Why the Market Is Wrong on Apple

In past issues of Morningstar Growthinvestor, we've looked at new investment ideas in this feature by examining base-, bear-, and bull-case scenarios. Our goal remains to buy stocks that are trading near a price that equals our most-pessimistic assumptions. But scenario analysis is also useful when trying to understand what types of expectations are priced into what appears to be an expensive stock.  Apple Computer (AAPL) is one such company, so I sat down with stock analyst Rod Bare to determine exactly where Morningstar disagrees with the market. (Note: Given that our fair value estimate is well below the current stock price, we've decided to run just two scenarios: Morningstar and The Market.)

Morningstar's Case
Our fair value estimate of $29 per share assumes 25% annual revenue growth over the next five years. We expect significant iPod growth this year and next, with sales declining thereafter due to lower prices and increased competition. In our view, iPod revenues will eventually decline as alternative music players emerge and the early-adoption phase comes to an end. At the same time, we think the iPod will drive increased adoption of Apple computers, resulting in the firm's PC market share (1.8% in 2004) expanding to more than 3% in a few years. That implies Apple will go from selling 3 million units to 6-9 million units annually. We also assume that margins will be flat to slightly down over the next five years. Not only do we expect less-profitable parts of the business, such as the iTunes music store, to make up a greater portion of sales, but it's also likely that Apple will increase marketing and R&D spending as it morphs into more of a consumer electronics company.

The Market Case
To arrive at a fair value estimate near the current stock price of $42 per share, we must make several optimistic assumptions. The first is that Apple will maintain iPod growth and suffer little pricing pressure as it rolls out new iPod features such as wireless and video. This would result in iPod sales doubling to roughly 40 million annual units five years from now. Also, we must assume that iPod sales will lead to greater Mac adoption than we currently expect, allowing Apple to double its PC market share to 4%. Finally, there will be significant leverage in the business, and operating margins will expand from the high single digits to the midteens.

Who Has it Right?
Many people believe the disagreement among investors over the future of Apple deals with whether or not iPod sales will increase Mac adoption and increase the firm's PC market share. But it actually boils down to whether or not the company can continue growing iPod sales over the next five years, which would be one of the most remarkable achievements in the history of consumer electronics. After all, they're all toasters in the end!

There are several trends that suggest iPod sales will slow in the future. Competition is growing and the early-adopter phase is coming to an end, which typically means that sales will be driven by replacement purchases (think cell phones). Also, it will only get more difficult to drive demand with incremental product improvements. Lastly, some think Apple is a margin-expansion story, but we've seen little evidence of this thus far. Even management continues to talk down the prospects of Apple meaningfully expanding margins beyond their current high-single-digit level. As a result, until we're convinced that the market has it right, we'll pass on Apple.

A version of this article originally appeared in the August 2005 of Morningstar GrowthInvestor. Click here for more information about GrowthInvestor.