Apple Inc. (AAPL): Why The Stock Is Severely Undervalued

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October 30, 2015 11:55am ETF BASIC NEWS

apple inc.David Zeiler:  Apple Inc. (NASDAQ:AAPL) stock was up about 3.5% today (Wednesday) following an impressive Q4 earnings report, but AAPL should be trading much higher.

“This stock is absolutely undervalued,” said Money Morning Capital Wave Strategist Shah Gilani on the FOX Business program “Varney & Co.” this morning. “They’re going to buy more shares, they’ve got so much cash. This stock is going to continue to grow.”

Currently trading at about $118.50, Apple Inc. (Nasdaq: AAPL) stock has a laughably low price/earnings ratio of 13.63. It’s forward P/E is just 10.88.

To get an idea of how cheap AAPL stock is right now, compare that to the P/E ratios of fellow tech giants Microsoft Corp. (Nasdaq: MSFT) and Alphabet Inc. (formerly Google Inc.) (Nasdaq: GOOGL, GOOG). The Alphabet P/E is 30, while Microsoft’s is 35.44.

The P/E ratio for the Standard & Poor’s 500 is just below 22. If Apple had a P/E of 22, it would trade at $190 a share – a 61% gain from the current Apple stock price.

So where is Wall Street going wrong?

Two related issues keep tripping up the “experts.” One is that Apple is too dependent on the iPhone. The other is that sales in China have become Apple’s primary source of growth.

It’s true. The iPhone represents about two-thirds of Apple’s revenue and profit. Although Greater China was just under 25% of Apple’s revenue in Q4, the year-over-year growth in that segment has been phenomenal.

In the Q4 Apple earnings, sales in Greater China (which includes Hong Kong and Taiwan) grew 99% over the same period last year. Total iPhone sales were up 120% in mainland China.

Many perceive this as a major risk for Apple stock. They speculate on the impact of a slowing Chinese economy, or the possibility that consumers will abandon the iPhone for lower-priced competitors.

And they might have a point if any of that was happening. Meanwhile, they’re overlooking a far more obvious and more likely possibility – that China will fuel massive sales growth for Apple over the next few years.

Here’s what I mean…

How China Will Help Push Apple Stock Higher

First of all, concern over the iPhone’s outsized role in Apple earnings assumes that the product has peaked, or that something else is on the verge of replacing the smartphone. Both will happen someday, but are years away.

And China is much less of a risk than it is a huge opportunity.

Money Morning Chief Investment Strategist Keith Fitz-Gerald pointed out that the perceived slowdown in China isn’t a sign of a failing economy, but the hiccups of a giant economy in transition.

“The Red Dragon has had the world’s largest GDP for 18 out of the past 20 centuries,” Fitz-Gerald said. “They will again as Chinese consumers set their sights on the things we take for granted in the West including homes, cars, appliances, electronics, travel, and education for their children.”

Not only is Wall Street wrong about the Chinese economy, they don’t understand the Chinese consumer.

Take the assumption that cheap smartphones running Android would undermine iPhone sales. Over the past year, Apple has jockeyed with Xiaomi Inc. and Huawei Corp. for the top rank in smartphone market share in China.

According to Counterpoint Monthly data, Apple was first in February and March, fell to third through the middle of the year, then jumped back to No. 1 in September. The September numbers put iPhone market share at 19%, with Huawei at 17% and Xiaomi at 16%.

But the point is it doesn’t matter who’s No. 1 in any given month, but that the iPhone’s appeal to Chinese consumers has remained consistent.

It’s because Apple isn’t selling a generic piece of hardware, but a complete ecosystem. Apple is expanding its chain of retail stores in China and has introduced Apple Music there. Revenue from the App Store in China grew 127% in Q4.

Just as key is that Apple is perceived as a luxury brand and status symbol in China.

When you think about it, the Chinese middle class are buying iPhones for the same reasons as the U.S. middle class. And the iPhone has a 44% share in the United States.

The difference – and a big part of Apple’s opportunity – is that China’s middle class is growing much faster.

What China’s Middle Class Will Do for AAPL Stock

In the analyst conference call, Apple CEO Tim Cook noted that the Chinese middle class stood at 50 million five years ago and will be 500 million five years from now.

A Credit Suisse Group (NYSE: CS) report released two weeks ago put the current size of China’s middle class at 108.76 million, bigger than its estimate of the U.S. middle class of 91.86 million.

Think about it. Apple’s Greater China revenue in Q4 was $12.52 billion. A five-fold increase in the size of China’s middle class may not translate to a five-fold increase in Apple’s revenue there, but it’s hard to imagine it won’t at least triple.

Let’s do some back-of-the-napkin calculations. Roughly tripling Greater China sales would add $25 billion in revenue and about $5.39 billion in profits, or $0.95 per share.

That means China alone will add at least $3.80 per share of earnings over the next five years. Even at a P/E of 13.63, that puts the AAPL stock price at about $169.

And that’s not counting the contributions of such new Apple ventures as the Apple Watch and Apple TV or future products like an Apple Car. Nor does that include iPhone growth in other emerging markets, particularly India, where Apple recently partnered with India-based electronics chain Croma to create a “store within a store” program.

Underestimating the Chinese market – and Apple’s ability to exploit it – is why AAPL stock isn’t trading higher.

Someday Wall Street will realize that. But in the meantime, Apple stock is a steal.

The Bottom Line: Wall Street worries over the Chinese economy and how the iPhone dominates Apple earnings have resulted in a severe undervaluation of AAPL stock. With the Chinese middle class expected to grow five-fold over the next five years, Apple will have more than enough customers to sustain healthy iPhone sales growth.

Money MorningWritten By David Zeiler From Money Morning

We’re in the midst of the greatest investing boom in almost 60  years.  And rest assured – this boom is not about to end anytime soon.  You see, the flattening of the world continues to spawn new markets  worth trillions of dollars new customers that measure in the billions;  an insatiable global demand for basic resources that’s growing   exponentially; and a technological revolution even in the most distant  markets on the planet.  And Money Morning is here to help investors profit handsomely on this seismic shift in the global economy. In fact,  we believe this is where the only real fortunes will be made in the  months and years to come.

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