AAPL suffered a huge gap down after Jan earnings. The gap down was not immediately bought. The AAPL chart was already oversold on an intermediate term basis. Those three things combined means we need to step back a bit, look at the big picture in a holistic manner, reevaluating the landscape of technicals, fundamentals, and valuation. Let’s get started …
Revaluation, Not Capitulation
The gap down reaction to earnings was a sudden revaluation of AAPL, not capitulation. Capitulation is a TA term and comes about with increasing downside momentum as more and more swing traders throw in the towel, which spills over into longer term investors throwing in the towel on their positions, until finally all weak (and some not so weak) hands give up. That’s not what we just had. This huge gap down after earnings was a sudden revaluation of AAPL. It is based on fundamentals, the new earnings growth environment and uncertain growth prospects. It is a sudden and abrupt change in the AAPL valuation equation.
Yes, there will be some sort of technical bounce. AAPL usually trades in a range each quarter that is about 2.5 CPE high. With current earnings that means 110 points as a median expectation. I’ve been using that number a lot recently, talking about the size of the February rally I’m expecting. The problem we have at this point, however, is trying to figure out where that roughly 110 point range will take place. We could have a technical bounce in February and then make a lower low later in the quarter such that we don’t get a 110 point rally right now, but instead get a 110 point range for the quarter with the current price somewhere in the middle of that range.
Realizing this is a sudden revaluation of AAPL results in another important conclusion. In terms of the Valuation Range, we need to ignore the higher CPE levels seen in 2012. I had already come to the conclusion that the 2012 swings indicated a rejection of CPE 16 valuation, and that we would never return to those valuations again, and had included this analysis in some previous posts. The effect of this sudden revaluation means we need to pretty much ignore all previous valuation ranges and concentrate on watching for a new valuation range to be defined. For example, instead of a CPE range of mostly 13-16 in 2011-2012, we may now trade in a CPE range of 10-12.5, or 9.5-12. We should even consider something even lower. That’s because if there’s one thing I’ve learned about AAPL it is that it is common for something more extreme that I am expecting to happen. I do always like to maintain a median expectation, and I will come to a conclusion soon about the rest of this quarter. However I need to see more price movement in the coming days and weeks.
At the top I said this past week was not capitulation, it was revaluation. That means capitulation is yet to come. It could be short term, even this upcoming week, or it could be after a technical bounce in price and subsequent capitulation decline. I did a couple Fibonacci and measured move calculations to see what might be possible. I got 395 and 383. My first reaction to those numbers is to just reject them as too low. But then I take those numbers and add the expected 110 point range for the quarter and I get 505 and 493. Those make some sense as an expected trading range high as those would fill the earnings gap. There would be a lot of long term and intermediate term sellers near that level, and therefore an expected resistance level. So maybe all these numbers do make sense: 383-395 on the low end to 493-505 on the high end (483 area might prove more significant). That would mean we see CPE 9. I still have a really hard time believing that. Maybe as part of a V bottom capitulation selling is how that valuation level would occur. This is meant as speculation, as thinking out loud, if you will, trying to fit together the puzzle pieces we have been dealt and generate some expectations.
It’s worth mentioning the AAPL Time Cycle analysis from recent weeks’ posts. It calls for a bottom of significance during the week of earnings and then a top of significance during the week ending March 1. So far this analysis remains valid. It bears watching for further confirmation from the price action.
Let’s now step back and look at the big picture for some perspective:
The Big Picture: Growth, Free Cash Flow, and Long Term Valuation
Apple’s growth has been strong for several years. And has declined rapidly recently. This wasn’t a surprise. My Earnings Growth Chart projected this drop in earnings growth. Declining growth deserves a lower earnings multiple. A lower P/E multiple combined with flat CPE lines (see CPE Weekly Chart) opens the door for a significant price correction — a revaluation. Declining growth supports the AAPL decline. It is one of the primary reasons for it.
One number in the Jan earnings report that stuck out was the large increase in cash. I dug deeper and noticed the strong cash flow. This convinced me it was worth the time to create an additional Continuous Valuation Chart. Check it out: Continuous Price / Free Cash Flow (CP-FCF). Some things to note: Free Cash Flow remains strong. The occasional quarters with flat or declining FCF lines are those quarters where Apple had especially high CapEx spending. Apple has spent an extraordinary amount on CapEx for the quarters ending Sep 2011 and onward, and it remains high and growing. Tim Cook is an operational savant. We have to assume the continued CapEx spending is in anticipation of continued growth of free cash flow. The CP-CFC Chart is especially useful to illustrate recent over-valuation and under-valuation. What FCF multiple looks to be the most accepted valuation for AAPL over the past two years? My answer would be 10 to 14. Now look at the Aug-Sep 2012 rally. From a FCF multiple standpoint, that rise and fall stands out as an out of the ordinary over-valuation. Similarly, the drop since Jan earnings release stands out as an under-valuation, at least in terms of this valuation metric. The Free Cash Flow chart also includes my forward projection. Even though the earnings projection through the end of the fiscal year is modest, the free cash flow projection remains robust.
Now let’s look at the CPE Valuation Range. AAPL has now dropped below the CPE level seen as the depths of the financial crisis. It is hard to imagine that is a valuation level that makes sense. Nevertheless, the earnings gap down needs to be respected as part of seeking out a new valuation base, even it is under-valuation during a period when Apple’s growth prospects are uncertain.
Lastly, let’s look at the long term quarterly range charts. There are three: CPE Range, PE Range, P/Cash Range. The CPE and PE range charts show well just abruptly AAPL has moved to record lows over the past few years and below the 2009 valuation levels. But the P/Cash Range chart is especially striking. The huge gap down is so severe because priced moved down dramatically while cash jumped up dramatically, all overnight. That made the Price/Cash ratio plummet to financial crisis levels, a valuation level AAPL hadn’t traded anywhere near since early 2009. I see this as another piece of evidence of what I consider the current under-valuation of AAPL shares.
The conviction in AAPL being the safest big cap investment in town is being questioned, rightly or wrongly. Which do I think it is? I think it is wrongly. I respect Tim Cook’s statement “Don’t bet against Apple.” I respect the recent CapEx spending trends, and think it preludes continued growth. Free Cash Flow remains strong and is growing, and that’s even when taking into account the CapEx spending that is part of the FCF equation. I understand the drop off in earnings growth. That’s a valid criticism on the surface. However I chalk that up to the tough comparison of the blowout earnings in the Dec and Apr earnings reports from a year ago. Apple is a victim of its phenomenal success from a year ago.
The big problem is that we have to wait another full quarter to get more information on the fundamental analysis picture, confirmation of the Free Cash Flow trend, and clarification on the earnings growth prospects.
Short term we are in wait and see mode to see where the short term swing low will occur, whether we get capitulation right now or later in the quarter, and where the roughly 110 point range for the quarter will be positioned relative to current price.
Bottom line: AAPL has undergone a sudden revaluation. I consider it to be a temporary under-valuation condition.