Apple Looks Cheap, but It's Not Without Risks

Even as it reported record sales, Apple disappointed investors with a falling gross margin and weak guidance, which caused the stock to tumble. Apple looks extremely undervalued on paper, but the company's lack of diversification is a problem that needs to be solved.

Jan 28, 2014 at 5:00PM

During its fiscal first quarter, Apple (NASDAQ:AAPL) managed record-breaking revenue and sales of iPhones and iPads, but investors were not impressed. The stock opened the next day down more than 8%, with lower-than-expected iPhone sales, weak guidance, and concerns about gross margin being the principle concerns. Apple is, without a doubt, at bargain levels based on its current earnings, but sustainability of these earnings remains an open question.

A look at the results
Apple recorded $57.6 billion in revenue for the quarter, up about 5.7% year-over-year. Gross margin fell to 37.9%, down from 38.6% in the same quarter last year, and the company has guided for gross margin to be between 37%-38% in the second quarter. Both R&D and selling, general, and administrative costs grew faster than revenue, leading net income to actually decline slightly year-over-year. Extensive share buybacks were able to boost per-share earnings, however, with EPS jumping approximately 5%.

Apple sold 51 million iPhones, up from 47.8 million in the same quarter last year, but below Wall Street estimates of 54.7 million. iPad sales totaled 26 million, up from 22.9 million in the same quarter last year.

Apple looks cheap
Looking purely at the numbers, Apple looks like an incredible bargain. On the balance sheet, Apple now has about $159 billion in cash and investments, up from $147 billion last quarter. After the post-earnings decline, this cash represents roughly one-third of Apple's total market capitalization. Backing this cash out, the market is valuing all of Apple's future profits at around $300 billion.

Considering the current earnings, this looks absurd. Apple had a net income of $13.1 billion in the first quarter alone, and net income in fiscal 2013 was $37 billion. This puts Apple's P/E ratio (adjusted for cash) around 8.1. Plus, with buybacks capable of boosting per-share numbers by 4%-5% per year, Apple seems like a slam dunk at these levels.

But, there are risks
The problem is that these earnings may not be sustainable in the long-term. Apple is one of the least diversified big tech companies out there, relying on the iPhone for a majority of its sales. In the first quarter, 56.4% of Apple's revenue came from the iPhone, followed by the iPad with 19.9% of revenue. Together, these two products account for more than three-quarters of Apple's total revenue.

Apple's lack of diversification makes it much harder to believe that current earnings levels can be sustained. The same arguments being now used to defend Apple, such as a strong ecosystem and high customer loyalty, could have also been used to defend BlackBerry a few years ago, before its collapse. If Apple can't diversify with new products, it runs the risk of eventually succumbing to a similar fate. Apple is undoubtedly in a far stronger position now, compared to BlackBerry a few years ago, but the consumer electronics market is a fickle beast.

Another problem for Apple is the domestic market. Revenue in the Americas actually declined year-over-year in the first quarter, down about 1.2%. All of Apple's growth came from China, Japan, and, to a lesser extent, Europe. While there's plenty of room to grow in these regions, Apple doesn't have the same advantages there as it has in the United States. When the iPhone first launched, it was truly in a class of its own. Now, as Apple tries to grow sales in China, competition from Android devices is fierce.

Apple's recent deal with China Mobile (NYSE:CHL) will certainly be of help, creating a larger potential customer base for the company. Previously, the iPhone was sold only through smaller carriers, so the China Mobile deal should help jump start Apple's sales in the country. However, Apple's devices are expensive compared to local rivals like Xiaomi, and it will remain difficult for Apple to convince Chinese consumers to pay more for its devices.

The bottom line
Apple certainly looks cheap, with a cash-adjusted P/E ratio of just 8.1, but it's important to understand the risks involved with the company. Relying so heavily on just two products, both of which are now facing more competition than ever before, is a strategy that will eventually end in disaster if Apple can't diversify its revenue. Investors are getting anxious waiting for Apple to announce the next big thing, and the stock is probably stuck until the company can deliver.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and China Mobile. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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