Apple Shareholders: Do Not Hit The Panic Button

Jul.27.12 | About: Apple Inc. (AAPL)

On July 24, 2012, Apple (AAPL) released its Q3 2012 results at the closing bell. Apple (AAPL) reported $8.8 billion in net income on $35 billion revenue. The $8.8 billion earnings mark breaks down to $9.42 in earnings per share. Prior to this earnings release, a CNNMoney poll of 68 analysts expected $11.87 Q3 EPS on average. Thembelani Kewtane of The Braeburn Group set the high water mark with his $13.85 projection, while Morgan Stanley's (MS) Kathryn Huberty bookended the low end at $9.45.

In any scenario, Apple's Q3 financials badly missed earnings expectations. Immediately after hours, shares lost twenty-five points and collapsed from $600 to $575 during the conference call. For Apple bears, of course, this decline was inevitable. The catcalls to shout this stock down began in 2007, after a fawning New York Times piece described the Apple movement as a "cult becoming a religion." Today, Apple boasts of a $540 billion market capitalization that values it as the world's largest corporation.

Nominally, Apple's 2012 run from $353 to its $644 April high has been nothing short of spectacular. Amid increasing volatility, long-time Apple investors will be tempted to hit the panic button, abandon ship, and cash out. I, however, would argue that Apple remains fairly valued. At its absolute worst, Apple will match Microsoft as an investment where shares would merely track the S&P 500 and kick out dividends. At best, Apple will retain its monopoly on "cool" and generate substantial wealth for shareholders over the long term.

Apple is Still Cool

The spirit of Steve Jobs lives on. Despite its market dominance, Apple still retains its brand appeal as an ode to the counterculture set. This je ne sais quoi locks consumers into a closed circuit loop of integrated Apple products. A day for your typical hipster might include making a trip to the Apple Store, downloading music from iTunes, finishing a Great American novel on the iPad, and taking calls from the Apple iPhone. In business terms, "cool" translates into pricing power and fat profit margins. Consumers will happily buy in at any price to join the movement. For Q3 2012, Apple still registered gaudy 43% gross profit margins. This mark compares favorably to the 42% margins in the year-over-year quarter.

Rather than losing share to competitors, Apple is actually cannibalizing its own profits. For example, Apple iPhone sales in the third quarter came in much weaker than projections, as consumers await the much-anticipated Q4 2012 or Q1 2013 release for iPhone 5. Still, Apple managed to sell 26 million iPhones in Q3, which is a 28-percent increase above the year-over-year period. Apple iPhone sales account for roughly 60 percent of profits and are especially important.

The upcoming iPhone 5 launch will not necessarily be a game changer, but it will put Apple back on track for another blowout quarter. As always, Apple is taking care to lower expectations. Peter Oppenheimer, CFO, announced Q4 expectations for $7.65 earnings per share on $34 billion revenue. After this latest disappointment, financial analysts will also be scrambling to revise forward expectations downward.

The Competition

Apple's success has made some of its very own products obsolete, in regards to any growth story. The revolutionary Apple iPhone is able to make calls, download gaming software applications, and play music. As a mini-computer, these features overlap the iPod and iMac platforms. In Q3 2012, Apple sold 4 million Macs and 6.8 million iPods. In terms of units, Mac sales improved by 2 percent year-over-year, while iPod sales declined by 10 percent. These formerly blockbuster hits are nearly immaterial to shareholder returns. The stock market mechanism discounts future growth, rather than flat sales.

While iPhone sales steadily roll along, Apple shipped 17 million iPads this past quarter for an 84-percent year-over-year increase. At present, Apple is the focal point for a technology war fought on two fronts. Google (GOOG), Samsung, Microsoft (MSFT), Research in Motion (RIMM), Nokia (NOK), and Amazon (AMZN) have closed ranks to challenge Apple's dominance above the smartphone and tablet market. The competition, however, has destroyed its own self through its copycat ways. The technology business proves that "cool," hefty profit margins are applied to alpha leaders, and not beta followers. Apple's success radiates from a culture that introduces must have products to the marketplace that we never dreamed would ever be essential.

Apple's 2006 "I'm a Mac. I'm a PC" advertising campaign was indeed, prescient. In a slew of devastating commercials, the chic Apple blackballed Microsoft as a functional, but dowdy enterprise unable to get with the times. Years later, Microsoft has perpetuated that message with its bungling of a tablet device alongside a disastrous Nokia partnership. According to Bill Gates, Microsoft's early forays into tablet computing were "almost painful to recall." Today, numerous consumer reviews indicate that the Microsoft Surface is no match for the Apple iPad.

In the smartphone sphere, The Wall Street Journal reports that Microsoft refuses to offer a Windows 8 update on existing Nokia Lumia phones, while also agreeing to provide software to Huawei Technologies, a Chinese handset maker. Yes, Microsoft has effectively abandoned ship and opted to compete against its own partner. Yet again, Microsoft proves that profitable business execution relies upon more than simply throwing briefcases full of cash at a problem.

Apple operates with little to no competition in the market for premium consumer electronics. Google, Samsung, Microsoft, and Amazon will design practical machines to battle over price-conscious consumers, while Nokia and Research in Motion are simply fighting for their corporate lives.

The Bottom Line

Despite the quarterly earnings miss, Apple's financials remain impressive. At $575 per share, Apple trades for fourteen times earnings. This price-to-earnings ratio is wildly cheap, considering the fact that Apple is averaging 66 percent annual profit growth over the past four years. For the sake of comparison, Amazon shares price out at 180 times earnings, although this corporation only averaged 12 percent annual profit growth during these last four years. Broken down further, Amazon's expensive price comes on the heels of a 54 percent profit decline over the past year.

Apple carries $117.2 billion in cash and securities on its balance sheet. This figure is up significantly from the $81.6 billion in cash and investments at this point last year. $117.2 billion in cash and investments above 936,596,000 shares outstanding calculates out to be $125 per share in cash. If Apple were to effectively pay off its $51.2 billion worth of liabilities, it would still be left with $66 billion, or $70 per share in liquid investments. According to Wall Street, Apple's future earnings power is worth a mere $500 at most.

Apple stock is cheap as a long-term holding. At the very least, we may bide our time with a 1.8 percent dividend yield upon investment. 1.8 percent is far more attractive than zero upon competing fixed income.

Disclosure: I am long AAPL.