Apple: Headwinds not reflected in current stock price (NASDAQ: AAPL)

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Investment thesis

As inflation picks up and central bankers’ rhetoric tightens, analysts are revising their forecasts for personal consumption spending. The drop in PCE will largely affect the high-end and high-end segments of technology hardware market in which Apple (NASDAQ: AAPL) works. The drop in iPhone SE production orders due to weak demand is a sign of a possible slowdown in sales. In addition, there are risks of lower profitability due to a decrease in the share of services in the company’s total turnover and macroeconomic factors. While declining consumer spending and high inflation are common challenges for many industries and businesses, they are not reflected in Apple’s current price. The company is trading slightly below its all-time high. According to our DCF valuation, the company is trading near its fair price. We value stocks as a Hold.

Growth challenges

If in June 2021, 11 of the 18 members of the Federal Open Market Committee expected that in 2023 the interest rate would be only 0.5 percentage points higher, then in March of this year the bank central predicted that by the end of 2023, the rate would reach 2.75%, which means 11 hikes of a quarter of a percentage point each. Investors always keep in mind that a tightening of monetary policy leads to an increase in the discount rate and a decrease in the net present value of future cash flows that the company generates. However, an equally important consequence of the hawkish policy is the reduction in personal consumption spending, which has a particularly strong effect on cyclical industries. Apple mainly operates in the premium and high-end segments of the technology hardware market, which are quite cyclical.

After an explosive 2021, a slowdown in growth is expected, but it could be larger than expected. The iPhone unit accounts for $192 billion in sales or 52.5% of the company’s total revenue. In late March, market research firm TrendForce lowered its smartphone production forecast for 2022 from 1.38 billion to 1.366 billion units. Recently, it became known that Apple has reduced production orders for the iPhone SE due to weak demand. Additionally, Mark Liu, chairman of TSCM, said there was a drop in demand for smartphones, PCs and TVs in emerging markets, especially China.

A similar situation could be with the Mac unit, the company’s second largest segment, which accounts for $37.4 billion, or 10.2% of revenue. The main driver of the unit is the new M1 processor. However, before the pandemic, the segment was growing unevenly, and this trend is expected to continue.

Mac segment revenue

Created by author, based on 10-K

According to analysts at Statista, the total laptop computer market revenue will increase from $126 billion to $124.1 billion in 2022 and remain stable until the end of 2025.

Global laptop revenue

Statistical

Profitability challenges

In recent years, a key driver of Apple’s growth and profitability has been the growth in the share of the highly profitable services segment, whose gross margin reached 69.7% compared to 35.3% in the product segment. The segment’s share has grown steadily since 2016, however, in 2021 the share has decreased to 21.3% from 21.8% a year earlier. At the end of the first quarter of 2022, the segment’s share decreased to 15.7% from 24% a year earlier. A further decline in the share of the services segment could lead to a contraction in the company’s gross margin.

Current macroeconomic factors may also put pressure on Apple’s profitability. This is a common challenge for companies producing complex global products. However, while other stocks have priced in macro risks, Apple is trading slightly below all-time highs.

Valuation of AAPL shares

Our DCF model is based on several assumptions. We expect revenue to grow in line with the Wall Street consensus. Over the past eight years, gross margin has increased by an average of 0.52 percentage points per year, we expect this trend to continue. A similar methodology is used to forecast operating costs and therefore operating margins. We expect D&A and capital expenditure as a percentage of revenue over the next seven years to be in line with the average of the past five years. Additionally, we expect Apple to repurchase shares at the same volume as the nine-year average, which makes our model quite optimistic. The terminal growth rate is 5%. The assumptions are presented below:

Hypotheses

Created by author

Based on the assumptions, the expected dynamics of the main financial indicators are shown below:

key ratios

Created by author

With a cost of equity equal to 10%, the weighted average cost of capital (WACC) is 9.8% because Apple has low financial leverage.

WACC

Created by author

With a Terminal EV/EBITDA of 16.4x, the model projects a fair market value of $2.168 billion, or $185 per share. Thus, the current price does not provide a sufficient margin of safety for the purchase.

You can see the model here.

Apple also seems expensive on multiples. Despite the expected tightening of monetary policy and slowing earnings growth, the company is trading well above average historical multiples.

Chart
Data by YCharts

In terms of futures multiples, the company also looks quite expensive.

Multiple forwards

Created by author

Conclusion

Over the years, Apple has demonstrated high growth rates and impressive profitability. The company could face headwinds in the form of slower revenue growth and weaker profitability. However, Apple is still trading slightly below all-time highs. According to our assessment, the current price does not offer a sufficient margin of safety for the purchase. We are neutral on AAPL.

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