Valuing Apple’s Crown Jewel — iPhone Product
Apple’s stock price and market cap had a mixed run this year. While the increase in interest rates due to rising inflation has impacted its iPhone sales, especially the iPhone 14 model, it is also facing supply chain issues. With China particularly severe to contain COVID and to have zero Covid cases, most of the locations in China were in lockdown in 2022. As China is the production factory for Apple phones, Apple has deliberated on derisking its dependency on China by setting up production plants in India. We need to evaluate the effect of moving to India on Apple’s cost structure and, subsequently, its operating income. Though Apple has shifted to services and entered into Buy Now Pay Later model, iPhone is still the biggest revenue driver for Apple. In this post, I value the iPhone business separately, understand how much of Apple’s market cap comes from iPhones and whether the decline in the smartphone business will impact Apple’s valuation in future.
When we analyze Apple’s financials in the June quarter this year, Apple’s revenues were $83 billion, with Products contributing $64 billion (77% of the revenues). Apple’s gross margin for its product segment is 34.5%, and its services segment is 71.5%. Though Apple has steadily increased its revenue mix towards services from products, it continues to depend on products.
Further, when we analyze Apple’s revenues and operating income by geography, we observe that the US contributes 45% of Apple’s revenues and 37% of its operating income. While Japan contributes 44% of Apple’s operating income, its sales have declined.
Thus, it is evident that Apple remains the American story as all of Asia (China, Japan and APAC) does not come close to US sales.
Further, when we segment Apple sales by product and services, iPhone contributes 49% of Apple’s revenues, implying that iPhone is the cash cow for Apple’s businesses.
Thus, when we depict Apple’s financials as an infographic, it will reflect as follows:
From Apple’s financials, we can conclude that the US remains the biggest market for Apple, and iPhone is the biggest revenue driver. iPhone contributes 14% of global shipments but 50% of US shipments implying that the iPhone has won the hearts and minds of US consumers.
The reasons for iPhone’s success are as follows:
- iPhone has the highest brand loyalty. Apple’s marketing campaigns have cleverly positioned iPhone with a unique sense of social equity among its users. A recent survey from Match.com published Apple users get more matches than Android users.
- iPhones depreciate at a lower rate than other smartphones.
- iPhone protects user privacy.
Valuing iPhone Business
From the earlier section, i have made my point that Apple’s market value rides on iPhone and thus, valuing iPhone helps determine Apple’s dependency on iPhones.
- iPhone generated $40 billion last quarter and will generate ~$200 billion in 2022 with a $42 billion after-tax operating income (21% after-tax operating margin).
- According to Fortune’s business insights, the smartphone market will grow at 7.2% CAGR in the next five years and reach $792.51 billion in 2029. At the end of 2021, the smartphone market was $457.1 billion. iPhone accounts for 15.7% of global smartphone shipments. However, because of the higher price premium the iPhone commands, the iPhone has ~30% of the market share in dollar revenues.
- iPhone has a short life cycle of ~ two years. Thus we see that Apple comes with a new iPhone version every two years. When we compare this life cycle with P&G or Coke, where the life cycle is long, Apple needs to reinvest its earnings in R&D to launch an iPhone that is better than its peers. In the case of P&G, diapers have not changed much, so there is no reinvestment, and the diaper sales depend on brand loyalty. We can apply the same logic to Coke as the taste of soda has not changed in many years. As P&G and Coke have strong brand names, they continue to generate substantial earnings despite low reinvestment. However, with a short product cycle, Apple faces two challenges. First, Apple has to reinvest to develop innovations constantly. This innovation has to ensure that its iPhone has better features than its rivals so that its users will not move away from the Apple ecosystem. At the same time, if Apple has to increase its market share, it has to get more of its competitor’s users to move to the Apple ecosystem.
Thus, in my effort to value Apple’s iPhone business using Discounted Cash Flow model, i assume the following:
- The smartphone market in 2022 is $615 billion, and Apple has a 30% market share in dollar revenues.
- Apple will continue to earn 20% in After-tax operating margin. As Apple shifts its supply chain to India, it will temporarily affect margins. However, in the longer term, i expect Apple to have a 20% after-tax operating margin.
- The smartphone will grow at 7.3% CAGR for the next five years and 6% CAGR in the next ten years. Most of this growth will come from the launch of 5G networks which will trigger an increase in the sale of smartphones. After that, smartphone growth will converge towards the US economy, i assume a 10-year treasury bond of 3.3% as the risk-free rate.
- I assume that Apple will continue to launch new iPhone models every two years. As Apple brings new models, it will incur lost sales of its earlier models due to cannibalization as its existing users upgrade to the latest model. Further, Apple has to reinvest some of its earnings to launch new models. I assume Apple has to reinvest 50% of its earnings in innovation in the cycle year.
- Apple continues to have high brand loyalty, and with the launch of services, i assume that ~5% of users will move away from the iPhone ecosystem. However, with increasing income in emerging countries, i assume that Apple will attract a more extensive user base to its ecosystem from the competition. Therefore, I assume that 8% of the competition will shift to iPhones.
- The iPhone sales have substantial risk as the failure of any model will impact Apple’s valuation. Further, if the recession impacts customer spending, iPhone sales can decline. I assume an 11% WACC (95th percentile for US firms) reflects this risk.
I assume the iPhone model will continue for the next 40 years before we have a successor for the iPhone or Apple stops production.
I estimate the value of the iPhone at $716.69 billion. Apple’s market cap as of 18 October 2022 is $2288.6 billion. If i assume Apple’s market cap reflects its intrinsic value, iPhone contributes 31% of Apple’s value.
However, my assumption of iPhone valuation rest on the following premises:
- Apple will continue to demand pricing premiums and will have the pricing power. Further, it will have the lowest cost of production. Thus, it will continue to generate 20% after-tax operating margins. If there is any decline in the margin, the value comes down. For instance, at a 10% operating margin, iPhone’s value reduces to $358 billion.
- Apple must continue to innovate, and if the life cycle of the iPhone reduces to 1 year, the value of the iPhone will reduce by 50%.
- Apple must attract higher users than it loses to the competition. In my valuation, i assume a 3% net increase in users reflects an increase in its market share. However, if Apple loses more users than it acquires from the competition, its value will come down.
The iPhone’s value depends on its pricing power, its R&D spend on innovation and attracting more users from its competition. As of today, iPhone captures 50% of the US market in the smartphone segment. However, with its low-cost iPhone SE model not a success in India, iPhone must rely on pricing power and brand loyalty to command superior valuations. Further, with smartphone markets already matured and there is little to differentiate between iPhone and its competition in value, users will move to iPhones only if they feel a sense of social equity. Thus Apple’s marketing campaign and branding must continue to expand its market share. In my view, if Apple has to move from an American smartphone company to a global hardware and media company, it must penetrate the Asian market.