Is AAPL Overvalued?

Is Apple’s stock (AAPL) overvalued?  As a person who’s been following the stock since the mid 1990s and has owned shares since 2007, let me play devil’s advocate.

It’s a sell:

1.  Everybody Loves AAPL:  According to Yahoo! Finance, there are 37 analysts covering the stock whose mean recommendations are a tad bit above “Buy,” with average target price of 301 and median target price of 315.  As of  the close of trading today, May 25, the stock was trading at 246, meaning, on average, analysts are expecting the stock to increase by 20%.  Any bearish sentiment is far and in-between.

The number one rule on Wall Street is when everybody loves the stock and skeptics have become apologists, the stock has become overvalued.  It’s time to sell because everyone has stopped asking tough questions about the company.

2.  Market Capitalization:  Apple’s market capitalization–the value of all of its stocks combined–is the third largest in America, behind Exxon Mobil (XOM) and Microsoft (MSFT) and above Wal-Mart (WMT).*  Comparing Apple to a company that does more than $1 billion in sales per day (Wal-Mart), that has a near monopoly in its major product line (Microsoft) or the largest company in an industry whose products we can’t live without (Exxon) seems preposterous.

And it is.

Apple has barely attained $50 billion in annual sales by having anywhere from minimal (Macs) to significant (iPod) market share making high-priced products for consumers who can live without their products.  Apple is a valuable company, but it’s not even close to third most valuable.

3.  One Man Show:  The Apple empire  is one heart attack away from collapsing.  True, the company survived a recent health scare of its founder and CEO, but everyone knows Steve Jobs’ vision is driving this company.  He can instill his vision into the corporate culture, but only so much.  Jonathan Ive may be a design genius, but he can’t replicate Jobs’ charisma.  Nor is Phil Schiller Steve Jobs, as he painfully demonstrates during his appearances at Macworld.  Without an answer to the question “who will replace Steve Jobs?”, the $224 billion valuation of Apple is really a valuation of one man:  Steve Jobs.

4.  Corporate Governance:  Steve Jobs handpicked Apple’s current Board of Directors after he returned to the company in the mid-1990s.  They are all yes-men.  The company handled Steve Jobs’  health issues very poorly; the story it was telling the market continuously changed until Jobs finally took a leave of absence.

I had suspected (and so had the Securities and Exchange Commission) that Steve Jobs simply lied to the Board about the seriousness of his condition.  After the recent death of board member Jerome York, Wall Street Journal published a troubling article reporting that York had wished he had resigned  for precisely this reason.

People who are responsible for holding others accountable aren’t doing so–or worse, can’t do so.  Apple  is essentially telling the market, “Just trust us, because we’re making shit loads of money.”  If this sounds awfully like Enron, it is.  And if that’s not enough to scare you,  remember that Apple is now worth more than four times Enron ever was.

5.  Hype:  Apple thrives on press coverage.  Even when Apple was on the verge of irrelevancy, the company received disproportionate press attention.  Now that the company, along with Google, moves the world of technology, its product announcements are national news and rumors of upcoming devices borders on the hysteria.  Before long, their “next big thing” will be expected to solve world hunger and cure cancer while weighing only one and a half ounces.

What if Apple fails to live up to the preposterously high expectations?  What if, God forbid, their next revolution flops?  The mystique will disappear and they’ll turn into just another Sony (a “has been”) or even a Dell (“never again”).

It’s a buy:

1.  Growth:  Apple is growing at a remarkable pace for a company of its size.  In the most recent quarter, its revenue increased 48.7% and profits rose 89.5% from the prior year.  During the last fiscal year, which ended on September 30, 2009, revenue rose 32.1% and profits rose 70.3% from the prior fiscal year.

And the run isn’t over.  Apart from the iPod, which has saturated the global market, Apple’s other line of products have plenty of untapped markets.  Its Macintosh line of computers still has, at most, 10% market share in the United States; globally, Macintosh doesn’t even register in the top five.  The iPhone, despite its ubiquity in the United States, is still tied to AT&T.  If international markets are any indication (and there is plenty of growth left there), once the iPhone is offered on other networks, its sales will explode.  The just-introduced iPad has sold 1 million units in less than a month, outpacing the original iPhone which was considered a tremendous success.

The company is hitting on all cylinders and should for the foreseeable future.

2.  Margins:  For a manufacturer of electronic devices, Apple makes helluva lot of money.  Its gross margins were 41.7% last quarter while Dell’s was 17.6% and Hewlett-Packard’s was 22.6%.

For years, people mocked Apple for not selling a computer under $1,000.  Now the joke is on Dell, which is unable to get out of the vicious competitive environment that it fostered as prices continue to tumble, its products turn into a commodity and margins get squeezed.  Apple says it doesn’t make a netbook because they don’t know how to make a computer under $500 that’s not a piece of junk, but it has also always understood that the purpose of a business is not to sell as many products as possible but to make as much money as possible.

It’s better to sell 100 computers for $1,000 rather than 200 computers for $300.  By refusing to participate in the race to the bottom, Apple has protected its margins and its brand.  It’s a sign of a disciplined company that understands profit is more important than market share.

3.  Balance sheet:  Perhaps unable to shake off the time when the company was days away from running out of cash, Apple now simply hogs its $23 billion (or $25 a share), refusing to pay a dividend and only tapping into it for occasional small-scale acquisitions.  On the other side of the balance sheet is its lack of any long-term debt.  That’s squeaky clean.

4.  Valuation:  Apple’s current P/E ratio is 20.9, actually below its historical levels.  It’s forward P/E is below the technology sector’s in general although slightly above computer hardware manufacturers.  AAPL has always tended to trade at a premium compared to the rest of the industry.

If you believe that revenue and earnings will continue to rapidly grow–a relatively safe assumption for the near future–valuation indicator and history says AAPL is not overly priced.

5.  Products: Everything Apple makes turns into gold.  In the 10 years since the introduction of the original iPod, the company has changed the way people listen to music, revolutionized the music business, heightened what people expect out of a phone and now, possibly, establish a whole new computing experience.

There’s hysteria about what the company will do next because it has established an impressive track record of rethinking the market that it is entering into.  That hype that everyone should be worried about?  Apple has exceeded it with the iPhone and  it is seemingly meeting it with the iPad.

Sure, it has had its share of duds.  Remember the PowerMac G4 Cube and the iPod Hi-Fi?  Nor have Apple TV and MacBook Air caught fire.  But where it has staked the its reputation, it has hit a home run.  That’s not easy to do even once yet Apple has done it continuously.  The company has an uncanny ability to understand what consumers want.

6.  Market dominance:  It’s hard to recall that only 10 years ago, Apple was a lovable loser.  Now, it’s a behemoth, and with size comes economies of scale.  Because of the iPod, iPhone and now the iPad, Apple consumes an estimated 20-30% of the world’s supply of flash memory.  Apple’s margins are ridiculously high but companies like Microsoft (with the Zune) still can’t competitively price because Apple with its volume can get the pricing on supplies that other companies can’t.

It also can act like the bully in the back yard.  They pushed around music executives, played chicken with NBC, held AT&T for hostage and now has forced the desperate publishers to its mercy.  Like a chip leader at a poker table, once you’re on top, you need to wield your influence to stay on top (within legal bounds).  Apple is new at this game, yet it plays it very well.

It’s a hold:

So where do I stand?

I’ve never followed a stock that has so many compelling arguments on both sides.  Ultimately, I can’t get over the fact that Apple isn’t remotely close to being the third most valuable company, no matter how quickly it’s growing, how much money it makes or how popular are its  products.  I simply don’t see the stock going much higher than $300 as reality of the valuation settles in.

My price target is $275, at which point I intend to unload at least a third and up to a half of my holdings.

AAPL is a hold, but for not much longer.

P.S. As of Wednesday, May 26, 2010,  AAPL is now worth more than MSFT, trailing only XOM in market capitalization in the United States.