Apple: Great Company with Lofty Valuation - Due for Pullback

Apple (AAPL) seems to do no wrong. The shares have vaulted nearly 50% since their March lows and the 3G iPhone is the current rage. The hype is at unprecedented levels, resulting in an analyst love-fest that is in full swing. Is another classic case of 'pump and dump' developing?

The case for the iPhone: There is ample opportunity for AAPL to penetrate and make further inroads within the corporate market segment, and in the process, take substantial market share from Research In Motion (RIMM). In fact, HSBC Bank is contemplating switching from RIMM's blackberry to AAPL's iPhone. This change alone could amount to a 200,000 unit order, however much of these potential orders could already be factored into the current share price.

Valuation is rich: Could AAPL start to sour? Everybody and his brother is tuned into the fact that AAPL management typically under promises on its guidance in order to over deliver. Most savvy investors can see right through this quarterly façade and likely incorporate a 10-20% "beat" modeled into the actual earnings results. The company is very reliable at beating estimates, however, and often the share price dives just after the release, as the phenomenon of "buy the rumor, sell the news" rears its ugly head. The analysts certainly appear to pander to management's guidance and sandbag their estimates to coincide. The consensus of 2008 earnings expectations of $5.21 and 2009 estimates of $6.06 (YOY growth rate of only 16%) compute to forward PEs of 34 and 29 which are on the high side compared with Google's (GOOG) forward PEs of 21 and 26. If you decide to "play the game" and pad the earnings estimates an additional 10% to offset the lowball guidance, you still end up with steep forward multiples of 26 and 31.

Insiders are heavy sellers: AAPL insiders have been on a recent selling spree. In just the last 6 months insiders have sold nearly $175 million worth of shares. Why are they selling? Do they know something the rest of us do not? Anthony Fadell, a Vice President, recently sold 71,500 shares on 8/11 at $172.49, after exercising an option to purchase 71,500 shares at $14.03 per share—this single payday of $12 million makes superstar athletes compensation look pale in comparison. The exercise of options creates three negatives (1) More shares are added to the supply (2) the added shares cause earnings dilution. (3) the company incurs payroll taxes on the gain that the employee realizes.

iPod and Mac: The success of the iPod is fleeting, as its market has been saturated. Its status is now similar to a star NFL running back entering his tenth season. The poor overall economy is bound to eventually slow Mac's desktop and laptop momentum, and the company could be forced into a price cutting mode to combat soft demand.

Wild cards: Will Steve Jobs be able to maintain his health? Will AAPL be successful in a timely manner in eliminating the glitches surfacing with the debut of the 3G iPhone? How much will the recent strength in the US dollar hurt AAPL's international sales when those foreign currencies are exchanged back into US dollars?

Bottom line: Don't get me wrong, I certainly think AAPL is a great company, I just don't like it at the current share price, as it has simply gotten too expensive by rising too far in too short of a time frame. I also think that some "weakening" of the fundamentals could begin to creep into the equation. The shares are overbought and due for a correction. The risk simply outweighs the reward at this juncture and a 10-20% drop is plausible.

Disclosure: Short AAPL

Comments

[Fedman]

Just one observation. Am I the only one who wonders why the pe of AAPL is always compared to GOOG? They are in very different businesses almost to the point where, I think, in the future, people will say, "Listen here. You got it all wrong. You're comparing apples to googles."

Anyway, other than that, I appreciate you points.

2008 Aug 18 07:30 AM

[Othmar]

You are such a negative and US centric person! Do you REALLY think the world market for iPod is saturated? Just think of Turkey, China - think of the World! There is a demand for iPhones, iPods and Macs out there, that's even bigger than the US sales up to now were! So - there are no weakening fundamentals, no saturation - I just see a person who is either short on AAPL or wants to buy some more on a lower price.

2008 Aug 18 07:53 AM

[kmg]

you do seem to cherry pick your information...so, if you have options that are expiring, and you exercise them (after which the company sells 1/3 to pay your taxes), that is insider selling? After all, had you not exercised them you would lose ALL the proceeds? You forgot to mention, or notice, that apple has 23 dollars in cash per share, and that they haven't yet accounted for the full iphone revenue, they have only accounted for half of the proceeds from iphone sales from LAST JULY, not to mention the ones they have sold this year...
good luck on your short, lets hope you have a tight stop

2008 Aug 18 08:07 AM

[uncle]

You fail to mention the over $23 per share that AAPL has in cash. This is not an insignificant amount should help ease your P.E. worries... And for a company that still seems to be growing at over 30 percent annually - with a tiny market share in their main business makes for a company that has a potentially very bright future that should be reflected in the stock price and valuation.

2008 Aug 18 08:07 AM

[bluemarlin1402]

"The poor overall economy is bound to eventually slow Mac's desktop and laptop momentum"

This statement, based on your personal opinion, has not been backed up by fact. The economy has been constrained all year and Mac sales increases have been triple the overall market PC market

Anyone can have an opinion, but when it is not back up by real world observation, you just look stupid and uninformed.

2008 Aug 18 08:09 AM

[Yo Bob]

>> The exercise of options creates three negatives (1) More shares are added to the supply (2) the added shares cause earnings dilution. (3) the company incurs payroll taxes on the gain that the employee realizes.<<

Payroll taxes? Get in the ball game. What about the huge tax deduction that the company gets with no cash outlay! The in-the-money element is a tax deduction to the company (and compensation to the employee).

I think that you're grasping at straws to put an unnecessary spin on AAPL. By the way, if AAPL can dent RIMM (and I think that they can jackhammer them within 3 years), what will this do to their earnings?

2008 Aug 18 08:12 AM

[jancarl]

There is are many points raised in your article. Many I disagree with, some not. But you are definitely wrong on the part about Apple's tax liability on exercised options. The person who owns the option pays the income tax out of proceeds, not Apple. Payroll taxes are not a factor.

Also, unless you have a very short time horizon. I would not bet against Apple exceeding its previous high within the next year. That still a significant gain form this level.

2008 Aug 18 08:20 AM

[Johnnymack]

junk journalism. Anything positive is already factored in the price, right? sure.
"recent strength of dollar" will hurt Apple's exports? give me a break! look at a 2 or 5 year chart of dollar vs Euro.
And I always love "Inside Seller" theories! "What do they know that we don't???" well, lots I'm sure, but if they start buying or selling based on inside information, their entire gain will be eaten up by legal fees and fines, and they will be having tea with Martha!
Hey! Look back at Ron Johnson (Officer), and his direct sale of 470,000 shares in Feb 07 ! He sold at $86 for a cool $40 million !
What did HE know??? I'm not sure, dut I guess he DIDN'T know that AAPL was going to touch $200 last Christmas!
So much for reading into Insider Trading.

2008 Aug 18 08:21 AM

[Richard Hyde]

Honest comments from someone who says he is short and I think these are fairly common among many who view Apple with skepticism. However like all the other analysts except Piper's Munster, Mark is trying to template a run of the mill technology company metrics to the one company that is truly is making things very different in terms of outsized growth. Apple's iPhone projections are NOT in the price, analysts are only projecting 10M in sales this calendar year...it is likely to be at least double that and then double that the next year (20M in 08, 40M in 09). Best Buy will sell them next month along with 22 new countries worldwide. Lines are still out the door at many apple stores. NPD and other IT intel firms report no slowdown in Mac growth, which both domestically and internationally show a growth rate of 35-40% year over year. At the same time, Microsoft, its leading competitor has a product (Vista) that by all accounts is a dismal failure. New lines of business such as movie sales/rentals and the Apple App store are beginning to gain steam and will be positive factors in Apple's earnings next year. Finally, the ipod is not slowing down. Sales indicate an 10% unit YoY growth rate based on the latest nunbers. So the bottomline is that the projected revenue and earnings numbers are woefully inadequate and therefore the current price is still very reasonable.

2008 Aug 18 08:22 AM

[VERONICA]

Well thought out piece, but there are of course, alternative points of view to yours.

Here's one... if you see value breaking technology development and inspired application, Apple is only at the tip of their iceberg. They are incredibly forward thinking and continually create unique, trend setting items that people feel they MUST have.

Since Apple released the iPod, I've been in the stock and have always made way above market. So, until their innovation and product release cycle slows or stops, I'm in like glue.
Thanks for listening.
Veronica

2008 Aug 18 08:24 AM

[Hugo van der Vlist]

So Mark Krieger is short AAPL and he writes why he thinks Apple will pull back. If AAPL pulls back that would suit him, of coursw. So why does he write this article. Is there any news in it? I don't think so.

2008 Aug 18 08:37 AM

[Anthony Dadlani]

Apple is a great company, however the US consumer and market is weak and getting weaker........Stock will pull back........but should resume its upswing towards the end of 2009

2008 Aug 18 08:42 AM

[Mark Krieger]

jancarl: You are right about who pays payroll taxes to a certain extent, however, AAPL is still responsible for paying its matching share of social sec tax, and the medicare portion has no ceiling. On the $12 million gain. AAPL would have to shell out $120K just on its matching share of medicare tax.

2008 Aug 18 08:55 AM

[Jon T]

Another analyst that measures Apple by it's P/E.

It's erroneous. Look at the cash generation machine working flat out with subscription accounting for iPhone, iPod Touch, Apple TV and Applecare

2008 Aug 18 09:04 AM

[Johnnymack]

What's all this "payroll tax" interest? It's small change!
If someone exercises options, aren't they now dealing with stock sales, subject to Cap Gains tax, and that's it?
I guess if AAPL shares STAYED at $14, so the options were worthless, we would all be toasting to the tax payments we saved, right?
I guess every silver lining has a black cloud if you just take the time to look for it!
Also, the "3 reasons" insider sales are bad really seem like TWO reasons, as the first two are sort of redundant:
- It increases the amount of shares out there
-It dilutes the earnings per share

Do I really care how many shares are out there, except that the earnings are diluted over that number? kind of redundant, and grasping, as the author realized that "two reasons insider options are bad" just didn't have the "zing" that THREE reasons did!
So he padded the reasons.
weak.

2008 Aug 18 09:13 AM

[Shorting Should be Banned]

There is a counter point to negate every one made in this article. The one I will focus on is "heavy insider selling". In the past six months those sales were at prices ranging from $140 to $172, AAPL closed last Friday at $176, so what is the significance of this selling?
People have to exercise options if they are about to expire. Personal income taxes have to be paid on the gain, and where will the cash come from to pay these taxes??

2008 Aug 18 09:22 AM

[mrtaxx]

Surprise: Author write a negative article and is short the stock. Writer is obviously acting to lower Apple's stock price, disgraceful

2008 Aug 18 09:24 AM

[WACG]

Options DO NOT increase the number of shares. Options DO NOT work that way. Get a clue.

2008 Aug 18 09:26 AM

[Andy Zaky]

I rest my case. Add Mark to the list of writers who have absolutely no clue:

seekingalpha.com/artic...

2008 Aug 18 09:40 AM

[brewer]

I could not disagree more with this analysis. To me, it's extremely short sided, doesn't factor in iPhone revenue, and the timing is horrible.

Short Apple in Fall? Last year it was up practically every day, it was unbelieveable. I think this fall will be bigger, because the iPhone sales are off the hook, and Mac sales will be much higher than ever because they included iPod touch or nano with every back to school laptop or iMac. I am on a campus in the midwest. We used to rarely see Apples, now most of them are Macs. This has all happened in the past two years, and again, last year was a phenomenal fall for Apple.

Good luck with your short, lots of people, no doubt, would love to get in cheap though, so I wouldn't wait too long to buy if I were you.

2008 Aug 18 09:46 AM