Why “Apple stock trades like a steel mill on its way out of business”

Apple’s a weird one. It’s the most profitable company in the world and yet it trades on a p/e you’d expect to see in a failing steel business. What gives?

At the end of last week, the Agora Financial brains trust and I sat down to talk about the markets. Ben Traynor warned about trouble brewing with the pound and Frank Hemsley explained how, for traders, a volatile month like the one we’ve just had can be very good news. And Glenn Fisher butted in with smart questions and awkward segues.

Towards the end of our chat I brought everyone up to speed on Apple, which had just announced its most recent quarterly earnings.

Apple’s a weird one. It’s the most profitable company in the world, and (up until this morning it was) the biggest company by market cap. It’s a technology company making cutting edge hardware and software.

But as Marc Andreessen pointed out on Twitter, it trades on a p/e you’d expect to see in a failing steel business. What gives?

A tenuous segue

BT = Ben Traynor, GF = Glenn Fisher, SK = Seán Keyes

GF Talking about volatility, then, in a tenuous segue, things going up and things going down, something that normally goes up has recently gone down and that brings us to Mr Sean Keyes and the story of Apple.

Apple, what’s going on? Why is it down? Will it stay down? Is this a good discount window for buyers or is it that other phones and Android and all that stuff coming up to steal it because it’s got a nice curved edge?

BT Is this true? I scan read an article. Did I read that Apple has a P/E of eight now?

SK Yes. You stole my lead.

BT To be honest, I thought you might be going to say that, so I thought I’d get in first. I saw all that and I thought that can’t be right.

SK As Marc Andreessen put it in a tweet last week: [on p/e of 8] “Apple stock trades like a steel mill on its way out of business.”

So, yes, then, you saw the news. Overnight we learned about Apple’s most recent earnings from Q4. And they were sort of good and sort of bad.

GF I just looked a bit further. I saw the initial story and thought, well, I’ll ask Sean about that because I know it’s his field and then I looked at it again today and, well, it is down but the sales are at the low end of expectations. It’s one of those things where it’s like, oh, we haven’t done that well, we’ve only made 18 billion.

SK Well, what they only did was make the biggest quarterly profit of any corporation in history.

GF Shame on them.

SK Apple is still a richly profitable company. But the thing about Apple is it’s just changing from being a growth stock into not being a growth stock. So, what I’m going to talk about for a couple of minutes are just the details of how that’s happened and whether eight is a fair price for the company.

So, yes, the headline figures from these earnings were, okay. They made 18.4 billion in profits which is the biggest ever, as I just said. But the bad news was that they indicated that revenue was going to drop next quarter and that would be the first time in 13 years that that’s happened. Digging slightly deeper into the figures, they show iPhone sales growth went negative for the first time ever this quarter. So that’s the news from Q4.

What’s the bigger picture? Basically, Apple is the iPhone company. The iPhone business is so huge.

They’ve got a big iPad business as well and for a while that looked like it was going to take off and supplement the iPhone business, but that didn’t really pan out and iPad growth has sort of stalled.

The iPad was a false dawn

GF Why is that? Just competition from the other people?

SK Well, I guess iPads aren’t as ubiquitous and as…

BT They’re too easy to replace. They’re not as essential as iPhones.

GF We were talking about this the other day where you’ve got an Apple Watch, that fancy kind of one, but I was saying my Apple experience: I originally had a phone and I thought it was the greatest thing in the world. I thought it was fantastic. I did all my life through it. Then, I got an iPad and I thought: this is even better. I don’t mind that it’s a bit bigger, it’s all right, and I adjusted my life to that thing. I thought that was fantastic.

Then I go, right, okay, I’m going to get a Mac, which is slightly familiar. My iPad is now lying on the floor. I don’t use it for anything other than like doing my Bluetooth music on the Bluetooth thing in my bedroom. I weirdly adjust to these things. And then you were saying that the watch kind of replaces some of the functionality of the others things.

SK Well, if you’d like to talk about Sean’s watch for a time, I’d be very happy to do that.

GF But my point being for the iPad, I think that was too easily replaced. The watch or the Mac too easily gets rid of it.

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Apple is the iPhone company

SK The iPad is still a great business for Apple. But it’s small fry compared to the iPhone.

The iPhone is like two-thirds of their profits and revenue, don’t hold me to that but it’s something like that, the iPad makes up about a quarter and then the Mac business is chugging along at the bottom.

The Mac business never really grew very quickly but it’s just been growing at a very steady, like 10% rate for a long time, so it’s a really big profitable business now but in the context of Apple which is, as I just said, the most profitable company in history, it’s only a footnote.

So, yes, Apple is the iPhone company and iPhones are a unique business. It’s an amazing business to be in for Apple. Okay, the first thing to know about the iPhone, to understand how it fits into Apple’s business model and all its competitors is that it makes so much profit on each iPhone. So, they control about 15% of the market worldwide, the very top 15%, so they’re not even the biggest single manufacturer.

GF In the whole smartphone market?

SK Smartphone market, yes. I think Samsung are still the biggest manufacturer. But despite only controlling 15% of the market, Apple makes 90% of all profits in the smartphone industry.

So, all these Android guys: Samsung, LG, Huawei, Xiaomi and those guys. All those companies, they’re all selling undifferentiated Android phones and they’re making no money on them because you can’t differentiate yourself; you can’t command a premium.

BT They’re commoditised.

SK Yes, they’re commoditised. Exactly. You can’t command a premium when you’re selling just another Android phone. They’re all the same.

And so, just to jump ahead a little bit, I saw a chart today which is that the iPhone selling price has stayed steady at around $700 since 2011 but the average Android selling price as gone from $400 down to $200 and it has very steadily marched downwards. And it’s going to fall further.

The bear case for Apple

So, Apple is making these iPhones which are very expensive. And they’re making a great profit margin in each one. That’s sort of the big worry for Apple: okay, if they’re making all their money from iPhones and if they’re making 40% profit margins on each one, how long can that last? How long until some competitor comes up with phones just as good and charges a slightly lower price?

BT Or even if they don’t, how are they going to grow the volumes or increase the margin?

SK Well, yes. That’s the next thing, the volumes, but I’ll come to that. So, yes, they sell mostly iPhones and they make a lot of money on each iPhone.

Over the last few years, the “bear case” for Apple was: one, another company was going along and they were going to sell, as I just said, a cheaper and just as good version. Two, that Android phones – which have a much bigger overall market share – would attract all the best developers. Then Android would have the best ecosystem, and that would give Android an edge in terms of quality that the iPhone can’t match. Sort of like with the Mac and the PC.

And so, for the last couple of years, that’s what people have been worrying about. But long story short, it hasn’t worked out that way.

Never stronger

iPhone is in a stronger position, I think, than it has ever been. It’s really consolidated its hold on its end of the market and nobody looks like they’re capable of challenging them. Why is that? I think it comes down to what we just quickly touched on earlier on.

I think a smartphone is such an important part of people’s lives now. Okay, it might cost 700 quid but it’s probably pretty good value for that price. It touches on everything we do. We check it in the morning and at night. It’s such an important and personal product and it’s not the type of product I think people are happy to trade down for a slightly cheaper, worse one.

They’re getting a good deal for their 700 quid, basically, on this incredibly important product for a lot of people. So, I think it’s much more likely that people will trade up to a better smartphone, up to an Apple smartphone from an Android than that they’ll trade down to a cheaper one.

GF I’m just going to support that. It’s the only thing… I’m not very technologically or brand aware, generally, and I don’t like to spend on things. The only thing I’ve ever really bothered about is my Apple product. I find the phone useful. With all of you I communicate on a regular basis through that phone through various apps and through these things. I do check it all the time. I do have the thing. I would never go downmarket. The only thing I think is: shall I go and upgrade ahead of an upgrade? I’m quite thrifty in other places but that’s the only thing where I think I pay the premium to get the next one.

SK And I think over the last five years it seems as though most people feel that way. The last big iPhone upgrade was the iPhone 6, the big one, iPhone 6 Plus, and that was an absolute monster hit for Apple.

GF This might get a little bit too philosophical and not very useful but why is that? Does it come down to usability or is the old, I imagine 300 million books have been written on this, but that idea that, yes, I am an Apple, I am a PC; the club mentality of being..? Is it that, oh yes, Apple is cooler?

SK No, I don’t think so.

GF I would make a case for usability. Bear in mind, I use a Mac now religiously. I don’t actually use the computers we have in the office. I use my own Mac that I bring in and I literally carry with me. I will admit to losing my Mac in a taxi once because I drank too much and it’s probably the only time in the past five years that I cried. I was also very drunk but I was so worried that I’d lost that piece of kit because it’s become so useful to me and so easy to use and I think that is usability.

As I say, I’m an alternative person. I don’t like hype. I didn’t listen to the Beatles until I was like 30 because they were too hyped but I finally went and said, right, let’s try it and I so quickly adapted to it. Is it that, that carries it on?

BT Well, I would say that – I’m sure Sean would agree with this – it’s a strong case of why people stick with the products, why they have a very loyal fan base and a loyal customer base. Does that help growth, though?

SK Well, I’ll come to growth. That’s the end of the story. As you said, talking about your Mac, the Mac is like a great template for understanding how the business will, I think, develop for the iPhone and for the overall company because that Mac has been around for a long time. They’ve been more expensive than PCs for a long time. Apple runs this 40% profit margin on average across all its businesses and that applies to Macs too. I think that the Mac user base has been very, very loyal and it has grown, certainly, over the years. I think the Mac user base is kind of a good indicator of what you can probably expect from the iPhone user base. So, that’s one thing. I think that people will be happy to pay for a premium phone.

Then, the next thing is could somebody else come along and make one that’s just as good because I think that if you care about quality and hopefully you’re not susceptible to branding and to marketing hype you might switch across to another one if it was just as good. And the indications are that Android just can’t really do it. They don’t have the scale. No big Android manufacturer can invest in the very, very best materials, can’t invest in the fancy force touch technology or whatever Apple is working on for now. They’ve been playing catch up since the very start.

… Right, that’s a good place to stop. We ended up going way over time on our discussion, because with Apple there’s just a lot to say. I’ll bring you the rest of our chat in the next few days.

What do you think – is Apple doomed? Even if it is, does it deserve a meagre p/e of 8? Let me know at sean@agora.co.uk

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