Apple: Long or Short?

According to Forbes magazine, Apple is the most innovative company on the planet. For the past three years it's also been the most admired. And it owns the world's most valuable brand.

These are fluffy, insubstantial measures. But on more useful analytical figures, it does even better.

With a market capitalisation of $US310bn, it's the third largest of all publicly listed companies. More impressive is the 21% net profit margin the company made on revenues of US$65bn in 2010, and its premium PER of 22.

But can such a valuation be justified? That's the question I'll try to address, although I'd like your help in doing so.

Three factors will largely determine whether Apple's price is stretched or not: Its ability to continue growing; the longevity and resilience of its technological moat; and its leadership.

Let's examine each in turn.

Future sales growth appears all but locked in. Consensus estimates have revenue cracking US$100bn this year. iPhone sales alone generated US$25bn of revenue in 2010, more than the US$24bn of revenue the entire business earned in 2007, the year of the iPhone's release.

The iPad could be an even bigger success. Pundits are forecasting 2011 sales of anywhere up to 50 million units, or more than US$25bn. This is a faster rate of sales growth than even the iPhone achieved, for a product in a category that barely existed before its launch.

Then there's the halo effect. Customers introduced to Apple by the iPhone and iPad are increasingly using Mac computers and laptops, as well as the iTunes content platform, which has a stranglehold on online music and application sales.

The results are astonishing. Between 2007 and 2010, Apple's revenue almost tripled to US$65bn, while profits quadrupled to US$14bn.

But this isn't General Electric. Apple sells phones, computers, content and apps, plus some plastic stuff to make them all look nice. That's it. It's a limited product range (which may be one reason for its success).

Who knows what we might be buying from the world's most innovative company a few years from now? Last year, the company was awarded 563 patents. Apple's past rates of growth are incredible. But one more success like the iPhone or iPad and future rates of growth may yet make them look meagre.

The bull case for Apple is strong—and that's why this stock trades at 22 times earnings. But what about the bear case?

The bleeding edge

Apple's performance is a result of it having the best devices and software on the market. Customers love the products, and the marketing, design and engineering is outstanding. The problem is that it isn't selling washing machines; Apple is selling devices with product cycles of less than 12 months.

That means that if the company doesn't constantly and successfully innovate, it loses its lead. Technology companies simply can't stand still.

If Apple can maintain its substantial lead, it'll continue to be extremely profitable. But that's a big if. History has shown that incumbents rarely stay on top of technology trends for long. Things change quicker in this area of business than in almost any other.

Google's once undisputed reign of the Internet, for example, is being attacked by Facebook. Twitter, a company that didn't exist five years ago, is challenging both. It won't be the last. And who can remember when Microsoft ruled the world? In just 10 years it's become an also-ran.

If Apple can trash its competitors to assume the dominant position it holds today, why can't a similar shift relegate Apple from the top of the portable audio, tablet computer or smartphone markets? There's certainly no lack of companies willing to try.

That brings us to Apple's main challenge: maintaining a culture of innovation. That requires exceptional leadership which, at least for now, it appears to have.

Key man risk

“There's an old Wayne Gretzky quote that I love,” said Apple's founder, Steve Jobs, in a 2007 interview. “'I skate to where the puck is going to be, not where it has been.' And we've always tried to do that at Apple. Since the very, very beginning. And we always will.”

Jobs is the driving force behind Apple's innovative culture. When he returned to the business in 1997, “We were 90 days from going bankrupt.” But, by slashing product lines and focusing on a select handful of ideas, he engineered its return to profitability and technological leadership.

Jobs is now battling serious health concerns and is on medical leave. Can his successors maintain his vision and focus in his absence? Has Jobs created an organisation that can transcend his own creativity and energy? Perhaps. We won't know until he's gone, but his eventual (permanent) retirement poses a formidable risk.

Long or short?

Apple's recent performance has the investment community transfixed. I've seen one observer use back of the envelope calculations to justify a US$1tn market cap.

Of the 55 analysts surveyed by Reuters, 49 rate Apple a buy or outperform. That's as cheery a consensus as I've ever seen. In a world where short-term profit is the primary concern of most analysts, it's not surprising either.

But this or next year's profit won't vindicate Apple's US$310bn market cap. Only many years of winning products will. On that front, there's enough uncertainty that most investors (myself included) would be best off putting this stock in the 'too hard' basket. But I'm not giving you that choice.

My question is this: If you had to invest 10% of an imaginary portfolio in Apple for ten years, would you go long or short?

Personally, I think this will be the second time an apple demonstrates the immutable laws of gravity. It's not possible for this company, or any other, to stay ahead of the technology curve forever. I'm short. What about you?