Ray Merola's  Instablog

Apple Inc (AAPL) investors, whether current or prospective, may wish to pay close attention to four specific problems facing the company. I contend they are at the root of the negative sentiment directed at the shares and the correspondingly low valuation placed upon the stock price. Until corporate management fixes these issues, I do not expect investors will enjoy a meaningful rally in the shares.

As an investor, I believe it is important to understand the drivers behind a company's business. Some may auger well for the share price. Others much less so. For instance, upon the second quarter earnings conference call, CEO Tim Cook spent a fair amount of airtime extolling the virtues of the Apple eco-system, customer loyalty, company mission to improve people's lives, etc. All good stuff. However, I do not believe much of it will advance the price of the stock.

I submit here's four key investor issues, that as they are resolved, will move the stock price:

• Margin Compression
• Declining Earnings
• Perceived Innovation Vacuum
• Too Much Balance Sheet Cash

Let's examine each one.

Margin Compression

Gross margin represents net sales less the direct costs associated with producing the goods and services sold by a company. It is commonly expressed as a percentage. Historically, AAPL has enjoyed very high gross margins. In the Tech industry, fierce competition makes retaining such numbers difficult.

Here's a five-year chart showing Apple's quarterly gross margins:

(click to enlarge)

courtesy of ycharts.com

Since the 47.4% peak captured in the quarter ending March 2012, the figure has fallen to 37.5% in the most recent quarter. Management has forecast a drop in gross margin to 36.5% in the upcoming quarter ending June 30.

Until gross margin stabilizes, the Street will conclude that it will continue to ease, thereby slowly eroding earnings and cash.

What can fix the problem? There are two ways. First, product costs and mix could change and rekindle higher margins. Alternatively, higher revenues can overshadow declining GM. The math for this fix is somewhat challenging, but plausible.

Let me illustrate the hurdle. Last quarter, Apple recorded a dollar-denominated gross margin of $16.35 billion on net sales of $43.6 billion (or a 37.5% margin ratio). A two-and-a-half point GM ratio increase, equating to a 40 percent margin would have generated $17.44 billion. In order for Apple to generate equivalent 40 percent gross margin dollars, it would have been necessary for the company to net $46.5 billion in sales, an increase of $1.09 billion; or a 6.7 percent uplift from actual. Actual sales were up 11 percent QvQ.

Declining Earnings

A close cousin to declining margins are Apple's declining earnings per share. Here's the facts:

(click to enlarge)

(Estimates from ameritrade consolidated forecasts)

Indeed, EPS has declined the last two quarters, and is projected to decline for at least the next two. Furthermore, on the conference call last week, Apple's management set expectations that the QvQ third quarter earnings decline will accelerate versus the 2012 comp.

In my previous S.A. article about Apple stock, the theme was that the AAPL price / earnings multiple was an anomaly. At 9x, it was just too low. A P / E at this level indicates the market believes the company has no future earnings growth potential. While my opinion remains that the market has overstated the longer-term case, it appears it is very well correct in the short-term: Apple's earnings are expected to contract through the remainder of this fiscal year.

Until earnings stabilize and both management and the Street begin to anticipate earnings growth again, the stock price is unlikely to move up quickly.

Perceived Innovation Vacuum

Under the late Steve Jobs, Apple Inc rode wave of customer and investor enthusiasm over his innovative capabilities and adherence to perfection. Since his departure, the company's ability to innovate has been called to question. Whether this true or false is mostly irrelevant.

In the investment world, sentiment and perception become reality.

Of late, one could argue that Apple has simply built upon previous breakthrough products: i.e., the iPhone and iPad.

Unquestionably, management has refreshed these devices with added features and improvements. However, they are still the same basic devices. These products, built upon incredible foresight and attention to detail, carried tremendous customer loyalty and high margins.

Quite simply, new CEO Tim Cook is being called out by Wall Street. He's being asked to amplify his role as an outstanding operations man into a visionary leader. I am not yet questioning his ability to do so. Nonetheless, the results have not materialized. Thus far, all sizzle and no steak.

Apple management must bridge the perceived innovation gap with some sort of product breakthrough. Otherwise, it is reasonable for the company to accept lower Street expectations built upon the premise that while the company remains an exceptional production, distribution and branded business, the days of unparalleled enterprising innovation and leadership may be ebbing.

Too Much Balance Sheet Cash

Previously, Apple's unusually high balance sheet cash and liquid investments were an asset. Steve Jobs' ferocious defense of the cash hoard was accepted due to his aura and a rapidly rising stock price. Sure, some investors murmured about the billions on tap, but they largely kept their mouths shut at shareholder meetings and corporate functions.

No more.

A plummeting stock price and weakening associated metrics have changed all of that.

Upon the most recent conference call, management and the board of directors got the message. They delivered some relief: a fifteen percent dividend increase and a 32-month, $60 billion stock buyback program.

My view is that these items may help create a floor under the stock price. They are not silver bullets.

The dividend was set such that it created an approximate three percent yield on the underlying stock price: admirable, respectable, but not earth-shaking. There are many 3% yielding stocks that have better near-term earnings growth potential.

The buyback plan is somewhat impressive if for no other reason than its sheer magnitude. However, it's spread out until the end of 2015. In the meantime, let's assume that AAPL generates an average of $8 billion in free-cash-flow (operating cash less capex) per quarter, or $88 billion through the 11 quarters in the period. Here's a chart of Apple's FCF over the past five years, outlining why I suggest this figure is defensible:

(click to enlarge)

courtesy of ycharts.com

Now let's premise that the dividend is raised annually by ten percent in 2014 and 2015. Therefore, the cash dividends paid will be about $42 billion between now and the end of 2015. Here's the all-in math:

Apple Balance Sheet Cash / Investments 2013 - 2015

(click to enlarge)

Certainly a step in the right direction, but evidently Apple management is intent on retaining the bulk of the current cash hoard. And while the stock buyback will retire up to four or five percent a year of shares outstanding, additional shares will be issued to management and employees in the form of options and restricted stock, thereby diluting the effort; at least to some extent.

Clearly, corporate leadership has begun to address this issue, but I do not believe it's "case closed" yet. In addition, I submit that Apple management could do itself a favor by taking a page from the Intel (INTC) playbook: invest the cash in a way that provides a better return. FY2012 10-K filings show a return of only 1.03 percent.

The Bottom Line

Apple management faces four key investor issues: margin compression, declining earnings, an innovation vacuum, and a huge amount of balance sheet cash / investments. Investors may wish to pay particular attention to these issues for clues as to how the business is performing, and the consequent movement in underlying share price.

The problems are inter-related.

Margin compression is a prime contributor to declining EPS. It is also a result of increased competition and the dearth of new "breakthrough" products since the passing of Steve Jobs. Potentially, these problems may be overcome through significant higher revenues. However, one may premise that such revenues are contingent and circle back to the need for new, breakthrough products. Finally, exceptional balance sheet liquidity has evolved from a corporate source of pride to a millstone around management's neck. The recently announced dividend increase and stock repurchase plan is a fine first step, but I suspect that these steps alone will do more to place a floor under the shares than drive its capital appreciation.

For longer-term investors, I suggest that AAPL stock remains undervalued as a function of its current 10x earnings multiple. This multiple assumes low forward multi-year EPS growth: in the neighborhood of two or three percent. This may prove far too pessimistic.

Nonetheless, without resolution of the foregoing problems, investors should not expect much enthusiasm for the shares, nor a rapid return to the ever-buoyant stock prices of 2008-2012.

Disclosure: I am long AAPL, INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

As the market continues to move higher, many investors ask themselves, “When is it time to sell my stock?”

Let's explore that question a bit.

I will begin by focusing upon three basic questions leading up to the tag line:

• Did I take the original position as an Investment or a Trade?

• What was my initial thesis for taking the position?

• What is the corresponding exit thesis?

Before one can decide when to sell, the security owner must sharpen their thinking around why they bought in the first place.
 

Did I take the position as an Investment or a Trade?

For purposes of this article, I define an Investment as a position in a marketable security with the intent to hold it for more than a year. The decision to buy is primarily based upon fundamental investment analysis, often coupled with studying technical charts. Certainly, there are cases whereas a chartist may premise a long-term investment through the using technical analysis alone, but this is less common.

Fundamental investment analysis include reviewing financial statements, company reports, investor communications, quarterly earnings conference calls, and the news wires. The fundamental investor wants to understand the underlying business, not just the price action.

The investor may determine an investment is worthwhile because it is undervalued, or has extraordinary revenue / earnings growth potential.

A Trade is typically associated with a shorter ownership time frame: less than a year, or as little as a few trading sessions. The decision to purchase leans most heavily upon technical charts and / or a shorter-term market swing or corporate event. The intent is not to dissect and understand the business metrics, but to profit from the current price action; as influenced by the market, industry or short-term events.

Technical charts may include momentum indicators: the MACD or Stochastic studies. Moving averages, Money Flow (MFI), and Market Strength (Chaiken Oscillator) charts are also common. There are dozens of good technical studies.

Let me be clear: Investments do not mean Buy-and-Hold, but they tend to have a longer-term horizon. Trades tend to move in and out of the market or a security more quickly, but they are not limited to utilizing only the technical charts, nor must all a Trade be short-term by definition.

Given the same information, an investor and a trader may come to very different conclusions as to when to buy and sell. Therefore, it's important to determine upfront if one is taking an equity position as an Investment or a Trade. Later in this article, I will come back to this point. Don't take a bad investment or trade and try to re-imagine the premises mid-stream. It's a losing strategy.
 

What was my initial thesis for taking the position?

Prior to buying a security, I encourage everyone to have an investment thesis; a clear set of reasons for wanting to own it.

An Investment may include careful reasoning around a company's strong balance sheet or future EPS projections. Cash flow, dividend or revenue growth prospects may be appealing. Perhaps the company is on the verge of a competitive breakthrough in some market or new technology or is staffed with an exceptional management team. Via metrics, ratios, historical statistics, and business intelligence may prove to the investor a given investment is undervalued, has an exceptionally strong future, or a competitive advantage.

A Trade, on the other hand, usually requires consulting the charts for to an entry or exit signal. The corporate financials, business strategies and management strength are of less interest. Indeed, Trades may not require the company to be making any money, nor even have a bright future.

Nevertheless, an Investment or Trade share a common goal: it's not important where the stock has been, but where it's going. The individual's thesis provides the rationale for why such an investment will make money.

Unfortunately, it is not uncommon to find investors who have no clear thesis as to why they entered into an equity position. Sometimes, it's little more than a hot tip from another person. I've never had much luck with tips. Tips are for waiters.
 

What is the corresponding exit thesis?

Now to the heart of the matter.

The corollary to having a thesis to buy is having a clear thesis by which to sell. This is often the most challenging part of investing. It's the upshot of this article. And it's imperative.

Even some generally sound investors fall prey to having a hazy view of what they expect an investment to do: and therefore a corresponding hazy view of when they should sell it.

I submit knowing the proper time to sell is a direct function of having a divestment premise in advance of the sale event.

“Waiting to see what happens,” is a recipe for disaster. Without a clear thesis to sell, the Investor or Trader is likely to be swept up by those two great impostors: Fear or Greed.

There are myriad potential exit strategies for any given stock, and any may be appropriate. The key is to have a set of sell premises or signals.

Selling an Investment

I offer two straightforward concepts for creating an Investment “sell” strategy:

• Create a target “sell” price via forecasting future EPS and P/E ratios

Forming a reasonable opinion of a company's future earnings can be forecast by reading previous corporate earnings reports, reviewing investor presentation materials, and listening to the quarterly investor teleconferences / reading the transcripts. Company management often provides “guidance” on future earnings, cash flow and plans. Years ago, these sessions were generally closed to the small investor. Not anymore. I can assure you that some management teams are very good at providing and meeting their guidance. Others are not.

While one can also review equity analysts' projections for future earnings, I prefer to use this information as an adjunct to my own personal analysis. Some analysts are quite good, while others are not as accurate. Analysts are subject to the role itself: workload, their knowledge of a particular industry, business relationships with their employer, or with the management team of the company being covered. Utilizing consensus earnings estimates have some element of safety in numbers. Nonetheless, I still believe the surest way to determine the future EPS for most stocks is to read and analyze the information yourself.

How about that P/E multiple?

This is where a combination of sound research and alchemy can provide pretty good results. The trick is to anticipate the future P/E based upon historic facts, a knowledge of the industry, and a general macro observation as to where the the overall market is heading. While I could write another article this subject alone, I'll offer some initial guidelines here.

I suggest the baseline data for projecting P/E multiples come from two sources:

1. the average multiple over the past five years and
2. a summary of the annual high and low P/Es for the equity over the same period or longer

They key is to have the data for a complete economic business cycle. The average cycle lasts about five to seven years. The average P/E multiple can be found on any number of web sites. The annual high and low P/E ratios may be found via the Standard & Poors investment stock investment reports.

Armed with this data, one can make an educated guess as to what multiple to place upon the stock. It involves a bit of math, some philosophy, and an understanding as to how different stock sectors react at different points in the economic business cycle.

The second concept is less granular, but just as effective.

• Plan an exit strategy when the macro trends say so.

I referenced the economic business cycle in the previous section of this article, and for good reason. Economic business cycles run for about five to seven years. Typically, the cycle ramps up on increasing industrial and consumer demand. Businesses increase production and such production meets increasing demand for goods and services. Initially, demand outstrips supply. Then they equalize. Towards the end of the cycle, businesses overproduce. Associated loose monetary supply tend to lead to inflation. As monetary supply is tightened, business contract. People lose their jobs and consume less. The overall economy contracts, often into recession. Finally, demand outstrips the reduced supply, interest rates are lowered, and the cycle starts all over again.

Drilling a bit deeper, various business sectors have demonstrated somewhat predictable results based upon their time and place within a given economic cycle. Here's a shorthand list:

Early Cycle, just after a recession: Benefitingfrom relatively low interest rates and starting from the bottom of the supply-demand curve, Financials, Consumer Discretionary, Technology and Industrials lead the way.

Mid Cycle, as the economy charges ahead: Demand is accelerating, output is strong, and people are spending money. Technology and Industrials remains strong, and are joined by Energy and Basic Materials.

Late Cycle, when interest rates are rising and things are looking a bit tired: A robust economy begins to show some fatigue as labor / material costs, and interest rates start to create a drag on businesses. While Energy and Basic Materials still have life, Consumer Staples and Health Care (think Food and Drug stocks) begin to take the stage. Investors look to safer havens and sectors that yield safe cash flows and steady, if unspectacular growth.

Recession Phase, whereas the economy weakens or contracts: Since people always need Food and Drugs, the Consumer Staples and Health Care sectors are most strong. They are joined by the Utilities and Telecommunications stocks, likewise day-in-day out necessities that offer ratable demand and conservative business strategies.

• Plan to sell when the chart says so.

Sounds so simple.  Whatever your plan, stick with it. If your premise is that the MACD must be confirmed by the Chaiken Oscillator, coupled with the stock must falling below the 50-day moving average....then do it.

Unless there is compelling reason to think you made an error in the initial “sell” premises, it's time to pull the plug.

• Sell when the “event” that prompted you to buy in the first place has passed.

This rule is pretty cut-and-dried. If a Trade is premised upon a specific macro or company event, and this event occurs, then it's time to sell. If the premise was correct, you will have made your money. If not, then take the hit and walk away. One no longer has a valid premise for holding the stock.

Do not turn a Trade into an Investment (Jim Cramer has this point correct) since it means one has papered over one set of premises with another set of parameters. The result is all but certain: Fear or Greed will kill you.

Conclusions

Have a clear set of reasons before investing.

Decide if you are Investing or Trading.

Forecast what you expect the security to do and how you will know it's time to sell at the time of your purchase.

The wise investor has two logical choices when the thesis, whether calculated or event-driven, is met:
 

1. Determine if the “sell” premises require re-calculation and re-assessment based upon new facts and information. If they do, then reformulate your thesis.
2. Otherwise, exercise discipline and pull the trigger.

So now that the election is out of the way, what's the U.S. economic prognosis given the new political landscape?

The sweeping changes to the House and Senate initially buoyed the markets, and for good reason. The Republicans ran as the “party of business.” Indeed, Dems in general and President Obama / Nancy Pelosi in particular have have demonstrated an irresistible urge for anti-business, populist rhetoric. Arguably, this has prolonged the Great Recession by stagnating business growth through sowing the seeds of uncertainty. Businesses do not invest upon the shifting sands of unknown future taxes, regulations or government mandates.

Is the Republican sweep just what the doctor ordered?

Instead of spouting off political slogans and talking points, let's begin by reviewing history: not election history, but economic history. We will focus upon the late 1930s. Specifically, the “Recession-within-a-Depression,” also called, “The Roosevelt Recession.” I picked this episode in American history since it came after the acute economic dislocation of the early 1930s; similarly involving the banks, real estate, and the Great Crash.

We will set the stage with some earlier background history:

From 1933 to 1936, the economy had begun to recovery from the depths of the Depression. President Roosevelt instituted a large number of economic and social policies, dubbed “The New Deal.” Arguably, they had helped to bolster the nation. These include F.E.R.A., or the Federal Emergency Relief Organization, who made federal loans and outright grants to cash-strapped States and municipalities. The W.P.A. (Works Progress Administration) and the C.C.C. (Civilian Conservation Corps) focused upon jobs: primarily national infrastructure improvement projects. Banking and investment reform were tackled, including the the creation of the FDIC and the SEC. The Social Security Act of 1935 was a crown jewel of F.D.R.'s first term.

Critics argued the government was running deficits each year, threatening to bankrupt the nation. Indeed, an endless chorus complained that the policies were destroying American self-reliance, were federal “boondoggles” that wasted taxpayer money, and were creating a socialist welfare state.

In 1937, upon a fresh landslide election, Roosevelt felt he had a mandate to continue his progressive policies. When he took office for a second term, most economic indicators had regained much of the ground lost since the late 1920s, with the notable exception of the unemployment rate.

Several key policies were pushed that jolted a fragile economy into a second recession.

Between March 1937 and 1938 the stock market fell 49 percent. The U.S. GNP declined 4.5 percent in 1938. A crisis of confidence ensued.

What happened?

Several government policy decisions enacted early in Roosevelt's second term that contributed to a second business shock:

• The curtailment of governmental stimulus in an attempt to balance the federal budget

• Additional government regulation; in the 1937 case, this included, amongst other federal meddling, increasing the power of labor unions, who in turn drove up wages beyond what the market could bear, and increasing bank reserve requirements, contributing to a refreezing of credit and liquidity

• Raising taxes further depressing job creation, employment and capital formation

The 1938 mid-term elections slowed down the Roosevelt Express. The public, while supportive of President Roosevelt, felt that some of the progressive policies had gone too far. A Republican mid-term landslide along with Roosevelt stepping back from some leftist policies changed the economic course. Unfortunately, it was after considerable damage was done to both Main Street and Wall Street.

Does any of this sound familiar some sixty years hence?

If history has the propensity to repeat itself, or we can learn from it, let's grade the Republicans on some key historical issues. While we cannot be sure of the final outcomes, we can project some likely results from their campaign rhetoric.

Balancing the Federal Budget

Republicans have generally espoused the need to “balance the budget” and “cut runaway spending” to “avoid bankrupting the country.”

Federal actions around similar rhetoric was a fundamental reason the economy tanked in 1937-38. Fed Chairman Ben Bernanke knows this history lesson all too well. While the idea of continuing federal spending to prop the economy is a political loser, the alternatives include a recessionary relapse and/or deflation. Deflation could derail the U. S. economy for years. It is extremely corrosive. True deflation is not the effect of price reductions in certain commodities, for instance tech gadgets. This is a false comparison. Deflation is when the prices for nearly all goods and services move downward at once. No one wants to buy anything today, since it will be cheaper tomorrow. Salary and wages go into the tank. Business growth heads into reverse, as both the top and bottom lines contract.

The Fed understands it must avoid this outcome, even to the point of risking future inflation. QE2 is a smart historical gamble. If the Republicans try to score voter points by dissing Bernanke, they flunk the course.

Grade: “I” for Incomplete. The author worries the GOP will not do their history homework and flunk the exam.

Government Regulation

Republicans tend to emphasize job creation and business growth over government regulation. It's likely that they will continue to advocate a pro-business stance instead of promoting the government to solve America's economic woes. I envision decent GOP responses to managing the details of FinReg, energy policy, and labor policy.

The Republicans will tend to seek more reasonable financial bank regulation than the Dems; looking to close the gaping holes versus punishing banking “fat cats.” I do harbor a concern they may try to score political points by grandstanding the anti-banker sentiment.

Republicans with will advocate a pro-America energy policy, including resumption of deepwater oil drilling and the use of our vast reserves of shale gas.

Private sector job creation will take the front seat.

Labor “Card Check” legislation is dead.

Grade: B      Republicans are making the right gestures.

Taxes

The GOP has been consistent about their desire to keep taxes down while the country is emerging from a recession. This lesson should be well-learned from the evidence from 1937-38.

The Republicans understand that whether we like it or not, and regardless of our personal thoughts on social “fairness,” the creation of jobs and capital formation in a capitalistic society is generated by “the rich.” The poor do not create jobs. While government can and should encourage temporary growth through targeted programs, the engine of a democratic capitalistic country are the people with extraordinary drive and a willingness to work hard. Those who take risks seek rewards.

The government may likewise attempt to spur growth through subsidizing new businesses. Indeed, this is also fleeting, unless it becomes a long-term handout. Sustained business activity and development is spurred by the hope by investors for future cash and recognition, not by the federal government “picking winners and losers” through tax engineering.

Grade: A      The GOP will get this one right. Their success pivots upon getting their ideas through Congress.  The author is optimistic.