Apple Buyers Beware
Summary
- Apple's operating margins/returns have been in decline for years.
- Basic valuations using trailing financial ratios are at 10-year highs.
- Several momentum indicators appear to be warning a top is approaching.
- Long-term risk/reward analysis seems to be skewing in favor of sellers.
Apple (NASDAQ:AAPL) stock has been a rousing winner for years. However, operating margins/returns are slowly shrinking, valuations are getting stretched, and there are signs upside stock momentum is starting to wane. The potential of Chinese trade retaliation against Apple is real, which could negatively affect sales and income going forward. Overall, the risk/reward situation is not the same as five or ten years ago. Apple ownership entails substantial long-term risk to your invested capital as competition and cost pressures expand in the coming years. Reviewing the entire investment story, the highest rating I can give the stock is a Hold.
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Apple has been one of the top Wall Street gainers since the company was founded. In its infancy during the early 1980s, it become a media sensation and a darling stock market mover with its invention of the personal computer. Then Steve Jobs was pushed out of the lead chair in favor of corporate-style management experience and CEO John Sculley. Jobs came back as CEO in 1997, after the stock went nowhere, despite a massive technology boom in America. The split-adjusted stock traded between $0.40 and $2.15 a share over the span Jobs went missing, and was priced at $0.60 when the co-inventor of the home computer was convinced to return. Of course, the rest is history as the tech visionary engineered/invented portable, solid-state, wireless internet-connected, touchscreen, mass-produced computer gadgets from iPads and iPods to iPhones, propelling the stock to its $333 quote today.
Below is a comparison chart of Apple's 10-year price gain against a number of large capitalization peers and competitors. On a $10,000 investment, price gains have been strong, but not at the top of the heap for performance.
Margins/Returns Declining
One problem with Apple's underlying business results is margins/returns have been steadily dropping for years. Its 38% gross profit margin is not particularly high for a technology company. The company earns a profit on extraordinary volume, not necessarily the biggest profit per dollar of sales. Below is a decade-long chart of gross margins vs. large tech competitors and peers.
Gross margins are down from a high close to 45% in 2012. In addition, declining net after-tax profit margins, income returns on assets employed and cash flow to total assets do not argue for well above normal valuations, especially with earnings projected by Wall Street analysts to only grow at a rate of 10% annually the next three years. In contrast, diluted EPS from continuing operations expanded by a 15% annual clip the last five years.
Extreme Valuation
My second concern is Wall Street valuations of the business. On trailing operating results, the stock is at its highest valuation in a decade per basic financial ratios. Below is a 10-year graph of the excessive price to earnings, sales, cash flow and book value situation. When you purchase Apple shares in June, you are essentially buying into the promise of growth, that may or may not appear into 2021. 20x cash flow and 5.6x sales are not the same as 2016's 8x cash flow and 2.8x sales reading. If China retaliates against U.S. trade protectionism by limiting the sale of Apple goods inside China and/or raising tariffs on product manufactured in the nation before export to America, one can argue the stock is quite overvalued presently.
Does a falling margin business, with downshifting underlying growth trends deserve its highest valuation on trailing results in a decade? My answer is no, valuations should logically be on the lower end of the historical scale.
Fading Technical Momentum?
Perhaps the best argument for ownership revolves around the majority of positive technical indicators of buying/selling trends. However, since December some failing momentum issues could be signaling a top is approaching.
Apple has been a terrific investment vehicle because new buyers have been added to the equation yearly on top of significant share buybacks by the company itself. Evidence of a supply/demand imbalance in favor of bulls has routinely existed for decades. Three indicators I like to track are the Accumulation/Distribution Line (ADL), the Negative Volume Index (NVI) and On Balance Volume (OBV) trends. Each is usually rising strongly, or at least in sync with new moves to all-time price highs.
The ADL reviews buying and selling during the trading session. A rising number means the closing price each day is nearer the high trade vs. the low print. Apple's ADL line is doing just fine, thank you, on the 6-month chart above. Plenty of buying throughout each day is occurring, as a trend.
Again, the NVI movement is quite bullish. The NVI only measures buying/selling on lighter news, falling volume days. Contrary to what you have been taught about watching high volume days for accumulation, stocks that consistently rise on low volume days are quite healthy. This condition signals a lack of sellers to offset buying, allowing the price to climb. At least that's the good news on the technical front.
Yet, a worrisome piece of trading data for Apple is the OBV line has not been able to rise meaningfully since March. The OBV indicator measures price change multiplied by volume daily, with higher volume and greater price changes creating the biggest impact. Apple's typical OBV trend is up, especially to match price moves to all-time highs. However, we are getting a divergence in action the past several days. Apple has reached new all-time price highs, but the OBV line is languishing. You can see the non-confirmation marked with a green arrow above and green circle on the 2-year chart below.
Another momentum problem is found in the fading rate of price change against the peer large cap Nasdaq 100 ETF (QQQ). Apple's leading percentage price change of a year ago has faded since February/March into a lagging position. In addition, the 14-day Average Directional Index (ADX) vs. the same QQQ creation highlights Apple has lost any type of trend leadership position. You can review these relative comparisons on the chart below, with the lack of ADX trend circled in red. All told, Apple's relative strength peaked between October and January. Its quote since February has drifted higher with other similar technology stocks, at a less than stellar rate.
The lack of confirmation of new all-time highs in the OBV and ADX indicators may be warning a peak is at hand for Apple. We won't know for sure, until an important breakdown in price occurs. But raising stop levels and quantifying your exit strategy in Apple may be a smart idea this week.
Final Thoughts
I currently don't own Apple, and consider the stock something of a Hold, with a Neutral rating. Will stock gains continue in the second half of 2020? Perhaps, perhaps not. If you need technology exposure, an investment in International Business Machines (IBM) makes more sense to me today. I wrote a bullish article on IBM last week here. The IBM story includes a new innovation-focused CEO, and dramatically better valuations to build an advance, including a 5% dividend payout while you wait.
If you own Apple shares, be mindful any "disturbance in the force," and/or rebalancing of tech power between China and the U.S. could derail Apple's price gains without a lot of notice. Apple's business is already reeling from the global economic shutdowns and supply chain disruptions resulting from the coronavirus pandemic. Another major hit to sales and/or production costs could mean falling income a year or two ahead, not the priced in growth expectation. I would also prepare for a large repricing event lower if a second wave of coronavirus appears in the fall/winter. Any way you slice it, Apple shares may now hold the greatest risk of long-term price decline since the 2009 end of the Great Recession.
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Comments (223)
Thank you for your excellent article and supporting analysis. I completely agree and sold the AAPL position which I bought in 12/2018 @ $157/share today. No doubt that Fed stimulus may drive it higher, however, I am very happy to lock-in my alpha now.
I also share your view on IBM which I have as a long hold. I agree that the acquisition of Red Hat along with new leadership has the potential to be transformational. It will require some patience, however, I view it as a relatively low risk, stable dividend, investment with substantial upside.
But you are talking about long term, and regarding the long term Apple is better positioned than it has ever been before.
You are recommending IBM for very questionable reasons. Did you take a look at the 5 year chart for IBM before recommending this stock? IBM is purely a bottom feeder play and unclear what the future holds.For Apple, the future is clear, they are dominating the technology of today and tomorrow, while enlarging their already historically huge and untouchable ecosystem and moat. Approx 50% of US population use IOs. Yet if you look at the teens, its 82% while 88% of teens want their next phone to be an Iphone. It would be wise to understand that the teenagers of today give an insight into the overall trends of society. The teenagers of today will be the adults of tomorrow. Speaking of adults, Apple's superior platforms and health care integration will cause many adults to switch to Apple products. Point being, most of the world is increasing their reliance and use of Apple products, including the supposedly saturated smartphone segment....which for Apple is far from saturated,
This phenomena translates to some extent to most other parts of the world. This means that even with just the Iphone, Apple has a lot of room for growth, but as most of us recognize, its not just about the Iphone for Apple and they have demonstrated that they are very capable of moving into huge new ideas and huge new revenue streams.
1. This pandemic has been amazing for the market - not economy - as it triggered trillions in stimulus. So many trillions I have lost count between the trillions from the FED and the Trillions from congress. Debt? long term cost? who cares says the market! let the suckers coming in later on pay the bills! Money Party is on!
2. As the FED balance sheet swells by trillions so does market valuations regardless of the terrible economic/corporate news. The market is no longer connected to economic reality.
3. The rich use the crisis to enrich themselves - see 3t stimulus from congress. Peanuts ($1200) for the masses to buy TP and mac & cheese while the vast majority of the 3T went to the top under the guise of helping mom and pop america. About 500B for us and 2.5t for them. Yup that seems fair.
4. Companies like apple with fortress balance sheets are getting stronger while the weak companies are getting crushed. Yes the fed cheap cash is allowing many zombie companies to live longer but the companies like apple, amazon, ms, google...they are getting more powerful.
C-19 is pushing many to move into these areas quicker... I have never purchased so many things online in my life vs hitting the stores. I may breakdown to get amazon prime...meh naaa I dont like signing up for anything. lol I'll hold my apple shares as I have for years. Let it drip to get more shares, watch the divy go up each spring, watch apple buy back a ton of shares... etc but I wont add new money here at all-time record highs. I'll wait on another market sale to add to my apple.
By the way, you prefer INTC! How does it compare with AMD?