Barclays has lost faith in Apple and thinks you should too. It believes the time has come to dump the most valuable company because of some superficial similarities to Microsoft, which traded sideways through most of the current millennium. While it’s certainly challenging to predict the future of Apple’s share price, it’s fairly easy to eviscerate the facile argument presented by Barclays in the Wall Street Journal (and elsewhere) concerning Apple. In telling investors to “step aside,” analyst Ben Reitzes says the smartphone market is maturing, nothing in Apple’s product pipeline will make a big difference like iPad or iPhone did, and there’s a whole host of reasons to see Apple as following in the footsteps of Microsoft. The last part of the reasoning is particularly lightweight and needs to be picked apart. So here goes:
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Barclays says: Microsoft’s market cap and Apple’s both peaked above $620 billion in market capitalization and then fell!
Most of the argument works like this: Barclays sees some kind of similarly between the two companies and then concludes that because of this similarity, history will repeat itself. It doesn’t consider that maybe $620 billion isn’t some kind of magic number. Nor does it spend a moment considering that it would be the same as $850 billion when you factor in inflation — so it isn’t really even the same number. It just decides that once you fall from that particular number, that’s that, you don’t start rising again. The observer with any sense of history might remember that when Microsoft was peaking it was 1999 and the dot-com bubble was getting ready to pop. Apple’s peak was in 2012, a particularly unexceptional time in the market’s current rise, it appears.
You and I might do the same kind of pattern matching that Barclays does with things we’ve seen before. We might, for example, get caught in a storm and arrive home soaking wet. But what we don’t do is run through a neighbor’s sprinkler on a different day and conclude that it just rained. The failure to spend even a moment comparing the fall in the price of Apple and Microsoft’s share prices is like not understanding the different reasons why the two sets of clothes are wet.
Barclays says: Microsoft’s multiple shrunk so Apple’s must do the same because… slow growth!
As Microsoft’s stock soared in the late 1990s, it’s price-to-earnings multiple soared too, reaching 81 at one point. When Apple hits its high in October of 2012, it was valued a hair below 16x earnings. What’s remarkable about Apple in fact, is that at no point during its rise in the Jobs-Cook era has the stock been especially expensive on a valuation basis. Because that differential would prevent Barclays from making any argument about how Microsoft and Apple are similar, it ignores the period from 1999-2004 when Microsoft’s P/E began slowly to return to earth and moves the timeframe ahead 5 years for this comparison.
Thus Barclays is left arguing: “Once the market decides that your main product will remain slow for a long time, there does seem to be a visible pattern for multiples to sustain lower levels for a long time even if revenues grow.” So first the market took Microsoft from 81 to around 20 P/E over 5 years. Then Microsoft produced a decade of slow growth. And during that time, the stock basically went nowhere, having fallen to 1998 levels to bring the out-of-whack ratio into balance. Apple has no such ratio problem while it may have a problem getting growth moving again. As a reminder, Barclays whole argument is: We think this is a case where the companies look similar. But in this case, they aren’t actually similar. They are at most “half similar” which sort of renders this whole idea of recognizing the pattern and concluding it will repeat as bizarre.
Barclays says: The peak in valuation occurs when some some kind of margins peak… sort of
Here the thesis gets especially muddled, so bear with me. “Both companies seemed to share a peak in the valuation that roughly coincided with the high point in gross margins.” But Barclays doesn’t really mean gross margins, it means a different computation on the income statement of each company. For Microsoft, that number is basically operating income over total revenue and it hit 50% in 1999. These days, the number has fallen to 34%, though it’s worth noting that net income has tripled to $21.9 billion from $7.8 billion 15 years ago. Such is the pain of seeing your P/E ratio parachute out of the stratosphere. The Microsoft of 2014 isn’t hugely different from the 1990s company; both still sell lots of software.
But today’s Microsoft is less relatively profitable because it sells a lot of Xbox game consoles, which don’t make money at the initial purchase; runs the Bing search engine, which has racked up big losses over time; and is committed to the Surface tablet business, which has cost a lot to get off the ground. While new CEO Satya Nadella hasn’t yet made his plans clear for those or any other Microsoft businesses, Steve Ballmer saw them as part of the company’s future and was willing to invest some of the company’s billions on short-term losses in exchange for potential long-term profits. The effectiveness of those bets may not be completely clear for years to come, but they were necessarily going to reduce margins as would anything Microsoft did to build new lines of business.
It’s certainly possible Apple will do no better than Microsoft has. Barclays notes that Apple’s gross margin happened to peak near its high valuation point. Gross margin also happens to be a different measure than operating margin and analysts are of two minds about it with respect to Apple. Some want Apple to cut margins, sell cheaper products in larger quantities and increase market share. Others go apoplectic ever time that magic number declines by tenths of a point. Whichever way Apple goes, gross margin isn’t actually a proxy for overall profitability, which is what ultimately affects the value of the company. (They are correlated but they not perfectly, for a lot of reasons.) Perhaps Barclays is still confused because of Microsoft’s huge “valuation hangover”, but it would be advised to look at Amazon’s low operating margins and low-ish gross margins to understand that neither of these numbers are magical. So again, we have a broken comparison and a real lack of clarity that lower margins are Apple’s destiny. But if they are, none of this proves Apple will make lower profits or be valued lower. Did I mention this was muddled?
Barclays says: Share buybacks will not cause the stock to rise!
“Both Microsoft and Apple bowed to market pressure to issue dividends and start buybacks – and it really did not lead to a resurgence in share price.” Uh oh, I kind of agree here. Except that it’s irrelevant. Apple has more cash than Microsoft and Google put together. And those two are among the richest companies on earth. Apple is also buying back shares because it has no other uses for the money and could still engage in acquisitions if it ever gets interested. Tim Cook said so himself. The implication is, again, that because this thing won’t lift the share price and didn’t lift the share price of some other company, the company is doomed to have moribund stock performance. Is Barclays actually arguing that Microsoft would have been better served by not buying its shares? That becoming wildly profitable is bad? Next up from Barclays: Google, too rich, too soon, time to sell!
Let’s just agree that the effect of the buyback is going to be limited to at best the mathematical benefit of the buyback. If Apple buys another 10% of its shares, it will see no more than a 10% lift in stock price. But so what? Apple is in uncharted waters in terms of how successful it has been. It’s able to pay a $12.20 dividend, spend tens of billions on buybacks and still have enough money to do absolutely anything it wants next. The fact that it can buy back stock while maintaining this flexibility can only be considered a negative in the bizarro world where being successful is bad. A perfectly legitimate concern is that it’s been in a similar position of strength for a couple of years now and it has yet to show its hand as to what “next big thing” it’s up to. But the tea leaves are beginning to reveal themselves. We’ll look at where Apple is headed and what it’s vulnerabilities actually are in an upcoming post. In the meantime, though this space doesn’t provide investment advice, it does recommend ignoring any that’s provided by banks named Barclays.
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