Apple's Valuation Still Compelling

Despite a mixed bag in the tech giant's fiscal first quarter, the firm's growing earnings power mean Apple's shares remain attractive

Jeremy Glaser 26 October, 2012 | 11:07AM Brian Colello, CPA

Video Transcript:

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. “Mixed bag” is not how you usually describe Apple earnings, but that's how our Apple analyst Brian Colello saw them this quarter. I am here with him now to get more details.

Brian, thanks for joining me.

Brian Colello: Thanks, Jeremy.

Glaser: So, let's take a look at some of the big numbers this quarter. What did Apple report and how did that compared to your expectations?

Colello: Sure. So, for fiscal Q4 for the September quarter, revenue was actually a little bit better than consensus estimates. EPS was a little light. So, a little bit again mixed bag there.

Looking ahead to fiscal first quarter for the December quarter, we think they are pointing at strong revenue growth, their forecast at $52 billion in revenue. Although Apple is typically conservative we think it will be easy for them to meet consensus estimates. So, it will be ahead of our estimates. We think that's going to point to a strong iPhone 5 launch, probably some decent sales of the iPad Mini as well. So, we think that's a good revenue number.

The other bit of a disappointment and again going back to the mixed bag is that EPS guidance was light and they hinted that gross margin for some of these products, the newer products, is going to be lower than anticipated, just higher component costs and other issues associated with launching so many new products at one time.

Glaser: So let's take a look at some of their individual product lines. First in iPhone, what trends were you seeing there?

Colello: I think iPhone for the September quarter was solid, but not spectacular and I don't think it really would be, again with the iPhone 5 that was only 10 days left in the September quarter. You certainly saw a trend in the months prior, of people waiting to buy the iPhone 5. So, in that regard, we think the September quarter was just fine in terms of iPad – iPhone excuse me.

Glaser: Now, one part of the earnings that may be a little bit more disappointing were iPad sales, what do you think drove that that slowdown?

Colello: Exactly. And Tim Cook hinted at this one at the Mini launch a couple of days ago, he said that Apple just sold its hundred millionth iPad. If you back in the numbers of what they sold in prior quarters that means that it was going to come in at something lower than 16 million. It came in at 14 million. So, that was even below our revised sort of estimates for the iPad.

What the company cited is that they had a big spike in sales in the June quarter to educations and intuitions and school districts in the June quarter and so they think there is going to be a little bit more of a seasonal trend, a decline in the September quarter and they think that's what they saw. I wonder if you could bake in a little bit of anticipation for an iPad Mini, maybe not much, but I really think that is more of a seasonal issue rather than a slowdown in iPad adoption or this is supposed to be a stronger product. We still think it will be. We think it's a little bit of hiccup more than anything else.

Glaser: Mac business might not get the kind of press that the iPhone or the iPad does. How important is it still to Apple and how is it performing right now?

Colello: Sure. So, Mac is a smaller part, the iPhone has exceeded it in terms of revenue and it's a bigger part of the story, but Mac sales were exceptional this quarter. The PC ecosystem has had extremely dismal results in recent quarters. A lot of companies have gotten crushed. Apple really did a great job showing strong growth, particularly in laptops and even above its own seasonal strength.

Again, September, I think the reason why PCs have been so disappointing lately is because the September quarter is a seasonally strong one with back-to-school season and things like that. So, for PC industry as a whole to be down 7% is very disappointing. Apple sales showing growth is really a good sign for market share gains and really a good sign for the ecosystem in general. More people buying iPhones and iPads. They want to kind of incorporate and benefit from the sort of iCloud and syncing across multiple devices. We think that's a good sign for Apple's Mac business and kind of strengthening those switching costs associated with the whole platform.

Glaser: Let's talk a bit about competitive pressures Apple might be facing. Certainly, there is a slew of new tablets on the market, Amazon keeps releasing new Kindles. Google are selling their own tablet, which we saw this quarter they are putting quite a bit of marketing muscle behind and the Microsoft Surface is now out. Are you seeing any impact, do you think some of those slower iPad sales are from those competitive threats, people are buying the Kindle instead, or do you think it's really just that seasonal issue?

Colello: I think it is more of the seasonal issue. Again, Amazon doesn't release Kindle Fire ratios, but I think the iPad is still the dominant tablet in the market. Fourth quarter will be interesting when they release the Mini and how that will compete at the low-end of the tablets. If you think about that Kindle Fire, Amazon is essentially giving that away at cost just to drive media sales. So, that's going to be a hard proposition for Apple to compete with.

As you could tell from the iPad Mini, they are not directly competing with it any way. They are pricing it at $329. So a good premium to sort of those lower end tablets. So, I think the competition will really ratchet up this holiday season. Again, for the September quarter, I think it is more seasonal issues maybe anticipation before the holiday season.

And again because it's such a new product, you don't really know what seasonality is March through September, you just knew that December was going to be good for Christmas purchases and things like that. So, I think that's why September is down a little bit and maybe a little bit lower than anticipated.

Glaser: So, you think that higher price on the Mini is something that they will be able to get away with the marketplace when there are those cheaper alternatives they'll be available to still command that premium pricing?

Colello: I think it will be very interesting to see. When we looked at the Mini initially, we thought it was going to be about a $250 device competing more directly with those, the Kindle Fire and the Google tablet, instead pricing at a $329, for a cost conscious, for price-sensitive buyers, they may still go with those lower end tablets and Apple may concede some of that.

But I think they will still make good margins on whatever they sell it at the $329 price point and then Apple could get the best of both worlds, if they start selling millions of these devices at $329 and they are able to extract even more value from those customers then it could be a positive for the stock and for the company as a whole.

Glaser: The stock after hitting an all-time high round the time of the iPhone 5 launch has sold off considerably, what do you think about valuation, does it look attractive right now?

Colello: Our fair value going in earnings was $770. We plan to maintain that fair value estimates. So, we still think it's a four star stock right now, stocks trading at close to $600. We think Apple is a company that's going to earn close to $50 a share next year and for the next few years. So, if you think about it in terms of a 12 P/E for a very strong growth company with tons of cash on the balance sheet, we think that's a pretty compelling valuation right now.

Again, I think an important thing and some of those fears from the stock going from $700 down to $600 may have been around the iPhone 5, may have been around Maps and some of those issues. If you look at Apple's forecast for $52 billion, I think that points to a very strong or close to a strong iPhone 5 launch maybe the Mini does better and maybe there is a mix issue, they don't disclose that. But I do think that points to a strong iPhone 5 launch. I think that overcomes some of those concerns. So, I do think that's a positive.

Glaser: Brian, thanks for your thoughts today.

Colello: Thanks, Jeremy.

Glaser:  For Morningstar, I am Jeremy Glaser.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Jeremy Glaser  is markets editor for Morningstar.com, the sister site of Morningstar.co.uk.

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