Is Apple Too Big to Succeed?

If, as I believe, the small-cap premium is at least partly due to the inherent efficiencies of smaller companies, larger companies have inherent inefficiencies and these inefficiencies will be reflected by the markets.  All of which brings me, via circuitous route, to a discussion of Apple.

For many years, Apple was a stock market juggernaut. Even with the recent setbacks, its price performance has been nothing short of astonishing.

Source: Y Charts

The obvious question is whether the stock price will recover or whether it has peaked.  That question has been analyzed repeatedly, of course.  But I want to look at it in light of Geoffrey West’s research on cities and companies.  In other words, will Apple inevitably scale into sub-linear territory and thus underperform?

Before the recent downturn, Apple’s market cap approached a level equal to 5 percent of the total value of the S&P 500.  As Barron’s has pointed out, when a company approaches that level, it seems to work as an inhibitor to further valuation growth. Indeed, “General Electric and [Exxon, now ExxonMobil] neared the 5% level in the third quarter of 2000 and the first quarter of 2009, respectively, before dropping back. IBM got as high as 6% at the end of 1985. That preceded a long down period in terms of its percentage of the S&P’s market value.”

We can also look at valuation in terms of market cap alone. Some (even West) have suggested that $500 billion in market cap is or might be a general size barrier, and there is intuitive appeal to that idea given the inability of any company to retain a value above that level.  Five companies reached the $500 billion level prior to Apple.  In chronological order they were Microsoft, General Electric, Cisco, Intel and Exxon.  None of them retained their half-trillion dollar valuations for very long.  Exxon crossed the $500 billion mark in July of 2007. By early 2008, it was back below $500 billion for good.  Cisco, Intel and Microsoft all reached the $500 billion level during the dot-com boom back in late 1999 and early 2000. When the bubble famously burst, each of these techs came tumbling back to earth. Today their combined valuation is roughly $130 billion less than Apple’s record-setting market cap. General Electric’s $500 billion valuation also occurred around the turn of the century and its decline has mirrored Microsoft’s.

Recall, too, what The Los Angeles Times wrote about Cisco back in 2000.  It almost sounds as if it could have been written about Apple not too long ago.

In a market in which the only stocks with any near-term potential are those that are already outrageously priced, we’re now asked to contemplate the possibility of the world’s first trillion-dollar company. 

It would, of course, be a U.S. technology leader–specifically, computer networker Cisco Systems…. 

On Wednesday, brokerage CS First Boston suggested that everyone should stop being so small-minded: Analyst Paul Weinstein declared that Cisco is on track to top Microsoft in the next few years and become the first company with a market value exceeding $1 trillion. 

On the face of it, that’s not really asking much of Cisco–just a little more than a doubling of the stock price from here, which is what the shares did in 1998 and again in ’99. 

At twice today’s price, Cisco would trade at about 260 times estimated fiscal 2000 earnings per share. The good news:  That would still be a lower P/E than, say, Internet auctioneer EBay’s.

Cisco lost 20%, or nearly $1 billion in market cap, about a month after reaching the $500 billion plateau.

But market cap is hardly a logical measure of size for these purposes (see below, for example).

As we have seen, entities with sub-linear scaling are ultimately doomed. Unbounded growth requires increasing cycles of innovation to support further growth and avoid collapse.  Companies aspire to the latter but usually resemble the former.  Note too that these cycles must be repeated at a faster and faster rate for unbounded growth to continue.

It seems clear to me that Steve Jobs has been the key driver of Apple’s performance over time.  That’s hardly a revelation, of course, even though Apple stock rallied for a year after his death. Jobs has long been widely recognized as a charismatic pioneer of the personal computer revolution and for his influential career in the computer and consumer electronics fields, transforming “one industry after another, from computers and smartphones to music and movies…”.  Still, he was “exiled” from Apple for a significant period after losing a power struggle in 1985.  Look at how Apple’s performance corresponds to Jobs’ tenure at the company.

 

Jobs left Apple in 1985 while the company was struggling.  But after a relatively brief recovery, Apple stagnated and then deteriorated.  Jobs returned in 1997, having learned a great deal in the interim, to invigorate and rejuvenate it.  Once the tech bubble was cleared, Apple stock essentially went straight up well into 2012.  Jobs’ genius was largely his focus and insistence upon innovation as well as his willingness to tolerate and even encourage a maverick culture. It is entirely appropriate that, upon his return to Apple, Jobs initiated the company’s “Think Different” campaign, which memorialized the Apple culture that Jobs wanted to restore (see below).

But Steve Jobs died (all too young) in 2011.  As Jeff Gundlach emphasized to those of us (among others) at a CFA event a year ago here in San Diego, without Jobs, Apple’s allure was likely to deteriorate, even though the company is “very much in the public’s psyche.”  While it is unclear whether Apple will be the “generational short” that Jeff predicted, it’s clear now that he was onto something.

Apple may no longer have the a hammer-lock on technology users anymore. It no longer offers momentum.  And whether it’s because of the loss of Jobs, product fatigue, a botched Maps application launch, increased competition from rivals like Samsung and Google, something else or some combination of factors, the company has found it increasingly difficult to please the markets and its shareholders. 

Since hitting an all-time high of $702.10 last September, Apple shares have dropped precipitously. These losses are even worse in context in that the Nasdaq has risen 2.32 percent and the Dow has gained almost 7 percent over that same time period.

What Apple will do with its huge stash of cash remains the $137 billion question. After a 17-year hiatus under Jobs, Apple started paying dividends last year and most analysts expect the company to up the dividend substantially going forward.  While I am a big fan of dividends generally, cash paid out in the form of dividends is cash that is not available to support innovation and Apple would thus be acting much less like a growing tech firm.  That isn’t exactly an obvious homage to the Jobs legacy.  According to my friend Barry Ritholtz (and I agree with him), having large cash holdings and pumping profits into research and development was Apple’s way of guarding against becoming technologically irrelevant.  Whatever the outcome, this entire scenario is entirely consistent with West’s general thesis, and it doesn’t bode well for Apple.

Apple simply cannot grow forever.  The math demands as much.  It’s the scale problem.  That said, the argument that Apple is a much better bet here than previous $500 billion companies isn’t a bad one.  A much more reasonable P/E, the lack of any apparent bubble and room for the company to continue to grow militate against a clear repeat of the Cisco (Microsoft, GE, Intel and Exxon) scenario.  But the stock is down roughly 13 percent this year and 35 percent in less than half-a-year.  Moreover, Apple is still trading at a level that no company has ever been able to sustain.

To be clear, I am in no way advocating any particular strategy with respect to trading Apple stock. This is not a “sell” recommendation. The company still may have room to grow and could readily do so on the basis of market sentiment alone. Apple products remain market leaders.  The lead it has lost in the smartphone industry could be regained (even though the next new product may not come to market until 2014, according to Henry Blodget).  As in the past, it could create an entirely new product in a new category that huge numbers of us become convinced we must have.

However, given that Apple’s market cap reached but failed to maintain an all-time market high, that even after the current drawdown the company trades at levels only five other companies have reached and none has been able to sustain, that Apple’s co-founder, undisputed leader and enforcer of the innovation culture there is no longer around, and that Geoffrey West’s research suggests that companies can and do get too big to succeed, it should be clear that we are likely a whole lot closer to the end of Apple’s dominance than to the beginning.