Apple's Post-Earnings Dip Was An Adjustment, Not An Exit

Strike one was Apple’s (NASDAQ:AAPL) loss of Steve Jobs. Strike two is Apple’s financial report, while dazzling, coming in below expectations. Strike three? The pitch is on the way – but more about that later. First, let’s discuss why those first two items are clearly strikes.

Why the Loss of Steve Jobs Really Matters

I have had a change of heart on this subject. When Jobs' health conditions became serious, I wrote about what happened to Disney (DIS) when Walt Disney died. At that time, the company and its stock actually did very well.

Then came my three-step conversion:

1. Bullish on Apple

Following the market’s August drop, I wrote about Apple’s exceptional value on August 24. The following day, after Jobs stepped down as CEO and the stock sank, I reiterated my Walt Disney thoughts.

2. Doubt

Having written about Apple stock being an “impossible dream,” I began to doubt my view of Apple’s value. It’s one thing to have a neglected stock lag and become a great value, but how could Apple be in that position with both its notoriety and its market cap position? (September 2).

3. A Different Vision

Now I see AAPL’s valuation as being reasonable -- not a bargain, given the loss of Steve Jobs and the risk it creates. Beyond his high skill at innovation, the company is now missing:

• His knack at deciding which innovations to pursue. Many inventers can create new stuff, but Jobs could also determine what would be popular -- commercially viable.
• His talent at getting it right first. Most (nearly all?) new, popular products originated elsewhere. Yet, here is Apple with an exceptionally successful record of creation, implementation and fulfillment. That accomplishment is especially remarkable because it happened with previously unknown products and Jobs able to decide what people would want without the help of consumer input.
• His cleverness in making technology's short product life cycle work for him. He was able to match the speed of technological improvements, thereby besting the competition with products that were better sooner.
• His ability to repeat success. iPod, iPhone, iPad -- they didn't easily percolate to the top of the "hey, let's do this" list, complete with instructions. Then, there are the all-digital-content iTunes store and the software-killer App store. Any one of these developments would have been enough to propel a company into the desired high growth company category. Yet Apple has them all. The probability of that happening is minuscule. Most importantly to us now, the probability of a repeat performance without Steve Jobs is highly unlikely.

To Sell or Hold

My newfound view of Apple raised the question of what to do with the stock: sell and invest the proceeds elsewhere, or hold until negative signs emerged. Because of Apple’s financial strength, its reasonable price and the possibility of a final Steve Jobs product emerging, I chose to hold.

However, I wanted to set boundaries on my patience, so I came up with a three-strike process, giving Apple Strike One from operating without Steve Jobs. I didn’t define the other two strikes, figuring they could emerge in different ways.

Why the Earnings Report Is Strike Two

Many articles have appeared saying, yes, earnings were below analysts’ estimates, but we shouldn’t worry for the following reasons -- with my rejoinders.

• The earnings growth rate, while less, was still exceptionally good. No matter the absolute level, investors react negatively to deteriorating growth rates, especially for high-growth companies.
• The iPhone sales (the source of the miss) reflect customers waiting for iPhone 4S’s release. The timing was not a surprise, and so analysts had incorporated delayed sales into their forecasts.
• The problem was with the analysts’ estimates – they were overoptimistic. After quarter after quarter of Apple beating analyst estimates, the miss is attributed to a sudden burst of analyst optimism in a poor stock market environment?
• The new earnings just made Apple’s valuation even better. On paper, but not in investors’ heads, as the stock dropped 5% on the news.

Those items are simply attempts to put a happy face on a worrisome occurrence. Investors weren’t expecting Apple to match analysts’ estimates -- they expected another quarter of gangbusters outperformance. Therefore, we should be worried about a shortfall – hence, Strike Two.

Strike Three Coming?

Barring a surprisingly negative announcement or event, Strike Three could be next quarter’s earnings release. That report needs to be a significant, positive surprise to put this week’s report into the “odd event” bin. Anything less could raise serious doubts as trend watchers connect the disturbing dots to form a worrisome picture.

With Tuesday’s earnings release came a puzzling management reaction, perhaps setting up that Strike Three. Instead of simply explaining the past quarter’s performance and making generalized statements about the future, CEO Tim Cook and CFO Peter Oppenheimer decided to make advance comments about the current quarter, giving higher than analyst projections (remember, this was only 13 days into the holiday quarter). Techcrunch has a good article that discusses the extent of those extraordinary predictions.

This action is a set up for disappointment. If Apple doesn’t succeed like in the past, management will be criticized and investors will not help dream up excuses for another poor earnings report. That’s why such an event, I believe, would be Strike Three.

The Bottom Line

Apple’s management has many challenges ahead as it faces technological innovation, competitive pressures and the ever-fickle consumer. Repeating past successes will be a Herculean task without Jobs. And now we have a poor earnings report, with management’s attempts to mollify disappointed investors by offering visions of a blowout quarter coming.

With two strikes, Apple’s management must really perform over this next quarter to reestablish investor confidence in Apple’s future without Steve Jobs. Unfortunately, they just set their own bar high, increasing the risk that they might not succeed. If earnings disappoint, it's Strike Three and AAPL is out of the portfolio.

Why Not Just Sell Now?

Certainly a number of shareholders are selling, as shown by the quick price drop of 6+%. However, I feel such a move is premature. Apple does have an excellent organization with a robust development process. Its renowned secrecy means we can expect surprising, good product improvements over the next year, at least. (I’m not so sure about seeing major new products, however.) The supportive customer base continues to grow, and reviewers regularly praise Apple’s products. Then, there is that $80 billion in cash and investment reserves. I believe it’s time to be patient, let the quarter evolve and see what more we learn. Then, the acid test -- the next quarter’s earnings report.

Based on fundamental valuation, Apple retains its very attractive pricing. However, based on investor activity, it looks like the stock is not a special buy.

Note that, while the stock is down over 6%, it had a recent run-up on anticipation of a glowing earnings report. Therefore, we are likely seeing an adjustment of that optimism, not a run-for-the-exits sell-off. A “bargain” price would likely be in the $360 range.

Disclosure: I am long AAPL, long U.S. stocks and long U.S. stock funds.