Despite a stock market that has approached all-time highs, the company that has been the market's darling for close to 10 years is trading at its 52-week low, which is down nearly 40% from its 52-week high. At T&T Capital Management, we profiled Apple (AAPL) when it was trading at around $547, making the argument that the price didn't provide for a great margin of safety. Mr. Market is a fickle fellow; therefore, short-term price movements don't necessarily validate our investment thesis, as ultimately it will be the business performance that tells the tale. Obviously, the company's success created extraordinary wealth for long-term shareholders, but unfortunately many market participants tend to buy high and sell low.
It is this same market psychology that causes most mutual fund investors to underperform the actual funds' performance because they tend to chase past performance, instead of maintaining a disciplined investment process. An example of this type of psychology can be found in the investors that fled Fairholme Funds after Bruce Berkowitz had one bad year, only to miss out on 30%-plus gains in 2012. This is extremely common and that is just one recent example. In this article, I will share my opinion on whether the drop in price makes Apple a compelling buy, and I will also look at strategic options for the company's capital allocation. In addition, I will also share a recommendation on a way to play the stock that might increase the probability of success for participants interested in investing in the company.
As of Dec. 31, Apple had an absolutely staggering $137.112 billion of net cash and investments on its balance sheet, or $145 per share. To put that in perspective, Apple could nearly buy Intel (INTC) and Hewlett-Packard (HPQ) at their current prices without incurring any meaningful debt. Based on 947.217 million shares outstanding, Apple's market capitalization is about $407 billion. The enterprise value of the company is approximately $270 billion, or roughly $285 per share. In the last decade, Apple has grown its net income from $69 million in 2003, to a staggering $41.7 billion in 2012, or $44.15 per diluted share. Regrettably, I bought the stock at $95 only to sell at $125-ish, so I'll be the first to tell you that I am no Apple investment ace. Over the last 12 months, Apple has generated in excess of $46 billion in free cash flow for a free cash flow/enterprise value yield of 17%. The company's returns on invested capital have grown from 1.55% in 2003, to 42.84% in 2012. Return on assets has grown from 1.05% a decade ago to a phenomenal 28.54% in 2012.
Apple's largest competitive advantage is the loyalty of its consumers. From my technologically deficient father in his 60s to my five-year-old nephew, Apple's products appeal to generations of people across the country. Consumer electronics has always been an industry of intense competition. Short product cycles and rapid change have imperiled countless companies that were once the darlings of the day. There are few better recent examples of how quickly a consumer technology company can fall from grace than BlackBerry (BBRY). This was a company that made products that were truly innovative and created a new paradigm of mobile phone usage, but like gravity's forces, increased competition and strategic missteps caused a precipitous drop in market share, profits, and the stock price. Apple, under the leadership of Steve Jobs, transformed the mobile phone and tablet markets, while cultivating an ecosystem including iTunes and iCloud, which increases the switching costs to users of its products.
In my previous article on Apple (linked to above), I made the case as to why I believed that Apple's growth rate was destined to slow materially due to the Law of Large Numbers, while margins had nowhere to go but down. This was not rocket science, but it does explain why the P/E ratio is as low as it is. I can tell you that I have absolutely no idea what Apple will look like in five years. Predicting the company's market share beyond one year is, in my opinion, a futile effort. But it is clear that Samsung and the other major competitors have closed the gap materially in design and functionality.
Apple has been enormously successful in obtaining generous subsidies from mobile services providers that have allowed the company to obtain industry-leading margins. AT&T (T) was enormously successful when it held a monopoly position in offering Apple phones, and Verizon (VZ) saw large increases in sales when it obtained the ability to sell them. Smartphones as an industry have boosted data usage, bolstering profits, but there is no incentive for these providers to push Apple products over their competitors, which are actually more profitable for them due to the lower levels of subsidization.
One potential catalyst that could greatly increase Apple's market share would be to come to a deal with the largest service provider in the world by subscribers, China Mobile (CHL), which has up until now been resistant to agree to Apple's terms. Concessions by Apple could potentially open the flood gates for further price reductions, impairing margins at an accelerated rate. The 650 million China Mobile subscribers are extremely tempting, and I do believe that at some point a deal will get a done. There is a danger that the longer the company waits, competition will enhance their position in the market, reducing Apple's eventual market share. Apple already makes phones for some of the other Chinese telecoms, such as China Telecom (CHA), and the opportunity for further growth is enormous.
On a similar note, there has been a lot of talk about Apple coming out with a cheaper phone to increase its market share, particularly in the more price-sensitive emerging markets. Apple has been hesitant to reduce its price point due the potential that it could diminish its premium brand appeal. I understand Apple's reluctance to lower prices when it has been so successful selling phones and tablets at the highest margins in the industry, but I believe that the company should enhance its offerings to include a cheaper form-factor geared toward emerging markets, and a phone with a larger screen. Consumers have clearly shown an interest in larger screens as exhibited by the Galaxy's robust sales, and it is really hard to fathom the company's reluctance to acquiesce on this.
Increasingly in my own social circles, I've witnessed some of the biggest Apple diehards begin to explore alternatives that would have seemed impossible just one year ago. This is anecdotal evidence that I would never invest on, but I believe Samsung's marketing plan has been pretty ingenious. BlackBerry waited far too long to enhance its devices and react to the changing consumer tastes, and as a result the company lost much of its appeal to its once zealous users. If consumers aren't getting a better-performing device, at some point rational markets will eat away at Apple's market share and margins, and therefore it might make sense for Apple to take more aggressive steps on putting out a cheaper phone. It is also important to fully leverage the Apple ecosystem, including its software, services, and applications. This can be accomplished by putting out a cheaper phone, which can serve as a starting point to attract new loyal Apple product users.
There is a big difference between consumer electronics and consumer luxury brands, such as Louis Vuitton or Hermes. Electronic device technology changes far more quickly than handbag preferences do, so Apple must continue to cater to consumer tastes or risk losing its appeal. The first-mover advantage Apple had with the iPhone and iPad created enormous wealth for the company, and overly inflated margins that must come down. There is nothing Apple can do to avoid this reality, so it is better to embrace the positive possibilities of increasing market share in key emerging markets. It is easy to say that the company must continue to innovate, but that is extremely obvious. I believe true innovation, like Steve Jobs was known for, is much more organic and cannot be acquired simply by spending more money. There are things that can be controlled such as capital allocation and strategic initiatives, which I believe can much more tangibly be traced to management acumen.
It is here where Apple falls extremely short. There is no reason whatsoever that Apple should be sitting on $137.112 billion of shareholders' capital in this low interest rate environment. That is absolutely appalling, and the company's meager efforts with its dividend and stock buyback are not very encouraging. $94 billion of the cash is held overseas, so it would be subjected to taxes if repatriated, but the company's onshore cash could certainly be returned to shareholders much more aggressively. A 10% compounded return on that money would double it within seven years, so the opportunity cost that management's cash hoarding policy is having is truly incomprehensible. Large cash hoards, far in excess of capital requirements, are not only an anchor on returns on invested capital, but they also tend to lead to unattractive acquisition decisions that can destroy shareholder value. Apple would have no trouble making any tuck-in acquisitions to shore up its supply chain with its existing foreign capital and cash flows, and very few large companies seem to make much strategic sense. So why is management reluctant to return capital to the shareholders who it belongs to? This is very alarming for investors and is an obvious reason why Apple trades at a low multiple to earnings.
David Einhorn's preferred stock idea is very creative and logical. I believe a special dividend and at least a doubling of the current dividend would be a good start as an alternative. Currently, Apple's $10 billion stock buyback is basically attempting to offset stock dilution. With Apple's attractive free cash flow margin, stock buybacks would be amazingly accretive if one believes that earnings are sustainable. I'm not talking about growth and maybe I will look like a fool, but I wouldn't bet on Apple earning more in five years than they do now. My hesitancy about the sustainability of Apple's long-term earnings is why I'd prefer dividends vs. stock buybacks if I were an Apple shareholder.
According to Morningstar, the mean analysts' earnings estimates for Apple are $46.53 per share in 2013 and $52.93 in 2014. The 2013 numbers seem like a good bet and I think Apple will do quite well over the next couple of years. Backing out the cash, an enterprise value of $270 billion is just too cheap when you look at just the short-term cash generating potential of the company, even if you were to put a much lower valuation on the terminal cash flow capabilities. I'm not capable of analyzing Apple five to 10 years out, which is why a very large margin of safety is required for it to be worth me investing in the company. The wild card in this equation is Tim Cook's capital allocation policy. Hoarding cash with interest rates so low and long-term inflation potential so high, is very damaging to shareholders. The willingness to do it is even more alarming to see from a steward of capital. Apple shareholders would be better off if the company invested the funds with a number of proven capital allocators or fund managers than maintaining the status quo. I believe that management needs to come down off its high horse just a little bit to remember exactly who it is that owns the company, and when that does happen there is little doubt that Apple's multiple would likely expand.
While a robust dividend policy would make Apple a much more attractive security, I have other investments that I prefer where I have a greater sense of conviction. This is why we don't currently have positions in Apple, but I must say that I've gotten a lot closer to being willing to pull the trigger on it, and I'm not personally a user of any Apple products. I view the cash as a ballast of sorts, which drastically reduces the downside potential for the stock, barring an Autonomy-like acquisition. In my investment experience, having worked with many clients across the globe, I've witnessed that emotion and overconfidence without suitable research are clearly detrimental to protecting and growing capital.
For those investors who are more bullish on the company's future than I am, a reasonable strategy would be to sell the January 2014 $430 puts for $51 per contract. Assuming the option is held to expiration, there are two possible outcomes. If Apple closes above $430 at expiration, the investor will keep the $5,100 of profit, which equates to 13.4% on the maximum risk of $37,900. If Apple closes below $430 at expiration, the investor will be long 100 shares of Apple at a breakeven price of $379. This would manufacture an entry point into the stock at an enterprise value of $222 billion using the current cash hoard, which will likely be $30-$40 billion greater in one year's time, depending on any capital allocation decisions made during 2013. This would be about 5 times earnings net of cash, and even if Apple's earnings declined much more rapidly than most people expect, an investor could still do OK assuming reasonable capital allocation from management. The other benefit of this strategy is that it can remove the emotion that seems to pervade many Apple investors' decision-making processes, and in my experience less trading activity generally leads to more investment success.