The Bear Case for Apple

 | Sep 24, 2012 | 12:00 PM EDT  | Comments
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This commentary originally appeared at 8:32 a.m. EDT on Sept. 24 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

Pride goeth before a fall -- also publicity, handshakes and celebrity. The biblical injunction about the first and the last trading places often has literal truth. Thus, stocks and bonds, which fared poorly in the inflationary 1970s, excelled in the disinflationary 1980s. The country's most admired companies (as listed annually in the glossy business magazines ) are frequently on their way to becoming among the country's least admired investments. When a cynical investor hears that there are too many optimists in the market, he will begin to worry. By the same token, an over-abundance of pessimists will give him courage. After all, he may ask, if everyone is already bearish, who is left to sell?

-- James Grant, Minding Mister Market: Ten Years on Wall Street With Grant's Interest Rate Observer

Apple (AAPL) has been a once-in-a-century profit dynamo that has prospered and has expanded its market share by delivering innovative products and expanding its self-sustaining ecosystem.

Here is the remarkable chart of Apple's shares since 1985.

In the 1960s and 1970s, the stock market was inhabited by the "nifty fifty," a small subset of one-decision stocks that had strong balance sheets, solid franchises (typically leaders in their field), relatively superior profit prospects and were generally credited with the bull market of that era. Some examples of the nifty fifty included Wal-Mart (WMT), Avon Products (AVP), Disney (DIS), McDonald's (MCD), Polaroid and Xerox (XRX). The stocks flourished for a while but ultimately became overvalued and were weighed down by the bear market that continued until 1982.

Today there is no more nifty fifty, arguably there is the nifty one -- and that one is Apple. The Wall Street analytical community and many money managers are unambiguously and unanimously optimistic about the company, but let's not lose sight of the fact that the sword is double-edged, as an investor who bought the nifty fifty at the end of 1972 would have had 50% less wealth by year-end 2001 relative to an investor who bought the S&P 500. (Sic transit gloria.)

Over the weekend, The New York Times' Joe Nocera wrote an interesting article which speculated that Apple has peaked.

It got me thinking, and below I highlight a list of 10 concerns, fully recognizing the current quarter will be ahead of expectations.

Apple's significant role in the indices as well as its extraordinary relative and absolute performances have been an important determinant of investment returns. A portfolio heavily weighted to Apple has been a ticket to outperformance. By contrast, a portfolio dismissive of Apple's prospects and underweighted the stock has underperformed.

But the above paragraph modifies the past; it does not necessarily hold for the future.

Investment history shows that when there is such unanimity of good will bestowed toward a corporation's equity, when the very share price performance of only one security has such a profound impact on aggregate investment returns, when a record amount of analysts (53) follow an individual company with enthusiasm and optimism and when a company's total capitalization is mentioned in the media constantly and throughout the trading day, resonating throughout the investment community, it is time to be on guard if not concerned.

Surprise No. 10: Despite the advance in the U.S. stock market, high-beta stocks underperform. Though counterintuitive within the framework of a new bull-market leg, the market's lowfliers (low multiple, slower growth) become market highfliers, as their P/E ratios expand. With the exception of Apple, the highfliers -- Priceline (PCLN), Baidu (BIDU), Google (GOOG), Amazon (AMZN) and the like -- disappoint. Apple's share price rises above $550, however, based on continued above-consensus volume growth in the iPhone and iPad. Profit forecasts for 2012 rise to $45 a share (up 60%). In the second quarter, Apple pays a $20-a-share special cash dividend, introduces a regular $1.25-a-share quarterly dividend and splits its shares 10-1. Apple becomes the AT&T (T) of a previous investing generation, a stock now owned by this generation's widows and orphans.

-- Doug Kass, "15 Surprises for 2012" (Dec. 27, 2011)

I have written positively about Apple this year.

While I recognize that valuation and concept shorts are usually a free pass to the poor house, Joe Nocera's editorial to me was a reminder that, as Grandma Koufax used to tell me, "trees don't grow to the sky."

There is no better time to consider the negative case for Apple given its marked outperformance and its recent penetration of the $700-a-share mark.

Principal Short-Term Positive: A Blockbuster Quarter

The upcoming quarter will be big for Apple. The fastest ever rollout for iPhone 5 will be accompanied by higher-than-expected margins, as there are two separate cost-reduced models now. Soon everyone will know that, and if not fully in analyst numbers, it will be in buy-side expectations. (See the recent rise in the stock even after what was viewed as a somewhat me-too product launch.)

10 Concerns

  1. Quality vs. price: Apple is now selling less or equal for more money. The company used to sell a better product for more money, which is a great strategy. Its products were simply market-defining, and competitors were not close. Recently, however, things have changed, and competitors have caught up. Now Apple is selling an equal to worse product than the competition for more money (both phones and tablets). That strategy cannot work forever. This is the biggest issue.
  2. Delivering a more complicated product: Products are also getting more complex and Microsoft-like. Apple's challenge is to deliver ever more complicated products (with a lot of new components) in sufficient quantities. See most recent Foxconn issue. Previously, we would never have seen such a story because there were never issues and nobody would dare voice them, especially not an avowed Apple zealot like the author of this interesting article.
  3. The Oracle of Cupertino: Steve Jobs is no longer around to convince consumers that his products are magical. There is no longer a single visionary voice, especially with the vision of Steve Jobs. There are stories floating around about internal disagreements and power struggles given the unique void created by the loss of a single dominant figure in an unusual corporate structure that he controlled.
  4. Increasing product homogeneity: Apple no longer has a huge ecosystem advantage. Most if not all the apps that consumers care about are available on Android and Microsoft (MSFT), which can also run Office apps such as Excel that Apple doesn't. The first-mover advantage might be lessened or lost if Apple continues to try to do everything on a proprietary basis -- for instance, maps (and who wants a smartphone with bad maps?).
  5. Economic headwinds: Some of the markets served by Apple are saturated, and in a worldwide economy facing strong headwinds, consumers may balk at a product that can be purchased at much lower prices from competitors. Until last quarter, Apple never missed consensus expectations during a product transition. There is more to last quarter's miss than transition.
  6. Poor economic proposition for Apple's partners: Apple's carrier partners do not like the economics they give to Apple. Apple's partners have shown that they can and will shift to the good alternatives that consumers seem to like (e.g., Samsung Galaxy).
  7. Roadblocks to new initiatives: Potential business partners in general do not like or trust Apple relative to other initiatives. The music industry and AT&T have not had great experiences with Apple, and the company might find it hard to sign deals for new initiatives.
  8. Product cannibalization: The iPad mini may cannibalize the higher-margin iPad -- or just be a neutral at best.
  9. Growing size mandates delivery of more product blockbusters: An investor better believe in a huge new blockbuster product next year. TV is complex due to relationships with cable companies, set-top box manufacturers and channel guide programmers. Google may one up Apple in the space, as it owns Motorola's set-top box division and has Google Voice already. If it comes to integrating more complex solution for TVs with content, cable companies and other media partners have learned not to trust Apple given the poor outcomes other Apple partners have had (e.g., music industry, AT&T, etc.).
  10. Valuation: Apple's stock is cheap on a P/E basis but arguably very expensive on price/sales (4.4x) and total absolute market capitalization basis ($625 billion).

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