Here's Why Apple Isn't Cheap as You Think

Whenever there's a discussion about Apple (AAPL), it usually doesn't take very long for an expert to assess that the stock is "insanely" cheap.

There is little doubt that Apple's products are top quality and that the company is staffed with a talented and dedicated workforce, but I also think shareholders and potential buyers of the stock need to consider a couple of major reasons why the company's current valuation might not be that off the mark.

Apple's Product Refresh Cycle

The company seems addicted to an aggressive profit maximizing product refresh cycle. It seems Apple has pretty much instituted a new product upgrade launch on an annual basis.

For the iPhone it went something like an initial launch on June 2007 with upgrades July 2008, June 2009, June 2010, October 2011, and September 2012. For the iPad it was an initial launch April 2010 with upgrades in March 2011, March 2012, and November 2012.

While this pace of product refresh does extraordinary things for revenue growth and profitability, one has to question the long-term viability of such an aggressive revenue model. It is rare that a company, outside the fashion industry, can sustain growth via annual product upgrades for a significant period of time. The sustainability of such an upgrade cycle would seem to be even more difficult when incremental changes to the product become less and less vital.

Apple faces meaningful risk for a revenue growth slowdown or even revenue stagnation if an increasing number of those who have typically upgraded annually opt to stretch out their next purchase for an extra one or two cycles.

Apple's Reliance On iPhone Subsidies

Apple generates a significant share of revenue and profit from the iPhone. This is due to the extremely high revenue per unit generated and high level of unit demand. Both these factors could be attributed mainly to the current product subsidy by the carriers.

An iPhone would typically retail around $600 to $800 without carrier subsidy. Given current competitive product and pricing, it is a dubious contention that Apple's market share would be where it is if customers had to pay the unsubsidized price.

Because these subsidies are so onerous to the carrier's profitability, recent trends indicate that they are increasingly looking for ways to reduce or even eliminate them.

T-Mobile has recently announced that they will offer the iPhone but without subsidy and are looking at offering service via refurbished iPhones. AT&T and Verizon have increased their own marketing on lower subsidized Android and Windows based offerings. In China, Apple's target growth market, number-one carrier China Mobile has balked at the company's subsidy demand and China Unicom, Apple's first entry into China, has contemplated a subsidy change.

Up to now, the carriers have been at a significant disadvantage when dealing with Apple. They have taken poor deals due to the demand for Apple product and lack of serious competitive alternatives. This balance of power may be changing. I would expect that the carriers are watching and maybe waiting for any sign of Apple growth weakness to change the subsidy dynamics.

Any meaningful reduction of iPhone subsidies is a very significant risk. A reduction would seem to force Apple to consider either a sharp contraction in margin by reducing the revenue received per unit or risk sales volume by maintaining a much higher than competitive price for its product.

These business model risks seem to pose serious questions as to the sustainability of Apple's revenue growth and product margin over the long term. Given the maturation of the iPhone and the non-subsidy nature of the iPad, I believe that things won't be as beneficial for Apple over the next couple of years as they have been for the last couple.

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