Michael Santoli

Apple: 3 Areas of Serious Scrutiny Ahead of Earnings

Michael Santoli

Success, they say, has many fathers, while failure is an orphan. And so Apple Inc. (AAPL) has gone from being every investor’s favorite child to the stray that few are eager to claim.

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A year ago, Apple stock was around $600, up 90% over the prior ten months and headed for an eventual peak above $700, swelling its parent-owners with pride. The indulgent sort known as growth-stock investors gushed, “Look at how it thrives, inventing such marvels that no one ever before conceived, earning beyond our dreams, and with half a world yet to conquer.”

The self-professed stricter sort of parents calling themselves value investors asked, “When has the biggest, most profitable and most popular company also been valued so moderately - no more expensive than the average stock, and so prudent with a buck that cash absolutely piles at its feet?”

An unwelcome stock

Today Apple has proven a loser for anyone who’s bought it since Christmas 2011, having collapsed to just above $400. The stock actually ended last week below $400. As with any perceived failure, Apple stock is now without a welcoming home, as investors find easy reasons not to own it.

Growth investors point out that 2013 is a non-growth year, with no world-wowing product releases slated and profits forecast to remain flat with 2012, albeit at impressive levels. Value investors grant that on paper the stock is achingly cheap, especially when setting aside the more than $100 in tax-adjusted cash per share on its books, which drags its price-to-earnings ratio below 8, half the market-wide average.

But without clarity on where Apple’s elevated profit margins might decline to, and absent any clear view of what a “normal” rate of sales and earnings might be, the usual buyers of cheap and out-of-favor stocks are wary.

The Bloodhound System, an investor research service, keeps a database of some 1 million pre-computed hypothetical investment strategies, spanning every permutation of growth, value, momentum and any other quantitative approach spreadsheet jockeys might devise. Apple now “qualifies” for less than 4% of those rules-based portfolios, a mark of how the company has a neither-fish-nor-fowl problem.

The “sell side” has not disowned Apple to the degree that many of their hedge-fund clients have, but their ardor has cooled. At the stock’s giddy peak in September, 94% of the 50 analysts covering AAPL rated it a Buy and none a Sell - a level of unanimity seasoned investors know to view skeptically. There are now 55 analysts, 82% of whom recommend the stock. That still shows too much faith to represent washed-out sentiment or make it a contrarian Buy.

Black ink still flowing

Yet per-share profit forecasts for the latest quarter have sunk to $9.98 from $12.24 at the start of the year, and fiscal-year 2013 numbers have dropped to $43.17 from $49.08, according to FactSet. Mind you, even at that reduced pace, such forecasts imply more than $40 billion in net income on $180 billion in sales, a larger pool of black ink than is produced by any corporate power aside from Exxon Mobil Corp. (XOM).

One reason Tuesday's earnings report has become such an intense focal point of investor attention and media hype is that it’s rare for a company of Apple’s size and dominance to have so many elements of its identity open for question at once. This will drive intense scrutiny across three areas: Profit margins, use of corporate cash and product roadmap.

-Margins: Apple’s gross profit margins above 40% mean it commands most of the global profit pool for mobile devices. The market has been pricing in a downward slant to margins in the direction of Samsung Electronics Co.’s 18% or so.

Because Apple controls the vast software and application “ecosystem” enjoyed by Apple consumers, it's unlikely margins will soon decline to Samsung’s. But how far and fast could they slip? At Samsung’s profit margins, Apple’s business is worth less than its present share price, by this analysis.

How would Apple’s possible push into lower-priced phones to compete better in China and elsewhere affect margin outlook? Samsung owns its production chain while Apple uses outside suppliers, which it has been able to muscle around in years’ past.

Big-picture questions

Will Apple, over time, need to spend more to make components itself, or will its sway with third-party manufacturers decline to make production more expensive? These are crucial big-picture questions and investors crave any clarity that might come from Tuesday's results.

-Cash. Usually when a growth company has a growth crisis, careful investors can fall back on a stream of future dividends out of a long-term profit run rate. Apple’s insistence on maintaining a large trove of inert cash and securities, much of it overseas, sets it outside this norm. Apple’s annual dividend of $10.60 a share represents less than a quarter of its present net income, though the stock’s decline has lifted the yield to 2.7%, which could begin to provide share-price support. Then there is the $137 billion in cash-like assets, which many investors would like seen deployed in a special dividend, share buyback, acquisitions or another clearly stated plan.

-Product. This is where Apple has spoiled customers and investors. By creating or redefining entire device categories in an amazing streak dating back through the iPad and iPhone to the iPod, Apple conditioned the public to anticipate massive breakthroughs with some regularity. Last year’s slate of fresh models created an unusual surge in buzz and profit, setting the stage for the 2013 lull.

Now that the distance between its phones and tablets and their competitors’ offerings has narrowed, investors and the Street are decrying a failure of innovative spirit, costing Apple the benefit of the doubt that the “next big thing” is being readied.

It’s possible Apple’s penchant for coy secrecy about coming products is working against it, as the world clamors for hints about an Apple watch or television device.

Or perhaps there isn’t an obvious new disruptive iSomething on the way. In which case, the market will have to adjust to Apple being a fabulously profitable, category-leading company with a more moderate growth rate helped by incremental product advances. Or maybe the market has already made that adjustment, and it's investors who need to come to terms with it?

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