Apple valuation – out of line with reason

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What ‘s going on? The City and Wall St have given up on Apple.

Apple logoThe stock has tanked more than 40% from a peak of $702 last September to a new low of just under $400 this morning.

The stock is also now trading at a price/earnings ratio of 9X.

That P/E ratio is well below the market average, which is about 15X.  It is also a valuation so low that it is generally awarded only to companies that Wall Street thinks are permanently screwed. (Think Dell, BlackBerry, or HP).

Apple also has ~$150 billion of cash and no debt, which means that the market’s assessment of Apple’s actual business is even more pessimistic. (If you buy the stock, you get the $150 billion of cash along with the company). Apple is also already paying a dividend of 2.5% — and this dividend is expected to increase going forward.

To put this in the most direct terms: Apple is now trading at a lower valuation than Dell. And that is crazy.

That is a seriously low valuation! And it’s one that suggests that there may be a compelling risk/reward for those brave enough to buy the collapsing stock at this level.

To be sure, much of the pessimism around Apple is justified. The case against the company is very easy to make right now:

  • The company’s growth has vanished: Earnings are expected to shrink this year.
  • The company’s critical product, the  iPhone, has lost its edge, and the product cycle that drove Apple’s mind-boggling profitability over the last several years (premium smartphone growth) is nearing its end.
  • Apple’s profit margin is dropping, as its main products get commoditized.
  • The CEO of the company is not a product visionary, and has not articulated a vision of where he wants to take Apple going forward.
  • Apple’s internal management may be in turmoil or at least in flux, and employees are reportedly more willing to leave than they have been before
  • No one knows if Apple has any truly great new products in the pipeline.
  • Apple has cash coming out of its ears, but no clue what do with it.
  • Apple’s first quarter results (coming next week) are likely to be disappointing, and the company’s outlook will likely force Wall Street to slash its future estimates.

All of those points are legitimate. And it’s possible that Apple is indeed in the early stages of a long-term decline.

(Such declines happen frequently in the tech industry — think Nokia,  BlackBerry or RIM as they were called, Microsoft, our old firm Digital Equipment Corporation, Yahoo and Apple in the 1990s, to name just a few. To think that this can’t happen to Apple would be the height of reality distortion.)

But …

Buried in this heap of terrible news is some good news: Wall Street has now become so pessimistic about Apple that it’s possible that investors will be positively surprised going forward.

At this valuation, Apple really does have to be in the early stages of an inexorable long-term decline for the stock not to provide a reasonable return.

How do we know?

Because, in the last fiscal year (ending in September), Apple generated more than $40 billion of cash.

At that rate of cash generation, it would take Apple only six years to earn enough cash to equal the value that Wall Street is currently placing on its entire business ($240 billion).

In other words, if you were able to buy all of Apple today for the current market price of ~$390 billion, you would be able to pocket the company’s $150 billion of cash. Then, if the company’s cash generation remained the same, you would only have to wait six years before you got back ALL of the cash you used to buy the company. Then you would own Apple’s business free and clear, for nothing.

What this tells you is that, at the current stock price, Wall Street is assuming that Apple won’t generate anywhere near $40 billion of cash a year going forward. (If Wall Street did assume this, then every Warren Buffett-like “value” manager in the world would be loading up on the stock.)

The stock’s current price, in fact, suggests that Wall Street thinks that Apple’s cash generation will collapse going forward.

And it very well might.

Thanks to the competitive dynamics in the global hardware business, and Apple’s need to both reduce prices on its current products and launch lower-priced products, Apple’s profit margin will likely drop sharply in the future.

But …

The markets that Apple is selling into — global smartphones and tablets — should continue to grow on a unit basis. So, if Apple does launch lower-priced products to remain competitive, Apple’s overall revenue should continue to grow.

And here’s the key point: Even if Apple’s profit margin gets cut in half, and even if the company’s revenue never grows again, Apple will still generate enough cash to pay back investors in 12-13 years for buying the business today.

That’s how cheap the stock has gotten.

Even if Apple’s cash generation falls to $20 billion a year from $40 billion, which would be close to a disaster, Apple should still generate $250 billion of cash over the next dozen years. Add that to the $150 billion of cash the company already has, and the investment will have entirely paid for itself within 10-15 years.

In other words, to believe that Apple’s stock is worth even less than the current market price, you basically have to think that the company is becoming Nokia.

Before you laugh at that idea, please understand that Apple might be becoming Nokia. No one knows how the Apple story will turn out, including the folks at Apple. The folks at Nokia a few years ago certainly didn’t think they were becoming today’s Nokia. And Nokia investors didn’t think that world-beating Nokia was becoming burning-platform Nokia, either. That’s how it goes in the hardware business.

But the optimistic point here is that there is a distinct possibility that Apple might NOT be becoming today’s Nokia. There is a possibility that Apple might actually stabilize and remain a good if not mind-bogglingly amazing company.

That’s the bull case for the stock at these levels.

The bull case is that Wall Street has gotten so remarkably pessimistic about Apple that it might not actually be hard for Apple to positively surprise investors in the future — especially once we get past next week’s earnings and the presumably lousy first half of this year.

To support this bull case, here are some positive aspects of the Apple story that Wall Street is currently ignoring:

  • The stock is cheap (as illustrated above).
  • We are nearing the end of the new-product blackout that began last fall. (In relatively short order, excitement should begin to build about the iPhone 5S, the new iPad Mini, and other product refreshes, even if Apple doesn’t have anything truly new up its sleeves.)
  • While Apple’s management team without Steve Jobs in charge is unproven, it’s not stupid. Almost all of the folks who produced and sold Apple’s great products over the past five years are still on the team.
  • Apple appears to be working on a cheaper iPhone, which suggests it is finally willing to trade profit margin for growth. This is critical for the company’s long-term survival, and it’s something Apple should have done a couple of years ago, when it was still the industry leader. But better late than never.
  • A disastrous first quarter and second-quarter outlook should radically reduce Wall Street’s expectations for Apple — thus setting the bar lower. This will make it easier for Apple to positively surprise investors in the future.
  • It is still possible that Apple is working on a revolutionary new product like a TV or smartwatch that will suddenly get people jazzed about the company again. Yes, as time goes by, this possibility seems more remote. But it’s not zero.
  • Most importantly, Apple is still well-positioned strategically, and it still makes excellent products. We are not talking about a company like HP or Dell, which are in businesses that are dying (PCs). And we’re not talking about a company whose products have gone to crap. We’re just talking about a company that has lost its product edge and clung too long to its super-premium pricing strategy instead of using its phenomenal profit margin and financial resources to remain both the quality leader AND the price leader. The global smartphone and tablet industries are going to continue grow rapidly over the next several years. Assuming Apple makes smart decisions on the pricing side, Apple should grow with them.

Last summer, Apple was priced at such a high level that everything had to go right for the stock to continue to do well.

Now, however, the stock is priced at such a low-level that almost everything has to go wrong for the stock to continue its collapse.

Yes, everything may well go wrong.

But there is a distinct possibility that it may not go wrong. And if it doesn’t go wrong, Apple’s stock should provide a good return from this level. And it could even provide a great one.

(published on BI – Read more:

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