APPLE: The Fall of The Tech God & “Fundamental Investors”

Joon Ming "James" is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.


 
Applecules, aka Apple (NASDAQ: AAPL), reign at Mount Silicon Valley has been challenged by its peers.

In this article we will cover:

1. Limitations in valuing a tech stock

A classic obstacle suffered by most “modern value investors". Many valuation models end up generating earnings forecasts which largely deviate from actual results. Hence, the constant revisions of buy/sell convictions that you see every quarter.

Not surprising, as most models do not adjust for the following:

A. Lifecycle of innovation

A classic exponential graph which ends up looking like a high gradient, bell shaped curve (exactly the shape Apple’s stock price is taking currently). Both the price and earnings of many tech stocks will end up falling under this pattern, which is difficult to predict with precision.

Source: Finviz

The tendency to be under-optimistic when the stock carries high multiples, or conversely overoptimistic when the stock carries low valuation multiples is prevalent.

B. Industry psychology bias: Passion VS Job Requirement.

Wall Street has done the glamorous mistake of making almost every analyst trail Apple, regardless of whether the analyst was genuinely passionate about technology, thus creating a herd mentality (copycat mode).

 

2. Why Apple is not a bargain @$400+

Many fundamental investors got caught into believing Apple was a good bargain even at the peaks.

The rhetorical story of “Fundamentals” provided what seemed a convincingly solid argument that Apple was cheap-

  • Low P/E,
  • Very Low PEG,
  • Low P/FCF ,
  • High Gross Margins
  • Loads of cash

One core concept of Ben Graham was left out cold – A focus on the balance sheet. This helps reduce overoptimism & helps in computing the floor value. For a tech stock it is:

** Liquidation value/ Takeover value

Since Apple is massive, the latter is 100% unlikely. We will use liquidation value.

 

Let us consider the Fundamentals of this stock:

A. Earnings & earnings growth.

Right now Apple still looks like a bargain, with all that chatter that under conservative estimates of earnings growth, the stock is trading at a forecast P/E of 8-9.

 

Current

Scenario 1: Decline of 10%

Scenario 2: Decline of 20%

P/E

9.65

12.77

18.62

Gross Margin

41.91%

31.91%

21.91%

Operating Margin

33.46% (80% of Gross)

25.53% (80% of G)

17.52% (80% of G)

Profit Margin

25.35% (75% of Operating/60% Gross)

19.15% (60% of G)

13.14% (60% of G)

Source:Modified from Finviz


Take a look at Apple’s Gross Margin- a fantastic 42%. In contrast with its competitors:

  • HTC Corp 25% (Source: HTC website)
  • Nokia 28% (Source: Finviz)

Expecting further competition, a drop of gross margin from 40%/revenue to about 20-30%/revenue to match its peers is a reasonable expectation. Suddenly Apple’s P/E ratio doesn’t look that attractive anymore.

B. Price to Book

P/B currently is 3.14 (Source : Finviz).

If you are convinced that there is unaccounted value that can be unlocked from Apple’s patents, I would argue otherwise.

Apple is selling an ecosystem of product and software marriage.

From a software & services standpoint, it has boxed itself up to solely Apple products & is unable to license much of its patent portfolio to external parties for income generation. In contrast, Google and Windows both exercise an open architecture. Google is the frontrunner with Google Maps,Google Search & their takeover-every-industry vehicle, Google Ventures.

In terms of product design patents, Samsung and other China counterparts are responsible for piecing together Apple’s products. Right now Apple isn’t innovating fast enough to beat the copy-cat skills of its Asian counterparts. In fact, it is trailing Samsung (Samsung S4 anyone?) 

Recent lawsuits by Apple against Samsung have also proved that international patent laws can be an awfully sticky affair.

C. Cash levels.

Should a value investor celebrate when the company is holding huge loads of cash? Yes, only if the company is:

I. Not burning cash

II. Paying out great dividends (like Telstra)

III. Possess exceptional financial management skills.

Holding so much cash and not increasing its dividend during the highs of $600-700 makes Apple's financial decisions questionable. Apple did not go into acquisition spree like Google & should not hold so much cash.  Rumors mention that the majority of cash is buried into short-term money market investments and corporate bonds(sounds like a Markowitz Portfolio) through its “Secret Hedge Fund” Braeburn Capital. Why is Apple making market punts?

D. Debt levels

The vindicator among Apple’s financial ratios. Having almost no debt gives Apple a huge “time value option” premium to innovate itself to the top again.

But I remain in doubt of Tim Cook’s ability for exceptional leadership. 

E. Competitive advantage

Competition is a fluid process and competitive advantages get erased rather quickly in the tech industry.

Apple is losing its edge. Some graphs from Google Trends to show Apple’s popularity in contrast with some competitors.


Graph: Search trends for different OS
Source: Google Trends

Graph: Search trends for Apple / Samsung (might include normal searches for the fruit “apple”)

Source: Google Trends

Apple TV has been cited as a huge potential catalyst. I’m in doubt. What can Apple TV offer that is so distinctively different from Google TV, Netflix other Internet TV content providers?

Source: Google Trends

 

F. Position in the Consumer’s mind

By putting an “S” behind its products, Apple made good money in the short run, but shot itself in the foot in a longer term perspective.

We now have a wait-for-the-following-upgrade situation. The Apple 5S may not be enough for the consumer any longer. If it isn’t called iPhone 6, why bother?

 

G. Buffet is recommending a stock buyback

Clearly a misquote.

Buffet recommended a stock buyback at $200+ levels when he spoke with Jobs, not $400+.
 

H. Apple @ $250

Current P/B

3.14

Current EPS (ttm)

$44.10

Stock Price

$425.66

 

 

Valuation:

 

BV

$135.56

Plus EPS x 3

$132.30

TOTAL

$267.86

* $250 is my floor value.

Nokia (NYSE: NOK) went from top profit to losses within 3 years. Apple may take a twice the amount of time before ending up unprofitable. The chart below created a basis for the use of 3X current EPS.

Source: Modified from Ycharts

 

Conclusion:

The only reason to buy the stock at current "depressed" $400 plus prices, is to get the iPrefs(if it goes through) and sell on a quick gain. 

For me, my entry price is only at $250. Apple is neither a Buy candidate or a Short candidate at such prices.

 


Joon Ming "James" Ho has a long position on Jan 2014 and Jan 2015 Nokia Call Options. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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