Valuing Apple Shares And How Much Higher They Can Go – Seeking Alpha

I’m re-initiating full financial coverage on Apple (NASDAQ:AAPL) in this article, as I anticipate some meaningful value expansion on discounted assumptions pertaining to FY’18 results. This research report was first released to my premium subscribers last week.

I anticipate some multiple expansions on better y/y growth comps, which should drive sentiment absent any negativity from earnings reports, supply chain, or consumer surveys. I believe my estimates are fairly conservative, as I anticipate some FX headwinds to persist over the next two years, and upon weighing initial commentary on added component cost and increases to ASPs, gross margin accretion isn’t likely to be as meaningful, which implies perhaps 87 basis points of GM expansion between FY’17 and FY’18, which is already embedded into my financial model.

My FY’17 and FY’18 sales and GAAP EPS estimates are as follows: $228.66 billion, $246.8 billion and $8.88, $10.13, respectively. My estimates compare to current consensus expectations for FY’17 at $228 billion and $8.93. I’m slightly optimistic on revenue in comparison to consensus ($660 million above), and slightly below consensus in terms of EPS ($.05 below), as I’m expecting R&D cost ramp to sustain at the same q/q trajectory.

For FY’18, my revenue and EPS estimates compare to consensus expectations of $244.68 billion and $10.13. My FY’18 figure is above consensus revenue estimates by $2.12 billion, whereas my EPS figure is exactly in line with consensus figure of $10.13. I did not manage my OpEx assumptions to directly compare to consensus, as my assumptions on margins differ from many other analysts, as I’m expecting continued OpEx expansion on modest GM improvements, given unit mix shift is likely to drive more modest ASP upside, but mostly on less iPad/MacBook and iMac contribution in the following fiscal year, as opposed to higher iPhone mix above $800 SKUs.

Walking through my Apple unit shipment and ASP model

Source: Alex Cho, Apple Quarterly Reports

I’m expecting some divergence in quarterly shipment trends pertaining specifically to iPhone. In Q4’17, I’m expecting unit deceleration, as opposed to prior year, where Q4’16 figures were more elevated on differences in channel replenishment and introduction of iPhone SE. This implies we revert back to the usual q/q trends when it pertains to FY’17, and expect inventory burn in the final quarter, as consumers hold back purchases in response to mounting hype of Apple iPhone 8. I model FY’17 and FY’18 iPhone shipments of 226.1 million and 245.23 million, respectively.

I anticipate PC trends to stabilize; market forecasts imply 2% growth for the entire industry, which suggests MacBook/iMac growth should average at or above industry levels. For sake of conservatism, I’m embedding 2% shipment growth over FY’17 and 5% shipment growth over FY’18. Gartner and IDC may revise estimates lower in response to weakness/strength in channel inventory, so I’m not willing to embed more aggressive figures for FY’17. However, FY’18 should show material improvements as the PC installed base is due for some refresh in the next 18 months. Hence, I’m expecting Apple to perform in line or above industry average. Therefore, I model Mac shipments of 18.8 million and 19.74 million for FY’17 and FY’18, respectively.

In terms of iPads, I’m expecting the same sequential seasonal declines, and deceleration of unit shipments to the tune of 15% in FY’18, whereas FY’17 will likely show patterns of similar y/y weakness of 19%. While Apple’s CFO/CEO mentioned iPad shipments were weak on momentary inventory reductions in prior quarter, I believe it’s better to be conservative on iPad segment performance.

Furthermore, I believe weakness in iPad is driven by lagging feature additions, competition from phablets, and 2-and-1 notebook paired with sustained elongation of refresh cycles. This suggests y/y strength may not materialize for quite a while longer (perhaps five to six years from last major peak). iPad shipments peaked in Q1’14, so we shouldn’t see material replacement fueled demand for a while longer, perhaps Q1’19 (roughly five years from peak iPad unit shipments of 26 million in Q1’14 and 68 million shipments in FY’14). As such, I model full-year iPad shipments of 36.95 million and 31.4 million for FY’17 and FY’18, respectively.

Source: Alex Cho, Apple Quarterly Reports

I’m anticipating modest iPhone ASP (average selling price) expansion in FY’18, and trends in FY’17 to mirror that of Q1’17 and prior years, which is driven by declining unit mix of higher priced SKUs. Upgrades are most heavily concentrated in the first quarter, driving initial ASPs higher, but tends to level off as consumers adopt older models (in this case, iPhone 6S), which carries down the average. Emerging market consumption is more evenly distributed throughout the year, as smartphone installed base adds has higher concentration in the back half of Apple’s fiscal year (supply/demand rebalance paired with fewer upgrades and heightened emerging market y/y comps).

Therefore, ASP figures are modeled lower sequentially for the balance of Apple’s FY’17, whereas annual trends tick slightly higher to reflect adoption of higher-priced iPhones due to mix shift in storage configuration and iPhone 7 Plus. FY’18 ASP is modestly higher, as I expect full-year contribution of iPhone 8 at slightly higher retail SKUs, but I also anticipate sequential trends of declining ASPs, which is in line with historical comps.

I expect average ASPs of $672.48, $435.36, and $1,310.43 for iPhone, iPad and Mac, for FY’17 respectively. Furthermore, I estimate FY’18 ASPs to average at $686.64, $419.84 and $1,323.54, respectively for iPhone, iPad and Mac. This implies $14.16, -$15.52 and $13.10 ASP expansion y/y in FY’18 for iPhone, iPad and Mac, respectively. Furthermore, I expect modest gross margin improvement on heightened component cost, and further gross margin deterioration in iPad, which could be offset with higher margin service/software revenue mix in the following fiscal year.

Summarizing the financial model

The financial model is based on the prior observations when pertaining to hardware shipment/ASP trends combined with growth assumption on services and other products. In terms of other products, basically, the accessories business (inclusive of Beats headphones, iPod, Apple Watch and Air Pods), I’m fairly conservative, as I’m expecting iPod unit deceleration to continue, though granular data is not available. When looking at historical figures, the accessory business has either been stagnant or has been in decline. Though I’m optimistic on Air Pod and Apple Watch contribution, for sake of conservatism, I just extrapolate the historical trend line, and plan to revise my estimates later, as data becomes more incrementally positive.

The service business has grown historically at a 15% CAGR for the prior three years. I’m expecting those trends to remain stable over FY’17 and FY’18. I’m not expecting growth to accelerate, but may change my stance on confirmation of new services, apps and service offerings following this year’s WWDC announcement.

In terms of FX, I’m expecting a 1.5 percentage point revenue headwind on slightly better currency market trends for the balance of the year. I’m expecting a slight q/q tailwind on modest dollar weakness from Q1’17. I’m optimistic on near-term currency trends and FX readjustments to be modestly lower in 1H’17. But anticipate the strong dollar trade to revert higher in the following months given policy stance, and tax repatriation holiday likely driving dollar strength in 2H’17 or 1H’18. I’m anticipating patterns of FX volatility to persist in the following year when based on fund manager surveys, as investors are still overweight the dollar. Until sentiment diminishes considerably, it’s safe to assume global investors will continue to duck and cover behind dollar-denominated assets.

Source: Alex Cho, data from Apple’s Annual/Quarterly Reports

I’m expecting revenue to grow 6% y/y and 8% y/y in FY’17 and FY’18, respectively. I’m expecting gross margins to average at 38.7% and 39.52% for FY’17 and FY’18, respectively. Modest gross margin deceleration was factored into my FY’17 estimate based on management commentary and back-half shift to lower priced iPhone, iPad and Mac units. I believe gross margin figures inverts higher by 87 basis percentage points next year despite persistent currency headwinds due to iPhone 8 and Service contribution.

In terms of operating expenses, I’m expecting the same q/q trends to persist in terms of R&D, and y/y comps to be similar in terms of SG&A. The SG&A figure is more elevated in Q1’17 due to quarterly retail seasonality and tends to decline sequentially once we move past December. I estimate fairly conservatively on operating expenses, and anticipate R&D to increase by 24.7% in FY’17 and 10.5% respectively. I believe investment into this area will accelerate this year, and then moderate slightly in the following. Timing of expense ramp isn’t exactly clear, so I’m fairly certain my quarterly EPS estimate could swing below or above actual results on these assumptions.

Furthermore, my financial model assumes share buybacks to continue at the same pace, but could diverge from actual results if another ASR (accelerated share repurchase) were announced, or computation of weighted diluted shares differ from my calculation. I’m not factoring in a tax repatriation holiday or a lower tax rate into my financial assumptions; hence, my share buyback estimate mostly conforms to historical trends, and tax rate hovers at 26%, in line with the historical average.

When combining all those figures together, I estimate diluted EPS of $8.88 and $10.13 for FY’16 and FY’17. I’m slightly more optimistic on revenue than sell side, and slightly more pessimistic on operating margins given differences in expected R&D ramp. Hence my EPS figures are in line or slightly below, whereas my revenue estimate is just modestly higher than consensus.

Final thoughts

I’m expecting upside to near-term results, but moderate my expectations on back half revenue contribution. I guess, that’s what differentiates my estimates from consensus analysts. Investors should remain upbeat on the stock, as the near-term drivers to earnings/sales paired with meaningful y/y comp improvements in terms of diluted EPS likely drives valuation higher.

I’m now initiating a $156.55 price target on Apple shares upon applying a 15.46x forward multiple to FY’18 GAAP EPS. I arrived at this valuation, by discounting the forward implied multiple via the company’s current WACC (weighted average cost of capital) at 11.58%, and adjusting for both historical mean, and statistically aggregated valuations within the tech sector.

I continue to reiterate my high conviction buy recommendation.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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