Apple: It's Cheap For A Reason

| About: Apple Inc. (AAPL)
This article is now exclusive for PRO subscribers.


Apple has fought through its history of low trading multiples by significant earnings growth.

While I doubt "peak Apple", I don't doubt that Apple's growth will slow from here on out.

Apple needs to be willing to take more risks, otherwise it's just another technology company.

"Apple (NASDAQ:AAPL) is too cheap" is something you'll hear repeated pretty often on Seeking Alpha, and probably any other investment research forum. In tandem with this oft-repeated statement are calls for price targets from $160/share on up; calls which need Apple to undergo significant multiple expansion, create earnings growth well above expectations, or a combination of the two.

Before the Apple bulls start furiously typing their rebuttals before I've even started, I'll clarify that I'm likely more long, as a percentage of portfolio weight, than nearly any other Contributor here. 25% of my managed portfolio now sits in Apple, which is a function of years of market-beating performance, continued faith in management's leadership, the company's strong free cash flows, and a potential tax bill that pains me to even think about it.

That doesn't mean that I think Apple is a perfect company - far from it. I have my own ideas on why Apple trades at the multiples it does, and what it could do to improve.

Trading Multiple Expansion?

*Apple Forward P/E ratio, 2011 to present

I'm an Apple bull, but I'm also a realist. Long-term shareholders know that Apple trading cheaply isn't a new event. The market has always discounted Apple when it comes to valuing future earnings, and historically (if you take 2016 earnings estimates at face value), the company is at best marginally undervalued today based on one year expectations.

The reason for this discount is simple: Apple is a high-end consumer products company, and the company deservingly gets a discount to the market as a result. This is driven by the risk that underlies businesses currently earning high margins in expensive consumer goods. Other luxury peers have long been plagued by similar issues; Michael Kors (NYSE:KORS), Restoration Hardware (NYSE:RH), and many other high-end retailers all bear the same cross.

I don't find that discount inherently unfair, as consumers are a fickle bunch. While Apple has stayed at the forefront of various product categories for years, we shareholders can't assume that Apple tomorrow will be stronger than Apple today. Apple is top dog when it comes to consumer electronics, and wearing that crown isn't easy. When you're churning out 30% operating margins as peers drastically undercut you, you have to develop and deliver superior products to incentivize the customer to buy your products instead. As a result, even minimal margin accretion gains will be hard-fought, but it only takes a few missteps to undo years of brand-building and ecosystem development.

Luckily for Apple's equity returns, the company has managed extremely outsized earnings growth year over year, which has led to the company outperforming the market despite continued market pessimism. That is where Apple bulls face a problem in my opinion. Even the staunchest of Apple bulls should have a hard time imagining a repeat of the 133% earnings growth the company enjoyed from fiscal years 2011-2015 in fiscal years 2015-2019. Without earnings growth, the only way to alpha on the equity is by margin expansion.

Path To Margin Expansion

As far as company history goes, we've come to an important crossroads in Apple's future in my opinion. Apple isn't going to grow its way out of its problem without pulling a big rabbit out of its hat, and its current core products are not going to grow at the rate they were in the past. The market is going to grant the company earnings multiple expansion "just because".

In order to see the trading multiple expand, Apple has to deliver a new story; a story that dangles the possibility of more consistent, protected profits for investors than what the consumer products divisions can provide. The path forward for that, in my opinion, is within software as a service directed towards enterprise customers and businesses.

Business customers are simply more steady customers on the whole. Think forward to 2020 - what product is more likely to have maintained current margins, Microsoft's (NASDAQ:MSFT) Office suite or Apple's iPhone? Most professional investors will give Microsoft that win. Investors, especially institutional ones, will gladly pay the price (higher earnings) for that safety.

That doesn't mean that Apple needs to go out and try and compete in the cloud space with Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG), or Microsoft. The cloud computing ship has sailed, and it doesn't pay to start a race in last place and play catch up.

Honestly, a strong move by Apple doesn't even have to be directed toward businesses - although that's my idea. But overall, Tim Cook and team need to have the foresight to spot, or just flat out create, what could be the next big thing, without hesitation. Tim Cook has to be willing to whip out the checkbook, spending money early on in nascent industry on either acquiring businesses directly or poaching talent. Lately, Apple has been playing catch-up, rolling with the industry instead of driving serious innovation. More deeply, Apple's acquisition and cash management strategy has been incredibly passive. That's not a recipe for success, and it can't stay that way forever.

This will require a change of thought process at the top. When it comes to acquisitions, Steve Jobs and Tim Cook aren't all that different from one another. While I don't want Tim Cook to go "Ballmer" on me and start throwing money at the wall to see what sticks, I do want the company to be willing to put more of its cash to work and be more reactive. I do understand the Jobs/Cook strategy: buy small, buy cheap, buy complementary. I get that, I really do. But Apple management can't be afraid of making a mistake, otherwise you don't take home the top prize.

Apple's strength is in its people. As a group, you won't find a more motivated workforce that wants to impact change and develop innovative products. But Apple can do more to foster that environment internally. If not, it risks losing its most talented people to companies that do (see Google's "Other Bets" segment). I'm hoping Apple does not lose that luster. It's something that IBM (NYSE:IBM) has long suffered with, and I'd hate to see the company go down that path.

Disclosure: I am/we are long AAPL.

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.