Short Stories: Is Apple ready to drop?

Here are the key components of his argument for shorting Apple:

• Stock overvalued. Hickey suggested that at $75 billion (it's now at $73 billion) Apple's market capitalization is too high when compared to Hewlett-Packard Company's (NASDAQ: HPQ) $100 billion. He noted that with $21 billion in sales, Apple is one-fifth the size of H-P. It sells for 38 times earnings, four times sales and seven times book value. And he contended that AAPL's annual price appreciation is slowing -- noting that the stock went up 201% in 2004, 123% in 2005 and 18% in 2006.
• Slowing iPod sales. Hickey continued by pointing out that almost all that growth was driven by the iPod, which is now five years old. He suggested that the iPod's growth rate is falling apart -- arguing that in its most recent quarter, Circuit City Stores, Inc. (NYSE: CC) said MP3-player sales were flat year over year versus triple-digit growth the year before. Hickey questioned Apple's revenue guidance and his skepticism proved well founded when on January 17th it offered cautious guidance for the current quarter.
• Disappointing Mac sales. Hickey noted that the PC, which accounts for roughly 40% of Apple sales, experienced slowing growth even as its move to Intel-based PCs boosted its earnings. On January 17th, Apple reported disappointing Mac sales. And Hickey found Macs uncompetitive. In December he bought a wide-screen Hewlett-Packard fully featured notebook for $599, after $230 in rebates. He concluded that Apple's product costs twice the price for the same kind of features. Hickey argued that this will make it hard for Apple to gain PC market share, which he suggested was another unrealistic assumption reflected in AAPL stock.
• Jobs may exit Apple. Hickey pointed out that Apple CEO Steve Jobs was involved in options backdating or was at least aware of them, and might have approved some. The investigations by the SEC and Justice Department are ongoing. In his view, there's a risk Jobs won't remain at Apple.
• iPhone sales overestimated. Finally, Hickey said that unlike the iPod which created an entirely new product category, the iPhone is a late entrant into an existing product category. He argued that people who buy the iPhone will need to throw out their old phones and pay $400 for a new brand. Hickey concluded: "I've been investing in tech for 30 years. You don't pay seven times book value for a company whose growth rate is falling apart. Apple needs a big hit. The iPhone has to be a huge hit."

So why am I skeptical about shorting Apple?

• Solid financial position. I think it makes sense to short a stock if there is a reasonable chance that the company could file for bankruptcy. I don't see Apple filing for bankruptcy if for no other reason than its lack of long-term debt. Furthermore, Apple ended fiscal 2006 with $10 billion in cash and it added $2.9 billion to that balance during the year.
• Reasonable valuation given earnings forecast. 22 analysts who cover the company estimate that Apple will earn EPS of $3.13 in 2007 and $3.72 in 2008, a 19% growth rate. For the quarter ending this March, however, Apple's earnings are expected to grow 31% from the previous year. At a P/E of 31, I would agree that the stock is highly valued if compared to the annual earnings forecast but not overly high if compared to the next quarter. Also it's possible that Apple issued sober guidance so that it could soundly beat expectations when it reports earnings next quarter.
• Jobs's reality distortion field. Steve Jobs is one of those charismatic CEOs, like Martha Stewart, who seem to take control of the minds of their followers. For investors who are under Jobs's spell, it is difficult to see how they would be persuaded to sell their Apple stock as long as Jobs is at the helm.

With a mere 3% of its shares sold short, there is one thing that would certainly cause Apple's stock to fall out of the tree. Notwithstanding my comment about its financial condition, if you think Jobs's departure is likely, then shorting AAPL could lead to a quick killing. Otherwise, it could be a dangerous game.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches Management at Babson College and edits The Cohan Letter. He has no financial interest in Apple, Circuit City, or Hewlett-Packard.