Love the company! Love the product! Love the stock? An Update on Apple

My first computer was a Mac 128K. I was a budget-constrained doctoral student from UCLA, teaching my very first class at UC Berkeley. At $2,500, in 1984 dollars, it consumed all of my discretionary income for that year, but it was love at first sight. Having sampled what the PC world had to offer, with its collection of geek speak and inscrutable illogic, I was dazzled by the human interface of the Mac and impressed with the creative spirits that ran the company (Steve Jobs & Steve Wozniak). Suffice to say, I was a Jobs fan, before it was fashionable to be one.

As I watched the evolution of the Mac through the decade, I learned some lessons that I have tried to hold on to in my investing and that came to mind last week, as I read some of the comments on my Tesla valuation.
  1. Even great CEOs have their blind spots: The success that Steve Jobs had at Apple, in his second coming as CEO, had made us forget his missteps in his first iteration as Apple's head. His creativity and focus were still there in the 1980s but I think that his zeal to put his personal imprint on style and features overwhelmed any sense of what the market wanted or needed at the time. The Mac Lisa, in my view the most ungainly of Apple computers ever, stands as testimonial to that era and to Job's lack of market discipline.
  2. The best technology does not always win: Much as I would like to believe that the best technology wins out in the market place, I learned to my consternation that this was not always the case. After all, not only did Microsoft win the operating system battle against Apple, with a vastly inferior system (in my biased view) but VHS beat out beta in the videotape stakes. Success in the market place requires a lot more than a good product: a recognition of what it is the market wants, good timing and good luck!
  3. Good companies are not always good investments: When I an enamored about a company, I have to remind myself to separate my views of a company from my views of its stock as an investment. After all, the evidence from history is sobering. As I noted in this earlier post on value investing, the better regarded a company is by the market place, the worse it is as an investment. 
  4. It is difficult to maintain distance when you love a company and its products: Much as I would like to be objective and unbiased, I am human. When I value a company, I start with preconceptions and views that find their way into my numbers, no matter how hard I try. As I noted in this very first post I had on Apple from early last year, all that I can do is be transparent about my biases and let you make your own judgments on whether you buy into my assumptions.
I have a long and complicated relationship with Apple, both as a user and as an investor. As a user, I have bought almost every version of the Mac (except for the Lisa) that has come out since 1984 and will probably add the new version of the Mac Pro to the list this fall. As an investor, I steered away from Apple as an investment through the much of the 1980s and 1990s, partly because I knew that my bias would blind me to the facts.

In 1997, I succumbed and bought Apple stock (the split adjusted price was just over $5) just as the company faced its darkest days, as questions mounted about whether the company would make it in a world where Microsoft seemed to have won the PC wars. I would love to tell you that I bought the stock for intrinsic value reasons (because it would make me look good) but as I noted in a post from a little over a year ago, I did not. Instead, I bought the stock out of compassion and loyalty, the former driven by the feeling that the stock may not make it and the latter by the joy its products had delivered to me over time.  That “charitable” contribution turned into my best investment ever, a fact I remember whenever I have moments of hubris about my valuation skills. 

That investment stayed in my portfolio until April 2012, when the company’s stock price hit $600 and the market cap looked like it would climb inexorably towards a trillion, I revalued the company (as I am wont to do with every company in my portfolio, at regular intervals). While the value I obtained was close to $700, I decided that it was time for me to cash out, even though the company was undervalued (at least based on my assessment). I justified  that decision in my post on Apple at the time, arguing that the momentum investors who had come into Apple had made it a pricing play and that I was not skilled at that game. In late August 2012, as the hype for the iPhone 5 built up and the stock price hit $700, I posted a valuation of just the iPhone franchise and argued that it was the most valuable franchise in history. 
Early this year, as Apple’s stock price converged on $450, I revisited my Apple valuation to see if I could justify the sudden and dramatic loss of almost $200 billion in market capitalization from a value perspective. Even allowing for the tighter margins and the stronger competition (from Android phones) my assessment of value for Apple was about $600. Arguing that the price drop had driven some (but not all) of the price and momentum players of the game, I made the decision to become an Apple stockholder again. As I made that decision, I wondered how much of it was driven by my residual bias towards the company and its products.
In May 2013, after feeling some outside pressure from activist investors and their proposals for enhancing price (with David Einhorn’s well publicized push for the company to issue preferred stock, which I responded to in this post), the company announced its intentions to borrow money for the first time in its history and to augment its stock buybacks. I argued at the time that while these actions would have a relatively small impact on value, which I estimated to be $588 at the time, they might be the catalysts that caused the price to move towards the value.
I was clearly way too optimistic, since the stock continued its descent hitting a low of $385 in April. As the price dropped, I did hear from a lot of the readers of my blog post, asking me whether I was reconsidering my decision. The essence (and appeal) of value investing to me is that if you buy a company for its capacity to deliver cash flows to you as an investor, the fact that the market moves against you should change nothing. I would be lying if I said that I was unaffected by the price moving in the wrong direction, but Apple stayed in my portfolio. In the last few weeks, we have seen a piling on of big name investors (Carl Icahn, Leon Cooperman) into Apple and the stock price has risen back to close to $500. To those who have asked me how that has affected my value, I would argue that nothing that Mr. Icahn had said since he took his stake in the company is a revelation that changes my fundamental assessment of value.
Apple’s big announcement date is tomorrow, at 10 am. If you are investor (long or short, potential or current), here are my suggestions. 
  1. Ignore the lead-up to the announcement, with the rumors, stories and opinion that you will see thrown around. Much of it is hot air with no effect on value. 
  2. If you can avoid it (and it will be tough to do so), don’t watch or listen in on the Apple announcement and try not get caught up in the frenzied trading that will inevitably follow. 
  3. I updated my valuation of Apple to reflect the financials as they stand today. Incorporating the information in the last annual report and markets (US treasury bond and equity) as they stand today, my estimate of value is $617, about 4% higher than my estimate in April 2013. A factor contributing to the increased value per share is the decline in the number of shares outstanding from 939.6 million to 908.4, a logical consequence of Apple's aggressive stock buyback program. 

Once you have the details of the announcement, go through the news stories with a singular focus on how they will impact Apple’s revenue growth path, operating margins and investment requirements for the future. The key is to not only separate the wheat (information) from the chaff (distractions) but also to work out the consequences for value.

As an Apple investor, I will be doing the exercise as well to see the implications for my Apple holding. While it is always dangerous to prejudge a news story, I don’t think that anything that comes out tomorrow will be game changer when it comes to value, though it may very well move the price (and I have absolutely no idea in which direction), especially if, as is rumored, it will revolve primarily around the iPhone and the iPad. As I noted in my last post on Apple, I believe that Apple’s value creation over the last decade has come from its capacity to disrupt existing businesses and that Apple is now too large a player in both the smartphone and tablet businesses to be a disruptor.

In fact, I think that they face a bigger risk in both businesses of someone else disrupting their cash cows. It would be exciting and potentially value changing if Apple announced a new market that they were planning to enter that no one expected them to. In my last post on Tesla, I argued that one of the potential positive scenarios for a Tesla bull was a strategic buyer who would be able to pay a premium over $20 billion. While I named automobile companies as potential buyers, there is no reason why that buyer cannot be a technology company with a large cash balance. Apple clearly has the cash and if it can figure out a way to bring Elon Musk on board, it may have found a new market to disrupt. The Tesla iCar? Probably no chance of it happening, but I can still dream, can’t I?

Mod Note (Andy) to respond directly to Professor Damodaran, please comment on his blog

Comments (11)

Sep 17, 2013 - 5:37pm


Great post - reminds me of a presentation I heard which proved that Apple would have to have 0 growth going forward to justify a $450 share price

Yes, but is it really that unimaginable that 2012 will be Apple's most profitable year for a long time? The majority of Apple's profits come from two related businesses, smartphones and tablets, both of which are still relatively immature and constantly evolving markets. If you're buying Apple based on fundamentals you have to ask yourself what the market for smartphones/tablets will be like 10-20 years now; then consider that the two ecosystems which now dominate those markets, iOS and Android, have only existed for 6, 5 years respectively. I don't think anybody knows which company/companies will be the leaders in these industries 10, 20 years out. Sure, right now it looks like Apple and Samsung are the biggest players, but only six years ago even if you had been smart enough to anticipate the explosion in smartphones you would have likely invested in RIMM, which a few years later is only a marginal player. I don't think you can put much stock into past earnings when you're evaluating a company operating in an industry where within five years you can go from industry leader to marginal player desperate for a buyout offer.

More specifically I think the big risks are:

1) As I argued above, the market for these devices is constantly changing and consumer preferences are very fickle. Any of the players which are currently dominating the industry could, if they fail to innovate and anticipate what consumers care most about, fall out of favor and lose market share.

2) The long-term economics of smartphones/tablets isn't understood. Right now, most people upgrade their smartphones to the latest, greatest, high-end model ASAP. Smartphone performance has advanced very rapidly, just as computers did in the 90s; the A7 CPU in the 5S is 40x faster than the CPU in the original iPhone, within a 6 year timespan. Just as it originally did with computers, this rapid increase in performance has translated to real benefits for consumers, so they have had incentives to upgrade to a high-end model every year or two. But, just as computers got "good enough" and people stopped upgrading constantly (evidenced by weakness in PC sales the past few years, and a shift towards cheaper PCs), smartphones will eventually get to the point where even the cheap, freebie model is "good enough" to play simple games and web browse/check email. And if that happens, then Apple's insane margins go down the tubes, even if they maintain market share.

Apologies for the long post, but I'd like to hear what Apple bulls have to say in response. I'm probably just too risk averse to invest in most tech companies, but regardless I do think most people overestimate how safe Apple's earnings are.

Sep 21, 2013 - 12:19pm

Yes, it's true that the smartphone and tablet hardware markets become more commoditized as they mature. However, Apple is the best operator in this space by far. Apple still maintains the best margins in those product categories and, despite the markets' maturity in developed markets, Apple is still on pace to sell more than 200 million iPhones and iPads this year. The iPhone business is more profitable than all of Microsoft. Due to its premium product positioning, Apple also attracts the best customers who spend the most on apps, thereby incentivizing app developers to write software for iOS. The availability of apps entices customers to purchase iOS devices. These network externalities ensure that iOS will continue to be a robust, attractive ecosystem regardless of what the market share stats say. Finally, IMO, it's easier for the premium producer to innovate downmarket than it is for the commodity producer to produce upmarket. Given the product pricing, I fairly certain the iPhone 5C will generate higher margins than the iPhone 5S. In order for Android to really compete for the most profitable high-end consumers, Android needs to become less fragmented and its app store needs to thwart app piracy more effectively so that its ecosystem is actually attractive to non-value-oriented consumers.

The long thesis on Apple has always centered on innovative new products. The company has historically been able to profitably cannibalize its own PCs and iPods with new products. The bet is that Apple will be able to use its financial resources to develop the next hot product as smartphone and tablet margins become depressed. However, Apple has not released a successful mass product since the iPad and the market is beginning to doubt whether it is still able to shock the world since Jobs' departure. Tim Cook's evasive comments on innovation aren't exactly comforting either.

The frustrating thing about being long Apple is that the market is giving the company no credit for raising debt and spending most of its free cash flow on increased dividends and share buybacks. GameStop, a company whose retail stores have zero terminal value and with a softening used game business, has implemented the same shareholder friendly policies. Since July 2012, GameStop is up almost 3x while Apple is down about 20%.

Sep 17, 2013 - 1:28pm

Can someone explain to me why "analysts" don't think the iPhone 5c is priced low enough? It's essentially the same as my iPhone 5 that I paid $240 to upgrade to.

Comparable phones like the Razr Maxx and Galaxy S4 range from $200-300 with a contract. I think that $100 for an iPhone 5c is very cheap, and a really good idea for Apple to maximize profit for dumb high school girls who like pretty colors made of plastic. I think earnings are going to blow any estimates out of the water. I'd be all in here.

Sep 17, 2013 - 2:02pm


Can someone explain to me why "analysts" don't think the iPhone 5c is priced low enough? It's essentially the same as my iPhone 5 that I paid $240 to upgrade to.

Comparable phones like the Razr Maxx and Galaxy S4 range from $200-300 with a contract. I think that $100 for an iPhone 5c is very cheap, and a really good idea for Apple to maximize profit for dumb high school girls who like pretty colors made of plastic. I think earnings are going to blow any estimates out of the water. I'd be all in here.

The Iphone 5C is priced low enough for US consumers-I think Wal-Mart and Verizon will be door busting it at $79- but it is still considered high for the Chinese / emerging markets at $733 equivalent, without a contract. Chinese telecoms do not typically offer subsidies for contracts.

Winners bring a bigger bag than you do. I have a degree in meritocracy.
Sep 17, 2013 - 3:28pm

Agree with this article, and great points most definitely. I think it is insane how analysts now seem to expect Apple to invent an entirely new product category and sell tens of millions every few months, and when they don't, they see this as somehow some kind of "sign the company is falling apart" or whatever other bullshit you will invariably see on many articles about Apple on Seeking Alpha, Tech Crunch, etc. They continue to be more profitable every year. And even at conservative estimates, their share price is about 30% lower than what it should be. Not including future growth. I think with the new Mac Pro, we will see (I hope) a resurgence into the pro market, and the entire iPod, iPad, and Mac line (minus MBA) has still to be updated this year. Finally, when we see the iPhone 6 next year, almost certainly with a bigger screen and an all-new design, I think there will be once again record sales numbers, as many will feel the need to upgrade.

"When you stop striving for perfection, you might as well be dead."
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