[(Dell+Style)+(Motorola+Profitability)]*2 = Apple?
October 19th, 2007 by 
James Cullen
After my original article on “Why Apple (AAPL) Is Not a Good Value,†I was pressed to show more than my assumed growth rates in order to provide additional transparency on the process. In working up a spreadsheet for the valuation, I broke down Apple’s operations into the various segments - Macs, iPods, Music, Hardware, Software, and iPhone (units and licensing). What follows is a segment-by-segment breakdown of what I see as being priced in to the current market valuation of Apple. Keep in mind, this is not meant to be perfect (I could be overestimating Mac growth and underestimating iPod growth, etc. - if it is possible to overestimate anything having to do with Apple) but rather to show the general idea of how Apple is going to grow in the next decade, and what kind of share it is going to take.
We’ll start with the Mac line (both desktops and laptops), which accounted for $9.4 billion in sales, or 42% of Apple’s total revenues, in the last year. Unit volumes have been growing quickly here for Apple of late, and Macs are expected to benefit greatly from the “halo effect†as primarily iPod customers come to use more Apple products. In the next year, we’ll assume the Mac segment grows sales at 35%, followed by years 2 and 3 at 30% each, 25% in the year following that, and 20% in the 5th year. This gives us Mac revenues of $32.25B in 2012, or more than 40% greater sales than Apple as an entire company has now. Moving along, year 6 sees Mac sales grow at 15% to $37B, greater revenues than Dell reported in their last full SEC filing. Add two additional years of growth at 12% annually, followed by years 9 and 10 at 10% annually, and total compound growth for the period comes to 500%. Mac revenues in the 10th year total $56.3B
Next, I’ll address the iPod, which currently amounts to $8.25B in annual sales, or 36% of Apple’s total. Unit growth here has been slowing, as Apple already owns a significant portion of the market in this area. The iPod Touch may go a ways toward reinvigorating sales here, so we’ll assume growth of 15% for each of the next two years, followed by two years of 12% growth, then the 5th year at 10%. I don’t see those as low, given that Apple has largely saturated the space already, ASPs for iPods have been declining, and increased competition is likely to come from other manufacturer’s mobile phone devices in the future. After year 5, I give the iPod segment 8% annual growth to the 10th year of the model. Segment revenues in the out-year total $22.1B, or essentially equal to Apple’s consolidated revenues in the last year. Total growth for the decade is approximately 170%.
Because music, hardware, and software respectively comprise 10%, 5%, and 6% respectively of revenues, I’ll skip to something everyone cares about much more - the iPhone. There are two components here: actual unit revenues from sales, and licensing fees. I’ll place the licensing fees as going straight to free cash flow, and exclude them from revenue discussions here. That said… Average selling price (ASP) in the front-year is going to be a simple $400, which will be reduced by $11 each year going forward, for an out-year iPhone ASP of $301. I’m going to say that Apple sells 8 million iPhones in the next year, 15 million in the following, 25 million in the third year, 33 million in the fourth year, and 40 million in the fifth year - that covers the exclusivity period AT&T (T) has in America. Keep in mind, the size of Apple’s targeted market (North America and Europe) has about 460 million customers, and Apple will be able to sell to about 140 million of those through approved carriers. If the total market size grows at 5%, by the 5th year Apple will have over 13% of the handset market assuming a 2-year life cycle for the iPhone.
After year 5, let’s say Apple sells 50, 60, and 70 million iPhones in the next three years, respectively, followed by 77.5 million in the 9th year and 85 million in the 10th year, or a 22.9% market share. Out-year iPhone revenues thus become equal to $25.6B, comparable to Motorola’s (MOT) mobile device sales of $28.4B last year. And in case you are wondering, this kind of growth has Apple matching Research in Motion’s (RIMM) $4.2 billion in sales after 18 months in the market.
Now, the licensing component. For the first five years, we’ll allocate $90/iPhone as the fee Apple receives from the wireless carrier under the exclusivity agreements. In years 6 and 7, as the deals - estimated as 5 year agreements - expire, I’m going to half that amount because I see the chances that such an arrangement is negotiated a second time around as unlikely, although Apple will still be collecting its fee from residual users who signed up as the contract’s days wound down.
Moving on to hardware and software (a combined $2.6 billion, or 11.5% of revenues), both will be assumed to grow 20% annually for each of the next three years, followed by 15% for the two years after that. In years 6-8, add another 12% annual growth, followed by 10% growth in years 9 and 10. Having grown a total of 290%, the two now equal $10 billion in revenues for Apple.
With total annual revenues for each of the 10 years, we can now approach the “discounted cash flow†part of the valuation. To keep this simple, last year Apple had an 18% FCF margin, meaning that the company converted every dollar in revenues to 18 cents in free cash flow. This is a very good FCF margin, and I don’t think expecting it to increase in the future would be prudent - remember, margins decrease over time. Taking each year’s revenue and applying an 18% FCF margin gives me a rough estimate of each year’s free cash flow. Now I’ll also add in the wireless carrier fees from the iPhone (100% FCF margin), sum the amounts, and discount them. What discount rate to use? In one earlier example, I used 9.5% for the discount rate, a number derived from the Capital Asset Pricing Model (CAPM). I had several people comment that I was an idiot, CAPM is irrelevant, 9.5% was too high, etc. For what it’s worth, CAPM did win a Nobel Prize, and the spelling ability of those criticizing it wasn’t exceptionally high. I also had one comment that the historical equity risk premium is somewhere between 6% and 9%, and adding risk-free (>4%) plus Apple’s specific risk premium (beta is >2) should give me something close to 20%. Having plugged a 20% discount rate into the valuation model for fun and seen the result, the uproar would be enormous (hint: valued at $85.50/share), so I’m going to settle on a method suggested by Arbitrage Corner that yields a very reasonable discount rate of 11.5%.
Taking this and discounting each year’s estimated free cash flow, then taking a terminal multiple approach and adding in net current assets gives a valuation of $170.30/share. AAPL closed a dime higher, so I think the above growth expectations very closely represent what is being priced into Apple stock. So, where is the upside? Higher segment growth is an obvious answer. Current 10-year annualized growth is expected to come in at 15.85% under this model, and out-year sales are forecast at $121.1B, or about twice the aforementioned segment revenues of Dell (DELL) and Motorola (MOT) in the last year. I didn’t include the “new hit product†revenue stream in here, so if Apple starts entering vastly different markets and that spurs organic growth, that could add upside. One cost-benefit for Apple to determine is the exclusivity agreements with wireless carriers; the kickback on customer’s phone bills adds to FCF greatly, but it also adds limits to an already limited market.
Either way, it should be interesting to watch this one play out. Can Apple meet these huge expectations? If you think I missed something, feel free to add a constructive comment below, as I can go back and make adjustments to my valuation model to demonstrate different scenarios.
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October 20th, 2007 at 3:26 pm
I think this model is much more accurate although as you mention, there remains the potential for Apple to enter (or create) vastly different markets and thus substantially increase out year revenues.
I also think your growth estimates are generally too conservative as I don’t believe they factor in intangibles like good will. Apple’s growing acceptance in the enterprise and future halo effects from currently under-developed products such as Apple TV will lead to significantly stronger growth over the next decade IMHO.
But you are entitled to be as conservative as you like. Just remember that as long as Steve Jobs sits at the helm, Apple’s corporate culture will be anything but conservative. (And conservative corporate cultures are the real root of declining growth in large companies where fighting the law of large numbers and pursuing incremental growth becomes more important than the next “new hit porduct.”)
October 21st, 2007 at 4:35 pm
[...] certain sections of the markets have rich valuations: popular tech companies like Apple (AAPL), Google (GOOG), VMWare (VMW), Amazon.com (AMZN), and Research in Motion (RIMM) all trade at 30-80 [...]
October 21st, 2007 at 10:57 pm
[...] Cullen presents [(Dell+Style)+(Motorola+Profitability)]*2 = Apple? posted at College Analysts, saying, “An implied DCF analysis of Apple shows that the company [...]
October 23rd, 2007 at 4:35 pm
Height of Stupidity! Back to dot com! Instead of DCF determining the stock price, stock price is driving the DCF calculation. The growth rates mentioned in this article are impossible to achieve. Shame on you! This stock will crash flat on its face because a real (not tailored) DCF does not justify its price.
October 23rd, 2007 at 5:45 pm
Anon,
You aren’t taking this in the right context. The entire point of this was to show what Apple is expected to do… not what is reasonable. I already addressed my real estimates in my original article, which is linked to right at the start of this one. Read that and this might be more clear.
October 24th, 2007 at 12:30 am
Thanks. I remember an incident watching CNBC during the dot com times. Cisco’s price was $80. An analyst upgraded the stock to $90. The host asked, “Isn’t it overvalued already at $80?”. The analyst responded, “What do you mean overvalued? Wasn’t it overvalued at $60? The P/E and the DCF fair value does not justify the price of $60 either. This stock can keep on climbing up.” Somehow, Apple reminds me of that story. Fair value and P/E does not seem to have any bearing on the price since innocent investors think sky is the limit.
November 26th, 2007 at 11:03 pm
Can you post your spreadsheet so that we can understand what you’re doing with your DCF? Your explanation is good, but I’m still unclear on some elements of your valuation analysis.
December 11th, 2007 at 6:10 pm
I like the methodology better - I generally assume that the traditional ipods is already dead and the real impetus for the iphone is to develop on the ipod concept and the phone was the only way to do this. I dont see why you think that the terms of the exclusivity agreement work for apple and would never be repeated again. That seems to be a biased stretch at best. I also think the perception of what apple has ahead seems rather narrow, as does any comparison between this and CSCO. I’d actually argue that Apple seems to be too relaxed in taking over the world and really could take out BBI and NFLX in a matter of days if they actually chose to move into this segment. Itunes as it stands is just a hobby.
December 12th, 2007 at 3:05 pm
[...] An Implied Valuation of Apple (AAPL) [...]
December 27th, 2007 at 8:17 pm
Do yourself a favour and take a look at apple again. Im not saying its a buy here, but i am saying that your analysis underestimates the growth potential here (obviously) and its ability to stretch into other fields. We have the ipod, we have the phone, and now we need content… oh and to make apple tv a worthwhile experience. Bye bye networks, bye bye nflx, bbi, hello apple. And really why buy nflx as a business when you can just replace that business in a day? Yes imitating nflx didnt work for BBI but who ever saw such a bad plan? The comparisons to Dell i find interesting because really apple’s killer app is similar in terms of their use of balance sheet and capital, but remember Dell never really had a product. It was a computer with good service. Whereas Apple has a culture and an extraordinary efficient use of capital.
December 29th, 2007 at 12:58 pm
Speaker,
Why would the writer factor in goodwill to his growth estimates? Goodwill is a premium paid for the acquisition of a company, and not always accretive to EPS. So, please explain your position.
December 29th, 2007 at 1:34 pm
The previous comment should read that acquisitions are not always accretive to EPS.
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Wow, 16% growth over 10 years and he’s underestimating the growth prospects…hilarious!
Smartass, I would be very interested to see what model you’ve come up with and your forecasts for AAPL over the next 10 years.
But really, the fundamental analysis here is solid, but it doesn’t always work that way…at least not right away. Fundamental analysis is based on predictions, and predictions obviously have plenty of room for error.
There is always someone willing to build that castle a little bit higher in the air (e.g., smartass). Companies can trade at rediculously high multiples for a long time as long as there is someone else who’s willing to buy the idea that the company is going to continue growing at a high rate for a very long time (e.g., smartass). We all know where that type of thinking gets you (see 1999-2000).
Stocks like AAPL go up based on the idea that they will continue to grow at current rates (or higher). As soon as there is even an inkling that the predicted growth is slowing, the stock comes back to earth. Let’s be honest, 16% annual over a period like 10 years is not an easy thing to do.
Smartass, do yourself a favor and take a look at AAPL again
January 23rd, 2008 at 9:02 pm
16% growth over 10yrs is hardly remarkable and really I find that far too many people have taken to parroting these this catchall and forgetting basic maths. Its the law of compounding, and obviously extraordinary growth at the beginning reduces the need for growth at the end. As a random example 35% for 4yrs and 5% for the remaining 6 would give you more than 16% annually. Furthermore a company with high ROE that pays no dividends is hardly surprising me when they maintain 16% kind of growth. I am no doubt stating the obvious, but i really didnt think that the 16% comment was warranted or made any sense.
To be fair I came to similar numbers as you (177) which is why i took on the name smartass; for me though the security in those numbers comes with factoring a lot more growth into other sectors which i think apple has so far ignored. Its move into bbi/nflx territory seems consistently half hearted, even though this a very easy and natural progression; same goes for apple tv. This could of course all change now that touch now have added functionality.
I also couldnt understand how you could argue that Apple would suddenly be unable to renew contracts with the wireless providers, when there is a clear interest on the provider’s part if the product sells. Actually one could just as easily argue that Apple might be in a stronger position next time around.
The argument for market saturation is also interesting to me since i believe that the new touch is a completely different tool from the ipod and really requires a completely new purchase starting from scratch. Previously the battery life managed to force you into repurchasing as opposed to new technology so i guess that is an improvement at least.
Finally i think we have all been badly scarred from the last tech bubble, and we seem to think that anything in tech that is going up now must be in a bubble etc. By that I mean that Apple multiples are not even comparable to the multiples we saw in 2000, and there is today a lot more transparency as to its growth potential etc. and yet we still get the same naively simple comparison.
Apple already has pole position and a pretty serious moat if you ask me. This is their race to loose. Sorry this is a disorganized ramble but I was trying to do too many things at once, and thus have completed all of them badly. Good luck
January 23rd, 2008 at 10:53 pm
Smartass,
You didn’t come to a similar number as I did; my valuation was $131 - something I have a feeling you’d wholeheartedly disagree with. This article here was merely to show what was “baked in” to the stock price at the time, after I caught so much grief for saying that AAPL was overvalued… which, ahem, we all know what happened today.
-James
May 4th, 2008 at 8:27 pm
Thanks for the great analysis. I am looking to buy AAPL stock and it helps to review detailed analysis like this.