Monday, April 20, 2009

Apple: Stuck in a trading range?


I’m an Apple fan. I own multiple Apple products, and am a regular visitor to the Mac store. I’ve thought of owning Apple stock, but have not done so because everyone I know is so admittedly smitten by them. When a company is that well known and loved, a lot of its growth is already baked in.

Back in 2005, I considered buying Apple(AAPL) when it was around $80. Times changed, things happened. I remember there was this investigation against Apple by the European Union. Then we had the legendary iPhone release and the stock shot up to $200. After a spectacular double top, it traded a few weeks back at or around the $80 mark I had considered back in 2005. A nice cyclical gut wrenching round trip, in spite of everything that’s happened in between.

(Before everyone get’s really excited, I know Apple is up 50% in this rally. But up 50% in a 30% up market for a high beta stock like Apple (Beta is 1.5) is par course for the stock).

Issue #1: Overoptimistic and overenthusiastic fan and investor base:

Now consider this well-researched but overoptimistic recent article:

Back in 1982, you could have purchased 100 shares of this company’s stock for $160. Those same 100 shares would be worth roughly $92,000 dollars at today’s split-adjusted share prices.

That’s a 57,400% return, something most people won’t ever see in a lifetime of investing.

Fortunately for us, this company’s prospects are only looking brighter. In fact, it has plenty of space to grow and do it all over again. And it won’t matter whether you’ve been there from the beginning or jumping into the bandwagon today - the ride looks to be profitable nonetheless.

Issue #2: Fundamentals:
  • That really sounds like a siren call to own Apple and ride the road to riches! Problem with this argument is SIZE. Apple is already a $100 billion dollar company. A growth of 57400 % would imply a market valuation of $57 trillion, or 4 times the current US GDP. That’s also close to the total world GDP! Trust me, it AIN’T gonna happen in your lifetime. Even arguing for a TEN bagger from here sounds like a stretch.

  • Here’s my problem with a large cap high PE company: The growth assumptions imply that it’s market cap would be x% of the US GDP. Walmart(WMT) was a high growth high PE flyer in the late 80s/early 90s.. Someone in the early 90s did an analysis that if the growth assumptions of Walmart were true, it's market cap would be 10%+ US GDP in another 10 years. It pretty much went sideways for the next few years. Apple will also go through this growth stock to value stock transition sometime in the near future. Note that this valuation argument is also true for most of the current tech horsemen, like Google(GOOG) and Amazon(AMZN). Earlier growth stocks like Microsoft(MSFT) have already made that transition, but only after years and years of sideways movement.
  • The other thing is that Apple does not have a dividend. You might say that it’s reinvesting all that cash flow into high growth areas, but the growing cash balance earning rock bottom interest rate is inconsistent with that statement. We’re headed to a low growth world where investors will increasingly demand yield, and non dividend companies with optimistic growth assumptions will suffer.

Issue #3: Risks

  • The risk is that a lot of Apple’s sales are in the developed world (US, Europe). In a world where consumers in emerging markets are expected to make up for any slack, I count that as a risky attribute of Apple. (For instance, the iPhone is a big flop in India.)
  • In the PC area, the current slowdown should accelerate the trend of budget conscious buyers gravitating towards cheaper products (check out the new Microsoft ad).
  • Further, the handset market is ultra-competitive with low barriers to entry. Even a revolutionary product gives you maybe a year’s headstart before the competition hits back with competitive but lower priced products. The handset market looks ripe for a shakeout in the next few years. Sooner rather than later, your margins are going to contract. Just ask Motorola(MOT) about their Razr experience.
Hmm.. let's see what else we have. Handset revenues recognized over multiple quarters? It’s already been priced in. High cash reserves? That’s never been a reason to buy a company.

When the iPhone was released, everyone was talking about how Apple was getting a slice of the carrier revenues. With the release of the 3G version, the story changed to how carrier subsidies would drive handset volumes. Nevermind that no one’s talking of Ipod growth anymore. Nevermind that most Mac sales are in the slow-growth developed world, where consumer demand has taken a hit.

My point is that I’ve seen the story change repeatedly to justify Apple’s growth prospects. A lot of the good stuff is baked in.

Issue #4: Technicals:

Firstly, you cannot possibly ignore the massive double top. (And in case you think I'm imagining this, Louise Yamada seems to concur.)

More importantly, Apple was the darling of the previous bull market. New bull markets always bring with them new leadership. Leaders of the previous bull sit the next one out. Chances are, Apple may not go to the stratosphere as the article claims, but might be stuck in a trading range. The fundamentals based argument made above would also support this conclusion.

Fan boy articles arguing for Apple market cap to reach 4 times US GDP should give risk-averse investors cause for concern. Apple is and will continue to be a great company. Much of that is priced into the stock.

Stocks mentioned: AAPL, RIMM, PALM, MSFT, AMZN, GOOG, WMT.

Full Disclosure: No positions