Great Bullish feature story in this weeks Barron's re. Apple's new lease program - like these price targets!
www.barrons.com/articles/apple-shares-could-rally-50-on-new-iphone-plan-1442034492?mod=BOL_hp_highlight_2FEATURE
Apple Shares Could Rally 50% on New iPhone Plan
Leasing phones and offering annual upgrades could win big and pit the company against wireless carriers.
Apple likes to keep customers guessing about its latest products, but investors are rarely surprised by what they hear. Except for last week, that is, when Apple went off script.
The company announced that its latest iPhone would soon be available through monthly payments, starting at $32, with customers getting free upgrades every 12 months. The leasing and upgrade news overwhelmed the company’s long list of new products, including a 12.9-inch iPad Pro, a sophisticated stylus, a revised Apple TV, and the refreshed iPhone.
Those devices were never likely to move Apple’s stock (ticker: AAPL). That’s why the iPhone upgrade announcement makes things interesting for investors, especially as iPhone sales accounted for 56% of Apple’s revenue last year. “It takes what could have been negative sentiment—a sell-on-the-news event—and potentially turns it positive,” says Peter Karazeris, a senior equity analyst for Thrivent Asset Management, which owns $400 million worth of Apple’s shares.
That, it did. Apple’s shares finished the week up 4.5%, to $114.21, although the stock is still down 14% from its summer peak, making a cheap stock even more compelling. If the leasing program proves to be popular, Apple could soar 50% in the coming year.
At its current price, Apple trades for 11.8 times earnings projections for the next 12 months. Back out the company’s $150 billion in net cash, and the forward multiple drops to just 9.1.
That multiple is roughly in line with future profit-growth estimates. Wall Street expects Apple’s earnings to jump 34% in the fiscal year that ends this month, to $53 billion, or $9.12 a share, on sales of $233 billion. But analysts are forecasting a gain of only 6.5% in fiscal 2016, to $9.71 a share. Apple has a habit of beating estimates, however.
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To be fair, Apple’s shares consistently have been cheap. “Apple has been undervalued for six years,” says Mark Mulholland, portfolio manager of the $609 million Matthew 25 fund (MXXVX).
But the leasing program could be a game changer for the stock. Mulholland thinks Apple shares are worth $170, 49% above their current quote, based on a multiple of 11 times enterprise value to estimated 2015 pretax profit.
The leasing program attacks the primary bear case on Apple—slowing iPhone growth. Amit Daryanani, an analyst with RBC Capital Markets, estimates that the upgrade cycle for iPhones has stretched to 26 months from 22 months in 2013. After getting a jump-start from the larger iPhone 6 this year, analysts expect iPhone sales to flatline at 235 million units in 2016. The iPhone Upgrade Program, Apple’s official name, has the potential to reverse the trend, and more.
“You essentially create a certain group of your user base that is going to be on a 12-month upgrade cycle,” Daryanani says. The big question is how large that group becomes.
APPLE’S LEASING offer puts it in retail competition against the wireless carriers, which all offer their own installment plans for iPhones and other smartphones (see table). But Apple’s model takes advantage of its 266 U.S. stores, a better retail experience than anything offered by the carriers. Apple is also including its AppleCare warranty program as part of the monthly fee. (The carriers effectively have ended their subsidies for smartphones, so the days of a $199 iPhone are all but over.)
Apple’s program provides unlocked phones, so leasing customers, in theory, can move between carriers as often as they like. Over time, it is conceivable that Apple could add other perks, as well, although the company didn’t respond to a request for comment. Think: priority access to new phones, or iCloud storage, which improves the iPhone experience but carries little incremental cost.
It’s all vintage Apple, the kind of ruthless business deal Steve Jobs loved to make. “You’re taking the stickiness away from the carrier and putting it on Apple’s ecosystem, which is phenomenal,” Daryanani says. “When I run the math, this is a very gross-margin-accretive investment for Apple.”
Here’s that math, according to Daryanani: A typical iPhone sells for $700 (a portion of which was previously subsidized by the carrier) and costs $350 to make, for a gross margin of 50%.
In the first year of the leasing program, a new iPhone’s revenue will come to $384 ($32 times 12 months), against a cost of $175. (He amortizes the full cost over two years.) That’s a 55% margin, or 500 basis points better than Apple’s status quo.
The bigger difference comes in year two, after the leasing customer returns the phone to Apple in exchange for a new model. Apple can then refurbish and sell this phone for about $500, Daryanani estimates. “The cost of goods sold is [another] $175, for a year-two gross margin of 65%,” he says.
Thus, in a two-year time frame, each could phone could produce $884 in revenue, with a 60% gross profit margin.
More phones sold at better margins—that’s nirvana for Apple investors. The refurbished models could also become a good way for Apple to service emerging markets, since it will have a larger inventory of cheap phones. Apple runs the risk of flooding the used-phone market, and thereby reducing the value of its refurbished inventory. But the company has always been masterful at protecting its brand value, and there’s little reason to think that will change.
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Mulholland, of the Matthew 25 fund, is bullish on the upgrade plan, although he says he has never worried about the balance of power between Apple and the wireless carriers. Apple represents 14% of his fund’s assets. “This completely takes away the risk of carriers not underwriting the cost” of phones, Mulholland says.
Investors could get a peak at the program’s success in the coming weeks, when the new iPhone 6s goes on sale. Pre-orders started on Sept. 12, and the new model hits shelves on Sept. 25. Any positive news about the leasing program would be a catalyst for Apple shares, especially since it would also drive additional traffic into Apple stores.
“Today, Apple’s fair price is $170-plus,” Mulholland says. “Three to four years down the line, it is easily $200 to $250. And these aren’t aggressive numbers.”