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TheStreet Open House

Apple's Profits May Be its Biggest Problem

NEW YORK (TheStreet) -- Apple (AAPL), IBM (IBM)Oracle (ORCL), Intel (INTC) and Qualcomm (QCOM) could drive the tech sector's profitability to new records by year-end. Unfortunately, those firms could also be the cause of the sector's overall under-performance this year.

The scenario of rising profits and stagnant stock prices at many of the tech sector's blue-chip firms may underscore a new question throughout the industry: do profits matter?

Apple, with its nearly $40 billion in trailing 12-month net income, is the most profitable company in the tech sector. It also is the fifth worst performing stock in the industry this year, according to a screen of Bloomberg data.

It should be no surprise that Apple is one of the cheapest tech sector stocks by almost any valuation metric and has attracted the interest of activist investors such as Carl Icahn and value-oriented investors like David Einhorn of Greenlight Capital Management and Bill Miller of Legg Mason.

Many Apple investors look at the company's underlying profitability and proclaim that it is a "screaming buy," as Bill Miller did last week on CNBC. Apple is even one of the industry's best dividend payers, with an annual yield of approximately 2.5%.

But what if consistent and easy to understand profits and dividend yields are part of the problem for Apple's under-performing shares?

Investors may simply have too many tangible ways to value Apple, whether it is the company's impressive net income, cash flow, operating margin or dividend payout. That contrasts with far better performing tech sector stocks such as Facebook (FB), Amazon (AMZN), Netflix (NFLX) and LinkedIn (LNKD), who all have posted strong 2013 stock gains in spite of their razor thin profitability, or in some cases, losses.

What those stocks lack in profitability they appear to make back in a story attached to their growth rates.

Facebook's shares have more than doubled since July, after the company's second-quarter earnings indicated significant progress to the social network's mobile advertising business. Amazon continues to see its stock outperform broader markets based on investor expectations, even as the company struggles to break even in any given quarter. The same scenario holds true or LinkedIn and Netflix.

Investors in each of these stocks have few ways to reasonably value their shares.

LinkedIn trades at an enterprise value (EV) of over 200 times its trailing 12-month earnings before interest, taxes, depreciation and amortization (EBITDA). Amazon trades at an enterprise value of over 100 times it trailing EBITDA, while Facebook and Netflix trade at a multiple around 40 times EBITDA.

It's hard to see any investor, however, valuing those companies on metrics such as EV/EBITDA or their price-to-earnings (PE) ratios. Instead, valuations appear to be driven by expectations of future earnings streams. Maybe the likes of Amazon and Facebook will eventually be able to report the $5 to $10 billion in annual profits that could give tangible justification to their market capitalizations, which currently exceed $120 billion each.

To get to such endpoints, investors have to use their imaginations to rationalize a path for Facebook, Amazon, Netflix and LinkedIn to achieve blue chip quality profits.

In contrast, it takes little imagination to value Apple shares. The same holds true for steady earners like IBM, Oracle, Qualcomm and Intel. Those firms are all valued at a PE of less than 14 times trailing earnings. As of Friday's close, five of the eight most profitable tech firms were under-performing the broader market.

Of course, searching for cheap stocks by screening trailing earnings reports has ruined the careers of many value investors. It is the future that matters most.

In the case of Apple, Oracle, IBM, Intel and Qualcomm, it is reasonable for investors to wonder whether each firm will be able to grow or even maintain their profits in coming years, given competitive threats to their businesses and changing consumer habits. It is also reasonable to expect that Facebook, Netflix and Amazon may be on the cusp of meaningful and fast-growing profits.

Still, Apple's poor stock market performance and its solid and consistent earnings raise the prospect that investors are looking too far beyond profits for stock market value. Such a scenario may indicate a bubble-like lack of diligence within the tech sector. Investors may be relying too heavily on their imaginations.

-- Written by Antoine Gara in New York.

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