AAPL: The Reformation

REFORMED BEAR: Terrier Investing

For a long time, I’ve been an “Apple hater”. I’m unashamed to admit that I’m a PC/Android guy. I like being able to customize things, I prefer those OSes for computers and phones respectively, and especially for computers, I don’t like paying Apple’s premium margins when I can get an otherwise equivalent machine (with an OS I like better) for a lower price. A year or so ago, I was convinced that anyone standing in line to buy an Apple (AAPL) product on the day of release was somewhere on the spectrum between crazy and delusional. From an investment perspective, I believed that Apple’s margins and revenues might be unsustainable as the “Apple fad” faded and former fanboys opted for cheaper, equally-featured products from competitors.

However, several recent events have caused me to reevaluate my position, which is why I found a recent article entitled “Apple is in Deep Trouble: A Reformed Bull Speaks Out” to be curious. In the article, the author (Josh Arnold) discusses many of the same points I used to think about – commoditization of smartphones, waning of brand loyalty, etc.

I think those arguments certainly still have some merit, and should be considered by anyone considering a position in the stock. But as anyone who read my previous two articles has probably gathered, I tend to believe that for investors, qualitative analysis is as important as (if not more important than) quantitative analysis. Why is that? Well, as several of my professors used to say, there are lies, damned lies, and statistics. My statistics professor obviously disagreed. Nonetheless, the concept is probably valid, and applies to financial models as well. Garbage in, garbage out, as they say – if you really want a stock to be undervalued, all you have to do is tweak the discount rate and assume a few basis points extra margin and revenue growth (things that nobody will really object to) and boom, there you go. Conversely, if you really want to convince yourself a stock is overvalued, discount their cash for repatriation and jack up the discount rate and be extra-conservative in modeling growth and margins, and pretty soon you get to an ugly target price.

For these reasons, I believe models are primarily useful to help you A) understand how the business looks, operates, and is valued under different conditions and B) give you an idea of what sort of price you’re paying for it.

But even if I model a company and it looks like the stock is a screaming buy, I will refuse to invest in it if I don’t understand the story, the qualitative reasoning behind why this is a good investment. Markets are inefficient, yes, but often not brutally so, especially if we’re talking about a mega-cap that gets analyzed to death. If you think a company has drifted from its intrinsic value by a double-digit percentage, then you’d better have some justification for your variant view. If you don’t have that justification solidly backed up by your analysis of the situation, then who are you to say your numbers are better than the Wharton guys who get paid the big bucks to do this for Goldman and Credit Suisse and David Einhorn?

So Apple, obviously, looks cheap as an investment. Low P/E, lots of cash, etc. I don’t need to get into the details because ten million people (probably literally) have already done that and I’m not adding any value to your day by waxing on about something that everyone already knows. And see, that’s the problem – everyone knows Apple’s cheap on all the traditional valuation metrics. It’s been that way for a while, even when it was growing at a gangbusters pace. When everyone knows something, it’s not a variant view. If it’s not a variant view, how are you going to achieve above-average investment returns? You’re just doing what everyone else is; if you’re doing what everyone else is, you can’t do better than them. It’s impossible by definition.

Where am I going with all this? I agree with Josh on so many of his points – I do think that Apple will struggle to maintain margins if they try to expand beyond ultrapremium products or if their brand loyalty fades. I think most people agree the 5C didn’t work out so hot, etc.

Yet at the same time, while I used to call Apple a fad and laugh at the fact that Apple users’ brains light up like it’s their religion, I also came to the realization that some of the smartest people in my life are Apple devotees. A friend retired from a very lucrative career in management consulting has been an Apple user from day 1; a very smart hedge fund manager has as well. My friend and fellow tech enthusiast Ashraf Eassa called the 5S “gorgeous” after switching from Android and has been raving about the new lineup of MacBooks. There are others (though I know plenty of brilliant PC/Android guys as well).

Quite honestly, I still don’t get it, though perhaps my new MacBook (property of my employer – I’m still not a convert!) will change my mind. I’m open to it – in fact, the more I think about it, the more I realize that 90% of my computer time is spent in Microsoft (MSFT) Word, Excel, PowerPoint, or an internet browser. My experience in those programs should be largely the same as it is now, with a few buttons moved around at the most. Will I become an Apple devotee? I doubt it, although it is kind of amusing to ask Siri where to hide a body whenever I get my hands on my friends’ iPhones. (Between that and a few other joke requests, I can only imagine what the NSA thinks of my friends now.)

Anyway, if someone as anti-Apple as me can grow warm to the products, and if many people I really respect are as in love with their iPhones as the next guy, then perhaps my initial perceptions were wrong, and Apple’s not a fad. Maybe it really is the next brand as persistent as Coke (KO), and it’s not the next Motorola (MSI) or BlackBerry (BBRY).

I still don’t understand Apple, so I won’t invest in it, despite the fact that it certainly looks cheap on many metrics. However, in my reformed position, I cannot fully agree with Josh either – signs I would have taken as “deep trouble” a year ago now look more like continuation of an enigma.

If there’s one thing you should take away from this article, it’s this: know what you don’t know. I’m no longer overtly bearish on Apple, because there seems to be something I’ve been missing in this story. (Please note: I have never been short Apple. I was bearish on the stock but did not take a position.)

Like Josh, I’m willing to admit when I believe I may have been wrong. In this case, however, we seem to have reversed positions (to an extent – I’m not “bullish”, I’m just not bearish anymore). Apple certainly has strengths – I’m amazed, for example, that a laptop shipping out from China a night or two ago is apparently slated to arrive on my doorstep tomorrow afternoon. That takes a lot of supply chain tuning. Plus, Apple’s recent A7 chip is a very competitive offering. Apple clearly has plenty of smart people in their organization; I can’t claim to predict what they can or can’t come up with.

A brief postscript explaining my decision to hold a position in Microsoft but not Apple, despite the former’s continuous and egregious attempts to make investors shake their heads. While I’m not confident enough in Apple’s business model to invest in it, the one thing I am confident in is that enterprise will continue to remain a strength for Microsoft; Apple will also likely not sacrifice margins to compete in the low end of the market, leaving plenty of room for other players.

Ultimately, while knowing something isn’t enough to invest in it, you should only invest in it if you do know it, if that makes sense. If you get Apple and think it’s a rock star investment, then I won’t disagree with you. If, like me, you don’t get it, then that’s fine too – plenty of other fish in the investing sea. And if, no matter who you are, you read a point of view you disagree with – whether on Apple or another stock you have a position in – then you should read it with a clear head and determine if there’s any validity to the argument. After all, it’s your money on the line; why let emotion or pride set you up for a fall?


Let me preface my remarks here by coming clean about my past views on Apple (AAPL). In the last year or so I penned a number of bullish pieces on the Cupertino giant because I believed the growth expectations from analysts. I believed that innovation wasn’t dead at Apple. I believed that the company could continue to be great without Steve Jobs. I’m here now saying none of those things came true and that Apple is in serious trouble.

The much ballyhooed event that occurred earlier this week was supposed to be something of a game changer for Apple. Instead, what we got was more incremental improvements in its existing product lines. Yes there was a new OS, yes the iPad Air is neat and yes the retina display on the Mini looks great. However, none of these things address the concerns I (and other investors) have regarding Apple’s long term future. How long can it continue to sell the same devices year after year? How long will people settle for the same products that have existed in virtually their current forms for years? The answer, if market share is any indication, is not long.

In 2011, Apple had something like 65% of tablet market share. Last year, that number dropped to 54% and this year, Gartner expects Apple to be below 50%. Before you point out that one company owning 50% of a market the size of tablets is still amazing, you’re right, it is. However, the amount of customers voting with their feet and buying Android is staggering. Where is the bottom in terms of market share for Apple? We don’t know but this looks a little like BlackBerry (BBRY) did several years ago; “Yeah we’re losing market share, but so what?” could probably be heard in the halls of the corporate campus of BBRY in years past. The fact is there are far too many very good competitors for Apple to maintain a 50% market share over the long term in my view and it looks like we’ll see the market share number continue to fall as Apple clearly has no intention of innovating in the space any more. Making an existing product lighter is great but it’s no reason to run out and buy one (not to mention the ridiculous premium one is charged for the Air model). Where are the new features that blow our collective minds? I don’t see them in new iterations of the iPad and I think it’s because Apple is out of ideas.

The company also came out with the retina display for iPad Mini, which, again, is great (and 100% telegraphed prior to the event) but it’s no reason to run out and buy an iPad that you weren’t already planning to buy. There were also the usual processing power and battery life upgrades but all of these things are evolutionary, not revolutionary, and we’ve seen it all before. I don’t think Jobs would have settled for this long with Apple’s current product lineup and incremental change after incremental change. Maybe we’re all too spoiled by Apple’s rise from a nearly defunct computer manufacturer to the largest company in the country but there is nothing to be impressed by anymore.

Perhaps even more disturbing, Apple cut prices on a version of its iPad Mini. This coming from the company that historically discounts sparingly and is notoriously strict with its retail partners in terms of ensuring the premium for Apple products is respected. Apple’s margins have been falling for several quarters now due to a confluence of factors including lower ASPs and lower sales. In fact, for the first time ever, Apple sold fewer iPads in the June quarter this year than last year. The point is that the lack of innovation is catching up to the company’s operating results and shareholders should be concerned.

When Apple has tried something new, the iPhone 5C, for instance, it hasn’t worked. Yes, the 5S is apparently selling like hotcakes in relation to the C but I suspect Apple only had to raise its builds for the S because it was cannibalizing C sales. And besides, the C is just another iteration of the iPhone; it once again isn’t innovative or disruptive, it simply seeks to compete in a slightly different way. I acknowledge the formula Apple has worked with for years has succeeded like no other and made it the largest company in the country. However, tech companies, particularly hardware suppliers like Apple, always have to innovate or they will go by the wayside eventually. Is Apple the next BBRY or Nokia (NOK)? Maybe, time will tell. But the company is well on its way with its lack of innovation and new products.

With EPS expected to have fallen a whopping 11% for fiscal 2013 to just under $40 per share, Apple shareholders experienced a violent revaluation of shares in the past year or so. This company went from constantly destroying estimates to suddenly missing them and then to declining earnings. Given Apple’s inability to gain traction with the 5C and the marginal changes to the entirety of the iPad lines, I just don’t see how the company will be able to post the 10% earnings growth that is expected for next year. You have a company with declining margins, falling ASPs, a stale product line and its competitors taking market share in tablets and phones every day. Where is the growth coming from? With iPad sales numbers declining YoY and the iPhone 5C clearly a bust, I suspect there is decent downside risk to analyst estimates at this point. Even if Apple can somehow manage to hit its revenue estimates, margins are declining so rapidly that EPS would likely still be light.

Apple looks cheap at only 12 times next year’s earnings. In fact, 12 times earnings for a company with a declining customer base, declining margins and no catalyst for growth in the near to medium term is probably too generous. The fact is Apple gets the vast majority of its revenue when it sells a device; it doesn’t have the luxury of a recurring revenue stream like Oracle (ORCL) or IBM (IBM), which, by the way, sell for only 10 and 9 times next year’s earnings, respectively.

If you were fortunate enough to own Apple over the past three months you should take what the market has given you and get out. With declining market share, falling margins and no catalysts on the horizon, I think Apple could (and should) trade down to a multiple of 9 or 10. And given that I think there is a decent possibility for an earnings miss on next year’s $43+ EPS estimate, fair value for Apple is likely in the $380 to $420 range based on $42 in FY2014 EPS and my PE range of 9 to 10. That is a long way down from where we are now (shares saw $700 last September and by April, were languishing below $400, so it could happen) but Apple is currently receiving a multiple it doesn’t deserve and I think that the company will struggle to reach $43 in EPS next year without some kind of transformational new product. But given that Apple clearly has no imagination left whatsoever, I’m not holding my breath.

made to accuracy or completeness. I am long the companies mentioned in the disclosure and may change my position at any time without notification. Please see the full disclaimer in my profile, and do your own due diligence before making any investment.


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