Apple Stock (NASDAQ:AAPL)
It’s no secret that Apple (NASDAQ:AAPL) is a superior company at this moment. Warren Buffett, CEO of Berkshire Hathaway (NYSE:BRK.B), is upfront about his passion for business, saying:
“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 be adding to their holdings as Apple approaches the $3 trillion dollar milestone, private investors may wonder if buying AAPL stock is worthwhile for someone who does not manage hundreds of billions of dollars. I wanted to investigate further to find out.
In terms of quality, AAPL is a consumer monopoly that has successfully adapted and grown from a modest computer firm in the 1970s into a dominant ecosystem of products and services. Apple has consistently exhibited great ecosystem integration, from easy and smooth messaging from iPhone to MacBook to recording workouts on an Apple Watch and reviewing them afterward on an iPad. In addition to hardware, their service offerings are continually expanding and synergizing with goods such as iCloud storage, Fitness+, Apple TV+, and Apple Music.
AAPL also stands out among its peers in terms of quantitative performance. Its strong returns on investment and equity (55% and 175% in 2022, respectively) show that it is a superior business that generates big sums of cash. Even after adjusting for stock-based compensation, free cash flow has been continuously increasing, with more than $100 billion generated in FY 2022, up from roughly $60 billion in FY 2018. It also invests nearly all of its free cash flow in dividends and, more significantly, buybacks, thereby expanding shareholder ownership over time. Having said that, our models show that current prices look to represent a premium to fundamental value, however, as Phil Fisher would say, a high-quality company like AAPL deserves it.
Performance in the Most Recent Quarter
Despite macroeconomic headwinds, Apple has been able to sustain the majority of its revenue with 2.5% y/y reductions in the MRQ due to its diverse product mix. When comparing segments, the Mac and iPad were the lowest, offset by minor improvements in iPhone and services revenue. However, the iPhone, followed by services, is by far the greatest revenue generator, as illustrated below:
Apple portrays its products as premium, allowing it to keep its greater profits. If the macroeconomic picture continues to deteriorate, the Apple ecosystem and switching prices will provide a moat that will be tested. Will weakening businesses and consumers still be willing to pay full price for the next iPhone, or will they opt for less expensive alternatives? Cracks are already appearing in their other hardware divisions, and if this finally translates into decreases in iPhone revenue, the market may determine that AAPL’s $2.7 trillion valuation is too high.
It is reassuring that the high-margin services category appears to be resilient and is becoming a larger component of the revenue mix. Apple reported services gross margins of 71% in the MRQ, compared to 36.7% in its product categories. However, there is a considerable risk here because much of service revenue is also dependent on discretionary spending from wealthy customers. Customers can quickly reduce their premium subscriptions such as Apple TV, Apple Music, and Apple Fitness Plus to save money and make fewer app store purchases. The market may be under the impression that Apple has constructed a recession-proof business and may be disappointed in the short run.
Debt Is Reasonable
No firm analysis is complete without a glance at the balance sheet, especially the debt portion. At first glance, Apple appears to have a considerable amount of debt in comparison to many other large tech companies. AAPL has around $100 billion in long-term debt as of the MRQ. For comparison, Microsoft had over $50 billion, and Alphabet (NASDAQ:GOOGL) had approximately $13 billion.
Although debt exceeds stockholder equity of $62 billion as of the MRQ, this can be a sign of a superior firm. Apple invests the majority of its free cash flow in stock buybacks and dividends, reducing equity value. Indeed, in the most recent reported six months, the corporation generated $55 billion in free cash flow and paid $46 billion in buybacks and dividends to shareholders.
Clearly, a business like Apple, which generated $111 billion in free cash flow in fiscal year 2022, does not have an issue with a high nominal amount of debt on its balance sheet. Furthermore, the debt is adequately dated out, so investors can expect buybacks and dividends to continue on a regular basis even if the company decides to pay down the debt.
Valuation
When I examine tech companies and adjust free cash flow for stock-based compensation, the findings are frequently dismal. This is certainly not the case for Apple.
Apple has clearly performed well over the last five years, and these favorable outcomes have been bolstered by shareholder-friendly policies that have increased ownership of the company over time.
Apple anticipates comparable sales and gross margins in Q3 as in Q2. If this translates into cash flow, the YTD free cash creation would be $80 billion after Q3. If we assume that the macroeconomic slowdown continues to weigh on the corporation, we can expect free cash flow to be around $90 billion in fiscal 2023, after accounting for stock-based compensation.
As the economy improves, we can expect cash flow from this impaired value to return at a 15% CAGR through the conclusion of our prediction period in 2027. This rate of growth corresponds to the period 2018-2022. For terminal value, I estimated the corporation will expand at a 4% annual rate in perpetuity, owing to its strong consumer monopoly and ability to develop with the global economy. I picked a 10% discount rate because the company has little debt in relation to its market capitalization, and this is likely to be the minimum return equity investors would anticipate. These assumptions are resulting in a firm valuation of about $2 trillion.
According to these calculations, Apple stock is trading at a 30% premium, with a $2.7 trillion market value at the time of writing. It probably deserves a premium because it is a superior developing shareholder-friendly business, but it is up to the individual investor to decide if this is too much. In the recent past, there have been significantly better entry times, with the corporation trading around the $2 trillion mark as recently as January 2023.
Geopolitical Dangers
Despite ambitions to diversify outside of China, the company relies on Chinese manufacturing for its hardware as well as CPU chips from Taiwan Semiconductor (NYSE:TSM). Any deterioration in relations with China, or any escalation with Taiwan, may result in temporary losses for the corporation as supply chains must be restructured.
Uncertainty in the Macroeconomy
Many of Apple’s products are luxury items, with prices that are often higher than competitors for consumer products such as the iPhone and MacBook. This is a trademark of Apple’s higher brand value, but the competitive advantage may be put to the test if there is a long recession with a weakened customer.
The Company Is Surrounded by Optimism
Though the company’s monopolistic character is advantageous, it is not a 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 eventually be able to weaken Apple’s moat. Mr. Market has a tendency to alter his mind quickly, and his mood may shift from the current rosy picture.
Conclusion
With enormous buybacks and dividends, limited relative stock-based compensation, and excellent returns in the future presumably guaranteed by their strong consumer monopoly, I believe investors will have a difficult time finding a better firm than AAPL. However, the stock looks to be selling at a premium to our estimate of a $2 trillion fair value, so conservative investors may wish to wait for a better entry point. If near-term macroeconomic headwinds weigh more heavily on iPhone and service sales than currently projected, this chance may come itself. For the time being, I do not believe that Apple stock offers an excellent risk/reward profile at present pricing, and I am content to continue holding it indirectly through Berkshire Hathaway. If the company trades near the $2 trillion mark again, I may consider purchasing shares.
Featured Image: Unsplash @ blocks
