The technology sector harbors one of the most competitive playing fields for its players, with shorter product life cycle catalyzed by one key factor: Innovation, and Apple (NASDAQ:AAPL) has been the front-runner in harnessing the power of innovation over the last decade. As a result, the company has been able to reap the rewards, and has enough cash reserves to make major strategic decisions e.g. share buybacks & hefty dividend payouts.
Apple's recent fall is baffling for the majority of its investors, especially the retail investors. The stock remains extremely cheap based on the fundamentals, - it has one of the biggest cash piles in the industry and the highest profit margins, and still the stock keeps falling. The drop in the profit margin is a valid concern, but it should be kept in mind that the margins for the company still remain higher than most of its peers.
The silence of the management is even more puzzling when the company is sitting on a mountain of cash, which can be used to support the stock price. When I started writing this article, I had two ideas to share about the cash reserves of the company: increased cash payments to shareholders in shape of either increased dividend or a share repurchase, and strategic acquisitions to support the falling margins of the company. However, as the company has decided to return more cash to investors; my focus will be on potential acquisition targets that can support the falling margins, and a small part of discussion will be aimed at the impact of increased cash distribution.
How the Profit Margins Can Be Improved/Maintained?
Smartphones market is gradually entering the slow growth phase of the industry life-cycle and it is not operating at hyper-growth anymore. As a result, we are likely to see a steady decline in the margins of the participants. Driving the revenue growth is becoming a major challenge for Apple, and reducing price would not set in with the overall Apple brand strategy. In fact, starting a price war will be detrimental to already under pressure margins. Another way for Apple to look forward is to look back. At this point in time, Apple should start to ideally strategize itself in the industry by backward integration. It would realize gains from synergy, and the reduction in the production costs would boost profit margins.
Apple currently has suppliers across the globe with reasonable diversification. It has created an entire ecosystem of businesses that are heavily dependent on Apple's growth. The company is vertically integrated to some extent, yielding four businesses as one - it is a hardware company, a software company, a services company and a retail company, but it does not manufacture nor assembles its parts. It is in essence a design company not particularly a manufacturing firm.
Intel (NASDAQ:INTC) is currently providing chips for Mac and we might see increased co-operation in the future. A number of companies that are a part of the industry supply chain, if acquired, would place Apple in a much better position for the long-term profit margin sustainability, if not outright growth. This is also important since Tim Cook has marked 2012 as a year of historic low component cost. This implies that Apple's management expects further increase in the cost of goods sold. This will further damage Apple's gross profit margins. In order to support Apple's profit margins, it is imperative for Apple to gain greater control over its supply chain in an effort to sustain COGS.
OmniVision Technologies (NASDAQ:OVTI) is a potential candidate, which could provide strategic advantage to Apple. OmniVision is an image-sensor device producer and a key camera producer for iPhone & iPad. The company is expected to make $191 million from iPad cameras only; the iPhone camera revenue should be much higher. By acquiring OmniVision, Apple would be able to generate enough revenues in the next 4-5 years to offset the purchase. Market cap of OmniVision is $668.2 million.
The recent dip in the stock price was due to Cirrus Logic's (NASDAQ:CRUS) announcement of growing inventory, suggesting slowing demand for Apple - 90% of its revenues are linked to Apple. Cirrus is a very sound candidate for an acquisition; however, current level of pricing control by Apple on Cirrus might prompt the company to delay any acquisition plans. Nonetheless, access to Cirrus patents would be beneficial with regards to greater control over both value chain and intellectual property.
Logitech International Inc. is another important supplier for Apple from the perspective of Mac production. Logitech is the major provider of keyboards and mouse as of now but intends to provide the whole product line for the ultimate Mac experience. The products include gamepads, joysticks and headsets. The company has a gross margin of 34.41 and with the growing gaming industry worldwide; Logitech is well positioned to take full advantage. Market capitalization for Logitech is $1.13 billion and a premium of $300 million should suffice the deal.
Logitech specializes in PC navigation, gaming, Internet communications, digital music and home-entertainment control, which are linked to Apple products. The company is primarily focused on providing personal peripherals for computers and video conferencing - both the services add value to the customers' experience.
Multi-Fineline Electronix (MFLX.OQ) is a provider of advanced, flexible printed circuits and value-added component assembly solutions to the electronics industry. The company has a total market capitalization of $347 million, and is trading at a P/E multiple of 14.49, much lower than the industry and the sector multiples of 28x and 23x, respectively. The company also has a much higher ROI and ROE as compared to the industry. Acquiring Multi-Fineline Electronix Inc. would improve the supply chain flexibility of Apple as it would yield more power in assembly solutions. Circuits and small-electronics are used in virtually every iPhone product. The value proposition provided by the acquisition is the quick volume production capabilities.
In a recent development Apple has parted ways with Samsung and has included a new touch panel supplier from Taiwan, Innolux Corp. Innolux was established in 2010 via a merger of Chi Mei Optoelectronics (CMO), Innolux Display, and TPO Displays. It is a major supplier of LCD panels including LCDs for televisions, notebook computers and display for mobile phones. Apple uses Innolux Inc. as a supplier of iPad mini LCD panels - iPad mini is a drain on Apple at the moment, and the costs can be brought down by acquiring Innolux.
Almost all Apple devices except for iPod Nano use LCD panels. The company is priced in at $5.65 billion in terms of market capitalization. The company has improved its profit margins 5x. The sort of advantage that Apple would have is unparalleled in terms of cost cutting and gross profit margin sustenance.
Above-mentioned businesses are some of the potential candidates that can help the company improve its margins. At a time when the market is maturing; I believe this will be the best way to use cash. Over the next 3-5 years, the company will have to eliminate some stations in its supply chain in order to maintain margins.
A Few Words About the Increased Capital Return
There was a long-standing demand from Apple investors about an increase in the capital return. The majority of the investors believed that the company should pay more of its cash reserves to the shareholders. It looks like the board has realized the need and increased the capital return to its shareholders. According to the new payout ($3.05 per share), Apple will be paying $11.5 billion in dividends. While the increase in dividends is one of the most interesting factors for the shareholders; it should be kept in mind that the share repurchase plan has been increased by five folds.
Previously, Apple announced $10 billion in share buyback, but now the amount has gone up to $60 billion. In addition, $1 billion will be used each year to net-share-settle vesting restricted stock units. These actions indicate that the company has finally started to make some efforts to support the stock price by using some of its cash. However, these efforts will not be enough in isolation. It is clear that the company is now managing the decline in business, and does not enjoy the growth it has experienced over the last five years.
Increased competition from multiple fronts, Samsung, Microsoft (NASDAQ:MSFT), and Nokia (NYSE:NOK) launching windows phone; it is imperative for Apple to restructure its value chain in a way as to better position itself in the industry. The bottom-line for Apple is the proper use of its cash reserves; the stock price can be supported in a number of ways.
To some extent, the management can also be blamed for the recent fall in the stock price - they did nothing when the stock price was plummeting. As I mentioned in the introduction, the management has paid heed to the proposition of increasing dividend; however, the second component (acquisitions) of my proposition could further help Apple manage its gross margin.
Apple has started its next stage as a mature company churning out cash for value investors. The next step for the company should be to manage its profit margins through efficient use of its cash reserves.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.