Longbow Sees 31.5% Upside In Apple; Starts At Buy, $125 PT

Longbow said Apple Inc. AAPL shares are "undervalued" and sees 31.5 percent upside in the stock. Subsequently, the firm initiated coverage of the iPhone maker with a Buy rating and $125 target price.

Justification For 'Undervalued' Claim

"We see AAPL as undervalued against stabilizing iPhone demand, a growing subscriber base that aids in AAPL's ability to monetize its ecosystem, optionality provided by the notable jump in R&D spend, and sizeable free cash generation," analyst Shawn Harrison wrote in a note.

Harrison expects expansion in the iPhone installed base to 710 million users for FY16 (+110 million year over year), providing a tailwind for the launch of the iterative iPhone 7.

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"AAPL's current installed base should create a floor in iPhone shipments, while future iPhone models, growth in India (each 100bp of share in India adds $1B in sales), and the tailwind from a replacement cycle with a larger installed base should drive iPhone growth in coming years," Harrison highlighted.

Looking Forward

The user growth also provides a broader base of devices to monetize via the services unit. Services sales (net) to the installed base rose 21 percent year-over-year for the first half to $10 billion.

"We estimate $10 billion of incremental gross profit if AAPL's growth in sales of services from FY16–FY18 only mirrors Longbow's estimate of iPhone user installed base growth," Harrison noted.

Meanwhile, Longbow's ongoing checks highlight a flat outlook for iPhone 7 production versus the 6s and upside in SE demand. The checks show Alphabet Inc GOOG GOOGL's Google Search Trends, which correlate to iPhone volumes, indicate greater interest in the iPhone 7 versus the iPhone 6s, but not versus the iPhone 6.

The analyst estimates more upside if the Cupertino, California-based company generates more returns from its R&D spending, which grew 34 percent CAGR from FY12–FY15. For FY16, Apple should generate $10 of gross profit/$1 of R&D vs. $28/$1 of R&D for FY12.

"Whether the CY17 iPhone, a connected TV, connected home devices, or an Apple Car leads to increased returns, each $2.50 recovery in the ratio drives $25 billion of new gross profit," the analyst said.

Expectations And Estimates

In addition, Harrison noted continued monetization of the ecosystem, despite limited hardware volumes, could drive significant free cash generation of $50 billion annually, which could help fund a growing dividend and a share buyback. The dividend/buyback currently boosts EPS by 5 percent annually.

The analyst projects FY16 EPS of $8.16 on a 9.7 percent decrease in iPhone volumes to 209 million devices and FY17 EPS of $9.02 on a 2.9 percent increase in iPhone volumes to 215 million devices. The Street expects EPS of $8.25 for FY16 and $9.02 for FY17.

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On the valuation front, Longbow's regression analysis that compares price/sales for FY16 and FY17 versus consensus EBIT margin suggests Apple is undervalued by 17–21 percent, while a price/sales analysis versus consensus operating cash flow suggests Apple is undervalued by 16–17 percent.

Shares of Apple closed Tuesday's regular trading session at $94.99, and at time of writing, shares were down 0.40 percent on the day at $94.61.