Apple (AAPL) reported its Q3 2012 earnings yesterday (this was the fiscal 3rd quarter for the company), and disappointed investors on nearly every metric it possibly could. While the investing world has spent most of 2012 adopting Apple as its growth darling for the next few years, and pricing it accordingly, it appears that the old laws of investing still apply: one cannot grow until infinity. While no one can really question how great a company Apple is, the stock still appears to be overvalued in our estimation, and could suffer substantially as both their earnings prospects and the general global economy declines.
Shown below is a chart of Apple stock.
We previously wrote on March 19, March 21, and April 18 that we believed Apple to be in a speculative fervor, and recommended bearish options plays. We believe the timing of bearish trades on Apple is even more favorable at present time.
Simply speaking, there are only two ways a stock can advance: either the stock can grow earnings or it can grow its valuation (i.e. P/E ratio). In Apple's case, its valuation has actually declined even as earnings has gone through the roof. This factor has led many observers to believe that if and when investors place a prior valuation multiple on Apple again in the future, the stock price will be substantially higher than what it is now. However, this expectation ignores many key points.
First of all, the larger a company gets, the more difficult it is to grow earnings and revenues. This makes basic sense, as the more of a market's share you grab, the more difficult it is to take the next marginal percent. Considered from a different standpoint, the higher your earnings, the more you have to earn in absolute terms to maintain the same growth rate.
While nearly every other company in the market exhibits the characteristic of falling valuation as size increases, Apple has bucked this trend. For example, the Dow Jones Industrial Average is made up of 30 very large companies. Consequently, the DJIA trades at a 12.66x P/E ratio, whereas the S&P 500 index, which includes many smaller companies, trades at a higher 13.55x P/E ratio. The Russell 2000, which contains only small cap companies, trades at an even higher 14.76x P/E ratio. The market understands the concept of reduced earnings prospects as a company grows very well, yet has not applied it nearly as drastically to Apple to date.
Even after today's decline, Apple trades for 13.5x earnings, well above the Dow Jones, and in line with the S&P 500. While this might seem right, Apple's earnings growth prospects are much less than many small companies in the S&P 500. Even if Apple can make their earnings expectations for 2013 and 2014, they will be growing earnings at 17-18% per year. While this is nothing to sneeze at, this is a huge dropoff from the 141%, 83%, and 65% we saw in 2010, 2011, and 2012, respectively. Apple's earnings growth is clearly dropping as the company grows, yet the market is willing to pay an average multiple. To explore why, it is helpful to consider Apple's main markets.
The amazingly successful growth story of Apple must be attributed to two main factors: getting existing Apple product owners to upgrade frequently to newer versions of the same product, and expanding into new consumer markets (i.e. getting new users on the Apple platform). This formula has resulted in consumers waiting for days outside of Apple retail stores just to be the first to get a new product, and other amazingly successful corporate stories. However, there is reason to believe the tide may be turning on this front.
While expanding into emerging markets has been Apple's (and every other company on the planet's) preferred growth strategy, the addition of emerging market consumers may not be nearly as profitable as the pickup of developed market consumers was over the past few years. The reason why is simple purchasing power. While Apple has touted its growth prospects in China many times in the past, the fact remains that Chinese per-capita income is only $5,500/year. While Apple's products are so incredibly popular that many consumers who are not well off are still willing to purchase iPhones, will they be willing to buy news ones just a year later as American consumers have demonstrated they will? The answer remains to be seen, but there is reason to believe from Apple's numbers yesterday that the answer may not be positive.
Shown below is a table of Apple's geographical sales breakdown over the past 3 quarters.
As can be seen, the most significant sales slowdown from last quarter to this quarter was in the Asia-Pacific region. In fact, the amount that sales dropped by in the Asian region was equal to nearly the amount that Apple's revenues missed estimates by (~$2 billion). Especially considering that China has been a highly targeted growth market for Apple, this news is highly concerning.
As we discussed above, Apple needs either new users to buy iPhones or existing users to upgrade. As we pointed out, it may be asking too much to expect Chinese consumers to upgrade with the same frequency as US, but it also appears that Asian markets may be reaching saturation. While many analysts have blamed the softness in Apple's results on the impending release of the iPhone 5, if Asian revenue drops by nearly 1/3th every time there is not a new product release by Apple, how will Apple be able to grow earnings over the coming years? Even worse, the iPad did not even start selling in China until this past Friday, so the Q2 2012 results in Asia can only be attributed to the addition of major new carriers for the iPhones along with sales subsidies. If the effect of these carrier additions is wearing off this quickly, this cannot be a good sign.
Product segmentation is also showing concerning divergences. Shown below is a table of Apple's revenues by product.
As can be seen, Apple's overall revenues dropped substantially over the past 2 quarters despite introducing a new product, the iPad3, in that time span. It appears that the iPad can no longer be a primary driver of revenues. Despite the iPad 3 being released in March, iPad sales over last quarter were only the same as the quarter ended on 12/31/2011. This is concerning news given the fact that numerous commentators were claiming the new iPad to be a game-changer in many new growth industries for Apple, such as retail and others.
The iPhone looks to be increasingly Apple's only hope to grow earnings, but that is not great news. Analyst estimates for iPhone sales this past quarter were around 28.5 million, yet they came in at only 26 million units sold. Going forward, Apple needs to be able to increase iPhone sales in order to meet their earnings estimates, but exactly how they plan to do this is unclear.
Constantly relying on bigger and better product launches to satisfy growth is a very dangerous game. Among the risks are saturation of the market, a plateauing of the innovation curve, and lukewarm response as compared with previous launches. Apple appears to be suffering from all 3 of these problems. The US and developed world market appears to be highly saturated, as evidenced by the 28% revenue drop in the US over the past 2 quarters despite a major product release in that time span. As we highlighted above, the Chinese market may be becoming saturated as well, and the prospects for existing Chinese owners to upgrade is not nearly as good. The innovation curve is also becoming much flatter for Apple, as evidenced by the lukewarm response to the iPad 3 as compared to the iPad 2.
With all these problems, we struggle to see how Apple deserves a higher multiple than the next largest company in the US, Exxon Mobil (XOM). If Apple were to trade at the 10.2x multiple that XOM trades at, Apple stock would be at $433.90 now, and advance to only $464.61 by the end of the year. Before readers scoff at the assertion that Apple could trade at the same valuation as XOM, consider that AAPL is trading at only a 14x multiple even as they've increased earnings at absolutely huge growth rates over the past few years, averaging 80% over the past 3 years. What multiple would investors be willing to pay if Apple earnings growth was to move back to single-digits or even stagnate altogether? In such a scenario, a 10x multiple may actually be too generous.
When also factoring in the large headwinds in place in two of Apple's largest markets, Europe and Asia, the story for Apple going forward does not seem incredibly bright.
For most investors, we would advocate liquidating positions in Apple stock for the time being. For more aggressive investors, a short position in Apple stock either through the purchase of put options or an outright short position could be profitable. Given that today is the first time since December 2011 that Apple stock has violated the 100 day moving average (a level that has served as support over the past 3 months) , there is strong technical reason to believe that a selloff in Apple stock could continue.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in AAPL over the next 72 hours.
Additional disclosure: I am long put options on AAPL.
Disclaimer: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.