Question: Has Apple's fall begun?

Bull's Response

Do you remember where you were Sept. 18, 2012? That was the day Apple's (Nasdaq:AAPL) stock hit $700 for the first time. With the company valued at $656 billion, pundits around the world were predicting the stock would hit $1,000. And then the wheels fell off the bus. Since hitting $700, its stock has dropped on 48 out of 81 days of trading through Jan. 16. Down more than 30% from its September high, some are suggesting this is the beginning of Apple's downfall. I don't see it this way. Instead, I see Apple reloading for another big run later this year. It will recover. Here's why.

Top Stocks - 2013

Barron's annual list of its 10 favorite stocks gained approximately 17% in 2012, easily outpacing the S&P 500. Apple is one of its 10 picks in 2013. Stressing the $40 billion in cash it will generate annually, Barron's anticipate that the company will likely increase its quarterly dividend as well as stepping up the pace of its share repurchases. With the earnings growth rate slowing considerably, it makes sense to allocate some of its cash to shareholders as a reward for remaining patient as the company continues to evolve after Steve Jobs' death.

iTunes/Apple TV

Forget the music part of the equation for a moment and consider what a powerful tandem iTunes and Apple TV have become. Between Netflix (Nasdaq:NFLX) and iTunes, my wife and I don't really have a need for cable. We haven't cut the cord just yet but eventually I'm sure we will. The million dollar question is how Apple will position itself to take advantage of the millions of consumers who've become accustomed to streaming video. Clearly the evolution from set-top box to full-on TV isn't too far off.

KGI Securities analyst Ming-Chi Kuo sees the introduction of the Apple television set in 2014 once it's figured out how to get its retina displays on larger footprints. I'm not sure we'll be ready to buy a new TV set at that point but there will be plenty of people who are. As for iTunes, estimates suggest the store generated $12 billion in gross revenue in 2012. Once you take the 30% cut Apple gets and subtract the $3.5 billion it costs to run the business, it's left with $100 million or so in profits. That might not seem like a lot but given revenues have been compounding at more than 30% annually, it's probably looking at several billion in profits by 2018, especially if the introduction of the Apple HDTV comes sooner rather than later.

Low-Cost iPhone

John Sculley, known to many as the man who fired Steve Jobs, recently appeared on Bloomberg TV suggesting that smartphones in developed markets were becoming increasingly saturated; Apple's best bet would be to introduce a cheaper version of the iPhone that would sell in emerging markets. Smartphones are getting down in price; Apple can't let emerging market revenues slip away just because it wants to sell the most expensive products on the market. While you can't be everything to everyone, being a technology dynamo means figuring out how to do great things for less. I'd be shocked if the cheaper iPhone wasn't available sometime in 2013.

Valuation

Fortune ran an article in July 2010 that asked the question: Is Apple undervalued at $260? Using analysis from a University of Paris mathematician, the article basically subtracted cash per share from the current share price, then divided the trailing twelve month's earnings per share into the previous result and lastly divided the earnings growth rate with a lower number being better. At the time, Microsoft (Nasdaq:MSFT) was the cheapest of the five stocks with Apple a close second. Below, you'll find an updated table. I've included a link to the original article because the table is a little tough to follow. You'll notice that Hewlett-Packard is missing; I removed it due to negative earnings. The most important thing one should get from this exercise is that Apple two years later is still much cheaper than Google.

Apple and Peers - PEG Ratio Less Cash

Company

Share Price

EPS

P/E

C/S

Earnings Growth

P-C

P-C/EPS

PEG

P- CEG

Microsoft

$27.25

$1.85

14.8

$7.85

8.5%

$19.45

10.5

1.74

1.24

Apple

$502.68

$44.15

11.4

$30.97

20.9%

$472.06

10.7

0.55

0.51

Amazon (Nasdaq:AMZN)

$270.48

$0.08

3,226.1

$11.59

32.6%

$259.09

3,238.6

99.00

99.34

Google (Nasdaq:GOOG)

$711.32

$31.91

22.3

$135.80

14.1%

$575.52

18.0

1.58

1.28

The Bottom Line

In Barron's explanation for why Apple is one of its 10 best stocks for 2013, it listed two important factors in its decision: first, its P/E ratio is near its lowest point in five years; second, stripping out the cash, it trades at eight times its 2013 earnings per share estimate. The orderly two-and-a-half month retreat, with more evidently on the way, leaves little room for error. If you are short here, any positive news, especially those of an earnings nature, will have serious consequences. That's because the farther Apple falls, the more wound-up it gets. When the rebound happens, and it will happen, the strength of the recovery will be in direct proportion to how far it's fallen. Beware the bear trap!

At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.

Don't forget to read the Bear side of this debate and weigh in with your opinion below.

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