Kass: Dissecting Apple's Quarter

"Apple's shares drop back under $500 a share, never breaching $600 to the upside and spending most of the year under $525 a share as profit estimates are again shaved. (Icahn dumps the shares; see more on Icahn in also-ran surprises.)"

-- From my " 15 Surprises for 2014"

Apple ( AAPL) reported disappointing quarterly results and poor guidance after the close of trading last night. Depending on your perspective, it was either a good quarter or a bad one. It should take a few days for the market to sort that one out.

Prior to the quarter's release, the Apple meme shifted from fundamentals to the conspicuous Carl Icahn. The activist expanded his Apple position to over $3.5 billion worth, then tweeted about the stock and wrote an open letter to Apple's shareholders about why he has accumulated such a large stake. In his communiques, Carl Icahn expressed the notion that Apple was a no-brainer.

I suppose he meant that Apple is a very cheap stock. But maybe, after the release of the company's punk results and guidance yesterday, what he meant by no-brainer was that it takes no brains to own it.

This is not meant as an attack on Icahn. I, for one, have consistently observed that the only thing I am certain of in the stock market is the lack of certainty. This applies both to billionaires and to retail investors. Whenever I think I have a no-brainer investment, I find out that, in actuality, I have no brains!

Back to Fundamentals

The Bad: Apple's sales growth slowed and profit margins were unexciting. Forward guidance was conservative, the current product suite is mature, and there is limited visibility for new product offerings.

The Good: Apple can be viewed as a classic and well-run consumer-products company. It reported 6% revenue growth, superior free cash flow, stability of margins and a return of 33% of operating cash flow to shareholders. On conventional measures -- return on equity, return on assets, return on noncash assets -- Apple remains at the top of the class.

The Better: Apple's future looks better than revealed on a cursory analysis of the guidance. The China Mobile ( CHL) venture will take time to ramp, and a lot of revenue is being deferred. (Apple does not provide non-GAAP profit results, as apparently tech investors don't fully understand what "deferred revenue" means.)

Apple's valuation is inexpensive: The stock is trading at only 6x its earnings before interest, taxes and depreciation for the trailing 12 months. That compares with between 10x and 14x for General Mills ( GIS), Coca-Cola ( KO) and so on. Beam ( BEAM), which recently signed a deal to be bought out, is trading at 20x.

Critically, some of Apple's products may disappear over time -- but so might those of Philip Morris ( PM) -- and, judging by the margin decay, few of us will live long enough to see it. Apple's principal products have a reasonably high technological obsolescence factor. When this is coupled with high brand loyalty and its ecosystem, it is a powerful combination, especially at 6x EBITD.

On the new-product front, investors might be growing too impatient as development has tripled over the past three years. Overall, research and development continue to be vibrant, and the company has acquired some small but exciting companies over the years that are now bearing fruit.

Bottom line: In the fullness of time, investors might begin to think of Apple as a General Mills with a call option, and it is not on strawberry-flavored Cheerios! But that could take time.

Investment Conclusion

Given my observations in today's opening missive, I would conclude that the biggest problem facing Apple's shares is size. If the company were smaller, it would likely already have been acquired.

Regardless of financial engineering, investors -- and that includes Carl Icahn -- might have to be patient with Apple's shares in the near term. It seems to me that, in light of recent results and future opportunities, Apple CEO Tim Cook and the board of directors will likely hold their ground on the capital-allocation policy currently endorsed.

Again, in the fullness of time, Apple might prove to be an attractive investment as it slowly is perceived by investors as more of a consumer-products company and less of a hardware company, and as the stock gains a more lofty valuation. But this will take time.

As I suggested in my " 15 Surprises for 2014," Apple's shares will likely find it difficult to make much upside progress over the next few months.

As in 2013, Apple might be a good second-half stock in 2014.If I owned Apple, I wouldn't sell the shares at current prices (i.e., $510 to $515), and I would buy between $475 and $500.

This column originally appeared on Real Money Pro at 9:15 a.m. EST on Jan. 28.

At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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