Apple’s Undervaluation Brought To Light After 2016 Q3 Earnings

Apple (AAPL) announced its third quarter (Q3) results on Tuesday and largely beat expectations. Some key points:

  • Quarterly Revenue: $42.4 billion (beat by $310 million)
  • Quarterly Net Income $7.8 billion
  • Diluted Quarterly EPS: $1.42 (beat by $.04)
  • Gross Margin: 38%
  • $.57/share dividend declared (yield is currently 2.34%)
  • Service revenue grew 19% year-over-year. It now represents 11% of Apple’s revenue (up from 8%).

A flood of positive sentiment and articles came out almost immediately after Apple’s earnings release. Apple stock closed up 6.5% yesterday, which is great because I think the company is undervalued. That said, I initially thought the market reaction was abnormally bullish based on Apple’s only moderate beats, in my opinion. In reality, the beat was simply a wake up call to bearish investors who had allowed a temporary decline in Apple’s growth to rule the stock price.

Screen-Shot-2016-07-26-at-4.37.08-PM

Source: MacRumors.com

Source: MacRumors.com

 

As seen above, Apple’s strength of earnings is still entirely dependent on the iPhone, but I am happy to see the increasing relevance and success of their “services” product line, which is likely a more stable business to be in versus retail products. Apple’s TTM EPS is now $8.56, compared to $8.98 last quarter. As a note, Q3 is always Apple’s weakest quarter so that decrease was expected.

Valuation

As you may remember in my previous article on Apple, I valued shares at $110. Since then, I have delved into analyst estimates and Apple’s historical earnings to come up with a more precise five-year growth rate. My EPS projections are annual and based as if this quarter is the end of Year 0. Obviously because of the long-term duration of these estimates, they are highly speculative. They are not adjusted for any game-changing potential products by Apple. I also wouldn’t rely on any specific annual estimate; the purpose of this exercise was really to estimate a five-year annual growth rate.

  • Year 0 EPS: $8.56
  • Year 1 EPS: $8.8
  • Year 2 EPS: $10.8
  • Year 3 EPS: $11.3
  • Year 4 EPS: $11.9
  • Year 5 EPS: $12.5

Using a compound annual growth rate calculation, I thus predict a five-year growth rate of 7.8%. This is slightly lower than the analyst-predicted 9.77%. As a result, my new discounted EPS valuation of Apple stock is $117 per share, a 6% increase over my previous valuation. This valuation, however, is dependent on a decently successful iPhone 7 and a very successful iPhone 8 (or iPhone 7S, whatever it may be called).

In Conclusion

I still rate Apple a buy and believe there is about a 14% upside left if you didn’t buy when I first recommended it. Apple has traded higher than this in the last year and I think getting back there in another year is entirely feasible. By the way, if you bought Apple at the time of my previous article (July 7th), you would have already seen an increase of 7% in Apple’s share price. I would recommend selling Apple if it hits $117 this quarter. I will release another article on Apple after Q4 earnings so that I can revalue the company’s shares then.

Speculating

Beyond the tangible and expected, I am cautiously optimistic about potential new Apple product lines such as: smart bluetooth headphones (“Ear Pods”), Apple car, and Apple Live TV. With the last item, Tim Cook gave a particularly interesting answer to a question on the earnings call:

“On the Apple TV question, the introduction of Apple TV and tvOS in last October and the subsequent OS releases and what’s coming out this fall, think of that as sort of building the foundation of what we believe can be a broader business over time.

I don’t want to be more precise than that but you shouldn’t look at what’s there today and think that we’ve done what we want to do. We’ve built a foundation that we can do something bigger off of.”

To me, Tim is really hinting that Apple is still making progress on working out a deal to offer live TV through the Apple TV. It’s been long known that Apple has tried and failed to work out a contract with the cable companies to do this. I think a live Apple TV could be huge for Apple and I am glad to hear a hint that Tim has not given up.

Disclosure: I own shares of Apple (AAPL). I am not a financial advisor. Do not make any investing decision solely based upon what you read here. It’s your money, invest it wisely.

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