How do we value a company that's just not like any other company? How do you put a price on a business that currently has an active user base of more than 1 billion active satisfied individuals, after just adding another 75 million of them to the fold?
That's the great conundrum facing Apple (AAPL), the greatest wealth-creating entity of our generation and a stock in the Action Alerts PLUS portfolio. It's a quandary that highly paid analysts face when they, four times a year, must peer into the future and extrapolate the current set of facts that Apple presents in its quarterly earnings report, then give investors advice about what the stock is worth versus what it sold for before the report.
And for my money, I think they are blowing it. All of them.
Sure, they have price targets that they can move and models that they can adjust and phones that they can count. Those various inputs yield some conclusion that's very much in keeping with other decisions they might make about any hardware company, as they have made for HP (HPQ) or EMC (EMC) or Intel (INTC).
And what's that conclusion? I think it goes like this: Apple owns the cellphone market as it exists, and now that it's forecasting the first down year, the cellphone business must be saturated. To them the fact that Apple sold 74.8 million phones in the December quarter, an all-time high, signals a peak in business, not an ascension.
There's no base camp on the Summit of Everest. The perspective that CEO Tim Cook put on that volume, that "it's an average of over 34,000 IPhones an hour, 24 hours a day, seven days a week for 13 weeks," is just another nail in the peak coffin. Worse, the peak, to these skeptics, actually occurred somewhere in mid-quarter because why else would Cook point out, "We began to see some signs of economic softness in greater China earlier this month, notably in Hong Kong."
So, if a company with really one serious line of business is going to show a quarter-over-quarter and perhaps year-over-year decline in sales, then that's all they wrote. Traditional peaks in cycles yield declining estimates and a shrinking multiple for what you are going to place on those estimates. That's a fact of life.
Now it would be one thing if Apple had something else to make up for what is now viewed as the inevitable plummet in iPhones, perhaps by as much as a 15% to 20% unit nosedive as one analyst postulated on the call. But iPads aren't selling as well as they used to, and Macs even seem to have reached some sort of peak in units. The Apple Watch is doing well and so is the television, but sales are nowhere near enough to mask any iPhone deceleration.
That means the analysts have no cover. They don't want to downgrade the stock. It is too cheap on earnings, even if those earnings are going down. It has too much cash, roughly $40 per share, to out and out downgrade the stock -- hence, why so many keep it a half-hearted buy and wish they had downgraded it higher. It can return an immense amount of capital, giving you a sizable dividend that might serve as a trampoline at some level. It can shrink the number of shares, financially engineering a higher earnings-per-share number like so many of its compadres.
But, in the end, these analysts are traditionalists. They have seen peaks in mainframes that led to disastrous years for the old IBM (IBM).
They have seen peaks in midrange computers that meant the end to Digital Equipment or Yang. They have watched as once-proprietary minicomputer companies were destroyed by Dell and Hewlett-Packard and Compaq.
In other words, they have learned their lesson and each seemed to work hard to try to distance themselves from the Cupertino monster, with the best damning the company with faint praise. I know. I heard it on the call. I felt that every analyst did his very best to be respectful and acknowledge the company's greatness without point-blank saying it's all over but the shouting.
I know I easily could say, "You know what, I'm done with it, too. I have liked it since the twenties and I am willing to say, 'Hey, it was great while it lasted. Nice to meet you.'"
But I am a generalist, not a technology analyst, and I can't view Apple like just another hardware company. When I didn't like my Dell or saw a cheaper deal in a Hewlett-Packard, I switched. What the heck. They are barely different toothpastes, aren't they?
Worse, given how many times you heard the term macro on the call, you could tell that the upsetting world, the weakness and turmoil everywhere, makes an analogy to toothpaste too glib. That's a small purchase and you can trade down. People are spending $691 for a phone, up from $687 a year ago despite the super-freaking strong dollar.
And that's when it hit me. Every other international company I deal with has found it almost impossible to raise price in this environment. Almost every American company has had to deal with foreign exchange ratios that have per se lowered the average price of whatever the heck they were selling, including toothpaste.
But Apple didn't.
For a moment, though, I said, maybe this is a dead end. I mean, Lexus has great brand loyalty. So does BMW. But if the world is saturated with autos, then who cares?
Then I figured that maybe Apple is like tobacco -- there's a brand addiction. But tobacco is pretty interchangeable even as it might be shrinking in growth, as the analysts think Apple is.
How about a drug company? Maybe Apple's iPhone is like Lipitor, the greatest drug ever. You had to take it. But then again, Lipitor's patent ran out, and that left you holding shares in a company that had peak earnings. Although even at peak, you were paying 13x earnings because there were other drugs -- consider them the iPad, like Viagra -- to offset the patent cliff. That's because there's no economic sensitivity to Pfizer's (PFE) products, but there are to Apple's for certain, just not as much as you think because they are addictive once you own one. Still, I thought it worked earlier, so I threw it out there.
And then it hit me. We actually have a metric that can explain and monetize the value of brand loyalty. They just didn't explain it that way. I am talking about the slide in the Apple deck called "service revenue," which showed that installed base revenues -- the ones we all pay for iTunes, music, the app store licensing, service parts, iCloud and Apple Pay -- are growing at an incredible 23% year over year, from $25 billion in fiscal 2014 to $31.2 billion in fiscal 2015.
That's the number that we need to key on, not unit devices. That's the razor blade stream for Apple. Except unlike Gillette's razor stream, brand loyalty is so great you aren't going to use Barbasol shaving cream or switch to the Schick Quattro.
You are in.
I have always questioned the concept of the ecosystem of Apple. I mean, so what? I have always said that I do like the razor blade model, but that at a certain point you are going to see resistance to the price of the razor, which his happening now. But the higher gross margins and the higher prices paid for phones tell me there is no resistance.
Now I know that Apple has that $40 billion in cash. I know it can make $9 in earnings. I know that some would regard that as peak. But what happens if the people who are switching so rapidly to Apple from other brands, or are trading up in America or starting out in China and the incredibly younger demographic n India -- under 27 years old -- get as comfortable as we all are in the ecosystem?
That means the razor blade revenue, the real high gross margin stuff that you get from Gillette or Apple for that matter, isn't getting nearly enough credit as it should, especially at that growth rate.
So maybe Apple doesn't need the watch to trump phone sales, TV for that matter. Maybe it just needs to keep selling more devices and let the service stream do the talking. By this time next year, it wouldn't shock me if that weren't the line item to key on, especially with an iPhone 7 around the corner.
If that's the case, guess what? You are getting an incredible bargain with this stock even as all we hear about is that it's all over but the shouting. Maybe, just maybe, when we get the inevitable downgrades and the analysts take it even lower as we get away from the blast zone number, you will see that this stream is the one worth owning the stock for when others are throwing it away. All the more reason that, on still one more miserable day for the market, I say own Apple, don't trade it.