In this article I will discuss the fundamental and technical case for a continuation of Apple's (NASDAQ:AAPL) still-young trend reversal. There are many reasons why optimism towards Apple has disconnected from reality, underlying issues that may cause problems for Apple in the mid-term, and a strong case to be made for greater declines from current price levels.
Apple Sentiment Still Needs to Unwind
Reggie Middleton has done immense work sniffing around within the meat and bones of Apple's operations and presciently alerted investors to ongoing margin compression and upcoming earnings misses. He also pointed out that Apple's management has consistently understated earnings to give the appearance of surprising growth - for 12 quarters in a row! Investors who have taken Reggie's advice up to this point have saved themselves the heartache of watching what has been regarded widely as a "sure thing" go sideways and down on them. Professional advisers were even recommending Apple as a strong buy at $700 because people subjectively and irrationally value their product more than oil. Investors who bought into this sort of fluffy justification for late trend hopping are looking at 20% losses in a few short months.
The biggest red flag to astute observers, though, was the sheer participation level of long investors in owning Apple stock. It became the most widely held stock in 401k accounts in Q2 2012, and also by hedge funds (who have absolutely failed their investors with performance that lagged the S&P500 for the past 3 years and counting). One could say no wrong of Apple last year, and the calls for ever-increasing share prices became almost manic among professional analysts. Many $1,000 calls were made, with some advisers predicting prices much higher, even as high as $1650/share.
Apple's institutional ownership levels are at about 70%, and its short ratio as of Dec 14 was 0.80, meaning that less than one single day of average volume is enough to cover every open short position on the stock. Investors are still vastly weighted on the long side and optimism is still high (as determined by actual buy and sell activity). Professional Analysts are still overwhelmingly rating Apple a "strong buy" or "buy", with 45 out of 58 analysts holding to their optimistic positions through last month. Only 1 analyst has held a "sell" position on Apple for the past 3 months, and 2 analysts rate Apple as an "underperform". This sort of manic positive sentiment is rarely seen, and must be unwound for a sustainable rally to begin again.
Apple and the Laws of Economics
Almost nowhere do the laws of economics play out more observably than within the technology and electronics arena. Being one of the quickest moving sectors in terms of industrial development and innovation, it has less regulations than more static industries and thus moves in a direction that directly benefits the consumer much more quickly. This is comparatively at odds with business sectors with equally wide participation, but far higher interference from government, like the automobile industry or health care industry, where regulations pile on costs that are mandated to the end consumer and compress margins artificially, instead of organically via production expansion.
Capital Moves from Lower-Profit Allocations to Higher Profit Allocations
Apple has given investors unparalleled margin growth over the past 5 years, peaking out at just under 30% in Q1 2012. As will all business ventures, high margins attract more competition, as capital always seeks to be deployed in the most efficient and productive manner, and voluntarily-obtained profit acts as the only reliable and true indicator of whether resources are being properly allocated in the service of society. Apple's incredible margins and profits have sent loud and clear signals to competitors that their products are very much desired by society, and competitors have responded. Expect further margin compression as an inevitability in what is rapidly moving from a "new" industry to a mature industry. A recent, first-time-ever move by Apple to sell their products in the ultimate low-cost, low-margin retailer, Walmart, tells a tale of its own. From Reuters:
"Wal-Mart said it is selling the 16 GB Apple iPhone 5 for $127, versus an original price of $189.97. The price is valid with a two-year contract from wireless carriers Verizon, Sprint and AT&T, the retailer added.
Wal-Mart said it is also selling the 16 GB iPhone 4S and the 16 GB iPad with Retina display and WiFi at discounts.
The offers will be available for 30 days in about 3,000 of Wal-Mart's stores, which were not identified. They are not available online, according to the retailer.
Apple has focused on high-priced, premium gadgets for many years and has strictly enforced its prices with retailers and other distributors. However, a Wal-Mart spokeswoman said on Friday that the discounts were arranged with Apple.
"We worked together with them on this," the spokeswoman, Sarah Spencer, said. "They are a great partner."
Wal-Mart is pricing the iPad starting at $399, down from $499. Beginning December 17 the retailer said it will throw in a $30 iTunes card.
Wal-Mart is selling the 16 GB iPhone 4S for $47, versus an original price of $89.97, it said."
Unless Apple can come out with a completely new product that will give it the first-to-market advantage again, like the iPod or iPhone, the margin compression story is going to continue to be front and center:
Closed Systems Versus Open Systems - A Lesson From Apple's Own History
Apple's initial turnaround through the late 90's can be largely attributed to its move to adopt a more open system in its PC division. IBM's explosive 1980s growth in the wake of adopting off-the-shelf hardware components and software that wasn't restricted to its own machines essentially played Apple's hand. From 1981 through the mid-80's IBM and IBM "clones" (My very first computer was an IBM "clone") went from less than 5% market share and skyrocketed up to 60%.
This came at the expense of all of the closed systems, most of which don't exist in PC, tablet, or notebook form at all today, other than Apple's product lines. Where the companies who held on to 100% proprietary models ended up dying as competition in open hardware models drove prices down and widely increased availability for consumers, Apple stayed alive by adopting hardware that was interchangeable with PC components (most notably USB to enable wider peripherals, industry standard Intel chips, and compatibility of its operating system with PC platforms). Apple moved from a 100% proprietary model to a more hybrid model, and this helped to spur its computer sales and begin generating a profit again within its computer division. Apple's choice to re-engage the consumer was also a key driver in its success, and as all of its major competitors are taking the same approach, it will take a whole new series of innovations to give it the leading edge once again.
The iPod was the main driver behind Apple's explosive revenue growth. Despite this, the iPod still followed the same cycle of product maturity, competition attracted by high margins, and replacement devices (phones that are also mp3 players). iPod sales account for just 3% of Apple's total product sales through June 2012, and margins on iPods have been steadily declining. Apple must continue to introduce new, cutting-edge products that they can corner the first-to-market advantage on in order to maintain its impressive growth numbers.
Closed systems always eventually falter, long-term, against open systems. This is because a proprietary system can only exist either by artificial fiat or - morally - by individually contracting every buyer to forgo certain rights of usage with the product. Proprietary systems generally cost more, are subject to declining innovation relative to open systems over time, and limit access by third parties who add value to each system. This story has really started playing out since 2009 with Android's amazing market penetration in a very short time.
We are already seeing big things happening in open source software with Valve Corporation, porting its popular games over to linux and developing a linux based hardware console to compete with existing proprietary models on the market. Every android phone that gets sold is a Linux-using piece of hardware, which has drastically increased market penetration for the open source O.S.
Apple's recipe for success under Steve Jobs was taking an idea that was in its infancy (mp3 players, smart phones, tablets), putting together a high-quality hardware build and stable software, adding features that have only existed on the periphery (or not at all), and packaging it all within a beautiful design. This has given them first to market advantage on every product they sell.
Since Steve Jobs' handed off the reins to Tim Cook, we have only seen incremental changes in existing apple products, and no brand new product launch. There is speculation over Apple TV, but thus far it is speculation only, and any plans to launch a brand new product line have been kept very close to the chest. Apple desperately needs another first-to-market product in order to keep its margin edge, and if something doesn't materialize soon, it will be to the detriment of shareholders who are banking on a continuation of Apple's blazing revenue growth.
Seismic Market Shifts: The Patent Wars
One aspect of the tech industry that many investors are ignoring at their peril is the financial destruction that copyright and patents impose over the long term. They entrench business models, harming consumers, artificially construct ownership and therefore artificial scarcity of non-scarce goods, and create huge conflicts that cost hundreds billions of dollars and redirect innovation into less efficient avenues.
The end goal of the titan patent wars within the smartphone arena is to artificially increase the costs of competitive devices. With the lawsuits literally running full circle and each major company suing multiple other companies for patent violations, the net effect will be that consumers will have to shell out more money for the exact same product (Apple's lawsuit against Samsung for it's 10.1 tablet was an attempt to increase the cost of the product by $40.00 in royalties and suspend all sales until the dispute was resolved).
This is a negative sum game in the end, as the costs of meeting the resulting verdicts of these patent lawsuits, as well as the costs to bring them to the courts, losses in sales while products are suspended from different regions, etc., will outweigh whatever net benefits could be derived from the patent lawsuits. It is a great time to be a lawyer specializing in patent lawsuits for tech and software, and a dangerous time to be a shareholder caught in this battle of the titans.
All that "Cash That Apple Has"
Apple is often cited for its immense hoard of cash, which is gargantuan by any standards. What most investors don't know is that it is anything but "cash".
Apple is actually the world's largest hedge fund that you've never heard of. Our friends over at ZeroHedge posted a lengthy article on Apple's subsidiary, Braeburn Capital, including a bio of its management, and it's investment strategies.
The trouble for shareholders is that Braeburn is not actually registered as a financial adviser, just an asset management company, so it does not have to (and therefore does not) publish any of its holdings for Apple shareholders to see. There is no 13-F SEC filing of holdings, no detailed breakdown of the kinds of risks that Apple's mountain of accumulated profits is being exposed to.
CapitalIQ has the following description of the firm: "Braeburn Capital Inc. is the asset management arm of Apple Inc. The firm invests in the public equity markets. Braeburn Capital Inc. was founded in 2006 and is based in Reno, Nevada."
Shareholders are not informed what markets Apple is investing in, what sort of risk assets this cash hoard is being invested into, etc. If macro markets turn down, shareholders won't know just how much damage is done to the cash hoard until months down the line. As a shareholder, you are making a bet that Apple is managing its cash with restraint and stewardship, and not exposing itself to any serious investment risks. A key metric to keep an eye on will be the outstanding value of short term investments against new cash-flow. A serious decline in this number will cause great harm to Apple's pristine balance sheet.
Western nation-states spending themselves into oblivion has been the story of the decade from 2000-2010, and we are now coming to the final chapters. It is mathematically impossible for the US Government to cover even a small portion of its $87 Trillion (550% of US GDP) in liabilities using any amount of taxation, and the fiscal cliff drama is just a preview of what is to come.
77% of US households are going to see tax increases this year, and those increases equal out to a tiny portion of this year's actual projected budget deficit. You can expect that businesses will also see tax increases, and Apple will be right at the top of the list when it comes to terms like "fair share" and "profits".
We all hear the term Regime Uncertainty used to describe why businesses are moving operations offshore, scaling back their sales locally, etc. Drastic changes to tax codes in order to gobble up as much revenue as possible is absolutely nothing new where governments are concerned, and protracted bear markets make tax increases par for the course, as government revenues sink.
A prudent investor or would-be investor would be very wise to consider what a low hanging fruit that cash hoard is for a desperate, de facto bankrupt government.
Cyclical Fundamental Valuations
Apple's last cyclical low was at about 3.3x book value (this during an environment where revenue almost doubled, indicating a serious disconnect of price action from fundamentals, and creating a fantastic buying opportunity). Previous valuations at lows indicate a further drop of about 20% in the measure from here for a total decline in the neighborhood of 40%, to return to more conservative metrics.
Apple Revenue Quarterly
Apple Price to Book
Apple's last cyclical low was at just under 2x sales. With the previous quarterly misses, expect this to keep on to the downside as a greater than 33% reduction in price would be required to match the last cyclical low. Given a total range of roughly 20% from here, based on price/book, and 33% from here in terms of price/sales, the total decline on a fundamental basis should be around the 50% mark from peak to trough.
Apple Price To Sales
Balance Sheet Risk
Again, this should be a point of interest for existing shareholders, who have very little information on what kind of balance sheet risk Apple is subjected to. Blind faith in a ballooning asset pool managed by a small team, within a macro environment that is looking less and less friendly to risk assets, could erode the denominator along with the numerator in a price/book valuation model. This would push price targets for Apple's share declines even lower on a dollar-per-share basis as internal valuation contracts.
The Technical Case
When I do technical analysis, I not only look at chart patterns and internal momentum metrics, but also measure of sentiment by actively participating (buying and selling) investors, which I believe is the primary driving factor behind not only a business' stock price, but also its success. Technical analysis on the price action and underlying internal metrics lends a supportive picture to the fundamental valuation case, both placing the "ideal" price range for the decline within the same approximate range.
Apple's share price has exhibited a classic internal divergence on a daily basis. This indicates a mid-term trend change, a period of technical internal reset at the very minimum, and at least a partial retrace of the huge move off of the 2009 lows. The exponential nature of the rise, the level of overall household participation in Apple stock, the breadth between longer term moving averages all lend weight to the fact that Apple's stock is now in its own mid-term bear market. This means that it will correct the "typical" range of 38% to 61% that most stocks exhibit.
The technical price target on Apple stock is derived from calculating a typical bull market retracement range of 38% to 61%. This gives Apple a long term technical buy point of $270-$360. At $360, Apple will be just over 3 times its tangible book value, which currently stands at $120.37/share, a good, conservative entry point for a long investor.
Apple's last 2 cyclical declines were 83% off of its highs in 2002 (with bad fundamentals underlying it), 61% off of its 2007 highs (with rapidly growing fundamentals and expanding sales). We should expect a similar cyclical correction this time around. To reach the minimum retracement target of $360, Apple will experience a decline of just under 50% off of it's $705 all-time highs. To reach $270, the decline will be 62%, which is well within historical norms.
Apple is due for a further correction to alleviate the intense over-participation of the 2009 rally. Once this corrective period is over, Apple should start another cyclical bull market that will reward patient investors with a long time horizon. This downside move will also make their dividend far more attractive in yield terms. In the case of Apple, patience is a virtue.
Apple is a fantastic company that has revolutionized the consumer electronics market by taking technologies with shallow market penetration and repackaging them in beautiful designs and highly functional interfaces.
Participation in Apple's rally reached extreme proportions, which has paved the way for an era of unwinding. Shareholders will be more cynically evaluating Apple and will ask many of the questions above, and will want Apple's answers to the issues that they face. Apple will likely overcome these issues in the long term and alleviate the doubts that their bear market has, and will, introduce.
The big key for Apple is its first-to-market, high-margin business model. It will have to demonstrate that it has something in the works that can alleviate ongoing margin compression, which has been the story for the past year, and give it an edge once again. Apple has demonstrated that its consumer-focused business model is one that can drive high-margin sales. I believe that, while the near term future looks bearish, their unique business model and proven method of bringing a product from the very early adopter stage to the majority stage has a great long term future.
Post-Submission Edit/Update January 8, 2013:
The Wall Street Journal announced today that Apple is working on a "lower-priced Iphone". From the WSJ Article:
"While Apple has explored such a device for years, the plan is progressing and a less expensive version of its flagship device could launch later this year, one of the people said.
The cheaper phone could resemble the standard iPhone, with a different, less-expensive body, one of the people said.
One possibility under consideration is lowering the cost of the device by using a different shell made of polycarbonate plastic; in contrast, the iPhone 5 currently has an aluminum housing.
Many other parts could remain the same or be recycled from older iPhone models."
This is a departure from what Apple has demonstrated to be the driving factor behind its success - looking forward and bringing new things first-to-market with top shelf margins. Apple is more and more having to fight for customers in a market that is seeing margins fall drastically, and this will continue to put downside pressure on Apple's share price. Yet another piece of evidence that the assumed exponential growth in the future for this company is starting to plateau, and share prices are reflecting that underlying reality.