SUMMARY

1. Being the largest public company should not be seen as an obstacle to growth but rather a safety net that protects it from competitors.
2. Apple’s ability to generate an immense amount of free cash flow has been ignored by the market as it trades at a very reasonable price.
3. Its eco-system acts as a very strong economic moat and has allowed the company to expand its services and product categories.
4. Apple is poised for more growth while it continues to increase shareholder value in the times of a fast changing customer and technology environment.

 

1. Introduction

Almost every financial headline which addresses the stock market claims that it is overvalued. And perhaps, the finance media may be right. After all, the S&P 500 Index has seen an incredible run of almost 20% since the day Trump has been voted to be the President.

What are investors to do during such a time as this?

It’s never too late to heed Peter Lynch’s advice that the best stock to buy may be the one you already own. If you’re trying to build a manageable portfolio of 15 or so holdings, you should be thinking about adding to existing positions at least as often as you consider new ones. To that end, here is a stock that you may consider adding to your portfolio.

As the world’s largest public company, Apple (NASDAQ: AAPL) is a tech titan that most investors are familiar with. The company’s intense focus on the consumer experience and sleek designs have propelled it to be one of the most trusted and valuable mobile phone and personal computing brand. The company is trading for less than 20 times earnings which is remarkable after factoring in more than $250 billion of cash on its balance sheet. Still, there are plenty of reasons why this winner will continue to expand and dominate in its industry.

 

2. Business Overview

 

The best way to understand this cash cow is to study its business segments and see how it methodically extracts profits from its various streams of cash flow. From the previous quarterly earnings, investors were provided some clues as to where to look for growth in this tech behemoth.
Every single product segment of the company featured growth. The company’s rock star product, the iPhone, accounts for 55% of the company’s revenue which grew by a modest 3% year-over-year. Service revenue, which accounts for the second largest stream of revenue increased by 22% while Apple quiet grew revenues stemming from product segments such as Apple TV, watch, Beats products, and other accessories by 23%. While the iPhone contributed to the lion’s share of the company’s staggering revenues, it does not give much insight as to how profitable the other products are. Here are the numbers to show the net sales breakdown for each of the product segment comparing the company’s third quarter for the year 2017 and 2016:

 

Source: Apple Form 10-Q for the quarterly period ended July 1, 2017.

 

It is worth noting that few hardware manufacturers make money selling smartphones and tablets. The money found in the components business doesn’t come close to Apple-like profitability. Apple’s product line consists of the most profitable smart phone device, tablet, laptop, desktop, smartwatch and streaming TV box. The best-selling laptop and desktop manufacturers can only dream of Mac margins. It is no surprise that the company owns only 10% of the smartphone market while it cashes in on more than 90% of the profits made in the entire smartphone market. Apple is the most profitable wearables company. Even minor Apple products from a sales perspective, like Apple TV, are grabbing profit in an otherwise profitless industry.

But how can Apple earn supernormal profits when the entire industry is failing to turn even a normal profit?

The answer lies in the manufacturing deals that were structured by Apple.

Source: Author

 

Instead of acquiring and accounting for the capital expenditure of factories around the world, Apple relies on its manufacturing partners as it invests aggressively in machinery and equipment in other companies’ factories. The company knows that manufacturing is extremely capital intensive and hence, outsources an area of its supply chain that it has no interest in specialising. As a result, Apple’s capital expenditure is considerably smaller than the operating cash flows, leading to greater free cash flows.

 

3. The Numbers

When talking about numbers, there is no other company like Apple. Indeed, many would agree that it is in a league of its own.

Source: Author

 

Apple’s revenue over the last four years, while increasing at a steady rate, has been monstrous. To things in perspective, Apple’s TTM might just match Singapore’s gross domestic product (GDP) this year. It has also been able to churn revenue figures far higher than that of other tech titans such as Amazon.com and Alphabet (the parent company Google). Despite being in the hardware business, it maintained a net margin of at least 20% throughout the last four years.

With its one-of-a-kind balance sheet (over $250 billion in cash), enviable margins, and innovative culture, we have high confidence that Apple’s heyday isn’t close to being over.

 

4. Risks

While the company may still be relatively undervalued as compared to the overall market, it does not mean that it is a riskless investment.

The company has not been able to maintain its margins over the last four years and the flood of cheap competition that flooded the accessories market has certainly added tremendous amounts of pressure on the company’s already razor-thin margins.

Also, many analysts have induced fear in investors citing that the company’s growth engine may have been rusting away with little to no turnaround ever. While that is likely an exaggeration, the company has been extremely conservative in deploying cash towards its side projects and acquisitions. The iPhone has seen sales peaked in 2015 and many are doubting that the company will be able to repeat that phenomenal performance again. If the company’s main cash machine shows signs of considerable decline, investors would need to count on other segments to maintain its revenue.

Lastly, we should keep an eye on the company’s extracurricular activities such as Apple Music and Apply Pay. Both services require scale in order to become a better music streaming service. In addition, Apple Pay needs widespread retailer and consumer adoption in order to gain economies of scale and network effects – both of which ultimately leads to lower operating cost. While the Apple Music and Apple Pay adds value to the Apple hardware and improves the overall margins of the business, it should not distract the management from the bigger picture which is selling devices that surprise and delight its cult-like fan-base.

 

5. Conclusion

Investors can take comfort in the company’s management team as they have provided an outlook to reflect the company’s drive to rejuvenate its growth in revenues and profits. It is important to understand that Apple is more about ecosystems than products. It is more about experience than hardware. One should not bet against Apple just because it had a down season. For those who have the patience to wait, this could be an opportunity to invest in the lead-husky of the smartphone industry.

 

Marcus Ho
Research Analyst, Mind Kinesis Value Investing Academy

Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.