Apple: The Law Of Large Numbers And Declining Margins Point Towards Average Stock Returns

| About: Apple Inc. (AAPL)

While many market participants look at Apple Inc.'s (NASDAQ:AAPL) growth rate and price to earnings ratios, and believe the company is incredibly cheap, I tend to believe it is closer to fairly valued. I believe the uniqueness of the company's products is fading, as it tends to happen in the consumer technology industry. While I believe it is safe to assume that net income will be greater next year than this year, I'm less sure the further we look out into the future. While I may prove to be misguided, if I were a betting man, I'd bet that adjusted for inflation net income will be less ten years from now than it is now. This is no sure thing, but the same momentum and innovation that caused the company to meteorically rise, can work against it as once fat margins, decline over time. Competitors are already engaging in practices that ultimately shift the value proposition from the original equipment manufacturer (OEM), to the consumer, via selling products below cost. If you look at this history in once-hot sectors such as flat screen TV's, PC's, and normal handsets, the gravitational impact on commoditized products profit margins can be clearly observed. The law of large numbers dictates that the growth rate must slow, so to expect anything like the recent past in terms of stock price appreciation, is overly optimistic.

Even if my prediction turns out to be true, it doesn't mean that at current prices the stock will be a bad investment. It all depends on the length of time that the company can maintain its current high level of profitability, and how it decides to allocate that capital. I personally think the company's capital allocation strategy of hoarding cash, that is earning basically nothing, is an atrocity. While investors might look past that based on the company's operating success, when managers misallocate capital to the tune of $128 billion, I worry that when business slows, that same management might make stupid and costly acquisitions. Microsoft (NASDAQ:MSFT) in the Steve Ballmer era, is a perfect example of a company that had all of the momentum and cash, but through behaving in an entitled, non-shareholder friendly way, has lost many of its competitive advantages. It would be far more beneficial for the company to pay out the cash as a dividend if it doesn't have value-accretive acquisitions in mind. Share buybacks would also be attractive if the stock continues to drop further, but I'd certainly prefer to see a much more generous dividend policy.

At $547 a share Apple Inc., has a market capitalization of approximately $515 billion. Apple ended the quarter with $121.3 billion in cash and investments, up $4 billion since the end of the June quarter, and net of the $2.5 billion dividend payments made in August. $83 billion of the cash is held offshore, so Apple would incur tax implications if it brought it back to the United States. At the end of the quarter, the company had 948,186,000 shares outstanding. Therefore the company has a staggering $128 per share of cash and investments. Apple's core businesses are being valued at $387 billion, or 9.3 times trailing twelve month earnings after backing out the cash. This is slightly understated because it doesn't account for taxes or interest earned on the cash and investments. Stocks like Microsoft and Cisco (NASDAQ:CSCO) were terrible investments in 2000 despite strong business performance, due to the nosebleed valuations that the stocks traded at during that time. Apple's current price, does not have assumptions of extremely high growth, as those other companies did in 2000, so I'd expect much less downside than those stocks had moving into the future. Key to this assumption is the company's ability to generate free cash flow, and if the company were to hire an able capital allocator to manage their growing cash surplus, I believe there would be tremendous upside at current prices. I know it sounds crazy, but I believe that cash rich companies like Apple and Microsoft would be better served to hire a proven capital allocator to invest surplus cash. A 2% annual improvement in investment returns, adds billions to the bottom line, so frankly I'm disappointed more companies don't explore one of the key business characteristics that has made Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) so successful.

On October 25, Apple reported 4th quarter earnings that accurately portrayed the company's immense financial and operational success. Revenue for the quarter was $36 billion, representing YoY growth of 27%, based on the continuing growth in both iPhones and iPads. The operating margins are still exceptionally strong for a hardware maker at 30.4%, and operating income was $10.9 billion in the quarter. Net income was $8.2 billion, or $8.67 per diluted share. Total company gross margin was 40%, which was 150 bps higher than the company guided for. iPhone profit margins are estimated to be greater than 50%, accounting for the majority of Apple's profit. Any decrease in market share or margins would be extremely worrisome, despite likely unit sales increases from the increasing share gains of smartphones in the overall handset market.

The iPhone continues to defy gravity, with 26.9MM sold in the 3rd quarter, compared to 17.1MM last year. This 58% growth continues to outpace the 45% growth for the overall smartphone market in the quarter. Demand is exceeding supply for the product, which is important in maintaining Apple's robust profit margins on the product. iPhone revenue was $17.1 billion, up YoY from $11 billion on 56% growth. The iPhone is winning enterprise market share from incumbents such as Research in Motion (RIMM), and this could be an extremely powerful trend to propel growth. Because it is estimated the company has less than 25% of the growing total smartphone market, it is fair to say that the company has the opportunity to continue its strong growth trajectory in terms of unit sales.

14MM iPads were sold during the quarter, compared to 11.1MM a year ago. This 26% growth disappointed some analysts, but was ahead of the company's expectations. The company also released the iPad Mini to combat Amazon's (NASDAQ:AMZN) Kindle, and Google's (NASDAQ:GOOG) Nexus. The price seems quite high at $329, but at least that should limit concern to some extent on a dramatic hit to margins on the product. iPad revenue was $7.5 billion in the quarter, up 9% YoY. Tablet sales are likely to surpass PC's in the not too distant future, and Apple will most likely be one of the top two or three competitors in the space. There is a real danger of margin pressure however, because many powerful competitors like Amazon are willing to offer their tablets below cost, to make money off the software and application revenues that can be generated off of the devices. Thus far, Apple's first-mover advantage has held steady allowing the company to reap the rewards of fat profit margins, but of course the future is much more uncertain. Apple has combated competitive landscapes with new products, which transformed the marketplace. Through the leadership of Steve Jobs, the company became the most successful consumer technology company in history and one of the most successful businesses as well. I'm surprised at how much confidence investors have that the company can continue to be the most innovative company in the technology industry, without the leader that was named on several occasions as the most important CEO to his company.

Apple continues to drive consumers towards its iCloud offering, which allows people to access their music, photos, calendars, contacts, and documents on whatever device they are using. Apple focuses on keeping consumers on its own operating system infrastructure, as the company wants to make a moat out of high switching costs. Thus far the company has been successful, but I believe there is some risk to this strategy, as consumers often prefer the best a la carte products. Therefore, for some consumers, it is just not attractive to have every product be Apple because then you are a slave to the company's product cycle. I believe Samsung did a wonderful job marketing its Galaxy phone through highlighting the much larger screen, and attractive features in the commercial with actors that were obviously waiting in line to buy the iPhone 5. It would be frustrating to have an inferior product, but feel compelled to buy it because of iCloud, and while there is debate as to which phones are the best now, it is very unlikely that Apple will always carry the highest quality phones in such a short product lifecycle industry. Often once a technology product goes from being trendy and cool, to being something used by your parents or grandparents, preferences shift. Apple might be the 800 pound gorilla on the block, but it is in an industry where it competes with exceptionally well-financed competitors such as Microsoft , Google, and Samsung who are willing to throw billions of dollars to take away market share from the company in its key products. Competitors are likely to offer their own high quality products, at cheaper prices, putting extreme pressure on margins.

In the quarter, Apple sold over 4.9MM Macs establishing a new September quarter record. While this was only growth of 1%, this was exceptional in the face of 8% contraction in the global personal computer market in the quarter. Portable computers such as the MacBook Pro and MacBook Air, experienced 9% YoY sales growth, and represented a record of 80% of Mac unit mix. The company continues to upgrade its product cycle with sleek introductions, and few Apple units are as well positioned to maintain market share momentum as Apple, which is benefiting relatively from the commoditization of the PC space, as other brands seem rather ubiquitous, whereas Apple is the only choice for its most ardent fans.

The company also sold 5.3MM iPods, which was down from 6.6MM in the year ago quarter. iPod has greater than 70% market share in the MP3 players market, highlighting the company's dominance in the space. The iTunes Store generated almost $2.1 billion in revenue, which was a record in the quarter. Apple retail stores generated $4.2 billion in revenue, up 18% YoY, with growth being bolstered by record iPhone and Mac sales. The company exited the quarter with 390 stores, 140 of which are located outside the United States. Incredibly, average revenue per store was$11.2MM, up from $10.7MM in the year-ago quarter.

In the December quarter, Apple is expecting revenues of $52 billion compared to $46.3 billion last year. The company believes that gross margins will trend lower to about 36% reflecting additional expenses related to stock based compensation. Overall the company expects to earn around $11.75 a share in the quarter, but as always with Apple, one needs to take that with a grain of salt due to the company's reputation of under-promising and over-delivering. For fiscal year 2012, Apple generated $156 billion in revenue, up 45% YoY, and generated net income that was up 61% to $41.7 billion. These numbers are stratospheric and nearly incomprehensible for a consumer technology company.

In summation, I believe Apple is an average investment based on my future expectations for the company. Accurately predicting its market share and future innovations places the company in my "too hard" pile, where I'd only be willing to invest at a very large discount to a conservative estimation of intrinsic value. If I were to invest in Apple at current prices, I'd do so by selling long-term puts, and/or engaging in covered calls. These strategies generate income and reduce the risks in comparison to owning the stock outright. It also takes advantage of Apple's growing cash hoard, which serves as somewhat of a ballast against a significant decline in the stock price. I'm very curious if my 10 year prediction turns out to be accurate, but I'd only give my odds at 50/50.

Disclosure: I am long MSFT, RIMM, CSCO, BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.