After skyrocketing to $700 in September, AAPL has now dropped all the way back to the $450 range, without much obvious change in the numbers or outlook — which has provoked a huge amount of commentary, and led one big shareholder to propose a complex new dividend scheme.
If you want to cut through the noise, I recommend you do what I do and read Aswath Damodoran, a valuation expert and NYU professor who’s been writing intelligently about Apple for the last year, including his own investment decisions and valuation model.
I’ve got to disagree with his last post, though, which runs various “downside” simulations and concludes that the company is very unlikely to be worth less than the current price:
I started with a discounted cash flow valuation of Apple at the end of 2012, which yielded $608/share. With the stock trading at $440, that gives me an estimated gap of $168, impressive but meaningless without a measure of confidence about the magnitude of the gap. To arrive at this confidence measure, I used Crystal Ball (an add-on to Excel that allows you to do Monte Carlo simulations) and revalued Apple, with distributions, rather than single values, for three key inputs: revenue growth rate in the near term, target operating margin and a cost of capital…
All that I did to arrive at the 90% estimate that Apple was under valued was count the number of simulations that delivered values less than $440; in reality, it was closer to 94% but I rounded down to 90%. Note that to end up at values less than $440, the distributions for the key variables all had to be close to the “bad” ends of their distributions. Thus, for Apple to be worth only $440 (or less), you would need negative or close to zero revenue growth, pre-tax operating margins of 25% (current margin is closer to 35%, down from 40% plus a year ago) and the cost of capital would have to be at 15% (the 97th percentile of US stocks).
I haven’t looked closely at Apple’s financials, but I’ve been playing with the assumptions in Damodoran’s model (Excel link) and I’m not nearly as sanguine. Here’s why:
1. Prices and profit margins for smartphones, and the iPhone in particular, have a lot further to fall.
I think every investor realizes this, but not everyone appreciates the scale that we’re talking about here. I just got my Nexus 4, the best current Android phone on the market, and I’ve got several friends who have let me play with their iPhone 5. It’s pretty clear to me that this is the first generation where it’s really a tie. They’re both very, very good phones. It’s largely a matter of taste which one you prefer.
This has never happened before. I’ve always preferred Android phones for my own cranky reasons, but I freely admit that the newest iPhone has always been better than the best Android phone. Until now.
And here’s the kicker: unlocked, the iPhone 5 costs nearly twice as much as the Nexus 4 ($650 vs. $350 for the 16 GB model). Even if you believe that the iPhone is still better, you’d have to really be drinking the Kool-Aid to believe it’s that much better. Most consumers aren’t directly exposed to this difference because they’ll get it heavily subsidized with a 2-year contract. But it’s only a matter of time before that difference creeps into the numbers, one way or another.
To believe that Apple will maintain anything like its current pricing, sales volume and margins on the iPhone for more than another year or two, I think you have to believe that they’ll regain a clear lead in technology. It’s true that consumers, including me, will happily pay twice as much for a Mac laptop as a Windows one, but Mac laptops are still much better hardware. I can’t speak to tablets as I’ve only just ordered my first one (an iPad mini) but I get the impression there’s still a real Apple lead there too. With phones, that’s no longer the case, and phones are by far the largest component of Apple’s business and valuation.
2. The real downside case is unlikely in the near term, but it’s extremely bad.
What I described above is more or less a steady state, and it’s what I expect to happen. The next few generations of iPhones will be equal to or a little better than the best Android phones, and both the iPhone and the top few Android models will continue to enjoy very strong sales, but with increasing competition on price and everyone losing leverage over the carriers.
The real downside for Apple is that one of the next few iPhone models is a bust, with the consensus reviews saying that it’s worse than the top Android phones. If that happens, you won’t be scaling your annual revenue growth from 6% back to 3% or 0% or even -2%. You’ll be looking at an utter collapse.
Why? Because the entire price premium for the iPhone is based on the fact that for six years it’s been unequivocally the best phone on the market. That brand value is what’s driven such high sales and returns. But if you live by the sword, you die by the sword. As soon as there’s an iPhone that’s no longer the best, the “cool factor” of Apple products is going to drop off a cliff.
This isn’t happening to Samsung because they no longer have the best Android phone (with the S3 being surpassed by LG’s Nexus 4). Samsung makes lots of phones, and their brand value for consumers (to the extent they have any) has never been tied to any particular one. But Apple makes just one phone, and that phone has to be, if not the best phone in existence, at least close enough that its advocates can make that argument with a straight face.
Again, I don’t think this scenario is going to happen in the next couple of years. But it has to happen eventually, right? Nothing goes on forever. And when it does happen, I don’t think Apple will settle comfortably into second place, with a steady-state business as one of a group of industry leaders. I think it will experience a precipitous fall in sales. Just as a shark has to keep swimming, Apple has to be the best. That’s what the whole brand is based on.
So I see a much more binary outcome than Damodoran. In one scenario, they release an iPhone model that’s no longer the best, resulting in a flurry of bad press and a sharp decline in sales, which in turn tarnishes the brand and hurts sales further, in a vicious cycle. In that case, the floor for the stock is a lot lower, whatever its long term value.
In the other scenario, every new iPhone model continues to be the best phone on the market, and the stock continues its wild trading-driven swings, but is still unlikely to make it back to its highs because of compression in sales price — and because investors will be getting more and more nervous about Scenario 1. Every iPhone model that’s successful brings us that much closer to the first one that won’t be. The longer the iPhone is the best phone on the market, the worse the consumer and media backlash will be when it isn’t.
The bulls who read this and think “people have been worried about these things for the last few years and they’ve been wrong so far” are missing the point. The fact that it hasn’t happened yet doesn’t mean that it won’t. The real question is how things will play out when it does. Can you imagine Apple as a strong #2, like Schick razors or Pepsi cola or David Letterman? I know I can’t.
Disclosure: I have no current position in Apple stock or options, in either direction. Do not take investment advice from someone whose last post was about Dope Wars.