|Can the "golden theorem" take down Apple?|
A Law Apple Would Like to Break
By JAMES B. STEWART
New York Times
February 24, 2012
These days, it’s hard to find a superlative that adequately describes Apple. But maybe simplest is best: biggest.
Measured by market capitalization, Apple is the world’s biggest company. This week it solidified its lead over Exxon Mobil, the previous titleholder, as Apple’s shares hit an all-time high of $526.29, which gave it a market capitalization of just under $500 billion. Apple becomes only the 11th company to reach the top spot since 1926, according Howard Silverblatt, a senior index analyst for Standard & Poor’s.
Apple’s first-quarter earnings of more than $13 billion accounted for more than 6 percent of all earnings for the S.& P. 500, according to Mr. Silverblatt. Sales for the quarter ending Dec. 31 included an astonishing 37.04 million iPhones and 15.43 million iPads and totaled $46.33 billion, up 73 percent from the year before. Earnings more than doubled. Compare that with this week’s earning from the tech giants Hewlett-Packard (down 44 percent) and Dell (down 18 percent).
Apple shares have surged 68 percent from their low point in June, and it’s not just Apple shareholders who have benefitted. Apple is now such a large part of the S.& P. 500 and the Nasdaq 100 indexes that it has buoyed millions of investors who own shares of broad index funds and mutual funds, who account for an estimated half of the American population. This week the Nasdaq Composite reached its highest level since 2000 and the S.& P. 500 hit levels not seen since before the financial crisis.
Here is the rub: Apple is so big, it’s running up against the law of large numbers.
Also known as the golden theorem, with a proof attributed to the 17th century Swiss mathematician Jacob Bernoulli, the law states that a variable will revert to a mean over a large sample of results. In the case of the largest companies, it suggests that high earnings growth and a rapid rise in share price will slow as those companies grow ever larger.
If Apple’s share price grows even 20 percent a year for the next decade, which is far below its current blistering pace, its $500 billion market capitalization would be more than $3 trillion by 2022. That is bigger than the 2011 gross domestic product of France, Brazil and all but four countries.
Put another way, to increase its revenue by 20 percent, Apple has to generate additional sales of more than $9 billion in its next fourth quarter. A company with only $1 billion in sales has to come up with just another $200 million.
Robert Cihra, an analyst who covers Apple at Evercore Partners, told me this week that the law of large numbers as it applied to Apple had “been a concern for years now.” But, he said, “over the past couple of years, they have actually accelerated revenue growth. I don’t know that can continue indefinitely. If you extrapolate far enough out into the future, to sustain that growth Apple would have to sell an iPhone to every man, woman, child, animal and rock on the planet.”
The law of large numbers may explain why, even at its recent lofty stock price, Apple looks like a bargain by most measures. The ratio of its share price to its earnings, a common measure of a company’s stock value, is less than 11 based on earnings projections for this year. That is well below the market’s average P/E ratio of about 13. Apple shares are even being bought by so-called value investors, who are usually confined to stodgier, low-growth but arguably undervalued companies.
“The valuation on Apple stock right now is unjustifiably low,” Mr. Cihra said. “If it weren’t so big, the P/E multiple would be a lot higher. They almost doubled their earnings in calendar year 2011 and yet the stock is trading currently at a P/E multiple of less than 11. It’s trading way below the market average, even though it’s growing way above the market average. The multiple is being compressed simply because investors are asking how it can get bigger.”
There may be sobering reasons for that. Other companies that have reached the top appear to have been felled by Bernoulli’s law. Cisco Systems held the top position and hit a market capitalization of $557 billion — larger than Apple’s — in March 2000, at the peak of the technology bubble. Its market capitalization today is about $100 billion, and shares are down nearly 80 percent since March 2000. In contrast with Apple, Cisco’s market value and sky-high 120 P/E ratio were inflated by investor euphoria rather than actual results. But other titleholders have met a similarly disappointing fate, although far less drastic.
Exxon Mobil, recently displaced by Apple as the biggest company by market value, took over the top spot in 2006, seven years after the merger of Exxon and Mobil. At the end of that year, its market capitalization was $447 billion. Today it’s $35 billion lower. General Electric held the title for a number of years, most recently in 2005, when its market capitalization was $370 billion. Today, it’s just $205 billion. Microsoft was No. 1 in 2002 with a market capitalization of $276 billion. Today, it’s $262 billion. Of recent titleholders, the only one that has gained is IBM, whose market capitalization of $65 billion ranked first in 1990. Today, it’s $229 billion. Over the intervening 22 years, that is a compound rate of return of 11.2 percent including dividends — impressive but hardly the growth rate Apple shareholders have come to expect. Over the same period, an S.& P. 500 index fund returned 8.7 percent.
Can Apple escape a similar fate?
After never being a dominant force in personal computers, Apple surged to the top of the S.& P. 500 by transforming the cellphone into a multitasking smartphone, arguably the single most-important technological advance so far in the 21st century. It rolled over vaunted rivals like Nokia, Motorola and Research in Motion with a combination of brilliant technology, dazzling design and shrewd marketing backed by the singular vision of its late founder, Steve Jobs. “Everyone truly needs it,” Mr. Cihra said of the smartphone. “It’s the most transformative piece of technology in our lifetimes.”
Notwithstanding Apple’s huge size, Wall Street analysts are overwhelmingly positive on the company’s prospects. Of 57 analysts who cover the company, 52 have a strong buy or buy recommendation. Only one recommends selling: Edward Zabitsky, the chief executive and founder of ACI Research in Toronto, who specializes in telecommunications and has been Apple’s reigning Cassandra for years. He’s a favorite target of the Web’s “iPhone death watch,” which features negative (and thus far wrong) projections about Apple.
“In all my years as an analyst, I’ve never gotten the kind of attention I’ve gotten from my Apple call,” Mr. Zabitsky told me this week. “I’ve gotten get e-mails from everyone from radiologists to car repair people from all over North America telling me I’m a fool. We’re just a research operation, so we’re not trying to get any business from Apple. If we were, I doubt we’d get any.”
“Apple has created a tremendous ecosystem where there was none,” Mr. Zabitsky acknowledges. But he thinks competition will erode Apple’s advantages as computing shifts to the cloud. “The question isn’t whether this will happen, but why and when. The company that understands this best is Microsoft. They’re betting the farm on Web apps. They’ll be competing with Apple on every product. Microsoft is big enough and motivated enough to make this happen.”
But Mr. Zabitsky remains a solitary voice.
“The reason Apple has been able to continue growing at a spectacular rate, even as its revenue base has surpassed $100 billion, is because it targets the world’s biggest markets,” Mr. Cihra said. He rates the stock a buy and projects revenue for calendar year 2012 at $165 billion. “The simple fact is that they still have a small share of huge markets — single digit shares in both PCs and mobile phones.” Global mobile phone subscriptions neared six billion in 2011, with Apple’s share of the handset market at 5.6 percent, according to the market intelligence firm IDC. “There’s no mathematical reason Apple can’t keep growing at a premium rate for at least several more years,” Mr. Cihra said. “At the end of the day, there’s no good reason for market cap to be a ceiling.”
Apple fans are eagerly awaiting Apple’s next big thing. A voice-activated television that upends TV the way Apple transformed music and cellphones? Maybe. And Mr. Cihra may well be right that Apple investors have at least several years of breathing room. But history suggests that excessive enthusiasm can often precede a fall. At Cisco’s peak, every Wall Street analyst covering the company rated it a strong buy or buy. “Cisco continues to execute very well and demonstrates that it is in a class by itself,” Seth Spalding, an analyst at Epoch Partners, wrote, joining a chorus of analysts praising Cisco’s latest earnings — in November 2000.