Shorts: Terminal Value Analysis
May 22, 2016
- NASDAQ: AAPL
- Recent PPS: $95.22 (5/20/16 close)
- FD Shares Out: 5599.8 million
- Market Cap: $533,209
- Net Cash: $117,318
- Enterprise: $415,891
- EVPS: $74.27
- Normalized PE: 9.3 times
- 2017 ‘Street’ PE: 8.3 times
(1) AAPL’s fundamentals appear to have peaked. In other words, the ‘direction of fundamentals’ is likely down, creating a (powerful?) headwind to the stock price.
(2) The iPhone franchise is simultaneously impressive and frightening.
- Born in 2007, the iPhone has gone from $0 to $155 billion in sales in less than a decade – WOW!
- But the iPhone currently represents approximately 83% of consolidated gross profits – YIKES!
(3) With strong cash generation, a net cash balance sheet, and an enormous ecosystem, AAPL has (massive?) operational upside optionality.
(4) Worryingly, however, in bowing to market pressure and ‘returning cash to shareholders’, AAPL is not only squandering precious resources that would allow it to make a game-changing business development move, but also demonstrating little in the way of long-term thinking at the board/management level.
(5) In order to re-rate its terminal PE from a ‘run-off drug multiple’ of 10-12x to a highly integrated, sticky, wide-moat, tech/content/connectivity company multiple of 15-20x…AAPL needs to – at bare minimum – demonstrate that it is committed to diverting its iPhone cash flows into more durable, long-term, high-multiple assets that solidify its large-scale ecosystem.
(6) Unfortunately for AAPL bulls…until a game-changing business development announcement arrives, the direction of fundamentals will likely reign supreme, rendering AAPL a perennially ‘cheap’ stock.
(7) At its recent close, AAPL trades at an implied terminal PE of 9-13 times, depending on the scenario. To build in any semblance of a margin of safety against the highly unpredictable nature of long-term iPhone economics, somewhere between 5 and 7 times would be a more appropriate implied terminal PE to get excited about the stock on the long side.
- Under a very generous baseline scenario that assumes terminal iPhone sales and GPM of $144.4 billion and 45% (versus $155 and 50% currently), AAPL currently trades at an implied terminal PE of 9.1 times.
- Under a more realistic downside scenario that assumes terminal iPhone sales and GPM of $116.6 billion and 42.5% (versus $155 and 50% currently), AAPL currently trades at an implied terminal PE of 13.2 times.
(8) While the market is highly efficient in immediately reflecting ‘new’ information, it is very inefficient in appropriately pricing that new information. As such – even if AAPL’s stock pops on a big business development announcement, the market will dramatically underprice the long-term prospects of such a change in strategy, allowing profitable long-term positions to be initiated.
(9) Without a game-changing announcement however, a more appropriate entry point is below of $80, as at that level the implied terminal PE more appropriately reflects the highly uncertain future of the iPhone franchise.
In order to build out my short selling ability, I started a ‘paper’ short strategy in late October 2015. I hate paper trading, as it is tough to mimic the psychological side of managing real capital; but I am restricted from short selling due to my day job, so it is the best I can do for now. I will write about it more at length this summer.
Regarding AAPL, it has been a core short since late October 2015 inception, but is beginning to enter ‘coverable’, if not long initiation, range (big emphasis on beginning). While the decline has not been significant – particularly for an AAPL ‘long’ who believes in something along the lines of Carl/Brett Icahn’s analysis from October 2014 – it is in line with what I look for in a short that is: safe (i.e. limited risk of take-out) and well-behaved (i.e. limited risk of waking up to a 25%+ move).
As I have written about in various capacities, one of the bigger lessons of the last 12 months is the importance of the ‘direction of fundamentals’ (DOF). The friend who drilled the lesson into me likes to say: “You can press fundamentals – long and short – but not valuation.” At an optically cheap 8.3 times 2017 earnings, clearly an AAPL short thesis must be centered on the DOF.
But, without a game-changing diversion of cash flow away from ‘returning cash to shareholders’ and into more durable, high-multiple earnings streams, I believe AAPL’s fundamental business value has a serious terminal value issue – the focus of this write-up – which represents a powerful tailwind to the DOF thesis.
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The DOF concept is a bit more ‘art’ than ‘science’. At the very highest level it is probably best described as a Company that is growing YOY. McDonalds (NYSE: MCD) from 2006 thru 2011, then 2011 thru 2014 is a decent clean example of importance of the DOF.
Post-activist involvement in the mid-2000’s MCD stepped on the operational/financial engineering gas, unloading company-owned stores to franchisees, boosting margins, and repurchasing stock, all in a virtuous cycle backed by an impressive streak of strong same-store-sales (SSS) growth across its system due to weak global economic conditions. The stock price followed suit…before hitting a wall as soon as 2012 opened for trading. The stock went nowhere from 2012 thru 2014, as MCD digested its newfound market share, and competitors began to catch on to MCD’s remodeling strategy (i.e. 3G taking over Burger King) leading to flat to negative SSS growth for MCD and calls for an operational turnaround (an astonishing display of short-termism, after 5 years of highly impressive operational and financial performance). MCD’s stock began to turn around in mid-2015 alongside improvement in SSS growth.
Sounds simple in hindsight – obviously it’s not. Just an example.
AAPL has followed a similar operational DOF/stock price path. Yes, there was a ‘dog pile’ into the stock in 2012 leading up to a 40%+ decline into mid-2013…but the decline coincided with an inflection in iPhone sales (2013 growth was ‘only’ 16% v. 71% in 2012). And yes, sentiment/positioning turned very negative in mid-2013 leading up to a 100%+ return into mid-2015…but the rally coincided with an inflection in iPhone sales (2015 growth 52%) led by sales into China.
At a high level, the current direction of AAPL’s fundamentals are best represented by current ‘Street’ estimates for AAPL’s sales:
- FY 2015A: $233.7 billion
- FY 2016E: $216.2 billion
- FY 2017E: $226.6 billion
With the current sales base elevated by a large step-up in sales to ‘Greater China’ – $27B (2013) to $58.7B (2015); competition heating up; emphasis on ‘returning cash to shareholders’ over making a game-changing acquisition/partnership; and a very weak broad market backdrop on top…from current levels, the risk/reward is skewed to the downside, IMO.
THE VALUE INVESTOR & THE DCF/TERMINAL VALUE
Value investors are fond of taking pride in eschewing DCF and thus terminal value analysis. This value investing tenet is based largely on several wobbly (read: out of context) quotes by Buffett and Munger over the years. For example, this exchange regarding the use of DCF analysis at the 1996 BRK annual meeting:
“Warren talks about these discounted cash flows. I’ve never seen him do one.” “It’s true,” replied Buffett. “If the value of a company doesn’t just scream out at you, it’s too close.”
The critical context missing from the above quote is that Buffett is highly disciplined about investing within his ‘circle of competence’. Within that circle of competence are dilly bars, branded sugar water, car insurance, and railroads – all of which have A) been around for decades, B) change very little, and thus C) are able to be valued with a high degree of certainty on near-term earnings. If an experienced investor requires a DCF model to value a steady-state stream of Coca-Cola (KO) or KO-like cash flows, they are doing it wrong…let alone Buffett, who is quite literally a human calculator.
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AAPL’s economics – while hugely impressive – are a touch less predictable than dilly bars, branded sugar water, car insurance, and railroads. Setting new product development and/or entering an ancillary business line via acquisition aside, valuing AAPL based on near-term earnings power implicitly assumes VERY long-term stability in the iPhone franchise. Like, in perpetuity.
As such – I believe it is critical to, at minimum, consider what the current valuation implies from a terminal multiple/value perspective after making some long-term iPhone/non-iPhone segment assumptions.
Segments. I simplify AAPL’s product segments into iPhone and Core/Legacy. In the two forecast/valuation scenarios, I assume the Core/Legacy segment grows 3% p.a. and maintains flat gross profit margins.
iPhone. The iPhone franchise generated sales of $155 billion in FY 2015, or 66% of consolidated sales; and assuming a 50% gross profit margin, 83% of consolidated gross profit.
Using ‘Street’ projections for consolidated sales in 2016 and 2017, I back into implied iPhone sales of $135.2 and $143.1 billion. For 2018-2021, in the baseline scenario I assume flat sales at the 2015-2017 average; while in the downside scenario, I assume a 5% decline p.a. thru 2021.
In the baseline scenario, I assume the iPhone GPM declines from 50% in 2015 to 45% in 2021; and in the downside scenario, I assume the GPM declines to 42.5% in 2021.
Baseline Scenario. From 2015 thru 2021, consolidated sales and net income grow .33% and -3.5% per annum, and terminal iPhone sales are $144.4 billion (versus $155 in 2015).
The current stock price implies a terminal PE of approximately 9.09 times in the baseline scenario. Given this scenario is largely muddle thru, without investment in alternative earnings streams the market is highly unlikely to re-rate AAPL much beyond 9 or 10 times, IMO.
At an implied terminal PE of 5 times, AAPL would trade for approximately $76.
Downside Scenario. From 2015 thru 2021, consolidated sales and net income grow -1.7% and -8.4% per annum, and terminal iPhone sales are $116.6 billion (versus $155 in 2015).
The current stock price implies a terminal PE of approximately 13.2 times in the downside scenario.
At an implied terminal PE of 5 times, AAPL would trade for approximately $67.
- Net Cash = Cash – Debt – Deferred Revenue – Deferred Taxes = $117.3B = $21 per share
Normalized Earnings Power
- Baseline Revenue = Average (2014A, 2015A, 2016E)
- Normalized EPS = $7.95
- AAPL’s product segments are simplified down into two: iPhone and Core/Legacy
- Core/Legacy includes: iPad, Mac, Services and Other
- Very rough estimate of iPhone GPM is 50%, which implies 20.5% for the Core/Legacy segment
- At the estimated 50% GPM, iPhone comprised approximately 83% of consolidated gross profit in FY15
- Note, Core/Legacy sales are flat to down from 2013 thru 2015 – a trend to keep in mind when making bullish projections for ‘services’ and ‘sell thru’ rates…
- Core/Legacy revenue grows 3% p.a. from 2015-2021
- iPhone GPM declines from 50% in 2015 to 45% in 2021
- iPhone revenue flat at $144.4 billion from 2018-2021 (versus $155 billion in 2015)
- 2015-2021 consolidated revenue CAGR: .33% p.a.
- 2015-2021 net income CAGR: -3.5% p.a.
- 2021 iPhone % of consolidated GP: 77%
- Core/Legacy revenue grows 3% p.a. from 2015-2021
- iPhone GPM declines from 50% in 2015 to 42.5% in 2021
- iPhone revenue declines 5% p.a. from 2018 thru 2021 to $116.6 billion (versus $155 billion in 2015)
- 2015-2021 consolidated revenue CAGR: -1.7% p.a.
- 2015-2021 net income CAGR: -8.4% p.a.
- 2021 iPhone % consolidated GP: 72%
- Terminal PE implied at current PPS: 9.09 times
- FVPS at terminal PE of 15 times: $123
- PPS at implied terminal PE of 5 times: $76
- Terminal PE implied at current PPS: 13.2 times
- FVPS at terminal PE of 15 times: $101
- PPS at implied terminal PE of 5 times: $67
While I would more than likely cover between $67 and $76, without a game-changing change in strategic direction I personally believe the stock is uninvestable even in that price range. The downside scenario of $116.6 billion in sales and a 42.5% GPM in perpetuity for the iPhone franchise is a very, very difficult set of assumptions to handicap.
Critically, however, with robust cash flow generation, a squeaky-clean balance sheet, and an enormous ecosystem, AAPL has (massive?) long-term optionality. Unfortunately however (for longs), it appears Tim Cook is not in much of a hurry. Perhaps he’s sly/crazy/tactical like a fox and is waiting for his time to strike…but prioritizing buybacks in response to activist involvement over building up a war chest to enter the ‘connectivity’ and ‘content’ arenas is a bit troubling.
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The ideal scenario from a portfolio management perspective would be a decline to below $70 followed soon after by a game-changing ‘business development’ announcement allowing me to flip long.
Worst case scenario is likely a game-changing announcement somewhere between the current price and the 52-week high of approximately $133.
IMO, it is highly unlikely the stock ‘runs away’ to the upside on an operational inflection point with the current business mix.