A recent article was published on Seeking Alpha titled “Apple: Too High, Too Unreasonable“. The article, focusing on Apple’s (NASDAQ:AAPL) estimates of revenue growth as a fundamental premise, argued that the company’s share price was too high on a historical basis. However, as we’ll see throughout the article, the company’s longer-term growth potential makes it a quality investment.
Apple and COVID-19
One of the central tenets of the article was its focus on Apple’s 2020 forecast revenue as a premise for the company having “no growth”. However, the market is more forward looking than simply 2020, something that supports Apple’s current valuation.
Revenue Forecast – Opposing Article
However, the issue here is that this is incredibly short-sighted. The company’s TTM revenue picture for the upcoming quarters is based on the incredible loss of demand from COVID-19. Not only do people going out less tend to care less about the latest devices, but also the fact that one in four Americans have applied for unemployment means there’s a lot less interested in major new purchases.
In fact, with the current chance of a recession estimated at 100%, being able to maintain revenue in and of itself is quite impressive. Another way to look at this is that revenue isn’t everything. Apple’s revenue has only grown 15% from 2015 to 2020; however, obviously the company’s returns to shareholders have been much higher.
Gross Margin Forecast
What matters more in the long run is Apple’s potential for improved gross margins and EPS, along with long-run revenue growth. Specifically, the article discussed how Apple’s gross margin hadn’t changed much recently; however, that doesn’t mean it won’t in the future.
At the core of Apple’s ability to grow its revenue is improving margins. Specifically, the company’s overall margins are 38%; however, its services business margins are 61%. Apple’s services revenue has grown significantly recently and is expected to continue that growth going forward. In the long run, the forecast is for $100 billion in services revenue by YE 2024.
Given projected mid-single-digit long-run revenue growth, the company’s services revenue should grow more than twice as fast. This faster growth in a higher-margin business means the potential for much stronger returns for shareholders. It’s worth noting that the company has significant other businesses with higher margins.
The AirPod business is expected to grow from 1% of gross revenue to 6% of gross revenue. At the same time, the AirPod business has an almost 60% gross margin versus 40% for the remainder of the company’s business. The higher margins of the faster growing businesses mean the potential for significant growth.
Potential of New Product Lines
At the same time, outside of the company’s ability to grow margins, it has the potential to grow revenue for the long run. That’s true even if we remove the COVID-19 revenue drop forecast.
As can be seen above, revenue forecasts are expected to stay constant in 2020, as the other article alluded too. However, once the COVID-19 decline is over, steady revenue growth is expected to resume. More importantly, we want to take a moment here to highlight the strength of the company’s business, with consistent revenue during the COVID-19 downturn.
Earnings growth is expected to be modest but steady. Over the next eight years, revenue is expected to grow an incredibly respectable 75%. Combined with respectable growth in margins, that’s the potential for much stronger EPS for shareholders. In the long run, those who invest today will be well rewarded.
In fact, putting this all together, there is the potential for significant EPS growth. We don’t need to assume a historically high valuation for Apple here. Let’s assume the company stays in line with its average EPS at ~16.
The above image provides an indication of Apple’s EPS estimate. The EPS is expected to flat line for the year before resuming growth. On that path, the EPS is expected to hit roughly $25/share by the end of the decade. At the above P/E ratio we discussed, that’s a share price of more than $400.
That represents nearly 30% growth for the decade. For reference, over the next decade, forecasts for the S&P 500 (NYSEARCA:SPY) are for roughly 4-5% annualized gains. Apple reverting to the mean EPS would imply annual growth of 2-3% instead. However, it’s worth noting a key forecast here is that the company reverts to its historical P/E ratio while it continues to trade at highs.
However, what we’re skipping over here is Apple’s consistent share buybacks. A balanced approach to Apple (i.e. not buying back stock out of net cash) indicates it could repurchase 4% of its stock annually. That would mean that in 2030 it would only have 65% of the shares it has outstanding today. Given that our EPS to P/E ratio equivalent is based on market capitalization, that would actually imply a 2020 stock price of $615.
That would increase the company’s annual returns towards 7%. That would imply several % annual increases over the S&P 500. And that’s with a significant reversion to the company’s mean P/E. A P/E of 16 indicates a 7% annualized yield while a P/E of 25 indicates 4% annualized yields. In a 0% interest environment, a 4% yield from quality stocks is quite good.
That’s a great reason to invest in Apple for the long run.
Of course, the obvious risk to our thesis is that Apple is a single company that over the time period of a decade is subject to significant earnings fluctuations.
There are several competitive threats the company could face in the high tech business. It could see a new phone model that’s more competitive and replaces the iPhone. New streaming services are happening across major companies and can pressure services revenue. The company’s near $20 billion in annual R&D spend is indication enough of the pressures to remain competitive.
We believe Apple will continue, as it has, not only to innovate but also to create new products that increase its revenue and define new segments, such as the AirPod. However, there’s of course no guarantee of this.
The article on Apple from another author indicated that the company was overvalued because of its high P/E ratio and flat estimates for 2020. However, the article ignored the fact that going into the late-2020s, earnings are expected to increase significantly. That, even with a significant P/E reversion to the mean, means strong growth with share buybacks.
Based on estimates for the S&P 500, Apple should see earnings that are several percent more annually than the S&P 500’s returns. 7% in annual share price yield combined with several % in dividend under a worst-case reversion in P/E ratio alone indicates a stock worth holding for the long run. That’s why we recommend investing in Apple.
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Disclosure: I am/we are long AAPL. 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.