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The Unanalyzable Apple

This article is more than 10 years old.

BEIJING, CHINA - JANUARY 13

Once more, a trainful of analysts low-balled Apple’s numbers.  Nobody thought to count the number of iPhones sold in China, but concentrated on declining subscriber counts at Verizon & AT&T in the U.S.

Suddenly, too, the fear of $400 iPhone subsidies coming in surfaced and worried the stock down 80 points in a couple of weeks, some days at a 15-point clip.  I’ll deal with subsidies later, but let’s look at the sheer magnitude of Apple.  There’s nothing like this comet in the world’s financial history.

Apple is earning at the rate of $50 billion per annum.  It took Exxon Mobil about 100 years to reach a $40 billion run rate and it needs to reinvest much of its cash flow just to keep oil reserves from shrinking.  Apple is spending about 2 percent of its revenues on research and development.  Tech houses like Microsoft and Intel spend consistently 15 percent of revenues on R & D.  Within 2 years, Apple probably amasses up to $200 billion in liquid assets assuming no major share buybacks.

What caught my eye on the eve of Apple’s March earnings report was April $560 put and call quotes ticked nearly in equilibrium at approximately $20.  How’s that for trader ambivalence?  It would cost you about 3.5 percent of Apple’s tick at $560 to take a stance on whether you get the lady or the tiger.  Well, you saw the lady.  Apple rose $50 in the after market after its 4:30 p.m. earnings release.  You coulda more than doubled your money, overnight.  I did this when I was 27 years old and poor, but no longer.

In about six months, Apple introduces its 4G phone that industry observers tell me processes data at much higher speeds.  This is what users want and reduces operating costs for wireless carriers like Verizon and AT&T.  Phone subsidies, on everyone’s mind, may hold in place next year but not forever.  Verizon management has to construe a $400 phone subsidy as a negative dependency, but I’m betting on Apple, still!  Go, iPhone5!

Pre-earnings report, I wasn’t ready to turn my back on Apple, but properly scared.  As Apple descended like a short golf putt rolling away from the hole, I felt a sharp gut-wrenching pain.  Consider a broader context.  Years ago, I bought Apple in the thirties, convinced that its new intro, the iPod, would make toast out of Sony’s Walkman with 500 million users, worldwide.  Sony never recovered and today approaches basket-case status.

Apple sits with a boodle of $100 billion, growing at a $50 billion annualized clip.  Let’s hope they don’t bank it forever at a near zero rate of return.  Apple isn’t Polaroid which oozed into bankruptcy with acute technological myopia, but it needs to reassure Wall Street that the future belongs to them.

Big cap properties ran a good race in the first quarter.  Favorites crossed the finish line, going away.  Iconic names embraced Microsoft, Apple, General Electric, Coca-Cola, JPMorgan Chase, Philip Morris International, even Citigroup and Wells Fargo.  There was a little not to like in IBM’s numbers as well as Intel’s and Qualcomm’s, but nothing seriously wrong.

IBM won’t be more than a market performer because its topline barely budges.  Contrastingly, Apple, Google and Qualcomm show beautiful toplines but issues of valuation and competitive forces move to the foreground.

Considering historic carnage in the cellular phone sector, (Nokia, Motorola and Research in Motion) Apple is likely to sell at a big discount to the price-earnings ratio of the S&P 500 Index which approximates 13 times earnings.  In Apple’s favor, iPhone owners are super loyal with a renewal rate above 90 percent.

Apple is yet to hook up with China Mobile, a major carrier, some 600 million subs.  Future growth for iPhones is predicated on new hookups with other international carriers in the Far East.  The U.S. market has topped out and a new negative variable just cropped up, possibly a 6 month components delay in its next iPhone upgrade.  This could inhibit next 2 quarters’ unit growth but so what.  China Mobile could add 50 million iPhones per annum for a couple of years.

When I look elsewhere in the list of top 25 market capitalizations in the S&P 500, I find less controversial names at a discount to the index’s valuation.  Microsoft and GE come to mind.  Microsoft this autumn goes into its new cycle for desktop computing, Windows 8.  Meantime, operating income for Windows and servers comes in above estimates with good expense control.

The sell-off in Apple goes to show you how fast confidence can fade for any property, even if it’s cheap at first glance and coins money.  My gut feel hasn’t changed.  Google’s price-earnings ratio is likely to hold up better than Apple’s.

But, there ain’t any hard evidence to bang out Apple.  iPhone sales could expand for a couple of years and then we’ll see what’s what.  In the interim, I see Apple headed towards a discounted valuation of 10 times earnings.  This is comparable with an ably run bank like JPMorgan Chase, but lower than Microsoft and IBM and higher than General Motors.

For Apple, the crucial variable in 2013 - ’14 is whether carriers like Verizon cut subscriber subsidies that can run to $400 an iPhone for a 2-year service contract.  They could be contemplating either a $100 subsidy reduction or lengthening service contracts to 3 years.

All this suggests unit volume could be crimped sharply, impacting earnings as much as 10 to 20 percent.  Carriers also look to add newly introduced competitors phones like Samsung’s Galaxy at a reduced subsidy rate.  Either way, Apple stands a loser.  The good news is nobody expects this to happen overnight, but sometime next year starts the press.

The non-performance of Google is more subtle because earnings aren’t ever likely to fall off a cliff.  First quarter metrics were hard to find fault with.  Revenues, paid clicks, expense control and earnings were crowd pleasers, but the stock is doggy, down 5 percent for the year in a buoyant market setting.

Aside from management’s paranoia as control freaks, Google’s Motorola acquisition doesn’t sit well.  The market likes software and service businesses.  The world doesn’t need another smart phone operator flexing his muscles.  There are ironies here-in.

Google moves into Apple’s power zone, iPhones, while the dream of Apple is that it looks more like Google in a couple of years.  Advertising ramps up in iPhones and revenues from its proliferation of apps build up.  If Apple can move software up to 20 percent of total revenues there’s a case for a valuation at a market multiple.  So far, smart phone advertising ramps slower than expected.

Going forward, Apple must be construed as a smart phone enterprise backed by great software.  Over 60 percent of its earnings are driven by phones.  Macintosh computers, iPods and iPads stand nearly irrelevant to the story.  The Street actually called iPad shipments accurately for the March quarter.

As Steve Jobs once told his staff, “The journey is the reward.”  The next leg for Apple is probably a touch operated television set interconnected with your iPad and iPhone, but I’m guessing and have no way of modeling same into Apple’s income statement next year.

Apple sold 35 million iPhones last quarter, 5 million more handsets than the most bullish Street estimate.  With a hookup at China Mobile I can see a run rate of 200 million for a couple of years and then we’re back in no-man’s land.

I wish it were 1972 or even 1968.  Apple would be selling at 30 times earnings and ratcheting up 2 percent, monthly, instead of trading like oil futures or pork bellies.  Gut feel?  Apple is a cheap piece of paper unlikely to lose its primacy as far as I can see.

Martin Sosnoff: mts@atalantasosnoff.com

Martin T. Sosnoff is chairman and founder of Atalanta Sosnoff Capital, LLC, a private investment management company with $8 billion in assets under management. Sosnoff has published two books about his experiences on Wall Street, Humble on Wall Street and Silent Investor, Silent Loser.  He was a columnist for many years at Forbes Magazine and for three years at The New York Post. Sosnoff owns personally and / or Atalanta Sosnoff Capital owns for clients the following investments cited in this commentary: Apple, Exxon Mobil, Microsoft, General Electric, JPMorgan Chase, Philip Morris International, Citigroup, IBM, Qualcomm, Google and General Motors.