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Is Apple's Stock Really As Cheap As They Say?

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The launch of the Nexus 7, Google’s (GOOG) highly anticipated 7-inch Android OS-powered tablet, is expected any day now.  Judging by the stock’s impressive gain since the end of June, Apple (AAPL) shareholders don’t seem too concerned.  Let’s face it, Apple dominates the tablet market and it’s not even close. The company shipped 11.8 million iPads in the first quarter and increased its share of the global tablet market to 68%.  By comparison, Amazon (AMZN) shipped a paltry 750,000 Kindle Fires, which has been the most successful Android tablet so far.

There’s little doubt in my mind that demand for iPads will continue to soar over the near term.  Coupled with the expected launch of the next iPhone (a.k.a. iPhone 5) in the fall, 2012 will likely be another terrific calendar year for the tech giant.  I’m not the only one that thinks so either.  The current full-year consensus estimate for Apple of $46.84 per share, which is based on a whopping 51 analyst opinions, represents growth of 69% from 2011.  The fact that these estimates have often proved conservative suggests actual growth for the year could be materially higher.

So it may come as a surprise that even with its recent bounce back to around $600 the stock sells at just 13 times its expected earnings for the year.  Some may point to weakening consumer spending trends and softer-than-expected global economic conditions.  As a seller of consumer products, this is a legitimate risk for Apple.  But that argument would really only hold merit if Apple shares were selling at a much higher multiple then fell to current levels.  To the contrary, shares are trading higher now than they were in mid-April -- an impressive feat given most stocks are down during the same period.

No, I think the real reason why Apple’s stock isn’t able to command the type of market premium often associated with shares of such high-growth technology-driven companies is far simpler: Investors continue to doubt Apple’s ability to sustain its strong growth rate.

Sounds crazy, right?  After all, as far as operational performance goes, there aren’t many companies that have done a better job of consistently exceeding expectations time and again.  This is not to say the stock hasn’t been rewarded.  Indeed, shares are up 560% since the beginning of 2009.  But this doesn’t change the fact that shares of Apple, a company with prospects so bright it has to wear shades, trade at a lower price-to-forward earnings multiple than those of Procter & Gamble (PG) -- a company that’s about as mature as they come and is actually expected to see earnings shrink by about 4% in 2012 from the prior year.

However, as the assault on Apple’s enviable market share by its growing list of competitors continues, the possibility that its operating results could disappoint increases.  That’s why Apple shareholders should take the Nexus 7 -- or more appropriately, what the product represents -- more seriously.

With a starting price tag of $200 and a 7-inch display, the Nexus 7 shares both the size and the budget friendliness of Amazon’s Kindle Fire.  But make no mistake, the Nexus 7 is a far more capable device.  Its specs scream cutting edge.  It also isn’t bogged down nor limited by a proprietary user interface as is the case with Amazon’s product.  Like all Nexus branded devices, the Nexus 7 is designed to provide a completely vanilla Android OS environment the way Google envisioned.  Based on the plethora of overwhelmingly positive early reviews, it seems Google may have succeeded.

Despite its limitations, the Kindle Fire did one very important thing – it showed us that there is a significant market for smaller, more portable and affordable tablets.  If Apple didn’t know before, it sure does now.  That’s why the company is reportedly developing its own value-priced tablet sporting a smaller form factor (a.k.a. the iPad Mini).  But even if the rumor proves true, the product is months away from launch.  Google is set to capitalize on this demand right now with the Nexus 7.

This is significant because mobile operating systems have now become so refined and user-friendly that chances are pretty good that you’ll stick with which ever one ends up being your first OS experience.  Heck, there’s even a financial incentive to do so.  I’ve purchased more than my share of apps, books, movies and music from the Google Play Store, which I can install and playback across all my Android-powered devices.  The fact that I’d have to repurchase these products if I were to switch to an iOS device makes the decision to do so far less attractive.  To put it another way, it will likely take far more effort to convince a consumer who’s become accustomed to Android to switch to iOS and vice versa.  This has made capturing that first purchase so important.  After all, there’s a good chance you’re not just getting a sale, but a customer for life.  The value associated with this type of loyalty should not be underestimated.  Obviously, capturing this loyalty is much easier to do with products on the shelf than with products in development.

Another important factor that bears noting is the difference in the product lifecycle of smartphones versus tablets.  While two-year contracts and subsidized handset pricing ensures a steady replacement cycle for smartphones, there is no such mechanism with tablets.  Indeed, their lifecycles may be closer to those of PCs, which is much longer.  This is due to the fact that many of the things people do on a tablet, such as checking email, Web browsing, casual gaming and media playback, simply aren’t that taxing on the hardware.  Improvements in software have also increased product usability and longevity.  For example, upgrading my Motorola Xoom tablet to Android 4.0 earlier in the year resulted in such a performance improvement that I actually use it more now than I did when I first got it nearly a year and a half ago.  This longer lifecycle could be especially troubling for Apple since product upgrades by brand loyal customers likely comprise a nice chunk of its total sales.

Over the near term, these trends will have a minimal impact on Apple’s operations.  As I mentioned earlier, I expect 2012 to be another spectacular year, driven by significant growth in iPad sales, continual market share gains and what I believe will be a very strong debut for the iPhone 5.  The latter is expected to sport a larger 4-inch widescreen display.  This would represent the first increase in screen size since the iPhone was launched in 2007.  As such, I think sales will benefit from pent-up demand for a bigger screen, which many expected on the iPhone 4S last year.

However, Apple’s prospects beyond this year are less certain.  In the smartphone space, it faces growing competition from the likes of Samsung, which actually sold more phones in 2011 than Apple (95 million versus 93 million) thanks to its highly successful Galaxy S2 smartphones, which were the best selling Android-based devices last year.  The recent launch of its successor, the Galaxy S3, in numerous global markets and across all four major wireless operators in the U.S. certainly won’t make things any easier.  Apple’s significant lead in the tablet market could also take a hit if the Nexus 7 sells as well as I think it will.  The expected launch of Microsoft’s (MSFT) Windows 8-powered tablet, the Surface, later this year poses another threat.  At the very least, by launching a smaller tablet, Apple runs the real risk of cannibalizing sales of its more expensive (and probably more profitable) 10-inch iPads.

Perhaps the company has another game-changing innovation up its sleeve that will help maintain its high growth over the next several years.  If it does, it better be a bigger draw than the last one.  Don’t get me wrong, I consider Siri the most impressive new phone feature to debut in years.  But I also don’t know a single person who uses it with any regularity or found it so impressive, it cause them to become an Apple convert.

When it comes to stocks, the larger you are and the more coverage you have, the less likely you are to be undervalued.  Apple is the largest company in the world by market capitalization.  It also has 51 analysts covering it.  Frankly, shares have no excuse for being mispriced to the downside.  To the contrary, a stock with this much bullish sentiment is usually guiltier of being overvalued than undervalued.  While I don’t think that’s the case here, Apple shares are probably trading much closer to where it should be than what most analyst target prices may lead you to believe.

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