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What Google, Microsoft Valuations Teach Apple Investors?

 December 07, 2012 10:50 AM

(By Mani) Shares of Apple, Inc. (NASDAQ: AAPL) dropped 7 percent in the past five days after a DigiTimes story seeing a sharp drop in component orders by Apple, which hints at lower than expected demand, and an IDC report saying that Apple is losing market share in China.

At this juncture, Apple's stock faces a conflict between valuation and momentum. Its P/E of 12x trailing earnings and 11x forward expectations appears quite inexpensive for a company with a return on invested capital (ROIC) over 30 percent and growth of about 20 percent in the next two years.

On the other hand, slowing revenue and earnings growth along with potentially peaking margins create the kind of negative momentum from which tech investors often flee.

[Related -Sobering Quarter and Guidance for Long-Time Apple Bull]

Apple's multiple has been in a decline since 2009, with its peak coinciding with the release of the iPhone 3GS and before the iPad's debut in mid-2010. Steve Jobs died Oct. 25, 2011, but one might argue that some of the P/E compression has been in part due to investor concerns regarding his health.

"Indeed, the bears argue that his passing puts a permanent pall over innovation at Apple. We are not prepared to call innovation dead," UBS analyst Steven Milunovich wrote in a note to clients.

There are potential advancements including the incorporation of biometrics (fingerprint, optical sensors, facial recognition), a material leap in voice recognition (Siri), new consumer cloud services, or even a step towards augmented reality peripherals.

[Related -Amazon.com, Inc. (AMZN) Q4 Earnings Preview: Will Amazon's EPS Top Street?]

Apple's operating margin has grown from the mid-20s to the mid-to-low 30s thanks to an increasing mix of margin-accretive iPhone sales. Although profitability has improved, revenue growth has been cut in half from 50 percent plus in mid-2011.

At the same time, Android vendors have benefited disproportionately and now constitute 72 percent of global smartphone sales and 35 percent of profits. The success of Android vendors and the entry of lower-priced tablets from Amazon.com, Inc. (NASDAQ: AMZN) have triggered investor concerns that the best days are behind for Apple.

History says that valuations of giants such as Google, Inc. (NASDAQ: GOOG) and Microsoft Corp. (NASDAQ: MSFT) were affected as their businesses matured. Google and Microsoft enjoyed multiple expansion as they reached dominant market shares, but then saw their P/Es decline as earnings growth slowed.

Google's share of search has been steady in the mid-60s the last five years. As its search share peaked, so did its revenue growth. The stock's multiple declined significantly in the second-half of the decade despite maintaining high margins.

Revenue growth has accelerated in recent years as Google diversified into other business lines (DoubleClick, mobile advertising, Android/Motorola), but the P/E has not benefited with some of these additions not earning their cost of capital.

Similarly, Apple's revenue growth is bound to slow given its size, and margins likely are peaking with the iPhone two-thirds of profit.

"We expect Mac and iPad should continue to be successful but at lower margins," Milunovich noted.

Microsoft's P/E declined from its peak during the tech bubble, which coincided with a topping of PC growth. Despite a resurgence in PC sales and Microsoft's earnings growth toward the middle of the decade, the multiple continued to decline.

So, the experience of Google and Microsoft would suggest that an upward re-rating of Apple P/E is unlikely once revenue growth and/or operating margin declines commence. The stock can continue to rise though it is more likely to be through earnings growth than P/E expansion.

Meanwhile, a high P/E depends on the company's earnings in excess of its ROIC, and growth. Generally, investors fail to appreciate the magnitude and type of growth required to support a high P/E ratio. Although Apple's growth is coming down, its ROIC remains high.

"Our conclusion is that it is not over for Apple's stock, but without P/E expansion more moderate outperformance is likely," Milunovich said.



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