Summary:
- Apple appears to be one of the best companies of all time, and a classic Phil Fisher investment, considering both quantitative and qualitative factors.
- Currently, the company is trading at a premium to our estimated fair value of $2 trillion, though as it is a superior business it may deserve it.
- Apple is unmatched relative to its technology peers, shoveling nearly all of its free cash flow into buybacks and dividends and having a manageable amount of stock-based compensation.
- Conservative investors may want to wait until a better buying opportunity presents itself, though this may never occur.
Halfpoint
Introduction and Executive Thesis
At this point, it’s no secret that Apple (NASDAQ:AAPL) is a superior company. Berkshire Hathaway’s (BRK.A)(BRK.B) Warren Buffett is pretty open about his love for the business, saying the following:
If you’re an Apple user and somebody offers you $10,000, with the only provision [that] they’ll take away your iPhone and you’ll never be able to buy another, you’re not going to take it.
As BRK appears to continue to add to their position as Apple approaches the $3 trillion dollar mark, individual investors may wonder if buying AAPL stock is worthwhile for someone who does not have 100s of billions of dollars in assets under management. I wanted to take a closer look to find out.
On the qualitative side, AAPL is a consumer monopoly that has been able to successfully adapt and grow from a small computer company in the 70s into a dominant ecosystem of products and services. From easy and seamless messaging from iPhone to MacBook, to recording workouts on an Apple Watch and reviewing them later on an iPad, Apple has continuously demonstrated successful ecosystem integration. In addition to their hardware products, their services offerings are also growing rapidly and synergize with products like iCloud storage, Fitness+, Apple TV+ and Apple Music.
On the quantitative side, AAPL also stands out among its peers. It’s high returns on investment and equity (55% and 175% respectively in 2022) demonstrate that it is a superior business generating large amounts of cash. Free cash flow, even when adjusting for stock based compensation, has been growing steadily with over $100 billion generated in FY 2022, compared to around $60 billion in FY 2018. It also shovels almost all of its free cash flow into dividends and more importantly, buybacks, increasing shareholder ownership over time. All that being said, our models indicate current prices appear to be a premium to intrinsic value, though perhaps, as Phil Fisher would say, a high quality business like AAPL deserves it.
Most Recent Quarter Performance
Despite macroeconomic headwinds, with its diversified mix of products Apple has been able to maintain most of its revenue with 2.5% declines y/y when looking at the MRQ. The weakest segments when looking at comps were Mac and iPad, offset by slight increases in iPhone and services revenue. Of note though, iPhone followed by services are by far the highest revenue generators as can be pictured below:
Company Data
Apple markets its products as premium and is able to maintain its higher margins by doing so. The Apple ecosystem and switching costs provide a moat, that will be tested if the macroeconomic picture continues to decline. Will weakened businesses and consumers still be willing to pay up for the new iPhone, or will cheaper alternatives be selected? Cracks are already starting to show in their other hardware segments and if this eventually translates to declines in iPhone revenue, the market may once again decide a $2.7 trillion valuation for AAPL is too much.
It is encouraging that the services segment seems to be resilient and is becoming a larger proportion of revenue mix, as it is high margin. In the MRQ, Apple reported services gross margins of 71%, vs 36.7% in its products segments. There is some risk here though, as much of service revenue is also reliant on discretionary spending from strong consumers. Customers can easily cut back on premium subscriptions like Apple TV, Apple Music and Apple Fitness + to save money as well as make less app store purchases. The market may be assuming Apple has built a recessionary proof business and could be disappointed in the short term.
Reasonable Termed Out Debt
No analysis of a company is complete without a look at the balance sheet, with the debt section of paramount importance. Relative to many other big tech companies, Apple appears to have a large amount of debt on initial examination. As of the MRQ, AAPL had around $100 billion in long term debt. For reference, Microsoft had around $50 billion and Alphabet (GOOGL) (GOOG) had around $13 billion.
Although the debt is higher than stockholder’s equity of $62 billion as of the MRQ, this can be a hallmark of a superior business. Apple shovels most of its free cash flow into stock buybacks and dividends, lowering equity value. Indeed, in the last reported 6 months, the company generated $55 billion in free cash flow and paid shareholders with $46 billion in buybacks and dividends.
Clearly, the high nominal amount of debt in balance sheet terms is not a problem for a company like Apple which generated $111 billion in free cash flow in FY 2022. Additionally, the debt is termed out reasonably, so investors can assume buybacks and dividends will continue regularly even if the company decides to pay down debt. The maturity schedule can be visualized below:
AAPL 10K 2022
Valuation
Often times when I look at tech companies and adjust free cash flow for stock-based compensation, the results are abysmal. This is clearly not the case for Apple, and is demonstrated in the chart below:
This Writer, Data from Morningstar
Clearly, Apple has done well over the last 5 years, and these positive results are compounded by its shareholder friendly policies that increase ownership of the company over time.
Apple is predicting similar revenues and gross margins in Q3 relative to Q2. If this can translate to cash flow, this would put YTD free cash generation to $80 billion after Q3. If we assume the macroeconomic slowdown continues to weigh on the company, we can impair free cash flow to around $90 billion for FY 2023 when adjusting for stock-based compensation.
As the economy recovers, we can assume cash flow comes back at a 15% CAGR from this impaired value, until the end of our forecast period in 2027. This growth rate is in line with the 2018-2022 period. For terminal value, I assumed the company would grow at a 4% rate into perpetuity considering it has a strong consumer monopoly and will likely be able to grow with the global economy. I used a 10% discount rate as the company has minimal debt relative to market capitalization and this is likely the minimum return equity investors would expect. These assumptions can be visualized below, giving the company a valuation of around $2 trillion:
This Writer, Estimates
With these estimates, Apple appears to be trading at an approximately 30% premium with a $2.7 trillion market capitalization at time of writing. As it is a superior growing shareholder friendly business, it likely deserves a premium, but it is up to the individual investor to decide if this is too much. There have been much better entry points in the recent past, with the company trading around the $2 trillion mark as recently as January 2023.
Risks
Geopolitical Risks
Though the company has been making plans to diversify out of China, it is reliant on Chinese manufacturing for its hardware as well as processor chips from Taiwan Semiconductor (TSM). Any worsening of relations with China, or any escalation with Taiwan may lead to temporary setbacks for the company, as supply chains will need to be rearranged.
Macroeconomic Uncertainty
Many of Apple’s products can be considered luxury goods, with price tags generally higher than competitors for consumer products such as the iPhone and MacBook. This is a hallmark of the superior brand value of Apple products, but the competitive advantage may be tested if there is a prolonged recession with a weakened consumer.
Optimism Surrounding The Company
Though the monopolistic nature of the company is a boon, it is no secret, and the market is likely pricing in a competitive advantage for years to come. This may not be the case, and other companies may be able to erode Apple’s moat over time. Mr. Market tends to change his mind quickly and sentiment could always shift from the current rosy state of affairs.
Conclusion
I think investors will have a hard time finding a better company than AAPL, with the massive buybacks and dividends, minimal relative stock-based compensation, and high returns into the future seemingly guaranteed via their strong consumer monopoly. That being said, the company appears to be trading at a premium to our estimates of a $2 trillion fair value, so conservative investors may want to look for a better entry point. This opportunity may present itself, if near term macroeconomic headwinds weigh more heavily on iPhone and service sales than is currently anticipated. For now, I do not consider AAPL at current prices to provide a fantastic risk/reward profile and am happy to continue holding it indirectly through Berkshire Hathaway. I may consider purchasing shares if the company again trades closer to the $2 trillion mark.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of BRK.B either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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