In articles last year, I attributed Apple's heady rise to unrealistic growth expectations and investor over-optimism. Has Apple's (AAPL) 40% decline wiped out those excesses? If so, is AAPL once again an attractive investment? The short answers are: "Yes" and "No."
Answering the "Buy now?" question requires evaluating Apple from seven viewpoints. Here is the list along with quick summaries of my conclusions:
- Fundamentals (past) - Apple's suffering the effect of technology's notorious "S" curve (new product growth ramps up, then meets competition and stagnates or falls)
- Fundamentals (future) - Even beyond the lack of innovation (next item), Apple's future is unclear because of diminished, uncertain expansion potential
- Innovation - The jury's still out on whether Apple ex-Jobs has what it takes, but the clock is ticking and skepticism is rising
- Culture - Cook's Apple appears to be separating from the legacy of Jobs' Apple
- Earnings reports - The last three quarters' hiccups have reduced forecasts and increased uncertainty
- Valuation - Yes, AAPL looks cheap (its P/E is near the bottom of the technology sector), but that's a sign of trouble in this market
- Dividends - Neither the 2.5% yield nor David Einhorn's proposed cash payments is a good reason to buy a growth company - especially when growth is slowing and there is little basis for expecting that to change
(Stock chart courtesy of StockCharts.com)
1. Fundamentals (past) - Apple is suffering the effect of technology's notorious "S" curve (new product growth ramps up, then meets competition and stagnates or falls)
By examining the following graphs, we see a maturing company, with declining growth rates in both sales and earnings. While the profit margins are still within the historic range, they are in a period of decline. Why? There have been a number of developments such as keeping the iPhone 4 and 4S products in the lineup at reduced prices or the widespread discounting of iTunes gift cards during the holiday season. This chipping away at prices adversely affects Apple's two key measures: Sales growth and Earnings growth.
2. Fundamentals (future) - Even beyond the lack of innovation (next item), Apple's future is unclear because of diminished, uncertain expansion potential
Ignoring product innovation (discussed below), we should expect more price and margin erosion. For example, let's look at the once-anticipated huge international expansion. That expectation, key to many high growth forecasts, has been severely hit by reality. First, Apple's market share in other big-market countries (China, India) will likely be smaller than expected, relegated to those who can afford the high prices, with carriers unwilling/unable to subsidize as in the U.S. Second, competition is in full swing. Many features, once unique to Apple, are now found on competitors' less expensive models. Moreover, Apple's "one-size fits all" approach has allowed multi-version manufacturers to differentiate and segment to their benefit.
Does that mean international growth is unimportant? No, but, by not being huge, it leaves Apple with the challenge of maintaining growth and profitability in already saturated markets. As shown by the iPhone 5 release results, product improvements don't carry the same weight as product innovation, so let's turn there next.
3. Innovation - The jury's still out on whether Apple ex-Jobs has what it takes, but the clock is ticking and skepticism is rising
We all know examples of Apple's innovations like the iPod, iPhone and iPad. But what about the iPod Mini and the Apple Maps software? All took sizeable resources and time to accomplish, but are they the same type of innovation? The answer is "no" and can be understood by reading Business Dictionary's fulsome description. Here are the important points:
Innovation involves deliberate application of information, imagination and initiative in deriving greater or different values from resources, and includes all processes by which new ideas are generated and converted into useful products.
Innovations are divided into two broad categories:
(1) Evolutionary…incremental advances
(2) Revolutionary…disruptive and new
Apple's revolutionary innovation timeline
Here is a look back at Apple's history of revolutionary innovation. There are three observations to note:
- The company's fundamental and stock growth were linked to the revolutionary innovation
- All revolutionary products occurred under Steve Jobs
- The last revolutionary innovations, iPhone and iPad, are now 6-years and 3-years old
(Stock chart courtesy of StockCharts.com)
So, what about the yet-to-come innovations?
Remember that rumored list of nine unbelievable products Jobs had left behind? They were to be his legacy encore, beginning with the "coming soon" revolutionary TV product mentioned in Jobs biography ("I've finally cracked it"). Not one of those supposed revolutionary products has made it out the door.
So, what about that long-awaited TV product? Tim Cook assures us that it's coming. However, re-reading this October 2011 New York Times article, we can understand investors' diminished expectations and increased skepticism that iTV will be the promised blockbuster once envisioned. The TV market is now two years advanced, too long to have full faith in Jobs' former visions of such a dynamically changing industry.
What's Really Next for Apple in Television (October 27, 2011)
[Apple] could soon reap astounding financial returns. A recent report issued by Barclays predicted that if Apple made a television set, excluding content deals, Apple could generate an additional $19 billion in revenue a year. This number would not be a stretch either; Barclays said in the report that Apple would only need to capture 5 percent of television buyers to reach this goal.
So where's the Apple television? The company still has quite a bit of work to do on the project...The company is now close enough that it could announce the product by late 2012, releasing it to consumers by 2013.
So, then, what about the rumored iWatch? Doesn't that meet the revolutionary innovation criteria? Yes, and no. Innovation it is, but Apple is not alone in the burgeoning field of "wearables." This New York Times article gives some of the perspective. (Note that this is the same author, only he now puts Apple into the industry mix rather than on a pedestal.)
Disruptions: Where Apple and Dick Tracy May Converge (February 10, 2013)
While Apple continues its experiments with wearables, its biggest competitor, Google, is pressing ahead with plans to make wearable computers mainstream.
According to a Google executive who spoke on the condition that he not be named, the company hopes its wearable glasses, with a display that sits above the eye, will account for 3 percent of revenue by 2015. Olympus is also working on wearable computers.
Google is holding private workshops in San Francisco and New York for developers to start building applications for its glasses. At the event in San Francisco last week, Hosain Rahman, chief executive of Jawbone, the maker of the Up, a wrist device that tracks people's energy and sleep, said that "a decade from now we won't be able to imagine life without the wearables that we use to access information, unlock our doors, pay for goods and most importantly track our health."
In other words, everybody's talking about all kinds of wearables, not just watches. So, iWatch could be a nice product for Cook to reveal, but we shouldn't expect the audience to gasp in amazement. Perhaps that's going to be the view of Apple's innovations in the future: nice, but not dazzling.
4. Culture - Cook's Apple appears to be pulling away from the legacy of Jobs' Apple
Tim Cook is certainly not Steve Jobs. (Who could be?) But what about the rest of organization? What we know adds uncertainty, if not concern.
- Key staff movements and departures have changed the landscape and apparently diminished Jobs' legacy effect
- Meetings and presentations without Jobs' compelling innovation-cum-marketing style make his absence clearly felt
- The release of ho-hum improvements and the flawed maps app have adversely affected Apple's front-runner image
These cultural hits have a serious outcome: a diminished "cool" factor. This coolness is the Apple-generated feeling of being with a natural leader who knows where to head and how best to do it. It's been a key ingredient in Apple's sales growth, consumer loyalty and the ability to charge high prices. A good sign that Apple's coolness has waned is the spate of articles, like the one above, that now lump Apple into the Samsung, Google, Microsoft et al industry lineup.
Let's turn next to earnings, the primary driver of stock performance.
5. Earnings reports - The last three quarters' hiccups have reduced forecasts and increased uncertainty
Through the March 2012 quarter earnings report, larger-than-expected earnings were the rule. So much so that analysts and investors expected them. Then came the last three earnings reports, none of which had the expected surprise.
The effect of the non-surprise reports can be seen in the forecasts for this quarter and the next following that Dec-12 report:
As a result of the unexpected results and the increasing uncertainties given above, analysts' earnings projections cover a broad range:
These wide ranges make the median estimates unreliable. And without a good median estimate, the forward price/earnings ratio becomes unusable. Further, with broad disagreement about Apple's future earnings, the stock is overly vulnerable to investor whims.
6. Valuation - Yes, AAPL looks cheap (its P/E is near the bottom of the technology sector), but that's a sign of trouble in this market
The price/earnings ratios have come down to a low level.
For perspective, if Apple were in the DJIA, its 9.8 P/E would look cheap, ranking AAPL 4th from the bottom. Using the untrustworthy forecast earnings, its 8.6 forward P/E would rank 2nd, with Hewlett-Packard (HPQ) at the bottom. Apple's low rankings in today's stock market are not indicative of a great value. Rather, they're implying that analysts and investors see the deterioration, uncertainty and lack of progress discussed above.
7. Dividends - Neither the 2.5% yield nor David Einhorn's proposed cash payments is a good reason to buy a growth company
Looking at dividend yield, Apple's 2.5% ranks right in the middle of the 30 DJIA stocks. It's currently paying out about 25% of earnings, but some have argued for a higher payout. They and David Einhorn want shareholders to get a larger chunk of Apple's big cash pile. That's no reason to buy an uncertain growth company, but it could keep Wall Street and traders happy while the machinations go on.
The bottom line
I wish I could see a brighter future for Apple. Unfortunately, the company seems like a favorite restaurant under new management. The menu is the same, but it lacks that special something that made it the in place to go.
Tim Cook has said "wait and see" for the new TV product. At this point, that sounds like good advice for potential investors - to wait and see what Apple finally brings out. Is there a truly revolutionary innovation in Apple's future? The best we can say is it's uncertain. Meanwhile, we are seeing the natural erosion of growth rates without new products.
Let's say there is some new product whose innovativeness reminds us of Steve Jobs' heyday. Will the stock skyrocket overnight, leaving us kicking ourselves that we didn't buy now? Perhaps, but not likely. Chances are we can have our cake and eat it too by waiting. When a new product arrives, we probably will have the opportunity to analyze its impact on Apple and then, if we want, buy AAPL at still attractive prices.
The reason? These days AAPL is a stock non grata to many analysts and investors. Previously burnt, analysts are less willing to make high growth estimates until they see the results. Investors, many with oversized, underwater holdings, would be happy to have a chance to lighten up or bail out altogether. Instead of "buy the dip," the catchphrase likely will be "sell the bump."
Additional disclosure: Positions held: 100% cash reserves