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Apple's Broken-Expectations Game

By Alex Dumortier, CFA - Apr 24, 2013 at 10:15AM

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Living down success.

Following two days of solid gains, U.S. stocks are flat this morning, with the S&P 500 (^GSPC 0.01%) up a fraction of a point and the narrower, price-weighted Dow Jones Industrial Average (^DJI 0.03%) down a meager nine points as of 10:05 a.m. EDT.

Apple's earnings
Anticlimactic? If the share price reaction is anything to go by, Apple's(AAPL 0.17%) earnings report from yesterday afternoon -- arguably the most anticipated earnings report of this reporting season -- was, all things considered, a wash. The stock had rallied to close above $400 in the run-up to the release yesterday, and this morning it's down slightly, barely staying above that level.

Apple is a victim of its own success on a number of fronts -- first, with regard to the expectations for game-changing hardware. The market was hoping for a new product launch announcement, but CEO Tim Cook would only say that the company is working on "amazing new hardware, software and services" that will be released in autumn 2013 and in 2014.

Yes, the iPhone and the iPad have been phenomenal successes around which Apple has created a true ecosystem for consuming content and applications, but it's extremely difficult to replicate that performance, let alone do so on a timetable that conforms to the stock market's expectations. TV looks like an opportunity, but I'm much more skeptical regarding the prospects of an iWatch: If you own a smartphone, what functionality do you need permanently strapped to your wrist, rather than in your pocket? If anything, I think iPhones are reducing the wristwatch to a purely aesthetic function. Mind you, Apple has used aesthetics to brilliant effect in distinguishing itself from its peers. However, it's not in the jewelry business.

Second, Apple's profitability will be tough to sustain. Extraordinary profits attract competitors; that's a working principle of capitalism. Eventually, competition drives profits down, and while that process is not so inevitable as economics textbooks would suggest, even a company like Apple isn't immune to it; it's difficult to imagine that the company can continue to capture 70% of aggregate smartphone-industry profits, for example (per an estimate from research firm Asymco). In the first quarter, Apple's gross margin fell to 37.4% from 47.5% in the year-ago period.

All told, investors have already been forced to recalibrate their expectations for the shares, but at less than nine times the next 12 months' earnings per share, it looks plausible that this process has overshot at this stage -- creating an opportunity for patient investors.

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Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
^DJI
$31,261.90 (0.03%) $8.77
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
^GSPC
$3,901.36 (0.01%) $0.57
Apple Inc. Stock Quote
Apple Inc.
AAPL
$137.59 (0.17%) $0.24

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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