Overview
Apple Inc. (NASDAQ:AAPL) primarily designs, manufactures, and markets a variety of mobile communication and media devices, personal computers, and digital music players, in addition to selling related software, services, peripherals, networking solutions, and third-party digital content.
Some of their product offerings include the iPhone, iPad, Mac, iPod, Apple TV, and the Apple Watch. Their software solutions include the iOS, OS X operating systems, and the company offers cloud service via iCloud.
Net sales by operating segment were as follows for fiscal year 2014: Americas, 36%; Europe, 22%; Greater China, 16%; Retail, 12%; Japan, 8%; and Rest of Asia Pacific, 6%.
Net sales by product type for FY 2014 were: iPhone, 56%; iPad, 17%; Mac, 13%; iTunes, Software and Services, 10%; Accessories, 3%; and iPod, 1%.
Apple is currently the world’s largest publicly traded company by market capitalization.
Incredible Second Quarter
I mentioned when I initiated my position in AAPL back in April that I was going to look for an opportunity to add to it at some point in time. Well, this is that point in time.
What swayed me to add to it so quickly?
An incredible second quarter.
Let’s see: Revenue that had increased $12.4 billion YOY. EPS up 40.4% compared to Q2 2014. A record for sales of iPhone and Mac, as well as a record performance for the App Store. 71% YOY increase in revenue for the Greater China segment. A cash, cash equivalents, and marketable securities pile that has grown to over $190 billion
Wow.
They also increased the dividend by 10.6% and increased the total buyback authorization from the $90 billion announced last year to $140 billion. For perspective, that buyback authorization adds up to 20% of the current market cap of the company.
What that means is that Apple needs very little or really no core growth in the business at all to deliver solid EPS growth and dividend increases to shareholders. And that’s because the massive profit the firm generates is about to get cut into a lot less pieces. Add in the kind of growth they’re still posting and this stock could certainly surprise in regards to overall growth, especially with the company coming off of such a large base. Meanwhile, the Apple Watch hasn’t even been figured into this yet.
I admittedly waited far too long to initiate a position in Apple, but it just didn’t really fit my portfolio until somewhat recently. Sticking to my strategy means I’ll surely miss out on some winners here and there. But I’ll also weed out a lot of losers.
Nevertheless, I’m certainly happy to be along for this exciting ride.
Risks
AAPL is, of course, not without risks. I’ll highlight a few.
Primarily, the company faces intense competition across its entire spectrum of product lines, especially in the smartphone and tablet space. The iPhone is by far their most important product and accounts for the majority of revenue. As such, any competitive pressures here could harm the firm. This reliance on the iPhone is also concerning from a diversification standpoint.
In addition, Apple’s products are typically sold at a premium to their competitors. This leads to high margins, but it could hurt them in emerging markets where price is a major factor.
Meanwhile, the tech space changes quickly. If the company isn’t able to keep pace and offer the best tech with the best experience, it could harm their ability to not only sell products, but also the ability to continue selling at a premium.
Lastly, they face currency and geopolitical risks like any other international company.
Valuation
The stock’s P/E ratio is 15.71 right now. That’s actually quite a bit lower than the P/E ratio of 16.92 that the stock sported when I initiated my position due to the blockbuster Q2, so even though the stock is approximately the same price, it’s actually quite a bit cheaper now. The current P/E ratio is well below that of the market, though it is in line with AAPL’s five-year average. It’s perhaps a bit perplexing to see the stock at this level even though the company is still growing so quickly.
I valued shares using a two-stage dividend discount model analysis with a 10% discount rate. I used a dividend growth rate of 14% for the first ten years and a terminal dividend growth rate of 7%. I lowered the initial dividend growth rate from the 15% I used in April to 14% now to account for the most recent dividend raise that was a bit under 11%. The DDM analysis gives me a fair value of $131.48.
So even though I used a lower growth rate, I now get a higher value. That’s because the dividend is higher now. All in all, the stock is really worth much more now than it was in April. The company’s overall cash pile has grown by about $40 billion, profit is way up, the dividend is higher, and there are now less shares outstanding. It’s quite possible my valuation is even on the conservative side due to the modest payout ratio and strong buybacks that could allow for much higher overall dividend growth rate for the next couple decades (meaning my terminal rate might be quite conservative). But one has to weigh that potential against the inherent risks in tech, which is why I’m being conservative.
Conclusion
I’m certainly pleased to have had the opportunity to add to my position here. And even though I didn’t average down in price, I did average down in value. As always, price and value are not one and the same. And when buying stocks, I look at value, not price. Price only tells me how much money I need to exchange for equity. Value tells me what I’m actually getting and what that stock is worth.
I mentioned my desire to buy more AAPL when sharing my watch list for June, so I decided to use some of the cash from the LO acquisition to make that happen.
Apple has the capability to aggressively grow the dividend for the foreseeable future. The payout ratio is approximately the same now as it was back in April, even though the dividend was increased more than 10%. And that’s because EPS continues to climb. The company could increase the dividend annually at a rate well into the double digits for the next decade even without underlying EPS growth and the dividend would still be well covered. Of course, what’s more likely is that profit continues to climb, the dividend grows at an attractive rate, and the payout ratio remains comfortably low for years to come.
There’s a possibility that Apple is undervalued right now, perhaps significantly so. It depends in large part on how well the Apple Watch sells, whether or not international growth and sales remain strong, how exactly Apple uses that massive and growing cash pile, and, most importantly, the sales of the current iteration and future versions of the iPhone. But if Carl Icahn is to be believed, the stock is worth $240 right now.
