People shop in a Apple store in New York, New York
The Street is locked in some kind of sadomasochistic embrace with Apple. For years, Apple’s management egged on this tension by continually low-balling its projections on revenues, operating margins and earnings. Now the shoe is on the other foot. Apple’s numbers are set to implode in terms of revenues, gross margins and of course, earnings. So management going forward wants to issue quarterly guidance in a realistic range. About time their act folded.
I expected to see in print a bunch of mea culpas from sell side tech analysts, but I couldn’t find any. Even more disturbing I missed any rationale for sticking to a range for Apple from $750 to $850.
My column two weeks ago (take a look) said “If Apple loses share of market in smartphones and tablets, I put it at $400.” Hey guys? This is happening. The good news is I can’t rationalize Apple below $400, but it could bang around there unless management borrows a bunch of money stateside, raises the dividend payment as high as $20 a share, 50 percent of earnings, and buys back 20 percent of outstanding equity.
I rate this expectation less than even money, but within the range of rational initiatives at the boardroom level. Look at IBM and Intel, very shareholder friendly. And, yet, Intel with a 4 percent yield had few takers as fundamentals soured. Computer hardware looks weaker for longer and Intel is a major components supplier.
It took me about 15 minutes to rescramble Apple’s operating metrics. I came up with earnings of $40 a share this fiscal year. The analyst fraternity had been carrying gross margins above 42 percent, but signed on the line with management’s new guidance level, around 38 percent. Many analysts previously had projected Apple’s earnings power over $50 a share.
These statisticians (I don’t consider them analysts) have lowered Apple’s price objective to $600 from their $800 - $850 range. Nobody’s at $1,000 any longer. The $600 price point is actually a shabby construct. It gives Apple a credit of 60 percent for its cash hoard – heading towards $150 a share soon.
Apple desperately needs to field a low priced iPhone. Share of market is down to 33 percent in a market growing 40 percent (but not forever.) I assume China Mobile is waiting for a low priced iPhone before putting Apple on its networks, maybe later this year.
Alas! Our sadomasochistic syndrome plays on. Analysts see 2014’s numbers at $50 a share, awarding Apple a price-earnings ratio of 11.5 times. I’m no higher than $40 and put Apple’s multiplier at 10. I grant that Apple’s enterprise value, which deducts cash from the market capitalization, is a reasonable 6.5 times multiplier. This is what many large cap properties sell for on the Big Board, but nobody pays attention.
My what if scenario takes a dark view on gross margins for Samsung and Apple, the two big smartphone players. Let’s remember what happened to Nokia. Gross margins trailed off to zero for smartphones, before showing some late rebound. Nobody knows Samsung’s gross margins. They don’t break out smartphone metrics, but I’m told they’re well over 50 percent. Unlike Apple, Samsung is integrated on components so pared pricing favors them.
There are analogies. Take a look at Dell, one efficient computer hardware operator. It sells a commodity. No breakthrough features in their boxes. Past years, Dell’s gross margin averaged around 20 percent. This is benchmark for most tech hardware players who are also-rans.
Turning to operating margins, Apple is at 30 percent. Conceptually, if Apple loses share of market to Samsung its margins must head towards commodity parity of 20 percent. I’d pause on this metric and ponder it prayerfully.
If Apple’s gross margins tail off to 35 percent, my call, EPS this year and next averages no more than $40 a share. This assumes 9 percent revenue growth, a fair but far from horrific projection. Ask yourself whether Google’s Android operating system, which is free, gains traction. Maybe yes.
One more factor concerns me, namely, Apple’s new initiative to integrate backward into semiconductor wafer production, a tricky business in terms of production yields. At the least, this reduces Apple’s considerable free cash flow yield.
My memory is long. In the eighties, IBM management chose to integrate state-of-the-art semiconductor needs. The reinvestment rate on billions was negative and practically bankrupted them. Many of us viewed IBM as a national resource. More then, than now, however.
Boiled down, Apple sells near 10 times earnings, may yield 4 percent and average close to $40 a share in earnings next couple of years. If my dire scenario unfolds, with operating margins clipped from 30 percent of revenues to a commodity based operator of 20 percent, we’re looking at earnings closer to $30 a share. Hopefully, management doesn’t do something stupid like making a major acquisition and years later writes down $50 billion in goodwill.
Apple could be analogous to Polaroid in its heyday. Polaroid ran out of new toys to sell while photo technology passed it by. But, nobody is going to bury Apple. It sports too much in liquid assets. I’d like to see ‘em spend more on research and development. This ratio to revenues is markedly low for a major tech house.
Comparisons count. Google’s non-GAAP operating income approximates 38 percent of revenues and gross margins rest solidly over 60 percent. Apple’s peer group in technology sells in line at an 11 times price earnings ratio.
Using a wide angle lens, the world is bigger than Apple, Google et al. The market whistles in the dark over this coming March showdown on the country’s debt ceiling limit. If Republicans prevail, forcing Obama to take the meat ax to entitlement programs, the economic consequences spell near zero GDP momentum. The S&P 500 Index could retreat 100 points on this construct, particularly if other domestic programs sustain cutbacks, too.
Do we get the lady or the tiger? ¿Quién sabe? I refuse to discount the resiliency of our economic setting currently. My call so far is on the money. In the back of my mind is cost of carry on the Federal debt - never been lower.
Yes, I know it won’t last forever, but right now savings run into hundreds of billions, annually. Surely the FRB jots this down and won’t move on money market rates prematurely. I do see a steeper yield curve in the cards, so bank stocks shine as my big play, starting with JPMorgan Chase and working down to Citibank and Bank of America. Viscerally, I hate them for nearly imploding the financial system, but when the circus comes to town you buy peanuts.
Reversion to the mean is one of the strongest and most repetitive metrics in financial markets. The corollary is a great growth stock’s life expectancy averages 5 years, rarely 10. Ironically, Apple fits this bill all too eerily. I didn’t expect Apple as a falling star to approach $400 so fast, but it’s there and I think I know why.
Martin T. Sosnoff is chairman and founder of Atalanta Sosnoff Capital, LLC, an investment management company with $6 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, IBM, Google, JPMorgan Chase, Citibank and Bank of America.
Martin Sosnoff: mts@atalantasosnoff.com
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