Why Wall Street Got Apple Wrong This Week

BALTIMORE (Stockpickr) -- Today may be Friday the 13th, but Apple's (AAPL) bad luck came on Wednesday, when shares dropped 5.4% on the heels of the firm's highly anticipated iPhone event. Apparently, the new iPhones were bad enough to erase $27.1 billion from Apple's market capitalization. Ouch.

Apple would literally have been better off buying Nokia (NOK) and Blackberry (BBRY), shutting down their businesses, giving away their patents, and burning their offices, than releasing the iPhone 5s and iPhone 5c.

It would have destroyed less shareholder value.

But that should be the first indication that Wall Street got Apple very wrong this week.

Before we get any further, I want to make one thing clear: this isn't some "unbiased" article about Apple. I'm no journalist. In my day job, I'm an investment professional -- I pick stocks, and I've recently built a position in Apple. So yes, I'm talking my book right now. But that doesn't make what I'm about to say any less true.

For most of this year, I've said that Apple looks cheap, but that I wouldn't touch it with a 10-foot pole. Apple's stock sucked. But that's changing, even in spite of Wednesday's selling.

Dissecting the iPhone Event

The second Apple's price started reacting to the firm's Tuesday event, it was clear that Wall Street got it all wrong.

Every other year, Apple announces an all-new iPhone – and in between those years, Apple announces a faster, slightly upgraded "S" model. Last fall, Apple released the iPhone 5, so the announcement of the 5s wasn't a huge surprise. But the 5c was a departure from Apple's past strategy.

Previously, Apple has always offered the older version of their phones for a $100 discount to the current iteration. That meant that the iPhone 5 was likely to go on offer for $99 with a 2-year contract when the iPhone 5s was announced. But the introduction of the 5c changed that, repackaging the iPhone 5 into colorful plastic cases with a few minor upgrades (a better front-facing camera and bigger battery, for example).

Basically, the iPhone 5c changes Apple's lower-cost offering from a dated model into a new one – a new one that's cheaper to make. That change means that phone buyers choosing between the lower-cost iPhone variant or a similar-priced Android competitor are no longer choosing between old and new.

It also widens the gap between the top of the line iPhone and the less expensive model by changing differentiating their appearance, a factor that's more important to non-technical consumers than analysts are giving credit for.

This isn't the first time Apple has split a product line into two pieces. As Apple follower John Gruber points out on his Daring Fireball blog, Apple has had huge success marketing its computers as a "two-sibling family": with a consumer model that appeals to non-techies and a "prosumer" model that packs more horsepower.

Apple took its successful approach to iPhone's mid-cycle refresh, and improved it. So, why did shares sell off? The price.

Pricing the iPhone 5c

This iPhone launch was unique because it was the first time that Apple-watchers were able to get ahold of so many leaked photos and specs before the company had a chance to announce them. Ahead of Tuesday's event, we already knew that Apple was announcing a plastic-shelled product called the iPhone 5c.

And it didn't take long before the media had made up the narrative: it was going to be a super-cheap iPhone targeted at boosting sales in emerging markets. When Apple unveiled a $99 starting price tag for the 5c, people were disappointed. How could a factory worker in China afford a $99 cell phone?

But it never occurred to anyone that Apple wasn't courting that market in the first place – it wasn't a failed attempt at a super cheap phone, it was a replacement for its existing lower-cost offering.

Investors were mad that Apple failed to deliver on a promise it never made, for a market it never wanted.

What everyone forgot is the fact that Apple didn't earn its success as a high volume low margin tech manufacturer. It became the biggest technology company in the world by selling (relatively) expensive products with extremely high margins.

The Case for Buying Apple

One thing I'm not going to do in these pages is speculate.

I have no idea how many iPhone 5s models Apple is going to sell in 2013. I don't know what implications moving to a 64-bit architecture on the iPhone could mean for Apple's Macintosh lines. I don't know how the public is going to react to the release of iOS 7 next week.

And I certainly don't know if Apple is going to release a watch, a television, or a submersible flying car later this year.

But what I do know is that Apple took a strategy for selling phones that's been supremely successful for the last six years, and they made it objectively better.

Yes, contrary to the headlines in the last year, and contrary to Apple's share price action, the firm's sales have been stellar. In the trailing 12 months, Apple has earned a record $37.7 billion in profits on $169.4 billion in sales – that's a 22% net profit margin.

Can Apple sustain its breakneck growth rates forever? No – of course not. There aren't enough human beings on the planet to keep that pace up. But even if Apple was guaranteed to never grow again, just keep pace with its current numbers, it will earn enough profits to cash out every share in just seven years. That's ludicrous.

And that assumes that Apple won't get any of the huge smartphone market growth estimated for the next several years. That's not even a conservative scenario; it's the worst-case scenario.

The cash situation in Apple is unthinkable for a firm of its size. As of the most recent quarter, Apple held $146 billion in cash and investments – as I write, that's enough to pay for more than a third of the firm's outstanding shares. So, take out Apple's enormous cash reserves, and the firm's trailing price-to-earnings ratio drops to 7.5.

For comparison's sake, Google (GOOG) trades for a whopping 27.5 times earnings right now.

Apple hasn't had any trouble executing its strategy. Instead, it's only had trouble convincing investors to buy its stock.

Certainly, part of that has to do with failing to release a killer product in 2013. But I'd much rather see Apple disappoint by releasing too few products than disappoint by releasing garbage. When the "iWatch" comes out, I'll leave the blind forecasting to others – as long as Apple is bargain priced for its existing businesses, buying is a no-brainer.

Apple doesn't have to release "the next big thing" to be a bargain right now. It just has to avoid doing something really stupid.

There is a caveat, however.

As I mentioned before, Apple's stock has been shellacked in 2013. That's got more to do with buyers and sellers of Apple's stock than it does for buyers of Apple's products. But the technicals are showing some signs of strength this month.

Yesterday, I mentioned that Apple was very close to key support at $460. That's being followed up by a bounce. From a technical standpoint, this stock is starting to look a whole lot more in synch with its fundamentals.

Returning Value

I'd anticipate Apple to ramp up its pace of returning yield to shareholders in the form of share buybacks and dividend payouts.

Buybacks are probably the most attractive of the options for a couple of reasons: first, the stock is cheap, and second, it can repatriate much of its overseas cash at a much lower tax burden if it's used for buybacks. With a very vocal shareholder in Carl Icahn asking for boosted buyback efforts, Apple has very few remaining reasons not to do just that.

The bottom line is this: Wall Street got Apple wrong this week. But there's still time for investors to right themselves.

-- Written by Jonas Elmerraji in Baltimore.

RELATED LINKS: >>5 Tech Stocks Spiking on Big Volume >>5 Stocks Setting Up to Break Out >>4 Red-Flag Stocks to Sell This Fall

 

Follow Stockpickr on Twitter and become a fan on Facebook.

At the time of publication, author was long AAPL.

 

Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.

 

Follow Jonas on Twitter @JonasElmerraji