Apple: Will Compressed Margins Thwart Its Growth?

| About: Apple Inc. (AAPL)

Juicy profit margins and windfall profits do not last forever. Other firms envious of the success of Apple's (AAPL) iPhone and iPad are adopting parallel, copy-cat, and legal strategies to try to capture some of Apple's thunder. Though Apple does face threats from competitors and potential substitute products, its current valuation makes it a reasonable investment.

Assaults from All Sides

Unless you have been away from the investment world for the past few years, you know that Apple really is the "it" stock among institutional and retail investors alike. There is good reason for this: 83% of the increase seen in Standard & Poor's 500-stock index is attributable to Apple, making it the highest-valued company worldwide. It's fantastic assent has perversely rewarded mutual fund managers who do not rebalance (letting Apple's gains ride) or who were poorly diversified, concentrating too much investment in Apple shares. Though many of these fortunate mutual fund managers have done well by not touching ever-larger positions in Apple, this tactic is starting to look less advantageous as Apple becomes more and more an outsized position. While Apple has dodged the bullet of slowing growth that faces most big companies, its high volume of sales has increased its share price and market capitalization, posing a risk to investors should Apple or the market as a whole drop dramatically.

Success like this attracts trouble. Third parties including competitors and collaborators won't sit on their hands while Apple shares skyrocket. Companies like (AMZN) and Microsoft (MSFT) repeatedly roll out mobile devices to try to find a foothold to compete against Apple in its own market.

Many companies try to get a slice of the Apple pie more directly, through legal means. Chinese company Zhizhen Network Technology is suing Apple over Siri, one of Apple's software programs. Zhizhen claims that Apple infringed on Zhizhen's voice technology patent for its Xiao iRobot. This lawsuit follows the close of legal action taken against Apple over the name 'iPad,' in which Apple paid $60 million to Proview Technology.

Similarly, the British courts ruled against Apple in its patent case against HTC, the Taiwanese-based maker of smartphones and tablets. As per the outcome of this court case, Apple will not be able to keep HTC's products out of the British market. This decision threatens Apple's performance in the UK, especially after dropping 6% in June with the release of Samsung's new Galaxy S III.

External Factors will Trump Internal Ones

The attractiveness of Apple's potion and the success of future product launches is clearly more a function of what its competitors do. Investors should count on Apple introducing nifty new products, and that these products will have technical issues which Apple will iron out. In addition to the much-discussed Apple TV, Apple is also rumored to be producing the iPad Mini, a smaller and less expensive iPad by the end of the year. This has become par the course for Apple, the innovation machine.

Issues such as signal strength, battery life, and device heating are routinely overcome by Apple. Most recently, Apple's third-generation iPad is being revamped to address overheating caused by the tablet's battery. By using only one LED backlight instead of two, the revamped iPad model could potentially be even lighter and skinnier than previous generations. Apple is also addressing issues with the camera lenses to improve utility as well. This new model is tentatively planned to hit stores in time for the holiday season.

Apple and Peer Valuation

Ignoring any possible continuation of its lauded growth trajectory, Apple is fairly priced:





























Research In Motion





At a 14.8 price-to-earnings ratio, Apple is priced as a firm with run-of-the-mill earnings prospects. If you factor in its historic growth, it is cheap (as can be readily seen by its price-to-earnings-growth ratio being significantly less than 1).

These valuation metrics also show how Apple could be a target. It has a very high price-to-sales ratio, which reflects the high gross and net margins enjoyed by the firm. This makes it a target as other companies try to replicate and undercut its products.

Apple's current price seems to be a balance of the prospects for future growth and a reduction in its phenomenal margins. For this reason, Apple can be said to be fairly valued. Growth investors should seek a fresh growth story and value-focused investors should look elsewhere.

Bear in mind that stocks can be cheap for good reason. Research In Motion shares dropped 19% to $7.39 on Friday June 29th. This loss followed a number of adverse statements that RIM released, including that the BlackBerry 10 would be released in early 2013 (much later than originally expected), company losses were higher than predicted, and RIM would be laying off 5,000 employees. With this drop in the market, Research In Motion's market capitalization fell to $3.81 billion. Although the company is currently debt free and still has $2.2 billion in the bank as well as a large credit line, investors are skittish about RIM's capacity to launch the BlackBerry 10 given the BlackBerrys and PlayBooks that remain unsold in warehouses.

Though the stock price has recovered, it is trading at very low valuations relative to book value. Research In Motion is now more interesting as a potential takeover target than as a growing concern based on its trailing net loss and net cash inflows. Each of these firms trades at an attractive price-to-free cash flow and a price-to-earnings multiple. If either firm can crack the mobile device market, today's investors could be rewarded very handsomely as their valuation multiples expand.

Value investors who fear mean reversion of Apple's margins should consider Dell (NASDAQ:DELL) and Hewlett-Packard (NYSE:HPQ) as potential value investments. These firms are cheap turnaround candidates.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.