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Should Apple Shareholders Be Worried About The 35% Decline?

 February 19, 2013 10:17 AM

(By Aristofanis) "Prediction is difficult, especially about the future" (Yogi Berra)

Apple (AAPL) is by far the most popular subject of stock market analysts, investors, even consumers. It is also the stock with the most diverging opinions among investors. Apple became a legend for its outstanding innovations, which led the stock price from $7 to $700 in exactly 10 years (September 2002 - September 2012) while its earnings multiplied by about 500 times. Steve Job's death about a year ago raised doubts about the ability of the company to sustain its growth, but the company has continued to thrive till today. However, the first clouds appeared in the stock performance in the last five months, with the stock losing about 35% of its value. The big question is whether this is a temporary correction or a significant fall from an all-time high.

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Apple's loyal shareholders will claim that this question has often been raised in the past, and the correct answer was always the same: just a temporary correction.

However, I would like to express a different view. First of all, Apple achieved such great, unprecedented, performance in the last decade largely due to the unique personality of Steve Jobs, who succeeded in conceiving and implementing great innovations. Some people will claim that Apple has increased its earnings by about 60% after Steve Job's death and is expected to grow earnings by an additional 15% in the next two years. This is true but it is largely due to the momentum maintained from the era of Steve Jobs as smartphones and tablets have had plenty of room for growth in 2012 and 2013 because they are cutting-edge products.

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Nevertheless, the technology sector is so fast-growing and so intensely competitive that the momentum cannot last for long unless a company continuously comes up with new excellent ideas. This is not very likely now that Steve Jobs is gone. The intense competition is already evident in the market of smartphones, in which Samsung has been quite aggressive, earning market-share from Apple and squeezing the profit margins of the market. This is very important as smart phones represent 51% of Apple's sales. Experience has taught us that this is always the case in such profitable markets; the exceptional profits always attract new companies, which enter the market and squeeze the margins of the leader. The leader of course has the advantage of making exceptional, monopoly-like, profits in the beginning, but this lasts only until its competitors manage to reproduce the initially unique product.

More specifically, in the latest earnings announcement, Apple reported that its gross margin fell from 45.9% during the first half of 2012 to 38.6% during the last quarter of 2012. To make it worse, the company now expects a further decline of its gross margin to about 38% in the second quarter of 2013, attributing this consistent decline in its gross margin largely to the shift of consumers to lower-priced products. To realize the impact of this decline of gross margin from 45.9% to 38%, it would mean a reduction in the annual earnings of about $8 B (about $8 lower EPS) if sales were to remain constant.

Of course, Apple is expected to continue growing sales. However, only in the last two years Apple sold about 200 million iPhones and 90 million iPads. This means that 1 out of 30 people on earth recently bought an iPhone. If one takes into account the ages that are interested in having an iPhone and the percent of those people who can readily afford to buy an iPhone, one will conclude that the above performance cannot be repeated often in the future. In addition, in every quarter of 2012, the total sales of Apple were lower than those of the previous quarter except for the 4th quarter, in which sales stabilized. Therefore, I seriously doubt that Apple can sustain its recent annual growth rate unless the world is filled with iPhones.

Another interesting fact is that analysts have reduced their expectations of Apple's earnings growth to just 1% this year (down from expectations for 11% growth three months ago). This is by far the lowest growth rate for Apple in the last decade. Even in the great recession of 2009 Apple increased its earnings by 30%. This means that the analysts do not believe that Apple will keep coming up with new great ideas but will just cash in the profits from its past exceptional innovations. That's why the stock market assigns such a low P/E ratio to Apple (about 10 for the closing stock price of February 15th, $460).

To make it worse, please try to remember the context in which the stock recorded its all-time high of $705. The enthusiasm from the expectations for the imminent record sales of iPhones was overwhelming, and everyone was in an unparalleled euphoria, predicting that the stock was destined to reach $1000 in a matter of months. These are conditions that prevail in every major top in the stock market. It is really difficult to realize the top during its formation, but an experienced investor should be able to recognize it after its formation.

Therefore, even though I am a great fan of Apple and its products, I am afraid that the company cannot sustain its current annual growth rate and will inevitably face smaller margins due to the increased competition. Consequently, I believe Apple will not reach its peak again and will be in a downward trajectory in the future.

However, unlike the decline of other companies from their peak, Apple exhibits a unique feature. Thanks to its unprecedented performance, the company has accumulated $137 B in cash and equivalents and is likely to approach $200 B in the next 2-3 years if it does not markedly raise its dividend. This unbelievable amount of cash can give Apple a unique power to defend its share price by share repurchases even if the earnings decline in the next years. The company will be able to purchase more than half of its shares at around $400 and thus prevent its EPS from falling even if its earnings decline. Just as the central bank of Switzerland declares that it will not let the Euro fall below 1.20 Francs (by selling Francs), in the same way Apple can declare that it will not allow its stock price fall below $400 by purchasing all the shares available at levels below $400. Therefore, Apple can significantly restrict the rate of decline of its stock price in the near future. Unfortunately, for the company's shareholders, Apple has not shown any interest in share repurchases so far and has let their outstanding number climb about 5% in the last 3 years. Of course, the strategy can change at lower share prices, which will render share repurchases more profitable for the company and its shareholders.

As a final note, I would like to emphasize that Einhorn's proposal for issuance of preferred shares will absolutely fail to prevent the decline of Apple's share price. As I expect the earnings of Apple to decline in the next few years, the company will progressively lose value by paying high dividends that cannot be sustained for long. On the other hand, share repurchases will provide permanent value to the company as they will provide permanent support to its earnings per share.



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