and we'll all be cruising around in Apple Cars in 2025. But that seems like wishful thinking to me.