H.J. Huneycutt's  Instablog

It's rare that I venture into the world of megacap companies.  I'd rather find underpriced small cap companies, particularly ones in volatile industries.  Yet, it occured to me that in the past year, I have never once looked at Apple's (AAPL) financials.  There were reasons for that:

(a) It's a megacap company and large companies typically have less room to grow

(b) It's too heavily followed to create much in the way of huge pricing inefficiencies on the downside; plus, it's been a trendy stock for years, which drives up its price further

(c) I've never felt comfortable analyzing companies with their hands in too many jars

(d) The consumer electronics industry is constantly in flux and most investors tend to value these companies based on overly optimistic long-term assumptions that rarely hold true

All the same, given AAPL's market dominance over the past few years, you'd think I might have looked into once before just so I'd know what was up with it. 

Well, today was the day!  I glanced at Apple's financials and while I realize I could be missing some growth catalysts in the pipeline or that I could be underestimating Apple's growth in the smartphone market, I'm left with one major takeway:

Apple's stock has VERY HIGH EXPECTATIONS priced in!

To be sure, Apple has a great balance sheet, strong cash flows, and a very bright near-term future, but it would have to have one phenomenal performance over the next decade to justify the current stock price.

The Valuation Dilemma

As a value investor, the first thing I look at when analyzing any company is their balance sheet.  I want to see is the company is in sound financial shape and how much their underlying net assets are truly worth.  In Apple's case, their balance sheet is very sound and their Net Tangible Assets are worth roughly $28.50 per share.  Of course, if you're buying Apple, you're not too terribly interested in the assets.  You're interested in the earnings, cash flows, and future growth. 

Apple's earnings and cash flows are spectacular --- but are they $170-per-share-spectacular?!   It's reasonable enough to assume that AAPL earns $6 per share for the current fiscal year.  When you consider all the cash flows they are raking in (tucked away on the cash flow statement as "deferred revenue"), it might not even be a stretch to say they have truly earned over $10 per share this year.  If you assume that $9 - $10 per share is a reasonable approximation of their "real profitability", then you could argue that AAPL is worth somewhere between $150 - $200.

But should that be the end of our analysis?  Should we simply assume that Apple will meet these expectations?   

The Problem with Apple

Of course, given Apple's dominance in the smartphone market, it doesn't seem unreasonable to claim that they will continue bringing in mega cash flows over the next few years.  But the funny thing about stocks - you don't really make much money by buying companies that merely live up to expectations.

Apple may have earnings upwards of $6 per share and free cash flows upwards of $10 per share for their current fiscal year when all is said and done, but just two  years ago, earnings were around $2.30 per share and free cash flows were around $1.80 per share.  From this, we can tell Apple has experienced phenomenonal growth over the past three years, but how long will it last?

Should we simply assume that Apple continues to grow free cash flows over the next decade?  Will its earnings and cash flows stay flat?  Or will their earnings begin to "normalize"?  

There is a concept in business called "abnormal earnings."  The basic premise is that a company can gain a huge competitive advantage for a limited amount of time and earn these "abnormal profits", but eventually, the rest of the market will catch up.  

Whether or not Apple's cash flows begin to erode depends upon a number of factors.  Can competitors such as Research In Motion (RIMM), Palm (PALM), Nokia (NOK), and T-Mobile (DT) [partnering with Google (GOOG)] undermine AAPL's market dominance at some point?  Will the huge margins that the iPhone brings in begin to dwindle sometime over the next few years as smartphones become the norm and the market continues to become more competitive? 

Maybe the most pertinent question is Apple a "fad"?  Apple set itself up as the anti-Microsoft (MSFT) over the past several years, but at this point, it might be safe to say that Apple is the more dominant gorilla.  In fact, Apple's $153 billion market cap is closing in on Microsoft's monstrous $220 billion market cap!  How can Apple claim to be the little guy when it may very well overtake Microsoft in size at some point in the near future?  Could we see an Apple backlash or Apple fatigue develop sometime soon?  For that matter, could we simply find that consumers are less willing to pay high premiums for Apple products at some point? 

My real point here is that a lot can happen in the next decade and Apple's stock already has very high expectations priced in.  Maybe they meet them.  Maybe they don't.  But what are the odds that they significantly exceed those high expectations?  The odds are low in my estimation.  

Apple in 2009 Is Microsoft in 1998?

Which brings to the question I posed in the title of the article:

Is buying AAPL today like buying MSFT in 1998? 

To be sure, there are distinct differences and AAPL has had a much better record of finding growth catalysts than MSFT, but people thought MSFT was invincible at the end of the '90s, as well.  In September '98, MSFT traded at around $27.  In September '09, it now trades around $24 - $25.  In other words, if you bought into MSFT 11 years ago and held all the way till today, you basically had a "lost decade" on your investment.  

It wasn't that MSFT collapsed.  It wasn't that MSFT's dominance was dramatically weakened.  In fact, MSFT has held up through this recession and the early '00s recession much better than 90%+ of the companies traded on the American markets.  However, MSFT was priced with very high expectations in 1998 and one can say that it has done little more than meet them.  While the stock did have moments where it traded upwards of $30, as a long-term investment, it has been a dud.

Of course, naysayeers might point out that MSFT traded upwards of $60 in 1999 and 2000 during the tech bubble.  This is quite true.  Maybe AAPL jumps up to $300, as well.  However, betting on a speculative bubble isn't particularly wise.  It might have worked out in 1998 (if you were wise enough to sell within the next year or two), but it's normally quite a poor investment strategy.  

Apple is a great company.  They will probably continue to rake in cash flows from the iPhone and maybe even gain more market share.  But it's going to be very difficult for them to grow their earnings and cash flows much more over the next 10 years.

The way I see it, the risk that their profits fall is greater than the chance that they manage to increase cash flows to even greater levels.  Great company or not, it simply doesn't look attractive over $170. 

Maybe I'm wrong; after all, my speciality is finding underpriced small cap and microcap companies; not analyzing large consumer electronics firms.  All the same, I see buying AAPL right now sort of like buying MSFT in 1998.  How much more upside can there really be at this point? 

If you bought in at $80 earlier this year, congratulations.  If you're buying in now at $170 ... I don't think risk-reward is on your side.  And if it creeps above $200, keep far away!

Disclosure:  No position in any companies mentioned in this article.