Apple Exits The Steve Jobs Era, Bets On Engineering Of The Financial Kind

Apr.26.13 | About: Apple Inc. (AAPL)

Apple Inc. (NASDAQ:AAPL) has made it official: it has moved on from Steve Jobs (SJ). SJ was against stock buybacks. Apple has now dramatically announced that it is launching the largest one in history, tens of billions of dollars worth over the next few years. Not only that, for tax reasons it's going to borrow part of the money to do so, even though it has cash and marketable securities on its balance sheet that far exceed even the total buyback. This doesn't mean that the Jobs point of view was optimal, but it was a strongly-held one. The initial Apple buyback implemented last year was merely to "sterilize" employee options grants, so it's hard to see that he would have vigorously opposed that on, but by announcing this immense one, the implication is clear: this is a new Apple. It's going to be more investor friendly based on the preferences of this era.

This article explores some of the implications of this evolving situation. Many investors remember the following bit of history:

When Amgen (NASDAQ:AMGN) engaged in financial engineering years ago by issuing low-interest rate convertible debt, that marked the end of its highly-innovative period. When Microsoft (NASDAQ:MSFT) began shrinking its share count and raising its dividend, that also marked the end of its pre-eminence and the beginning of a flat share price.

Does the advent of financial engineering in an innovator mark a peak in actual product innovation? Perhaps. It's up to Apple to show that it's not following the above examples.

With hindsight, one can suggest that an optimal time for Apple to have launched a buyback was years ago, when it was clear to insiders that the stock price was much lower than it would be if the iPhone and iPad were the successes they expected. But Mr. Jobs was against it, so it was not to be.

For months, there have been reports (rumors) of indecisive decision-making at the highest levels within Apple. Now we see the company taking on financial leverage months before any new product is going to be announced. This may be a public relations ploy; it creates no new profit stream. It does, however, warn short sellers off of the stock. More leverage means that the stock can move even faster than before. But why would the board not wait on the large buyback until it was certain that the new products were actually introduced on time and looked to be the successes that they expect them to be? What's the rush?

Apple soared to a very high price:sales ratio (about 4:1) for a consumer electronics company because its margins were extraordinary. Profit margins soared in the past decade when virtually every new product Apple introduced was a smash hit, and the Mac line revived. Thus the company's R&D was highly productive and ended up being small as a percent of revenues. Similarly, outsourcing manufacturing let Apple focus on the most profitable parts of its business, namely product design and retail. Going forward, though, Apple has few areas in which it can become more efficient; it may need to increase both R&D and capital spending as a percentage of sales. Margins will be harmed if those occur, and that would be separate from the general deflationary forces it is fighting at the retail level.

At the peak last year, AAPL was valued at a level rarely achieved by any company. Its peak valuation of about $700 B was about 4% of US GDP. Only Standard Oil and a few other companies ever reached that level. $700 B was also just about 1% of the entire GDP of Planet Earth. Yet this was done with a small product line wherein one product, the iPhone, was responsible for more than half of corporate profits. Yet the iPhone was known to be subject to strong competitive pressures even as the stock was reaching those levels.

Deflation is always the order of the day in electronics. Average selling prices and margins are always at risk. We see that occurring now with Apple; there is no way even for management to know how powerful and long-lasting those trends will be. This phenomenon is a major risk for the success of the buyback.

With this week's earnings report and updated forecast for Q3 sales already in the rearview mirror, Apple is again finally seen to be a cyclical company. Will AAPL ultimately deliver $400+ worth of dividends per share, even ignoring a discount for present value (i.e. the income a bond would provide)? There is no way to know. Might Google glasses, increased deflationary pressures, unknown smash hit new product forms from other companies, poorly-received new Apple products, etc. end up returning Apple to the ignominy it reached in the '90s before SJ returned? Could the iPhone go the way of the BlackBerry? Could the retail stores falter and be an albatross around the company's neck?

In other words, could the buyback help bring Apple eventually to real trouble once again, which was the fear that led Steve Jobs to keep such a conservative financial posture?

I'm not predicting anything, but I'm questioning the wisdom of announcing not a limited buyback, which could always be renewed or expanded, but a giant one at this particular time.

Meanwhile, AAPL is not cheap with a price:sales ratio of about 2:1. Sales are no longer rising year on year, and the P:S ratio can go much lower, as we see with Nokia (NYSE:NOK) and BlackBerry (NASDAQ:BBRY). Price:earnings ratios are not reliable guides to value in Apple's industry.

Even in theory, large share buybacks are risky things. All they do in the real world is reward sellers of the stock with a slightly higher price. Any earnings per share benefit is just a number. The money that goes to buybacks does not benefit operations, and it is money that could have gone to dividends for all shareholders. An EPS benefit is only a number. To benefit existing shareholders, profits must grow.

The risk of this particular buyback is accentuated because the borrowing is being done domestically in order to keep Apple's funds offshore as much as possible to avoid repatriating them, which would mean paying US corporate income tax. What will happen as a result is that a casual observer of the balance sheet will see more cash and marketable securities on the balance sheet than is available to shareholders, whereas the debt is fully represented. This will fool no competent Wall Street analyst, but it may fool individuals who purchase an expensive Value Line subscription or just do their own investing based on what they see on Yahoo! Finance or other free media. A dollar of cash on Apple's balance sheet will no longer fully offset a dollar of debt.

AAPL has been churning since Tuesday's announcements. This lack of direction is consistent with the view expressed in my last AAPL article on Seeking Alpha titled Why Most People Should Neither Trade Nor Try To Analyze Apple's Stock.

That message was that Apple/AAPL is/are too heavily analyzed to allow an independent investor a realistic possibility of accurately perceiving mispricing in this security. This is, I argued, much easier to do with less-studied entities. That's the sector of the market where a small investor can be equal to or even gain an edge over large institutions, which cannot move as fast and can't care too much about smaller cap stocks. [I have written about a number of them on Seeking Alpha, most recently First Solar (NASDAQ:FSLR) and Yahoo! (NASDAQ:YHOO). One does not have to go to microcaps to get to less-analyzed, less-followed stocks.]

The amazing operational and financial performance of Apple/AAPL over the past decade rightly gripped the hearts and minds of consumers and investors worldwide. But now the heart, soul and leading brain that twice powered Apple to amazing success will have no third act. New management led by a supply chain expert and a board led by a Ph.D. biochemist are setting a new path for the company. The existing financial assets and future distributable cash flows from the product line developed under SJ are thoroughly understood by the investor community. So are the company's wonderful global brand image and other attributes. But the future success, or not, of the products in the pipeline remains completely uncertain.

AAPL is so thoroughly analyzed that it is one of the only stocks where I believe that the Efficient Market Hypothesis is basically valid. It's hard to see that spending much time and effort analyzing AAPL is financially worth the effort. If you love doing so, that's different, of course. One can, however, love the products and just let the stock do whatever it will do, whether one owns it or not.

It's time to let Apple/AAPL just be one of many "names" in the stock market. It is followed as intensively, or more so, as it was in the SJ era, but in some ways it's a new company.

There's no way to know how the Tim Cook era will go for AAPL shareholders, but in many ways, it's a new ballgame for the stock. It will take time to see whether "Team Apple" can hit one out of the park once more. I'm rooting for that to happen, but from the stands. My money has moved on to bet on other less-followed teams.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over 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. Not financial advice; I am not a financial adviser.