Apple Investor Amnesia


December 26, 2012 (5:30 pm)

I came across an article today called “Apple Investor Amnesia Sets up 2013”. Great headline, but a weak article overall. I thought I’d take a shot at taking over where the author fell short.

The trading dynamics heading into year-end are very different from the rest of the year. The main reason is that fund managers know that the year is over, and have essentially closed up shop for the holidays. They’ve earned their fee and don’t want to mess with their performance on the low volume this week. And if they didn’t outperform, they’re likely on vacation anyways. So we should take this week to lay out plans for 2013 instead of trying to identify specific patterns. The exceptionally low volume this week makes identifying technical trends much more challenging.

Price-to-Earnings

The author of the article I mentioned earlier explained that “Apple entered 2012 with a price to earnings ratio of 11.53 and heads into 2013 with a PE of 11.69 – only a 1.4% rise over the course of a year”. But that 2012 figure is not only misleading, its wrong. I’ve been keeping a spreadsheet with a variety of trading metrics and guidance on Apple. On December 31, 2011, the shares were trading at a 14.6x PE. It wasn’t until after Apple demolished earnings estimates in January that it’s PE effectively dropped to a 12.7x (it traded nowhere near the 11x PE ratio until November 2012). And that wasn’t because the market was comfortable at that level. It was simply a matter of the earnings beating to such a large degree, that only an immediate and dramatic spike would have prevented a drop to the mid-12 PE level.

Apple’s Fiscal Q1 (October-December)

It’s interesting to compare the current Q1 price action to last year. In 2011, we saw a peak near the beginning of the fiscal first quarter (October) at $425. That represented a 16.8x P/E. This year, we saw a peak in late September at $705, or a 16.5x P/E. The shares then slipped toward the low end of the multiple range – 13.0x in November 2011 versus 12.0x in November 2012. So in both cases, we saw a peak near the beginning of the quarter and a low in mid-November. In a normal year, we probably should have seen a bounce as we head into the new year and nearer to Apple’s best seasonal quarter. But we didn’t. Instead, we saw a quick bounce followed by more selling. Apple is the best stock to look at when considering the implications of the fiscal cliff. It was the most widely owned stock, and likely the one that most people had at least some gains in. And why not sell to lock in the gain, and wait until shares stabilize to buy back in?

Heading into January

The point of the tangent comparing price action to last year’s is that once the tax selling is over, I wouldn’t be surprised to see a similar run after January earnings. It may not be to the same extent as the parabolic rally last year (the same 18.3x PE would bring shares to $840 a shares in late March), but I do expect the share price to return to its natural average between 14.0x-15.0x PE. The shares should trade range bound between $640-$680 in March once investors understand that the Apple story has not ended.

What Investors Have Forgotten (or Missed)

  • Demand for the new iPhone isn’t as strong as it used to be.
  • Competition is catching up and the iPhone isn’t as amazing as it used to be.
  • Supply is constrained, and Apple won’t be able to meet estimates.
  • iPad sales won’t be robust because they’re too expensive.
  • Macs are being cannibalized by iPads and netbooks.
  • Who buys iPods anymore?
  • Steve Jobs is dead, and Apple is lost without him.
  • Apple won’t be able to innovate the way they could when they were smaller.
  • Growth will no doubt slow – how could it not for such a big company?

You probably get the point – and I bet you know where I’m going with this. Yes, these are all fears and questions that investors are using to rationalize the current steep decline in Apple shares. But I actually took this list from an article from November 2011. It was an article explaining that Apple wouldn’t see $425 again after they miss expectations in January 2012 (obviously, that didn’t happen).

Margins will likely be lower this quarter than for the foreseeable future. When Apple first switched to the iPhone 4 design, margins dropped due to the new form factor. They’d be silly to switch the form factor of the iPhone 5 so soon. I bet it’ll be around for 15-20 months at least. Even if they switch to a semi-annual introduction of new products (versus the current annual introduction). Margins will improve substantially for the coming quarters, driving EPS growth. And look at how the share price has tended to mimic growth in earnings in the past. Right now, that trend is breaking. We should see another increase in EPS in about four weeks. Don’t bet against the share price responding.

And don’t forget to look at any Apple store during the holiday season. It’s incredible to see the dichotomy between Apple stores and their Microsoft/Sony rival stores. One is packed every single day, with little white bags flowing out the doors. The other two are consistently empty and sad to look at.

Once we get this quarter over with (which can’t come fast enough), I think things will look very different. It will become more clear that Apple still dominates mobile, tablets, music and the education markets. They’re breaking into the enterprise. Growth is bursting out of every seam. But because the price action has been so horrible over the past few weeks, early 2013 is now setting up to be just as explosive as 2012 was. People just aren’t looking anymore…