Wednesday, August 29, 2012

Apple's Crown Jewel: Valuing the iPhone Franchise

If you are a stockholder in Apple, it is time to celebrate again! The last week has been an eventful one for the company. In addition to claiming the title of "largest market cap" ever, when its market value hit $623.5 billion on August 20, the company also won its lawsuit against Samsung on "patent infringement" charges. Samsung will not only be required to pay $ 1 billion in damages but may also have to remove some of it products from the US market as a consequence. To add to the mix, the iPhone 5 will shortly be arriving on the shelves and there is talk again of Apple becoming the first trillion dollar company ever.

As with my last two posts, I want to set the record straight on my posts on Apple in the last couple of years. In January 2011, I posted on Apple's immense cash balance (of $50-$60 billion at the time). and argued that, as a long-term investor in the company, it has earned my trust after an unmatched decade of success, both in terms of profitability and stock returns, and that I was okay with them holding on to the cash. In March 2012, I returned to the question partly in response to news stories that suggested that Apple may initiate a dividend. Noting that dividends would attract a very different group of stockholders into the company and put them on collision course with the existing stockholder base, I posted that if Apple was intent on returning the cash (as Tim Cook seemed to be), it should do a large stock buyback. I also valued the company at about $710/share (the stock price was about $550 at the time). In April 2012, the stock hit $600 and I bid my farewell to the company as an investment, with much regret and gratitude. I justified my decision to sell not on valuation (since I found the stock to be worth $700+) but on two counts. First, I argued that the company had become a momentum play and that the pricing process had lost its connection to the valuation process. Second, I also felt uncomfortable with the mix of dividend, growth and momentum stockholders, with differing expectations about the company and differing demands of it. Even though Apple’s stock price has gone up about 10% since I sold it, I have no regrets about selling. Since my original case for selling the shares was predicated on a fickle investor base with conflicting views, I believe that the stock price gyrations over the last six months supports that thesis. The stock price dropped as low as $530 and now risen to its high for the year without any dramatic news announcements for the most part driving the price (until the last week). My intrinsic valuation has not changed much in that period and remains over $700, with the updated numbers through the end of last quarter. 

No matter what your views (bullish or bearish) are on Apple, I think that there can be little disagreement on the proposition that Apple's market value rides more on one product, the iPhone than ever before and that it is worth taking a closer look at the underpinnings of that value. Looking at the numbers, here are three key points worth making about the iPhone franchise (and its value to Apple):
  1. The iPhone is a money machine: In the most recent twelve months, the iPhone generated about $100 billion in revenues and approximately $21 billion in after-tax profits for Apple.
  2. The iPhone is a dominant player in a growing market: The smartphone market grew about 40% last year,  primarily as cell phone users switch to smart phones. During the year,  more than 150 million smart phones were sold, with Apple accounting for about 20% of the units sold. However, with its heftier price tag on the iPhones, Apple had a 43% share of the market, if it is defined in dollar revenues. 
  3. The iPhone has a short life cycle: One of the reasons for Apple's disappointing earnings in the most recent quarter is that customers stopped buying the iPhone 4S, waiting for the iPhone 5 to arrive. Since the iPhone 4 came out in June 2010 and the iPhone 4S was introduced in October 2011, that puts about a two-year life cycle on the product.  So what? Companies like P&G or Coca Cola produce products that have very long life cycles; diapers and sodas have not only not changed much over the last few decades but are unlikely to change by much over the next few. Protected by strong brand names, they can be expected to generate earnings for long periods, with relatively little investment or innovation by the companies in question. With a short product life cycle, a company is faced with two challenges. First, it has to come up with innovations to its product to retain its customers when the cycle is renewed, and that will require investment, especially during the later parts of each cycle. Second, even with these innovations, there will be customers who switch to competitors' products (either because they are cheaper or because their innovations are more attractive) and for a company to maintain it's market share, it has to get more of it's competitors' customers to switch to its products. 
Given the iPhone's profitability and dominance in the growing smartphone market, I tried to value the iPhone franchise, incorporating the effect of the short life cycle. In assessing the value, I made the following assumptions.
  1. Profitability: Apple will be able to maintain its current after-tax operating margin of 21% on future iPhone sales. 
  2. Smartphone market: The smart phone market will continue to grow at a 6% compounded rate for the next 10 years, with growth tapering down towards the growth rate of the economy in the long term. 
  3. Product life cycle: The life cycle for a new iPhone will continue to be two years and Apple will have to reinvest half its after-tax operating income in the second year of each cycle (this 50% also incorporate the lost sales in the second year, as each iPhone ages and customers wait for the next version).
  4. Switching assumptions: iPhone customers are assumed to be loyal, with only 5% switching to competitors' products at the end of each life cycle. Apple will be more successful at attracting competitors' customers, with 10% switching into iPhones. 
  5. Risk: Needless to say, there is substantial risk in this process and the cost of capital of 11% (at the 90th percentile for US companies) reflects that risk.

The value that I estimate for the iPhone franchise is $307 billion, working out to a multiple of 3.39 times revenues and about 16.17 times net income on the iPhone. You can download the spreadsheet that I used and change the assumptions, if you so desire. In fact, as with my Groupon and Facebook valuations, I have opened a shared Google spreadsheet for you to enter your estimates of value for the iPhone franchise.

Here is the larger point, though. About 55% of Apple's business value comes from its iPhone franchise and there are three pressure points that will test this value.

  • The first is Apple's capacity to maintain pricing power and earn its current margins; there isn't a competitor within shouting distance of Apple, when it comes to margins. If the after-tax margin drops to 15% from its current 21%, the value of the franchise drops to $219 billion.
  • The second is that Apple will be able to prevent the life cycle from speeding up further and that it can continue to innovate at a reasonable cost (with this cost in conjunction with the loss in earnings during the second part of the cycle not exceeding 50% of the after-tax earnings during the period). Reducing the life cycle to one year from two almost halves the value of the franchise.
  • The third is that Apple is able to maintain a net positive switching ratio (more of the competitors' customers switch to Apple than vice versa), allowing it to increase in market share in dollar value terms. Assuming a neutral switching ratio (customers switching in = customers switching out), reduces the value of the franchise to $255 billion. 
There is an internal tension between these three variables, since keeping iPhone prices high (preserving the high margins) and spending less on innovation (reducing the cost of innovation) may increase the risk that more customers will switch away than into the iPhone. Using the "life cycle" model also provides some perspective on why the lawsuit victory against Samsung may have a bigger effect on the value of the iPhone franchise than how the iPhone 5 fares with customers in a few weeks. Samsung's loss will have a deterrent effect on competitors planning an assault on the iPhone kingdom, thus increasing Apple's pricing power (preserving margins) and improving its odds of holding on to its customers (improving its switching ratio).

With the iPod, iPhone and iPad, the company has been able to count on the unmatched loyalty of its customers, while both attracting customers of less innovative competitors and increasing overall market size. The question that investors face right now is whether Apple can continue its winning streak. The high valuations attached to the company assume that the company can keep doing what it is right now, that the iPhone 5 will not only launch successfully, but be followed by the iPad Mini and the iPhone 6 and so on. The risk that investors have to take into account when investing in Apple is that somewhere along the way, the winning streak may will be broken. Unlike other large market cap companies with long product life cycles or diversified product portfolios, Apple’s value rests on being a Phoenix, constantly reinventing itself every few years.

57 comments:

Anonymous said...

What is the high valuation you speak of?

Sure, it's a high dollar price but that's irrelevant as you obviously know.

Aswath Damodaran said...

Actually, I don't obviously know. $620 billion is a high value, no matter how you slice it and what you relate it to.

Macky said...

hi aswath,

while iPhone is a great product i am not so sure if it will continue to have the greatest market share.

1. iPhone gained market share primarily because of its sleek design. A first in the mobile world. Functionality wise it lags behind Android.
2. Since, innovation is no one's territory, 5 years down the line Samsung and HTC might overtake Apple. There's a lot of talk about Windows 8 based phones and they might overtake the iOS.
3. I would use a more conservative switching ratio - zero.

Anonymous said...

Dear Prof. Damodaran,

I found some mistakes in your iPhone valuation spreadsheet,

in EV/Sales calculation, i think that sales should be total market*market share. So, EV/Sales is 3.39, i guess.

Also, EV/After-tax Operating income should be 16.17.

Thank you for your great posting.
Very inspiring, and helpful.

Aswath Damodaran said...

Oops. You are absolutely right. Fixed now.

guz said...

Hi Prof.

Very interesting post. However, I would disagree with your valuation because you are assuming that the equity risk premium is the 6%, which is not true. Part of their sales are coming from Asia, and I presume that when they refer to "Americas" in the last 10-K refers to the whole continent.
I would feel more comfortable with higher risk premium (around 7%), and also a higher Cost of Capital during the maturity period.

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Anonymous said...

Professor Damodaran,

What do you mean by a life cycle of 2 years? Certainly many US mobile phone users upgrade roughly every 2 years thanks to the incentives that mobile carriers create for them to do so. But in terms of the amount of time for which a new Apple product is the hot-selling king of the world, I would argue it's less than 1 year -- perhaps only 6 months, since after that point customers start thinking "if I buy now, this product is closer to the end than to the start of its reign as the hot new thing."

That might not be a problem, if customers in the second half of that 1-year window are willing to wait for the next release and buy it no matter what (despite the iPhone 4S offering few new features and coming out later than the 1-year cycle would have predicted, it sold huge numbers of units from pent-up demand). But it certainly leaves open the risk that sooner or later a new product fails to generate the expected level of interest.

bud fox II said...

Did I understand correctly if I say that according to you the value of Steve Jobs is $0?

Anonymous said...

Prof, Great post. I am not clear about what you think of AAPL's future. Your assumption about AAPL maitaining market share, maintaining 21% NOPAT etc are not impossible, but certainly not without any challenges.

I personally feel AAPL might be able to maintain it's lead in Macs. However, iPhone business is looking very very vulnerable. Few years ago, iPhone was the best choice. Today, Samsung Galaxy S3 is equally good or better. iPhone 5 will probably top that. The point is, the competitor has finally come up with a product that can rival iPhone.

Long story short, industry margins will be squeezed. Additionally greater amount will be spent on R&D.

What happens to AAPL's present value if AAPL no longer is able to sell the iPhone/iPad for 44% gross margin? What if this margin drops to 25% and the unit cost drops by 20%? Are you able to update your model and share the valuation please?

- Riyaz Hudda

Anonymous said...

Aswath,

My feeling is that one of the major reasons that Apple has been able to grow is delivering new form factors that reshape the technology and gadgets industries (iPod, iPhone, iPad, macbook air, etc). With Google introducing Google Glass in the future do you think Apple will be able to maintain its competitive edge if it is not creating innovative form factors?

Sam

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Anubhavalu said...

Hi Prof. Damodaran,
It's a very good writing and the points that are to be noted mainly are How to cannibalise own products without someone eating out my products.......Worth reading and ofcourse, for a big company like Apple to innovate with distinction would be tough in the coming future where the market is going to be more crowded and especially when the zeal of the founder is missing.

Anonymous said...

Hello Professor! Your fcffginzu spreadsheet on your stern.nyu.edu website is displaying a 'Security Alert - Office File Validation' pop-up alert when attempting to open. Is there any chance you could re-save the file onto the server? Would be greatly greatly appreciated!

Aswath Damodaran said...

Try now. I resaved it...

Anonymous said...

Hey Professor, the fcffginzu is still popping up the alert. Am I the only one having this problem? Is it alright if I just open it? I'm working on the fcff2st meanwhile. Thanks a bunch. KL

Aswath Damodaran said...

It should still work.

Anonymous said...

Thanks Professor! KL

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Ed said...

Hello Professor,

Why did you say "Apple will have to reinvest half its after-tax operating income in the second year of each cycle". Looking at the history, Apple never needed to spend that much money in their R&D to maintain its innovation. If you mean 50% of operating income every two years, that's about 25% per year, and looking at their R&D expenses for the past two years, it's more like 10% per year.

Eddie

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These days, demand of iPhone's increasing very fast in the world. So, there are many poeople thinking to buy a franchise of it. Although this article described about it very nicely. I am pretty impressed to read about it.


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Now a days so many applications are available in the market, day by day technology will increase rapidly. In that iPhone is the major thing, which brings the lot of change in our life style. So i am glad to see this post.
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Apple computers stock traded at just 5 dollars a share in 1998 the stock has never had a split. So everyone can see the massive amount that the stock has increased by in less than fifthteen years. The stock is now worshiped by many investors its time to take a step back from this stock no stock grows to the sky. Most companies over time regress to the mean.

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Anonymous said...

Looks like the iPhone margins are going down...
http://www.reuters.com/article/2012/12/15/us-apple-walmart-iphone-discount-idUSBRE8BD1D120121215

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