Apple (AAPL) and its leader Steve Jobs know as well as anyone, better perhaps, how to generate excitement around new products, as we've seen yet again with iPad 2 lines of people waiting in line for hours to be among the first to get their hands on a hot new product. But if we've learned anything from history, it should be that excitement about product launches does not necessarily translate into attractive, or even satisfactory, investment returns. (I presume it's not necessary to reiterate the decade-ago collapse of new-economy investing.)
When it comes to Apple, suggesting that investors separate themselves from the excitement is easier said than done.
For one thing, the company's Price/Earnings ratios look pretty reasonable: 19.05 when Trailing 12 months EPS is used in the computation, 14.75 when the consensus current-year EPS estimate is used, and 12.81 when the estimate of next year's result is factored in. Meanwhile, the consensus long-term EPS growth rate projection is 19.27%, which seems to already allow for quite a bit of deceleration from the blistering pace of the late 2000s (57.8% over the past five years). Accepting the consensus growth projection as is, we'd be looking at a PEG ratio of 0.99, 0.77, or 0.66 depending on which P/E computation one wishes to use.
By now, Apple fans probably know that Alex Guana, of JMP Securities, is unimpressed. While not detracting from Apple's stature as a great company, he downgraded the stock suggesting that a slowdown at a major Apple supplier might be signaling a slowdown in iPhone sales due to market share gains by Android handsets. Other analysts disagreed, but enough investors took note of Guana's caution to send Apple share down 4.5% in reaction to his report. I'm not in a position to pass judgment on Guana's theory or those of analysts who dismiss it. But with at least one respected observer doing an "emperor has no clothes" number on Apple on the one hand, I do think it would be appropriate to take another look at Apple's valuation.
The last time I did this was on June 25, 2010, when I concluded that a P/E similar to those we see now was "legitimate" given what seemed to be a reasonable or even conservative investment-community assessment of growth prospects. At that time, much iPad novelty and excitement still lay ahead of the company.
Given the spectacular success of the iPad launch and Apple's elevated earnings, we ought to again ask why the stock remains so modestly valued?
The key, I think, is now to be found in the Price/Sales ratio which based on trailing 12 month sales, is 4.12. That's very high. The medians for the industry, sector and S&P 500 are 0.70, 1.96, and 1.17 respectively. The current ratio is high even toward the upper end of Apple's own range, as we can see in Table 1.
Table 1 - Apple Price/Sales Ratios
| 3/23/02 | 3/23/03 | 3/23/04 | 3/23/05 | 3/23/06 | 3/23/07 | 3/23/08 | 3/23/09 | 3/23/10 | 3/23/11 | |
| Sales | 1.50 | 0.93 | 1.41 | 3.50 | 3.40 | 2.46 | 4.42 | 2.74 | 4.31 | 4.12 |
| Based on trailing 12 month sales figures | ||||||||||
The ratio is not now at record levels. But readings this high have been associated with some pretty spectacular sales growth rates.
It's easy to argue Apple deserves some measure of premium. It has, after all, been a stupendous growth story and one that is likely to persist for a while (assuming Guana's caution is premature). But consider its history.
Table 2 - Apple's Annual Sales Growth Rates (%)
| 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 |
| 8.1 | 33.4 | 68.3 | 38.6 | 27.2 | 52.5 | 14.4 | 52.0 |
| Fiscal years end September 30th | |||||||
The numbers are certainly huge. But they are choppy. We see mega-tallies as Apple launches new product followed by a move toward normalcy, at least until the next blockbuster comes along. Most importantly, we see that the highest Price/sales ratios are associated with periods when Apple was experiencing super-normal growth, or at least times when the market could easily anticipate such gains.
Right now, Apple is still riding high, a phase that's being stretched by its release of iPad 2 so quickly after the initial model debuted. But how long can this continue?
This is important. When I was unperturbed a the 4-plus Price/sales last year, iPad had just gotten started and had not yet had an opportunity to make its presence felt in the reported financials. Considering the situation today, where iPad is an established fact, what's ahead? Can iPad 2 serve as a blockbuster new product of the magnitude of the original tablet and generate a dramatically higher sales growth rate than Apple would have achieved had it continued to sell the original? Will there be an iPad 3 for Christmas followed by an iPad 4 by some time in 2012? Will there be an iPhone 5, or perhaps the better questions are when it will arrive, and whether the world will treat it as a completely new product category? Is there some other pioneering blockbuster on the horizon? Bear in mind that for several years now, Apple's growth has really come from what are essentially line extensions on just one product, the initial iPhone. Will all due respect to Steve jobs as an innovator, how many more times can he mount the big stage, tap icons and resize pictures by flicking his finger while preaching world domination, before it becomes white noise? Ultimately, how many more 50%-plus sales growth rates are in Apple's future?
Unless Apple can keep these super-sized growth rates coming, if not every year than at least with reasonable frequency, it may be time to start wondering about 4-plus Price/sales ratios.
What, you may ask, about the still-reasonable P/E ratios. After all, when all is said and done, what we really care about is earnings.
In my opinion, the disparity between the very high Price/Sales ratio and the seemingly modest P/E ratios is a red flag. Last year, with iPad first taking off, I was willing to let it slide, a call that was unspectacular but OK (Apple stock is up 28%, versus 20% for the S&P 500). That was then. Time marches on, so we always have to reassess the numbers in light of the new state of affairs. Looking at the situation today, even if Apple can grow sales enough to justify the Price/sales ratio (a very big "if"), I think the Street's unwillingness to pay up for it is more of an issue. Opinions that were reasonable when a growth surge was ahead of us aren't necessarily so reasonable when we've reached or are near the top of the cliff. Now, it's time to consider a different angle. Even if the Street is willing to accept the notion of powerful sales growth, can we assume it will continue to be at least matched by EPS growth. In other words, should we now be looking for margins to narrow.
Commentators were quick to honor iPad 2 as having permanently insurmountable dominance of the tablet market even before it and some rivals actually saw the light of day. Maybe that'll be the case, maybe not. Either way, the key question is: At what price? Can Apple be the first technology-product producer in history to avoid the precedent of narrowing margins over time? Maybe. But do you really want to bet your nest egg on it?
Consider Apple's gross margins.
Table 3 - Apple's Gross Margins (%)
| 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 |
| 27.5 | 27.3 | 29.0 | 29.0 | 33.2 | 35.2 | 40.1 | 39.4 |
| Fiscal years end September 30th | |||||||
We see the late-decade margin expansion that resulted from Apple's market leadership. But we also see what stock traders would call resistance at the 40% level, a time when Apple has been riding as high as any company in memory.
There is, of course, the iTunes agle. Bulls could argue that Apple isn't just a hardware producer and that we need to take into account its powerful distribution business. That's true. But distributors don't have 40% gross margins. At Amazon.com (AMZN), as powerful a cyber-distributor as we have nowadays, gross margins have been stable for a while in the 22% vicinity. It's too early to assess Amazon's new Android App Store and its potential impact on the rival protocol. Apple fans undoubtedly can cheer the company's trademark suit against Amazon's use of the phrase App Store. Actually, though, for investors, we can file that under "W" for "Who cares." Everyone knows who Amazon is and its app store will do what it will do regardless of what it's called and regardless of the outcome of lawsuit that is of interest to nobody except the Law and Public Relations firms that get to log billable hours. Ultimately, iTunes is no longer new. We have to assume the investment community knows it's there and is taking its potential into account as it determines how much it's willing to pay for each dollar of Apple's EPS.
so the valuation ratios are, in essence, telling us that investors are looking askance at the sustainability to the sales-growth story and are nervous about the extent to while Apple will be able to translate all the additional sales dollars it gets into profits. Put another way, Mr. Market, while enthusiastic (arguably giddy) about sales prospects seem skeptical about EPS estimates and the long-term growth projection. Indeed,if the numbers are to be trimmed, then it would turn out that the effective P/E ratios aren't as low as we now think. I was willing to disagree with the market last June. Now, with tablets out there and competitors coming, I think it's time to get on board with the consensus.
Do not think that any of this suggests Apple is a short candidate. For that angle, we'd need a market-wide calamity or negative sentiment (i.e. such as would occur if Apple were to break precedent and fail to beat guidance). Aside from that, it looks to me like Mr. Market has made a thoughtful assessment of Apple's worth as a company and is not likely to budge absent a truly significant new development, something beyond anything now being contemplated.
In other words, what we seem to have here is a case of fair valuation. Don't count on an attitude adjustment on Wall Street to make Apple run ahead of the market from here. Instead, we'll need something truly novel (probably beyond iSomethng X) from Cupertino.
