Apple: Not All Smooth Sailing Ahead

Once again, Apple (AAPL) impressed investors with results that handily beat analyst expectations. The company continued to move iPods en masse, and sold a record number of Mac computers and iPhones, staunchly defying the drag on consumer spending that has been the bane of this economy.

There can be little doubt that Apple is a well-run, exceedingly competent company. That much can be determined with a quick look at the company's financial statements, where equity returns of around 25% are commonplace. What makes those returns even more impressive is the fact that no leverage is employed in garnering these exceptional returns: Apple has no debt!

While this means the company itself operates with very little risk, that does not automatically translate into a low risk investment. That's because it's important for investors to be able to separate a great company (which Apple clearly is) from a great stock. What makes a stock great is a price that allows investors to buy the business at a significant discount to its intrinsic value.

Is Apple a great stock? That will depend on the value of its business. For a company that grows sales and profits as quickly as Apple does, the value of its business is very difficult to determine with any degree of precision. There will be wide-ranging opinions on what earnings will be next quarter, let alone next year or the year after, making predictions of Apple's business value a difficult venture to say the least.

But what is clear is that as the stock price soars in reaction to near-term profit expectations (e.g. upcoming product launches, or increased distribution of existing products) or the expectation that near-term upward price momentum will continue, downside risks for the investor increase. Twice in 2008 (once in January, and once in the fall), Apple's stock fell by 40%. This was not an indictment of the company, but rather it highlights the risks of owning a company (no matter how great it is) at a price that makes it difficult to determine whether it is indeed under- or overvalued.

Large, institutional investment firms often have no choice: there are a limited number of large companies from which to choose, and often investments are made when it is far from certain that there is value to be had. For individual investors, however, there are far better investments available (from a value point of view), where downside risk is minimal and upside potential is strong.

There are many smaller companies out there that trade at discounts to their inventories, discounts to their receivables, or discounts to their land holdings. There are even more companies out there that trade at discounts to their earnings despite the fact that they are market leaders in their categories.

Apple's stock holds a special place in the heart of many individual investor accounts, not only due to the well-loved consumer products the company produces, but also due to the fact that it is a superior company that continues to defy expectations. But investors must keep in mind the fact that price and value are two different things: just because Apple's business value is high, does not mean one should be willing to pay anything for the stock. Investors are encouraged to put a business value on Apple, and if they cannot assert that they are buying the stock at a discount to that value, they should avoid the downside risk that may be present in the stock price by considering companies that appear to trade at discounts to their intrinsic values.

Comments

[TheClevelan...:]

Killer comments. Keep costing people money. Ignore the deferred revenue that brings the P/E below 20 against annual growth of 25%. Maybe you spend your time on a new head shot instead writing these weak articles.

Oct 20 03:30 PM

[LiberalsSuc...:]

The headline of your blog is adrift at sea 1500 miles away from Cupertino, California and 36,000 light years away from the point of your story. The headline "Apple: Not All Smooth Sailing Ahead" misleads the reader into thinking there is something wrong with the company, it's products or market. Clearly, as you point out several times, you know the company is great. Just a catchy, or startling, headline to lure readers to your blog? Well, you caught me and now I must sail on...

Oct 20 03:36 PM

[chano:]

You are articulate, I will grant you that. But your article lacks merit. You clearly do not understand Apple's true franchise. It's not about the products. It's about where Apple's true focus is centred. In that arena, they cannot fail, no matter the recent volatility in prices.
To say 'What makes a stock great is a price' is nonsense. It is about the scope of its future operations and that seems to have little to do with Macs, iPods and phones.
Even visionaries will visit an optician fttt.
You are no visionary but you do need to have your eyes tested.

Chandra Coomaraswamy

Oct 20 03:44 PM

[Brandon:]

The stock does have a valuation problem going forward. That doesn't mean it's going down anytime soon though. The upside just isn't what it used to be.

Oct 20 03:55 PM

[lh1soda:]

uh... price discount to receivables? whatever happens to "Cash is King"?

Apple has $30 Billion cash money bling bling. Generates 15X Price/FCF. Not to mention depth of pipeline. You can keep your second tier companies, I'll stay with Apple.

Oct 20 06:46 PM

[Alan Young:]

The author's thesis is very simple and clearly expressed: the stock is volatile, so you can't assume it will always go up just because the company is good. No one can really argue with this. Apple lovers, don't get distracted by the headline.

I also agree that *most of the time* a diligent stock-picker can find more value in smaller companies. But this might be an exceptional time. Today, the large-cap NASDAQ-100 index was flat, while other large-cap indices fell, and the small cap Russell 2000 fell twice as much. This is an indication that big money is moving out of small caps, into large tech stocks. The next quarter (or longer) could be particularly rough sailing for the small-cap value investor.

Oct 20 10:03 PM

[Roger Knights:]

"I'd rather buy a great company at a fair price than a fair company at a great price." (W Buffett)

If Apple executes correctly with its iTablet, it's likely to get an iPhone-like headstart on "the next big thing." It also has great upside potential for the Mac outside the First World, if it can bring itself to license its OS to local boxmakers abroad for sales into their domestic markets. (Local governments would look on this approvingly and maybe encourage Mac purchases--especially as the Mac OS is more secure.)

AAPL's 40% price declines need to be seen in context. The first occurred when the price had gotten ahead of itself. The second occurred when there were dire rumors about the health of Steve Jobs (who was believed to be indispensable), a fear that the iPhone could be quickly equalled or bettered by competitors, and a misconception that Apple's premium products would be peculiarly vulnerable to a recession, instead of being strongly recession-resistant. Now that those worries are off the table, Apple's beta going forward isn't much greater than the other three horsemen.

Oct 20 10:29 PM

[Tom B:]

The biggest risk to Apple would be Google actually moving a whole lot of Androids. Seems unlikely, at least in the 1 year horizon. Obviously, a fair number of Windows loyalists will go out and get Win 7, but that's just warmed-over Vista-- still not UNIX; nothing to draw NEW customers or lure back lost ones.

Oct 21 12:17 AM

[mollytjm:]

Apple is a great buy and hold investment if you invest in technology companies.
This is a company that is here for the long term and will make $$$ for the investor with very little risk. Yes, it will go up and down as the world changes, but they stay at the cutting edge, they love their customers and act like it, they have no debt, huge piles of $$$, a great name, top rated products and they innovate better and faster than anyone in the business. They're going to start selling in China at 1000 difference places. They have a store planned for the Louvre. Their reputation is wonderful, worldwide. To me this all sounds like more than just a moat...this the entire castle, moat, drawbridge, and walled estate.
Can people make money investing in smaller companies? Of course there will always be the possibility of doing this. But right now, i think it also holds more risk.
If you invest in tech, can you really say the same positive things mentioned above about any other tech company? Will any of the others really make more for the buy and hold investor over the next 10 years? Will they all still be there with Apple, which will?
long APPL

Oct 21 10:58 AM

[chano:]

Agree entirely with mollytjm. Apple's success has always been due to the loyalty of its customers even through the manic, near-failure days of the late 80s and early 90s. Then there were relatively few who knew what Apple really stood for. Today that number is growing towards the billions - and the reason for this? Yes it's the products but the real reason goes far deeper with actual users. It is an addictive culture. It is about empowering the user and saving them money and giving them products that cause buyer's joy rather than buyer's remorse. It is about serving the customer in every way and even new customers realise this championing role pretty quickly. It works. It endures. It makes for lasting growth.
Which other tech company can match even one of these threads of customer-centricity?
Hint: You won't need even one finger to count them.

Oct 22 12:27 PM