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Apple Is a Great Company With a Dubious Valuation

On Oct. 30, Apple Inc. (NASDAQ:AAPL) reported a surprise earnings beat for the fourth quarter. The company touted its services and wearables businesses as key supporters of the results, while signaling that these segments would be key to driving long-term growth.

Why the need for new business segments to drive growth? The answer is simple: smartphone market saturation.

As I discussed in a previous article for GuruFocus, Apple's growth over the past decade has been fueled in large part by the exceptionally popular iPhone smartphone platform. As mobile saturation has gradually gone global, opportunities for market expansion have petered out. Consequently, Apple has found itself in need of new growth drivers in order to keep its narrative - and high-flying share price - alive.

Earnings beat masks troubling slowdown

Apple defied market expectations with its fourth-quarter earnings beat. Tariff-related headwinds and secular mobile saturation weighed on iPhone sales, but other segments did better than expected. The result, especially the apparent strength of non-core business segments, caused some skeptical analysts to bend the knee to CEO Tim Cook once more. However, as tech analyst Beth Kindig observed in her post-earnings commentary, Apple's beat could not fully obscure the problems lurking below the surface:

"The fiscal Q4 earnings beat is at odds with overall performance. Although profit topped expectations, this is the first time since Tim Cook took over in 2011 that Apple declined in profit in all four quarters of a fiscal year...It's unlikely lightning strikes twice with the iPhone as it's not only one of Apple's best growth drivers historically, but it's also one of the best growth drivers we've seen across the tech industry. This is evident in last year's smartphone revenue of $165 billion."

The development of the iPhone was a staggering achievement of engineering, design and marketing. It transformed the mobile phone industry and inaugurated the "Age of the Smartphone." Yet, for all its revolutionary power, the iPhone cannot overcome economic laws. Smartphone saturation means that Apple can no longer rely on the iPhone to drive growth. Meanwhile, the company's great hopes for the future - services, wearables, AppleTV, etc. - lack the scale or growth trajectory to serve as credible replacement engines for long-term earnings growth.

Plugging holes with buybacks

In lieu of real earnings growth, Apple has been turning to a time-honored method for boosting the bottom line: share buybacks.

Buybacks reduce the share count, which means that earnings per share can appear to expand even if total earnings are stagnant - or even shrinking. Buybacks rely on cash, and that is something Apple has plenty of. Yet, for all their utility in bolstering earnings per share, buybacks are fundamentally limited, as stock analyst Knox Ridley discussed in a Nov. 9 report on Apple:

"Apple has turned to buybacks to boost its stock and spend its cash hoard. Since January last year, the company has spent more than $120 billion on buybacks. The question, though, is how effective these buybacks are to retail investors. Large companies with growth problems have used buyback programs as short-term solutions for sluggish performance. In the short-term, share repurchases can help boost a stock price. However, in the long-term, Apple's share price growth will depend on the performance of certain specific segments."

Buybacks can only support earnings per share; they cannot create real growth. Without tangible bottom-line growth over the long run, buybacks tend, ultimately, to fizzle out.

Good company, not so good stock

Despite my negatively tinged commentary, I want to make it perfectly clear that I still consider Apple to be a great company. It may even be one of the greatest of the past three decades. Indeed, barring some unforeseen catastrophe, Apple will remain profitable for an awfully long time, and it has a vast cash balance that it can put to a number of good uses. Yet, a great company does not necessarily have a great stock. Ridley made this exact point last month:

"If we look at the current valuations, Apple's stock price is trading with a P/S of 4.5, a P/E ratio of around 25 and a price to free cash flow of 20, as of the writing of this report. While these valuations are relatively mild compared to some of the valuations being shopped around in the tech industry, for a company with a market cap of $1.3 Trillion, these valuations suggest future growth in order to justify current prices."

Apple's share price implies years of very healthy growth, not merely stabilization, let alone retrenchment. Consequently, Apple appears to be a good company with a badly mispriced stock.

Disclosure: No positions.

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This article first appeared on GuruFocus.