The price of shares in Apple (AAPL) has fallen almost 40% from last year's high but the company has not fallen from grace for the investing public. While forecasts have come down, the average price estimate of $615 per share is still a staggering 41% off of the current price. Unfortunately, these estimates are based on a continuance of historical growth and may be overly optimistic. Near-term competitive threats make estimates difficult and the shares may be too risky for many investors with a low tolerance for volatility. Investors that still want to initiate or increase a position should look to component suppliers as a way to hedge near-term risk.
Yes, it's cheap…until
The bull argument for Apple is its strong revenue growth, amazing margins and a fan base that seems more a cult than consumers. The company has grown revenue by a compound rate of 45% over the last five years, no small feat considering a base of $24 billion in 2007. More impressive has been the fact that the iGiant has been able to do it with a gross margin around 40% over the period.
With these fundamentals, and on a trailing basis, the stock is an amazing buy. Shares trade for just 9.9 times trailing earnings, and that's before taking account of the mountain of cash and zero debt on the company's balance sheet.
The problem with looking in the rear view for your valuation model is that things can change on a dime in the fast-paced world of consumer tech. Anyone needing evidence should remember than Apple had trailing earnings of just $2.28 per share and a share price of $74.53 as recently as 2006. The bull argument on Apple's valuation is predicated on a continuation of stellar growth and margins, something that investors may not want to take for granted.
The battle with Samsung (OTC:SSNLF) is heating up with the Galaxy S4 unveiled in March and a goal to sell through 327 carriers in 155 countries. Samsung became the world's biggest seller of smartphones last year on a much larger range of low- to high-end devices. The company sold 63.7 million smartphones in the fourth quarter against 47.8 million sold by Apple.
The increased competition is causing analysts to rethink Apple's potential for growth. Total revenue surged 44.6% in 2012 from the year prior but is expected to grow only 15.3% in FY2013 on the tail end of the product cycle. Apple's gross margin slipped to 38.6% in the first quarter of 2013 from 47.4% in the previous quarter, and is expected to remain under pressure throughout the year.
The company sold only 26.0 million iPhones in the third quarter of 2012 for about $15.8 billion in sales, well under the revenue of $30.6 billion for the phones in the last quarter. The iPhone segment made up 50% of revenues in 2012, up from 42% in the year prior. This 26.0 million in unit sales may be a better estimate than the 38.2 million forecasted for the coming quarter unless the company can push through the next iteration of the phone. If unit sales do drop and margins come under pressure, the shares could easily test $400 per share or lower before reaching a bottom.
The company cut its orders for components of the iPhone 5 on January 14th on weaker-than-expected demand with orders for some pieces cut by roughly half. The shares tumbled 3.6% on the news and just barely managed to close above $500 at the end of trading.
Upside catalysts do exist
I am not saying that there are no significant catalysts for an upside move in the shares. Howard Ward, chief investment officer at Gamco Investors believes that the company will make an announcement very soon about what it intends to do with its $137 billion cash hoard and that this announcement will put a floor on the stock higher than where it is now.
Of course, any new product announcement could reinvigorate the shares. The company holds its worldwide developer conference in June, where it could potentially announce the next iPhone launch. Others are talking about September and the possibility of multiple new phones for different budgets. While lower-cost iPhones would help the company compete against the lineup from Samsung and BlackBerry (BBRY), the shares may still come under pressure if margins drop unexpectedly.
Speculators love the stock for its potential to pop and this article is sure to bring mountains of hate mail from die-hard ienthusiasts, but the fact remains that a stale product cycle, increasing competition and decreasing margins make it extremely hard to accurately forecast revenue and earnings for the next year.
Those investors with a low tolerance for volatility may find the shares too risky and should wait until management guidance on use of cash and new products improves.
A strategy for the long-term, risk-averse
Fortunately, for those looking to take a position in the shares immediately, there may be a way to mitigate the risk to weaker iPhone sales in the short term. Shares of companies that supply Apple with component parts for the phone have been volatile since Apple warned on slower sales. These companies, many with a large percentage of revenue from the Cupertino Colossus, offer the chance to hedge exposure to iPhone weakness. A list of component parts and data on return correlations for the shares is helpful in designing a hedge strategy.
The table below shows the correlation of returns for these four companies with Apple, over the last two years and since the stock's dramatic fall from grace in September of last year.
Broadcom (BRCM) is a semiconductor supplier for wired and wireless communications with system-on-a-chip and embedded-software solutions for connectivity. The company supplies the BCM5976 touchscreen controller for the phones. The chip is also used in the trackpad for Apple's MacBook Air. The shares fell a little more than half a percent (0.6%) on the announcement of Apple component cuts. The correlation of returns between Broadcom and Apple is not exceptionally high but it is consistently positive meaning that returns for the two stocks move in the same direction.
Cirrus Logic (CRUS) contributes an audio chip to the phones. The shares plummeted 9.4% on January 14th on the news of cuts to Apple's component orders and the shares offer the highest correlation of the group. Of particular aid in a hedging strategy is the fact that the correlation between the two stocks has increased since Apple shares began their decline in September.
OmniVision Technologies (OVTI) makes the image sensors for the iPad Mini and the fourth-generation iPad. Shares fell 1.0% on the January news of Apple's cuts to component orders. Like Cirrus Logic, the correlation of returns between OmniVision and Apple has increased during the downside period compared to the two-year period. At $1.38 billion and $742 million, Cirrus Logic and OmniVision are much smaller companies than Broadcom and Qualcomm and depend more highly on revenues for Apple components.
Qualcomm (QCOM) provides wireless technology and services, including the CDMA technology in most of today's 3G devices. The company supplies technology for connectivity including the MDM9615M LTE for both 4G and LTE connectivity and a RTR8600 multi-band transceiver to support ancillary networks such as UMTS and EDGE. Shares fell 1.0% on the January news of Apple's cuts to component orders. Qualcomm shares are the least correlated with Apple and has seen more divergence since September.
Selling these shares short to partially or fully cover a long position in Apple may help to mitigate headline risk of weak iPhone sales or weakening overall margins. Selling short involves borrowing the shares to sell them with the promise to buy them back later and close out the position. The investor earns a profit when the share price decreases but runs the risk of loss if prices increase. The investor is responsible for paying out any dividends issued during the period, so many short-sellers avoid shares of high-dividend paying stocks.
The caveat to a long-short hedge is that the shorted shares may increase more than the long position. For this, investors may consider buying put options on the correlated companies instead of shorting the stock. Buying puts means you will benefit from a decrease in the share price but your losses will be capped by the amount you pay for the options, all while leaving your upside potential in Apple intact.
Neither the long-short or the options strategy will remove all risk of further drops in Apple's shares. The idea is that the strategy might reduce risk enough that a retail investor with a low risk tolerance may be able to take a position in the stock without having to worry about near-term swings in the price.