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Should Apple Be This Cheap?

There is little question that Apple (AAPL) stock is cheap.

The stock's earnings yield is 16.8%, which is in the 95th percentile of all profitable companies.

The stock's free cash flow yield is 14.1%, in the 91st percentile of all cash flow positive firms.

More traditional? Fine. The P/E ratio is 10.3, less than half of the S&P 500's ratio of 23.8. Back the net cash on hand (nearly $200 billion - with a 'B') out of the market cap and that ratio falls to 8.0.

These are valuations you usually see with a firm in deep decline, financial trouble, scandal, or all of the above.

Apple doesn't really fit any of those descriptions. While there are reasonable concerns around the stock, none of them seem to warrant such an incredibly low valuation, particularly given all of the firm's competitive advantages and potential avenues for growth. Let's take a look at all of these and then try to come up with a decent price for the stock.

The Risks in Apple

The risks in this company are quite well-known.

Apple is increasingly reliant on one product, the iPhone, which accounted for 2/3rds of sales in fiscal 2015. However, many feel the growth trajectory for iPhone has flat-lined. They say that the iPhone 6 - with its bigger screens - milked the last really major catalyst for upgrades. China and India represent growth potential, but China sales fell over 20% last quarter, Apple may be too high-priced for India, and in any case, the move away from a subsidy model in the U.S. may lengthen upgrade cycles and suppress sales in its most important market. iPhone sales are down 8% in the first 6 months of fiscal 2016, and are expected to decline over 10% for the entire year. Not inspiring.

Apple Products

Worse, Apple's other product lines are also struggling. After exploding out of the gate and at one point (in 2012) accounting for over half of the firm's revenue, iPad has declined precipitously, and now represents less than 10% of sales. In the first 6 months of this year, iPad revenue is down 20%. Is it possible the tablet craze was just a fad? Possibly...

The Mac has done better than the PC market, but that's not saying much, with PC sales free falling for many years and now back to 2007 levels. Mac will always make money for Apple, but at only about 10% of sales and falling, it is hardly a growth category.

What about the Apple Watch, and the Apple TV, and Beats products? Collectively, they are doing well, up 30% last quarter. But all together, they still represent less than half of depressed iPad sales, and a laughable 7% of iPhone sales. These products are fringe contributors to the company at this point.

Perhaps worse, we haven't really seen a major new product from Apple since the 2010 introduction of the iPad. And let's just say it... there have been ZERO major new successes since Steve Jobs passed away in 2011. That's over 6 years, which is a much larger gap than iMac to iPod (3 years), iPod to iPhone (5 years), or iPhone to iPad (3 years). And we haven't heard any rumors of big new launches in the pipeline. The keynotes have become rather... boring and derivative.

I understand the concerns. Apple does not *feel* like the same company everyone was once excited to own a piece of. That's a problem.

What Apple Can Do

Here are the handful of reasons to be optimistic about Apple, besides a clearly cheap valuation:

iPhone 7: We have the iPhone 7 coming later this year, and normally with a full number upgrade comes a new, fresh design that spurs upgrade sales. I expect much better iPhone comparables next year, which should help both financial results and the stock. I certainly don't see iPhone as a rapidly declining business line, not with a huge install base, limited lifespan, and big potential markets in Asia.

Ongoing improvements to Watch and TV: I don't see much hope for iPad, although sales declines are going to bottom out at some point, probably soon. On the other hand, there is a lot of room for improvement on both Apple Watch and Apple TV that could expand sales of those products. A revamp of the Watch software and faster hardware would make it a much better product. Apple could follow Fitbit's (FIT) lead and explore healthcare partnerships for its watch. On the TV side, improving that device's natural potential as a gaming machine could pit Apple against Sony and Microsoft and open up a new and fairly large market opportunity. Remember that neither the first iterations of iPhone or iPod sold that well... it was the 2nd and 3rd iterations that brought those products huge success (I see the current TV product as the first platform-driven Apple TV).

Apple Car

New hardware product lines: Apple is almost certainly working on new hardware product lines to expand its revenue potential. Virtual reality seems like a natural fit, although it would be a more "Apple TV-like" marginal product. An iPad/Mac crossover (similar to Microsoft's Surface) could have appeal and sell well. The "smart-home" has lots of potential for Apple - if it ever takes off with consumers. Then of course there is the Apple Car, Apple's rumored electric car project. Certainly, if done right, that is a massive potential revenue driver that could even exceed iPhone.

The services business is overlooked: Maybe Apple's brightest division - and most overlooked - is its services business. Services grew at 20% last quarter and was the company's second largest segment, bigger and more profitable than even the Mac or iPad. Services include folks paying month after month for iCloud storage, Apple Music subscriptions, App Store and iTunes downloads, and so forth. I love this division. The revenue is recurring and it helps ensure customers return to Apple to upgrade, creating switching costs. It is quite plausible to imagine Apple creating a credible Netflix (NFLX) competitor or a number of other services.

What Is Apple Worth?

Clearly there are risks, but just as clearly Apple has plenty of avenues to grow into as well.

Let's try to figure out what the company is worth. First, let's match a discounted free cash flow to Apple's current price of around $93. What assumptions is the market making?

Apple's earnings for fiscal 2016 are expected to fall about 9%, and with half the year done, let's use that as basically a done deal. Also, let's use a discount rate of 10.5% for Apple, a bit above a "standard" discount of about 9%. Finally, we will add in about $21/share in net cash for each DFCF given the strong balance sheet.

Assumptions at $93 (pessimistic): To get to $93, you have to assume that Apple's earnings decline back to 2011 levels over the next 2-3 years... and never grow from there. Now, consider in 2011 that Apple hadn't even launched the iPhone in China, sold fewer iPads than even today, and had a Services business about 1/10th the size of today's. And that's not even considering 3-5% share buybacks per year! Do we really think the future is that bleak? I don't.

Assumptions at $125 (modest): To get a $120 valuation, you can assume that the company's earnings rebound to flat for 2017... then never grow from there. In short, if Apple can just "hold serve" on this year's depressed earnings, it would be worth about 30% more than it trades at today. You just need to believe that the positives are just about equal to the negatives we listed above.

Assumptions at $165 (optimistic?): Analysts are expecting the iPhone 7 to drive a 10% earnings rebound in 2017. All we have to do is assume this, and then assume that Apple flatlines for 5 years, then returns to a long-term inflation growth rate (3%), you get a DFCF equaling $165... nearly 70% upside.

Conclusion

What do you think? Is Apple doomed to smartphone cost competition and longer upgrade cycles? Or can it continue getting users to upgrade every 2 years while expanding in Asia, adding new major and minor products and services, and re-igniting the brand's appeal? Your opinion really determines which of the 3 valuation scenarios you think Apple is worth.

For my money, Apple has far more advantages - a powerful brand, an unmatched war chest of cash and cash flows, multiple growth avenues - than disadvantages, and deserves a better-than-pessimistic outlook. The stock looks attractive here.

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