Apple: I Bought The Panic

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Apple Holds Product Launch Event At New Campus In Cupertino

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Apple (NASDAQ:AAPL) stock took its biggest dip of the year Wednesday, falling 5.5% in a single trading day. It was a tough day for a stock that, until recently, had avoided the worst of 2022’s tech selloff.

A few weeks before the crash, Apple put out a mixed earnings release. It beat on both revenue and earnings but had weak guidance that hinted at a possible $8 billion hit from supply chain woes.

No material news about Apple was released on Wednesday. The stock’s slide correlated with a broader selloff in the NASDAQ, which erased 3.18% of its value the same day. Apple’s 5.5% selloff was worse than the index average, though, so something else may have been going on.

It could be that investors took a second look at Apple’s second quarter release. While the release was old news by Wednesday, a number of tech stocks like Coinbase (COIN) and Rivian (RIVN) released horrible numbers after it came out. Perhaps investors took the “$8 billion supply chain hit” claim more seriously after other companies delivered materially bad news. Apple has manufacturing in China, and recently it came out that Tesla’s (TSLA) Chinese sales had taken a hit due to lockdowns. Although Apple’s manufacturing is not in Shanghai, its Shenzhen operations were impacted by lockdowns earlier this year. A nation-wide lockdown would impact Apple’s sales, which is perhaps why the previous quarter’s guidance mentioned a “possible $8 billion hit.”

Whatever the case, investor sentiment turned on Apple this week. Amid the panic selling, I doubled down. On Wednesday, when the stock was down 5%, I went ahead and averaged down on it, buying a handful of shares. While the number of shares I bought was small, I had purchased the stock in a bigger lot a few weeks earlier, so I brought my average cost down a little.

Why do I think AAPL is a good value today, even amid all this selling?

Mostly because Apple has a strong competitive position. Its most recent earnings release was part of the story-Apple was one of the few big tech players that managed positive growth in both revenue and earnings per share. Other big tech stocks saw earnings decline for reasons ranging from “on-paper” stock portfolio losses to genuinely weaker operating performance. Apple’s avoidance of these issues was certainly a positive. But the bigger part of my thesis is the fact that Apple has the potential to put out more strong releases in the future, because its brand identity and competitive position are second to none. It’s for this reason that I’ll continue buying AAPL no matter how low it goes.

Competitive Landscape

Earnings releases are the main things investors look at when judging the value of a stock. Not only can a release influence a stock’s price immediately after it comes out, a history of strong releases can lead people to spot trends in revenue/costs that they think will continue. However, past trends in revenue and costs do not always continue. Sometimes, they reverse. To ascertain whether trends will continue, you need to look at a company’s competitive position.

This is where Apple really shines.

The company enjoys a solid competitive position in most industries it operates in, which provides reason for long term optimism.

Apple is in second place in mobile operating system user counts after Alphabet (GOOG), and first by revenue.

It’s second after Microsoft (MSFT) in computer operating systems.

It’s first in tablets and smartwatches by both sales numbers and revenue.

Apple is in first or second place in most of its verticals. Jack Welch, whom Buffett called the “Tiger Woods of CEOs,” once said that first or second place was his competitive goal. So, AAPL passes the Jack Welch test.

Will it continue to do so?

There are signs that it will. Apple has been consistently ranked by Forbes as the world’s most valuable brand. Last year its brand value was estimated at $250 billion. Certainly, the Apple logo is one of the most recognizable in the world, and Apple has a community of influencers pushing its products on YouTube. So, Apple’s brand strength and dedicated fan base point to continued strength.

Second is Apple’s ecosystem. Apple products integrate with each other very well. Macs are set up with the same apps that iPhones have, so the second you set up your Mac with an Apple ID, you have your Apple Music library, your photos, and your iCloud storage ready to go. This integration can be achieved in the Windows/Android world by downloading apps to your devices, but it isn’t ready to go the second you buy a device. For example, you will not have Google Photos right on your desktop after you set up a Windows PC; you’ll need to download Google Drive separately. So, Apple has the most seamless and easily integrated of the major tech ecosystems. It also has the most comprehensive one, boasting all popular hardware categories as well as apps for photos, music, gaming, news and TV.

Taking Apple’s brand and its ecosystem together, you get a picture of a company that could maintain its strong competitive position well into the future.

Supply Chains: the Trillion Dollar Question

Apple’s competitive position points to a company whose products will be in demand well into the future. That’s a positive. But even the most popular product in the world won’t move if its supply chain is jammed. This is the dilemma that Apple is facing this year.

In its first quarter release, Apple hinted at a “possible” $8 billion revenue hit due to supply chain issues. It was likely referring to China’s lockdowns. Currently, 45 Chinese cities are locked down. Shenzhen, where Foxconn (Apple’s contractor) makes iPhones, emerged from lockdown on March 22. Henan, where another Apple manufacturing facility is located, has some cities locked down today. Foxconn officials said that they might be able to keep up production amid lockdowns at facilities with on-site employee housing.

The facts above show why Apple used the word “possible” to describe the supply chain hit. In a worst case scenario, part of its manufacturing could get shut down, but it isn’t in the midst of an active shutdown like Tesla is. So, there is a risk factor here, but it isn’t material yet.

Financials

Having reviewed Apple’s biggest advantage and its biggest risk, we can turn to its financials. There’s a reason for Apple’s products to remain popular, but there are also threats to its supply chain. Potentially, there could be a short term hit to revenue. With that established, let’s take a look at Apple’s most recent financials.

In the most recent quarter, Apple delivered:

  • $97.3 billion in revenue, up 9%.

  • $29.9 billion in EBIT, up 8.7%.

  • $25 billion in net income, up 5.9%.

  • $28 billion in operating cash flow.

  • $1.52 in diluted EPS, up 8.5%.

As you can see, the growth in net income was pretty tepid, but buybacks helped boost the EPS growth considerably.

Historically, Apple’s growth has been strong. Over the last five years, its five-year CAGR growth rates in revenue, earnings and cash flow have been:

  • 11.8% in revenue.

  • 23.5% in diluted EPS.

  • 18.6% in free cash flow.

Pretty strong for a company as gigantic as Apple already is. Bottom line growth has compounded at over 20%, and revenue has steadily gained. On top of that, Apple has a strong balance sheet, boasting metrics like:

  • Assets: $350 billion.

  • Liabilities: $283 billion.

  • Equity: $67.3 billion.

  • Long term debt: $103 billion.

From this we get a debt-to-equity ratio of 1.53. Compared to some of the nearly debt-free internet companies out there, this is not super low, but it is low enough that investors don’t have to worry about Apple’s solvency.

Valuation

Having looked at Apple’s financial picture, we can turn to its valuation. There are two ways to approach this:

  1. Multiples.

  2. Discounted cash flows.

We can start with multiples. According to Seeking Alpha Quant, Apple trades at the following multiples:

  • P/E: 23.7.

  • Price/sales: 6.2.

  • EV/EBITDA: 18.6.

  • Price/operating cash flow: 20.

These are not exactly rock bottom multiples, but note what I explored in the section on competitive dynamics. Companies that have strong economic moats often merit high multiples. Because they have strength in their industries, they have a lot of pricing power, and that tends to produce steady, uninterrupted streams of growing earnings. This phenomenon partially explains why Costco (COST) trades at high multiples, even though it’s a relatively slow growing retailer. It doesn’t face a lot of head-to-head competition. The same applies to Apple, whose ecosystem is not easy for competitors to match.

Now, we can do a discounted cash flow analysis for Apple. In the trailing 12 month period, Apple had $6.43 in free cash flow per share. The five year CAGR growth rate in free cash flow was 18.6%. Given that Apple is a massive company, and is facing supply chain issues, we should figure conservatively. So, I’ll estimate the free cash flow growth for the upcoming five years at just 10% annualized. That gives us the following forecast:

  • Year 1: $7.07
  • Year 2: $7.78
  • Year 3: $8.55
  • Year 4: $9.41
  • Year 5: $10.3

So we get to $10.3 in FCF per share after five years.

The next thing we need is Apple’s discount rate. I’ll use Apple’s weighted average cost of capital, which ValueInvesting.io has estimated at 7.7%, as the discount rate. This gives us:

Year 1 Year 2 Year 3 Year 4 Year 5

TOTAL

Cash flow

$7.07

$7.78

$8.55

$9.41

$10.3

N/A

(1 + r)^n

1.077

1.159

1.249

1.345

1.449

N/A

Discounted CF

$6.56

$6.71

$6.84

$6.99

$7.1

$34.2

We arrive at a $34.2 present value for five years’ cash flows discounted at 7.7%. Next, we need to assume at what level Apple’s earnings growth will taper off. For the sake of being extremely conservative, we will say 0%. In that case, the sixth year’s cash flow would be $10.3, and the terminal value (discount rate minus growth rate) would be $133. Adding the five years’ cash flows and terminal value together, we get a present value of $167. That’s about 19% upside to today’s price.

Why I Bought the Panic

Having looked at Apple’s competitive position, its biggest risk factor, and its valuation, I can now explain why I bought into the Apple panic:

Because the stock is worth more than it currently trades for.

Apple’s competitive position provides a good reason to think it could keep growing its earnings for the foreseeable future. The supply chain issues could eat into the growth, but growth will still likely be positive over the next five years. In fact, if we cut the growth rate nearly in half, to 10%, and assume no growth after that, we still get a present value $27 higher than the current stock price. This stock certainly looks like it’s worth the risks. Knowing this, I went ahead and bought the panic. I’ll buy more if the stock continues to fall.



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