Apple – The Staple of Luxury

Hello! Here’s a piece by our new analyst Pēteris Celms. Many more to come!

Apple’s Business Model

Apple has every right to the outsized profits it makes on the iPhone. Consumers could buy cheaper Android devices, but they don’t. Why? Because they value Apple’s hardware, or iOS software, or most likely, the ubiquity of the brand and the status that it has come to represent.

If you want the Apple experience, you buy Apple hardware, and in turn, use Apple software. And in order to access the digital content market install any other applications, you also have to go through Apple’s App Store. Apple does nothing to increase the value of Netflix or Spotify subscriptions, among many other digital services from app providers purchased through the App Store, but they charge a percentage for every one of these transactions (e.g. 30% in the first year, 15% every year after that for recurring subscription payments) just because they can, and will continue to be able to do so while ~45% of U.S. consumers, the world’s largest market, carry Apple devices.

In fact, Apple’s services segment has been thriving as of late, seeing 24% year over year growth during fiscal 2018 to 14% of total revenue and new revenue records for the App Store, Cloud Services, AppleCare, Apple Music and Apple Pay. Another positive signal is the growth in the number of subscription customers are paying for, which is the cornerstone of recurring revenues in the segment. During their latest fiscal year Apple sold roughly 330 million subscriptions, up 57% year over year, mostly through third-party applications on the App Store, but also growing the number of subscriptions for Apple Music and other services.

But what makes us confident that Apple can continue to have this rent-seeking and hold sway over US consumers? Look no further than Apple’s ability to keep increasing the prices of its products, which has helped the company achieve growth even as unit sales have been slowing down. Apple deserves enormous credit for building up the sort of customer loyalty that it can extract ever more revenue from its user base (its current flagship products were the first smartphones to surpass the symbolic $1,000 per unit product cost). If you then factor in the hassle of switching thanks to the ecosystem they’ve developed across their devices (how many people do you think know how to access iCloud on a non-Apple device? Do you think Apple has made it easy?), it’s likely that a good portion of this user base will continue to pony up to get the latest and greatest from Apple.

Where it’s not taking advantage of a natural monopoly, Apple is also still innovating and creating new products, the most promising of which are in its wearables category. The Apple Watch, for example, has over 40% of US market share in a segment where Fitbit once reigned supreme and Android is all but an afterthought, and AirPods have been widely hailed for both their quality and style (how quickly have complaints about iPhone’s lack of headphone jack disappeared?). Although the value might be questionable for some, there’s no denying that Apple makes the most desired smartphones, laptops, tablets, smartwatches, and wireless headphones. As a result, Apple is making more money today than it ever has before.

Apple has an unimaginable amount of cash on hand and is making more of it (i.e. you can expect more stock buybacks), excellent and very profitable established products, new growth products (Apple Watch and AirPods), services growing at a high pace, and an ecosystem that’s nearly impossible to walk away from, giving them advantages that no other hardware manufacturer can even come close to claiming. In fact, Apple has achieved something most companies can only dream of – the company’s products that are both as symbols of luxury and near necessities.

Comparison to Consumer Staples

The market turbulence over the past few months has resulted in declines across growth stocks, especially in the technology sector, and Apple has been the most affected. Apple has seen its shares decline by 30% since reaching its highs at the start of October, in part due to the overall market volatility, but also in part due to the “law of large numbers” – as the first company to hit 1 trillion dollars in market capitalization, its shares quite predictably sold off from highs. And while Apple has taken the biggest hit, some companies actually fared better, particularly those in the business of consumer staples.

In theory, investors rotate into high-quality defensive names in consumer staples because they offer relative stability during periods of market volatility (demand for food and toilet paper tends to be fairly stable) and generally pay nice dividends to stockholders. Does it really make sense to offload Apple, the biggest and most profitable company in the world, and replace it with consumer staples players? And with Apple’s stock now trading lower than at the end of 2017, couldn’t it be that the stock has been oversold?

P/E Ratios of Apple (Blue), Proctor & Gamble (Brown), Walmart (Red), Coca-Cola (Purple), Estee Lauder (Yellow) over 5 years (Source: Bloomberg)

While Apple’s price/earnings (P/E) ratio, showing how much investors are willing to pay per dollar of earnings at any given time, has consistently been lower than those of Proctor & Gamble, Walmart and Coca-Cola over the last 5 years, the recent price declines have widened the gap and increased the relative discount at which Apple shares are trading to its greatest point since the first half of 2016, when its shares traded at an average discount of 43% against these three companies between February and June and bottoming out at 48% on 13.05.2016. Currently, Apple is trading at 13x earnings (or an average discount of 37%), while Proctor & Gamble, Walmart and Coca-Cola are trading higher, at 22x, 19x and 23x, respectively.

For some context, in 2016 Apple had reported 2Q 2016 results where it saw revenues decline year-over-year for the first time since 2003 and the company sold 10 million less iPhones (51.2 million vs 61.2 million) than it did in the previous year. But this year, when Apple reported 4Q 2018 results on November 1st, its earnings beat Wall Street estimates on both top and bottom lines, saw average selling price of the iPhone increase and grew its Services segment revenue by nearly 30%. But, because the company missed shipment estimates on iPhones, offered weak, but positive guidance and announced that it would no longer report individual unit sales, sentiment turned negative. While it can be good to be cautious, does today’s situation really warrant the same level of concern that some were expressing in 2016? I don’t think so.

While some may argue that investors are willing to pay a premium for less volatility and steady dividends, high dividend yields come at the cost of growth potential, which is evident if you’re comparing the growth figures of Apple, Proctor & Gamble, Walmart and Coca-Cola. Over the trailing 12 months, Apple has seen double-digit top- and bottom-line growth (revenue growth +16% y/y, net income growth +24%), while the growth of the Consumer Staples leaders has been almost non-existent, or in the case of Coca-Cola, negative. These growth figures are useful for calculating another valuation multiple, the price/earnings to growth (PEG) ratio, which determines a stock’s value while taking the company’s earnings growth into account. Comparing using this metric, Apple looks even more undervalued as its PEG ratio is around ½ that of these Consumer Staples players (currently ~1.2x vs +3x for all three).

Among the top Consumer Staples stocks in the US, the only company with comparable growth figures over the past 12 months has been Estee Lauder (revenue growth +14% y/y, net income growth +20%). This looks like a good find and a potentially safe consumer staples pick to move into, right? Like Apple, Estee Lauder, has oriented itself more as a luxury play thanks to its prestige skincare, makeup, fragrance and hair care products. While someone buying Head & Shoulders shampoo (a Proctor & Gamble brand) may switch to a cheaper or generic product if money becomes tighter, it’s likely that Estee Lauder clients won’t be making these choices as often or as readily. So how large of a premium should that warrant?

Once we look at the same P/E and PEG ratios, the case for Estee Lauder quickly falls apart. Its current valuation multiples (P/E of 29x, PEG of 2.4x) are more than double that of Apple and it has traded at a significant premium to Apple over the past 5 years, but it’s clear that Estee Lauder has little competitive advantage if you’re comparing these two companies outright. Sure, both companies sell products that play on people’s insecurities and wants – desirability, status, acceptance, etc. – but there’s only one who’s products allow you check your emails, consume media, and arrange for a car that can be outside to pick you up by the time you’re done reading this.

Comparative 5-year stock returns of Apple, Proctor & Gamble, Walmart, Coca-Cola and Estee Lauder (Source: Bloomberg)

It’s astounding that Apple and has created products and ecosystem that is indispensable to almost a majority of American consumers, yet its price to earnings has consistently been discounted to other companies with lower real growth and weaker return to shareholders. Even taking into account the significant drawdown since October, Apple’s stock has outperformed Proctor & Gamble and Walmart by more than 80% over the last 5 years and Coca-Cola by 79% over the same period. As for the other “luxury staple” player Estee Lauder, while returns have been admirable, the company’s stock has still underperformed Apple by nearly 34% over the same 5 year period. Perhaps more impressive, however, is the performance of Apple’s stock since 13.05.2016, the point at which Apple shares traded at the largest relative discount to these other names during the past 5 years. In the roughly two and a half years since, Apple shareholders have experienced a total return of 81% – 63% better than Proctor & Gamble, 37% better than Walmart, 69% better than Coca-Cola and 42% better than Estee Lauder. And this is including the recent 30% decline.

Is it really rational to believe that the company’s value has dropped by a third? After Apple posted 41% year-over-year growth in earnings per share in the 4th quarter and double-digit sales growth in all of its geographic segments. After Apple increased the installed base of all its major product categories to an all-time high and saw its services revenue earned on those installed devices grow 27% year-over-year. Maybe the concerns over China and growing negative sentiment are warranted. Or maybe it’s time to buy Apple shares.

Pēteris Celms
Analyst – BlueOrange Bank