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Apple: Great Company with Lofty Valuation - Due for Pullback

by: Mark Krieger August 18, 2008 | about stocks: AAPL / RIMM    

Mark Krieger

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Apple (AAPL) seems to do no wrong. The shares have vaulted nearly 50% since their March lows and the 3G iPhone is the current rage. The hype is at unprecedented levels, resulting in an analyst love-fest that is in full swing. Is another classic case of 'pump and dump' developing?

The case for the iPhone: There is ample opportunity for AAPL to penetrate and make further inroads within the corporate market segment, and in the process, take substantial market share from Research In Motion (RIMM). In fact, HSBC Bank is contemplating switching from RIMM's blackberry to AAPL's iPhone. This change alone could amount to a 200,000 unit order, however much of these potential orders could already be factored into the current share price.

Valuation is rich: Could AAPL start to sour? Everybody and his brother is tuned into the fact that AAPL management typically under promises on its guidance in order to over deliver. Most savvy investors can see right through this quarterly façade and likely incorporate a 10-20% "beat" modeled into the actual earnings results. The company is very reliable at beating estimates, however, and often the share price dives just after the release, as the phenomenon of "buy the rumor, sell the news" rears its ugly head. The analysts certainly appear to pander to management's guidance and sandbag their estimates to coincide. The consensus of 2008 earnings expectations of $5.21 and 2009 estimates of $6.06 (YOY growth rate of only 16%) compute to forward PEs of 34 and 29 which are on the high side compared with Google's (GOOG) forward PEs of 21 and 26. If you decide to "play the game" and pad the earnings estimates an additional 10% to offset the lowball guidance, you still end up with steep forward multiples of 26 and 31.

Insiders are heavy sellers: AAPL insiders have been on a recent selling spree. In just the last 6 months insiders have sold nearly $175 million worth of shares. Why are they selling? Do they know something the rest of us do not? Anthony Fadell, a Vice President, recently sold 71,500 shares on 8/11 at $172.49, after exercising an option to purchase 71,500 shares at $14.03 per share—this single payday of $12 million makes superstar athletes compensation look pale in comparison. The exercise of options creates three negatives (1) More shares are added to the supply (2) the added shares cause earnings dilution. (3) the company incurs payroll taxes on the gain that the employee realizes.

iPod and Mac: The success of the iPod is fleeting, as its market has been saturated. Its status is now similar to a star NFL running back entering his tenth season. The poor overall economy is bound to eventually slow Mac's desktop and laptop momentum, and the company could be forced into a price cutting mode to combat soft demand.

Wild cards: Will Steve Jobs be able to maintain his health? Will AAPL be successful in a timely manner in eliminating the glitches surfacing with the debut of the 3G iPhone? How much will the recent strength in the US dollar hurt AAPL's international sales when those foreign currencies are exchanged back into US dollars?

Bottom line: Don't get me wrong, I certainly think AAPL is a great company, I just don't like it at the current share price, as it has simply gotten too expensive by rising too far in too short of a time frame. I also think that some "weakening" of the fundamentals could begin to creep into the equation. The shares are overbought and due for a correction. The risk simply outweighs the reward at this juncture and a 10-20% drop is plausible.

Disclosure: Short AAPL

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This article has 71 comments:

  •  
    Aug 18 07:30 AM
    Just one observation. Am I the only one who wonders why the pe of AAPL is always compared to GOOG? They are in very different businesses almost to the point where, I think, in the future, people will say, "Listen here. You got it all wrong. You're comparing apples to googles."

    Anyway, other than that, I appreciate you points.
    Reply
  •  
    Aug 18 07:53 AM
    You are such a negative and US centric person! Do you REALLY think the world market for iPod is saturated? Just think of Turkey, China - think of the World! There is a demand for iPhones, iPods and Macs out there, that's even bigger than the US sales up to now were! So - there are no weakening fundamentals, no saturation - I just see a person who is either short on AAPL or wants to buy some more on a lower price.
    Reply
  •  
    Aug 18 08:07 AM
    you do seem to cherry pick your information...so, if you have options that are expiring, and you exercise them (after which the company sells 1/3 to pay your taxes), that is insider selling? After all, had you not exercised them you would lose ALL the proceeds? You forgot to mention, or notice, that apple has 23 dollars in cash per share, and that they haven't yet accounted for the full iphone revenue, they have only accounted for half of the proceeds from iphone sales from LAST JULY, not to mention the ones they have sold this year...
    good luck on your short, lets hope you have a tight stop
    Reply
  •  
    Aug 18 08:07 AM
    You fail to mention the over $23 per share that AAPL has in cash. This is not an insignificant amount should help ease your P.E. worries... And for a company that still seems to be growing at over 30 percent annually - with a tiny market share in their main business makes for a company that has a potentially very bright future that should be reflected in the stock price and valuation.
    Reply
  •  
    Aug 18 08:09 AM
    "The poor overall economy is bound to eventually slow Mac's desktop and laptop momentum"

    This statement, based on your personal opinion, has not been backed up by fact. The economy has been constrained all year and Mac sales increases have been triple the overall market PC market

    Anyone can have an opinion, but when it is not back up by real world observation, you just look stupid and uninformed.
    Reply
  •  
    Aug 18 08:12 AM
    >> The exercise of options creates three negatives (1) More shares are added to the supply (2) the added shares cause earnings dilution. (3) the company incurs payroll taxes on the gain that the employee realizes.<<

    Payroll taxes? Get in the ball game. What about the huge tax deduction that the company gets with no cash outlay! The in-the-money element is a tax deduction to the company (and compensation to the employee).

    I think that you're grasping at straws to put an unnecessary spin on AAPL. By the way, if AAPL can dent RIMM (and I think that they can jackhammer them within 3 years), what will this do to their earnings?
    Reply
  •  
    Aug 18 08:20 AM
    There is are many points raised in your article. Many I disagree with, some not. But you are definitely wrong on the part about Apple's tax liability on exercised options. The person who owns the option pays the income tax out of proceeds, not Apple. Payroll taxes are not a factor.

    Also, unless you have a very short time horizon. I would not bet against Apple exceeding its previous high within the next year. That still a significant gain form this level.
    Reply
  •  
    Aug 18 08:21 AM
    junk journalism. Anything positive is already factored in the price, right? sure.
    "recent strength of dollar" will hurt Apple's exports? give me a break! look at a 2 or 5 year chart of dollar vs Euro.
    And I always love "Inside Seller" theories! "What do they know that we don't???" well, lots I'm sure, but if they start buying or selling based on inside information, their entire gain will be eaten up by legal fees and fines, and they will be having tea with Martha!
    Hey! Look back at Ron Johnson (Officer), and his direct sale of 470,000 shares in Feb 07 ! He sold at $86 for a cool $40 million !
    What did HE know??? I'm not sure, dut I guess he DIDN'T know that AAPL was going to touch $200 last Christmas!
    So much for reading into Insider Trading.
    Reply
  •  
    Aug 18 08:22 AM
    Honest comments from someone who says he is short and I think these are fairly common among many who view Apple with skepticism. However like all the other analysts except Piper's Munster, Mark is trying to template a run of the mill technology company metrics to the one company that is truly is making things very different in terms of outsized growth. Apple's iPhone projections are NOT in the price, analysts are only projecting 10M in sales this calendar year...it is likely to be at least double that and then double that the next year (20M in 08, 40M in 09). Best Buy will sell them next month along with 22 new countries worldwide. Lines are still out the door at many apple stores. NPD and other IT intel firms report no slowdown in Mac growth, which both domestically and internationally show a growth rate of 35-40% year over year. At the same time, Microsoft, its leading competitor has a product (Vista) that by all accounts is a dismal failure. New lines of business such as movie sales/rentals and the Apple App store are beginning to gain steam and will be positive factors in Apple's earnings next year. Finally, the ipod is not slowing down. Sales indicate an 10% unit YoY growth rate based on the latest nunbers. So the bottomline is that the projected revenue and earnings numbers are woefully inadequate and therefore the current price is still very reasonable.
    Reply
  •  
    Aug 18 08:24 AM
    Well thought out piece, but there are of course, alternative points of view to yours.

    Here's one... if you see value breaking technology development and inspired application, Apple is only at the tip of their iceberg. They are incredibly forward thinking and continually create unique, trend setting items that people feel they MUST have.

    Since Apple released the iPod, I've been in the stock and have always made way above market. So, until their innovation and product release cycle slows or stops, I'm in like glue.
    Thanks for listening.
    Veronica
    Reply
  •  
    Aug 18 08:37 AM
    So Mark Krieger is short AAPL and he writes why he thinks Apple will pull back. If AAPL pulls back that would suit him, of coursw. So why does he write this article. Is there any news in it? I don't think so.
    Reply
  •  
    Aug 18 08:42 AM
    Apple is a great company, however the US consumer and market is weak and getting weaker........Stock will pull back........but should resume its upswing towards the end of 2009
    Reply
  •  
    Aug 18 08:55 AM
    jancarl: You are right about who pays payroll taxes to a certain extent, however, AAPL is still responsible for paying its matching share of social sec tax, and the medicare portion has no ceiling. On the $12 million gain. AAPL would have to shell out $120K just on its matching share of medicare tax.
    Reply
  •  
    Aug 18 09:04 AM
    Another analyst that measures Apple by it's P/E.

    It's erroneous. Look at the cash generation machine working flat out with subscription accounting for iPhone, iPod Touch, Apple TV and Applecare
    Reply
  •  
    Aug 18 09:13 AM
    What's all this "payroll tax" interest? It's small change!
    If someone exercises options, aren't they now dealing with stock sales, subject to Cap Gains tax, and that's it?
    I guess if AAPL shares STAYED at $14, so the options were worthless, we would all be toasting to the tax payments we saved, right?
    I guess every silver lining has a black cloud if you just take the time to look for it!
    Also, the "3 reasons" insider sales are bad really seem like TWO reasons, as the first two are sort of redundant:
    - It increases the amount of shares out there
    -It dilutes the earnings per share

    Do I really care how many shares are out there, except that the earnings are diluted over that number? kind of redundant, and grasping, as the author realized that "two reasons insider options are bad" just didn't have the "zing" that THREE reasons did!
    So he padded the reasons.
    weak.
    Reply
  •  
    Aug 18 09:22 AM
    There is a counter point to negate every one made in this article. The one I will focus on is "heavy insider selling". In the past six months those sales were at prices ranging from $140 to $172, AAPL closed last Friday at $176, so what is the significance of this selling?
    People have to exercise options if they are about to expire. Personal income taxes have to be paid on the gain, and where will the cash come from to pay these taxes??
    Reply
  •  
    Aug 18 09:24 AM
    Surprise: Author write a negative article and is short the stock. Writer is obviously acting to lower Apple's stock price, disgraceful
    Reply
  •  
    Aug 18 09:26 AM
    Options DO NOT increase the number of shares. Options DO NOT work that way. Get a clue.
    Reply
  •  
    Aug 18 09:40 AM
    I rest my case. Add Mark to the list of writers who have absolutely no clue:

    seekingalpha.com/artic...
    Reply
  •  
    Aug 18 09:46 AM
    I could not disagree more with this analysis. To me, it's extremely short sided, doesn't factor in iPhone revenue, and the timing is horrible.

    Short Apple in Fall? Last year it was up practically every day, it was unbelieveable. I think this fall will be bigger, because the iPhone sales are off the hook, and Mac sales will be much higher than ever because they included iPod touch or nano with every back to school laptop or iMac. I am on a campus in the midwest. We used to rarely see Apples, now most of them are Macs. This has all happened in the past two years, and again, last year was a phenomenal fall for Apple.

    Good luck with your short, lots of people, no doubt, would love to get in cheap though, so I wouldn't wait too long to buy if I were you.
    Reply
  •  
    Aug 18 09:50 AM
    No way the iPod is over. I look for a new lineup this fall. No other company can compete, not because of any Microsoft-like monopoly but because the product is head and shoulders above any other product and because they have the best support (iTunes) and ecosystem (Griffin, Nike, every audio company on the planet, etc...) There is great business in upgrading and replacing them. Kepp in mind that iPhone is an iPod as well, and makes a great upgrade from any iPod.
    Reply
  •  
    Aug 18 10:01 AM
    These arguments are so old and boring, they could have been written at any time in the last four years. Excluding Steve Jobs health, any time in the last SEVEN years.
    This is like saying "everything is reflected in the price" one year after the introduction of iPod - imagine how much was lost by "investors" that listened to exactly the same points then. There is every reason to believe that iPhone will be much bigger for Apple then iPod could ever be.
    Have to give the credit to the author for stating his short position. Most of the same negative spin is recycled by the media as unbiased opinion. Perhaps that is what the author refers to as "hype", since there is some negative article somewhere about Apple and it's products practically every day.
    Incredibly shortsighted, intentionally so.
    Reply
  •  
    Aug 18 10:27 AM
    I think Krieger is missing the significance of the foothold that iPhone has in the 'mobile space', as the jargon goes. It has no competition more than a year after its introduction, but what it certainly does have is the means to be redefined/expanded into whatever more you'd like it to be, with a couple of clicks. The App Store has seen to that. I think people are just seeing how this will change everything.
    And again, Apple's vertically integrated platform has no competition because Apple owns all the parts, from hardware to the App Store.
    I say hold Apple for the long term; pullbacks are just buying opportunities for this company. Just my opinion.
    Reply
  •  
    Aug 18 10:37 AM
    apple has just started to open stores in other countries...how can those not even on the list yet be 'saturated' with ipods? macs? iphones? apps? and whatever is coming next from this innovative company?
    will execs with lots of shares cash in from time to time to get lots of $...yes. will apple shares lower from time to time?...yes. are there people who want to push the price down so they can grab shares cheaper? yes.
    it won't matter. Apple is here to stay, even if, eventually, without Jobs.
    not even CEOs live forever. But today's apple is different from the past. it's huge with an enormous company of talent, innovation and vison... and, it's got a lot of cash reserves, multiple profit streams, no debt...and...more amazing products in the pipeline.

    it's really not comparable to google, dell or anyone else. apple has the most profitable retail space in the country. i don't see anyone else being even close. i suggest that before writing about apple, stop into one of the apple stores...play with the toys...maybe you'll start to understand this company which is unlike any other.
    Reply
  •  
    Aug 18 10:38 AM
    Anybody who opines as to AAPL's valuation, while ignoring both AAPL's cash holdings and the subscription accounting for the iPhone, is not to be taken seriously.
    Reply
  •  
    Aug 18 10:47 AM
    Again with the Google and Apple PE comparisons? Really? The advertising market is contracting. Were it not for the Olympics and the Elections, the aggregate ad market would be significantly smaller this year. PEs are a measurement of market expectations for growth. Apple's growth warrants a big PE premium over Google, whose growth may well have totally stalled at the moment.
    Reply
  •  
    Aug 18 10:56 AM
    Cover your short before its too late; I gave this advice to another short seller last month who had shorted at $168....
    Reply
  •  
    Aug 18 11:17 AM
    Another person who doesn't look deep enough to understand Apple's valuation. Here's what should jump out as you do basic research into Apple v. Google (why we keep comparing Apple to Google, I don't really know, but...):

    Reuters numbers
    Trailing P/E: GOOG - 32.86, AAPL - 35.06 (Reuters)
    Trailing P/FCF: GOOG - 38.34, AAPL - 26.53 (Reuters)

    At this point, a knowledgeable researcher would wonder why Apple's free cash flow was so high relative to Google's, since its earnings were slightly lower. Digging into the details, one would learn that Apple defers 7/8 of new iPhone revenue every quarter. What that means, dear reader, is that Apple's future earnings will be augmented by money that's already in the bank. So in this case, P/E doesn't provide a good view of Apple's profitability, and is a poor means of comparison.

    Unfortunately, I don't think we get FCF forecasts (Andy Zaky would know, however), so future valuation comparisons based on it are difficult. You could use expected earnings growth, but I think that the consensus on AAPL's 2010 earnings are low, based on low iPhone estimates. Note that AAPL is expected to grow earnings faster than Google in 2009.

    "AAPL insiders have been on a recent selling spree. In just the last 6 months insiders have sold nearly $175 million worth of shares. Why are [insiders] selling? Do they know something the rest of us do not?"

    Do you have any idea of the value of shares and options held by insiders? I don't, but I'm guessing it's in the billions. And if my wealth were concentrated to such a degree, you're damned straight I'd be selling to diversify. Add to that the significant chances that a Democrat in the White House would increase capital gains taxes, and you've got a huge incentive to sell now.

    "the iPod...market has been saturated."

    Could be - but I think we've been hearing this for years. I expect further innovation from Apple in this area, as the Touch concepts work their way through the lineup. And don't forget, one of the primary drivers of this market are teenagers, and there's a new batch of them every year.

    "The poor overall economy is bound to eventually slow Mac's desktop and laptop momentum, and the company could be forced into a price cutting mode to combat soft demand."

    Looks to me like the company's already anticipating this (see earnings call transcript), and may be on the verge of a significant push to grow market share through less expensive models. Decreased margins? Sure. What's the most successful retailer in the history of the planet? Did it get that way through higher margins or higher revenues?

    "The risk simply outweighs the reward at this juncture and a 10-20% drop is plausible."

    Enjoy the ride.

    Disclosure: Long AAPL
    Reply
  •  
    Aug 18 11:37 AM
    If Apple is overvalued, then what do you think about RIM? That company also has a high valuation. It's starting to sell the Bold and soon the Thunder. Apple should sell far more iPhones than RIM can sell Bolds. RIM has been up as high as $148 a share this year. Is it worth that much?
    Reply
  •  
    Aug 18 12:03 PM
    Mark, Seriously, you should stick to your background of covering restaurants, airlines, and companies selling donuts, sugar, tea, auto parts, etc. Obviously the high technology industry is not your cup of tea.
    Reply
  •  
    Aug 18 12:06 PM
    Ridiculous - insiders sell because THEY have to pay the taxes.
    Reply
  •  
    Aug 18 12:19 PM
    One of your co SA bloggers just wrote almost the exact same thing. The problem with your theory: The people that drove the stock price up know the number you're working back from is incorrect. I find it amusing how you even say, "The analysts certainly appear to pander to management's guidance and sandbag their estimates to coincide" yet your hypothesis is entirely based on estimated earnings of $6.06.

    I can't even believe you wrote this knowing that Apple would beat those numbers, Apple is gaining market share, and Google is stagnant in terms of market share. You obviously don't remember why Google got hammered after they reported last quarter.

    Google is not as a good a stock as Apple.
    -They aren't going to grow the market share in their core business like Apple will with the Mac.
    -Apple has proven income streams from multiple businesses.
    -Google's estimates are predicated upon growth in overall advertising and a continued shift away from 'traditional' advertising.
    Reply
  •  
    Aug 18 12:31 PM
    I almost forgot to ridicule this:

    "The exercise of options creates three negatives (1) More shares are added to the supply (2) the added shares cause earnings dilution. (3) the company incurs payroll taxes on the gain that the employee realizes."

    1. More shares added to the supply is not, in and of itself, a negative; it increases the liquidity of shares, so technically it's a positive.

    2. Earnings dilution - absolutely right. And the dilution caused by a million new shares? A whopping 0.113%. That's right, instead of EPS of $5.21 this year, you can only expect $5.204.

    3. Payroll taxes. Since Social Security tops out at around $100K, I'm going to assume that the payroll taxes you write of is just Medicare. At 2.9%, that comes to about $5M for the two quarters you reference. This caused a reduction in FCF of less than 0.25%. So instead of $2.35 in EPS over that period, AAPL might have hit $2.356!

    You're right, those options, which keep key employees around, are just too expensive.
    Reply
  •  
    Aug 18 12:38 PM
    But wait! I got the math wrong! Because the Medicare tax is split between the employer and employee, the cost to Apple for the $175M in options exercised is no more than $2.5M, causing a reduction in FCF of no more than 0.125%. So rather than $2.35 EPS, Apple could have reached $2.353! Carrying the effect out to the stock price, rather than trading at $175, it might be trading at $175.22!

    I thought it was okay at $175, but now that I've learned it could be as high as $175.42 if not for those pesky options, I'm not so sure anymore...
    Reply
  •  
    Aug 18 01:09 PM
    Obviously you have never been in a situation where you have stock options to exercise. The US government requires you to pay taxes on the paper gains between the original option price and the market price. For example, if you have 1000 shares at $0.10 a share, to purchase the shares would only be $10, but if the market prices was $500 a share, the feds would want you to pay cap gains of on $500,000 less the $100 you paid for it. This makes it very difficult to exercise shares and then to own them unless you wanted to make arrangements to get a loan to do this. I'm being very basic and elemental because you obviously don't have a clue why employees exercise and sell their shares. It's because FASBA and the IRS changed the rules where you have no choice but to sell unless you're already wealthy and have lots of cash laying around.
    Reply
  •  
    Aug 18 01:15 PM
    NEWS FLASH, Mark - options have expiration dates so you have to 'use them or lose them'. If a lot come due at the same time, of course they will be exercised. Companies typically set fixed dates during the year for options and it may be that one of those has recently come up.
    Reply
  •  
    Aug 18 01:43 PM
    I would suggest that the writer is new to Apple stock. This issue has traditionally maintained a P/E greater than where it is today. If anything, with all of the positive news and market penetration, AAPL is due to have an increase in valuation in the near future.
    Reply
  •  
    Aug 18 01:56 PM
    My prediction: Apple will control 100% of every consumer electronic product category within 12 months; their stock will trade at $25,000 per share - hurry before it is too late! I mean Apple has such a great track record of turning innovation into market share...how can I be wrong?

    The kind of frothy hysteria I am parodying here makes me sure AAPL is due for a pullback. Certainly its a good company and inspires fanatical loyalty among its followers but nothing goes up for ever. Anedotally I think that many of the things that worked for Apple as a leading niche innovator may work against it, culturally, as a global technology hegemon that everyone here seems to believe it will become.
    Reply
  •  
    Aug 18 02:02 PM
    Yep; it will be for a pull back from $300 in 2010.
    Reply
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