Apple: Biting off More than It Can Chew?

It seems as though everybody and their mother has an opinion on Apple’s (AAPL) stock price these days. Well, at least everybody and their mother owns an iPod, and over the past six months, the stock has been the darling of Wall Street.

Since mid-July, shares have gained around 60%, profits have seen outstanding growth and their products epitomize ‘cool.’ But is Apple’s premium stock price warranted? Its valuations are high and dependent on outstanding future growth, which will be hard to deliver.

Apple’s most recent quarter saw year over year computer growth of 28 percent and iPod growth of 50 percent. Pretty impressive numbers, but can that kind of growth be maintained? When announcing the earnings, Apple lowered its guidance for the upcoming quarter, negating any push the stock might have received from the most recent quarter’s results (in all likelihood the results were already priced into the stock).

Getting Crowded in the Market
The Apple fanatics will come out and say that “they always put conservative estimates out” and that it shouldn’t be a sign of slowing growth. However, if we look at Circuit City (CC)’s MP3 sales, they were flat year over year and Best Buy (BBY)’s consumer electronics saw a modest 8.5% gain, mostly attributed to flat-panel TVs. The market is becoming saturated and a large portion of those 21 million new iPod users were gift recipients or consumers who are just finally catching on - people who aren’t going to drop another $300-400 on Steve Jobs’ latest masterpiece.

If we look at the latest product introduction, the iPhone, it is impressive, but that doesn’t cut it. The Blackberry dominates the business marketplace and you’ll be hard pressed to find a company willing to shell out the money for an iPhone, let alone a “Crackberry” user who wants to switch interfaces. The Treo has also established its presence in this marketplace. The iPhone is much larger than other music phones, granted it does have more capacity (4 or 8gb), but where does that added music capacity land it? No man’s land.

It doesn’t hold enough to satisfy the music junkie (who would have to carry around two “bricks” in his/her pocket, with the iPhone and an 80 gig iPod), while holding more music than someone, who just wants to load a few playlists, needs. Verizon (VZ)’s disclosure that it turned down the iPhone is also an indication about expected profitability. Clearly Verizon has a solid place in the smart phone market, but if they projected the market for the iPhone to be huge, they would’ve found a way to deal with Jobs’ stipulations.

Also, the set price of $499 hurts Apple when consumers shop around for phones and find something with similar features going for $50-200. With margin contractions hitting the cell phone market and causing makers to halve their prices, this isn't the spot that Apple wants to start in.

Pricey Fashion
During this last quarter, Apple saw incredible growth. But that growth isn’t sustainable, as Apple will have to cut its margins to keep bringing in new customers. Their products are trendy and that will win buyers over in the short term: those who are willing to pay the premium price for the image that comes with owning an Apple product. They have been banking on this with their “I’m a PC/I’m a Mac” commercials, which brilliantly display the PC as a dorky, fashion-impaired thing of the past.

Eventually they will have to lower the price though, as the large number of PC makers operating on Windows has the ability to offer bargain prices in comparison to a Mac. When you bring Vista’s potential impact into the equation, all of this makes Apple’s valuations look a bit high.

Of course, Apple fanatics will scream and shout, pointing to features and ease of use that aren’t found anywhere else, all the while hailing Steve Jobs as immortal. People who thought Google (GOOG) was overvalued when its P/E was at 30 might also chime in. It goes without saying that Apple is a dangerous company to doubt and will always have its core group of buyers who don't flinch at the price premium. In conclusion, we can see that the iPod's growth will slow and it will face legitimate contenders. Those who doubt the latter should look at Apple gaining share of a market once thought impenetrable by Microsoft (MSFT)'s trumpeters.

In their other markets, their margins will have to come down for them to keep sales up. There is a lot of hype around the company (just watch the MacWorld video, I think there's a standing ovation after each sentence Steve Jobs utters) and hype can lead to big profits, but it can also precede a big drop (see: tech stocks in 2000). I'm not saying Apple makes a good short right now. But if there is a big run up in the price to the mid-90's and above, I would seriously consider it.

AAPL 1-yr chart

Comments

[Julian Ivan...:]

AAPL's PEG is 1.3. AAPL's forward PE is 22. AAPL grows earnings by 30-40% YoY for last 4-5 years. AAPL saw growth of almost 80% YoY last quartter. AAPL guided for 30% YoY growth for this quarter, its "traditionally slowest."
The iPhone, even if it just meets Apple's own sales targets, stands to boost earnings by between 30-40% annually. Possibly more if sales are more.

Someone tell me that doesn't add up to a grossy underpriced stock.

2007 Feb 05 02:07 PM

[Hayweed:]

The author assumes that all mp3 players are the same thus a commodity (kind of like PCs). Problem is when things are a commodity they are boring and people want something better. If cars were the point of this article then BMW, Porsche and Mercedes should be out of business but last time I checked Porsche was making a ton of money on a very expensive car compared to the Mustang or Corvette. Why, quality, product perception, and consumer desire. Apple figured this out and the gray box makers have not. Why is Gateway such a cheap stock, nobody needs it since you can get the same thing from HP or Dell. Apple is different and thus can have margins.

As for price erosion, Apple keeps holding the price and adding better features. My 5gb ipod from October of 2001 was white with a gray screen and black letters. Last year I bought a 60gb Video Ipod black for $400.00. Price is the same, product is way better.

Lastly, I paid $400.00 for an ipod, so why is $500 to $600 for a phone with the internet and a music player on it so expensive. Trading stocks on my Sony Ericsson phone is so tedious and time consuming that I can't wait to drop it from a tall building.

2007 Feb 06 05:59 PM

[Dan Poarch:]

Yawn.

The iPod continues to succeed in a market flooded by cheaper options. iPod sales will slow for sure, but there's too big a bed of users that will upgrade their iPods to make that slow-down anywhere near catastrophic.

The iPhone is for people that don't currently own a smart phone. Just like the iPod was for people who didn't own an MP3 player. As I've said before, lack of Exchange Server integration is an iPhone FEATURE. The iPod was useless to corporate users too, but they all seem to own one.

I am always shocked by Wall Street's love for lack of innovation. Verizon is a large bear with it's hind hanging off a log, sitting around waiting for the breeze to blow. Verizon's move is proof to me that Apple is right. To wit, a company like Verizon lacks hunger for risky growth, latching onto troubled Cingular and giving it something to use as a springboard is a wise decision. Apple's value is it's ability to wait and make wise decisions, not its rush to make obvious ones.

Vista is the best thing to happen to Apple. Did you know that when you install Vista on a MacBook Pro it comes up with a 4.5/5 rating for Vista compatibility? Your average year-old Dell not so much. Whether this sends people to the Apple Store I don't know, but it's yet another thing consumers will see and think to themselves, "Why not just buy a Mac?"

While I complement you for leaving off yet another misguided slam on the 2MP camera on the phone, I once again find an article that could have been written 5 years ago being peddled as news. Sorry to be snide guys, but I came to Seeking Alpha looking for astute journalism. Perhaps I should lower my standards.

2007 Feb 05 02:30 PM

[Tim Hussar:]

My point regarding the iPod is that 1.) the market is saturated and 2.) it has been on top of the pile too long. Sooner or later a viable alternative will grow in popularity. The majority of iPod users aren't died in the wool Apple fanatics who would refuse to look elsewhere. Also, how was the iPod useless to corporate users?

In regards to Vista being the best thing for Apple, you're comparing a new MacBook Pro to a year old Dell...thus your argument works just as well for traditional windows computer...why not just buy an HP/Gateway/Dell/IBM/Ac... that is duking it out in price competition.

2007 Feb 05 03:51 PM

[Tom B:]

"However, if we look at Circuit City (CC)’s MP3 sales, they were flat year over year. "

Does Circuit City sell iPods, that is, is this observation relevant?

"it has been on top of the pile too long. Sooner or later a viable alternative will grow in popularity"

Maybe. Can you show me a player NOW that is even 1/10 as good? HMMMM-- didn't think so.

"iPhone, it is impressive, but that doesn’t cut it. The Blackberry dominates the business marketplace and you’ll be hard pressed to find a company willing to shell out the money for an iPhone, let alone a “Crackberry” user who wants to switch interfaces"

Ummm-- the iPhone isn't a release product yet. Don't you think that might be a factor in the Blackberry's current success? As for the changing interfaces arguement-- most Blackberry users switch between Blackberry and Windows or Blackberry and Mac easily enough-- the iPhone interface looks like it has a shallow learning curve to me.

"Pricey Fashion"

Arguements about PCs being cheaper than Macs are absurd; the diffference in price is negligible while the difference in QUALITY (of the hardware AND the OS) is ENORMOUS. Let me point out the obvious: over 90% of people still use Windows. This presents a HUGE potential upside for Apple. HUGE. Do I believe 90% of people will be using Windows in 5 years? Hell no! Look at Vista-- 5 years in the making and what do you get -- nice eye candy? Yes? Modern, UNIX-based secure OS-- NO. Same old warmed-over NT.

2007 Feb 06 08:47 AM

[Michael Ch...:]

Look around, i think you will find some rock solid commentary. Obviously there is good and bad.

As to this article specifically, its a rookie assesment. Apple fanatics abound. However, i take note in the recent rise in negative sentiment regarding apple. Its arguement is too simplistic. iPhone is too expensive? Cmon. Pricing in mac book? Cmon. They have the best margins in the business. In fact it is the only PC company with any semblance of pricing.

The biggest mistake in this analysis as i see it, is its complete neglect of the Apple TV product. Shorting apple in the mid 90's is highly unlikely to net you anything but a loss. Apple has made its play to become the defacto distributor of video content. If you have used iTunes you will understand how large this opportunity is. Sure iTunes is not a major earnings driver, however, it has helped drive ipod sales. The video opportunity stands to be even bigger than iTunes, driving both hardware sales and content alike.

Apple has unbundled video. Whether or not they ultimately win as the standard for video content distribution, is anyones guess. But there is one thing certain. Now (or even the mid-90's) is not the time to short apple. not even close. They are on the verge of a major technological and sociological shift. Think about it. They just made a play to become Comcast and DirectTV. Victory may be 2 years out, but its here now. And if they begin to show signs of life in this battle, you will see a lift in price. The market for distributing DVDs and Television is much larger than even iPod. Controlling content has numerous intangible beenfits. And with this platform, distribution is easily scalable to a GLOBAL level.

For those of us who do not soak up 8 hrs of programming week, the decision to rid ourselves of our monthly Comcast bill will be easy. Why would i pay 100 a month for something of which i use 3% of? the answer: i wouldnt. And i wont. And im not alone. Buying the episodes of the Wire and being content with that, will save me some bucks, and make Apple some money. Its a simple concept, but investing in apple takes a simple approach, must liek its products.

Of course, apple has its work cut out in the meantime. Like signing up networks and production companies. Now if they fail in that; u may have a shortable idea. But shorting on its valuation at 95 is a dangerous game. This stock is expensive for a reason.

2007 Feb 05 04:01 PM

[Tim Hussar:]

I agree that it is a dangerous game, thus the statement that "apple is a dangerous company to doubt." I should clarify that long-term (year and half and up), I don't think Apple is dead money, but the last time Apple shot up to 95, we saw that it became a good short.

2007 Feb 05 06:28 PM

[Christopher...:]

Tim - I know you kind of chicken out at the end about shorting Apple, but in my opinion, Apple really isn't a good short. Sales and margins are strong. They are gaining market share and the company has a slew of new products. There are better shorts out there right now.

Lots of people said no one would buy a $1,500 tv either when you could get them for

2007 Feb 07 01:23 PM