Apple (NASDAQ:AAPL) shares fell 8% after-hours as investors digested the company's quarterly report (press release available here). While headline results actually beat estimates, guidance and iPhone sales were disappointing, which has investors punishing shares harshly. Carl Icahn certainly casts a shadow over these results as his rhetoric has been growing more heated the past week. In the past few weeks, he has added $1 billion to his stake, including $500 million in a single day last week. While his $3.6 billion stake in a stock he has dubbed a "no-brainer" has lost some value, he may now have more support from frustrated investors for his plan to dramatically increase the buyback to at least $50 billion.
In the holiday quarter, Apple earned $14.50 on revenue of $57.59 billion compared to analyst expectations of $14.09 and $57.46 billion. Revenue was actually up 6% year over year, but gross margins were down to 37.9% from 38.6%. As a consequence, net income was flat at $13.1 billion, though EPS was up $0.69 thanks to the share buyback. iPad and Mac sales were extremely strong at 26 million units (up 13.5% year over year) and 4.8 million units (up 17% year over year) respectively. The iPad continues to perform well despite increased competition from the likes of Samsung and Microsoft (NASDAQ:MSFT) while Mac sales buck the downtrend in PC sales thanks to continued market share gains.
While iPhone sales set a new record, they were less impressive at 51 million (up 6.7% year over year) with the street looking for 56 million. The only saving grace was that the company generated a sequentially higher selling price of $637 vs. $577 despite the launch of the 5C, which was supposed to entice price-conscious consumers. It is important to note that Samsung and Nokia (NYSE:NOK) also had disappointing phone sales in the quarter, so it is unlikely Apple's iPhone miss was due to market share losses. Management has noted that carriers have been requiring 24 months between upgrades to earn a subsidy as they try to cut their subsidy expense, which hurt North America sales. In this case, iPhone purchases were likely delayed and should appear in the coming quarters. This tighter subsidy policy is likely a major reason why revenue in the Americas was down 1% excluding retail. In fact, 63% of revenue now comes overseas. It should also be noted that the China Mobile (NYSE:CHL) was signed after the quarter.
Even with the iPhone miss, an 8% decline may seem steep given strong performance from the iPad and Macs, which is why this decline is likely being driven by guidance. Apple is looking for revenue of $42-$44 billion and a gross margin of 37-38%. Gross margins are fine as they are in line with last year's 37.5%, but revenue guidance was horrendous with analysts looking for at least $46 billion. Here is the problem with understanding Apple's guidance.
Under Steve Jobs, the company notoriously sand-bagged guidance. In other words, it offered guidance that was extremely conservative to a point where Apple could always beat its own estimates. As such, it really was of no value and was almost always well below what the street was looking for. However since everyone knew Apple was sand-bagging, most investors seriously discounted the forecast.
That appeared to change in the quarter reported one year ago when CEO Peter Oppenheimer said this on the call, "We're changing our approach to how we provide guidance. In recent years our guidance reflected a conservative point estimate of results every quarter that we have reasonable confidence in achieving. Going forward we plan to provide a range of guidance that reflects our belief of what we're likely to achieve. While we cannot forecast with complete accuracy we believe we're likely to report within the range of guidance we provide." You can read the full call transcript here. Still even with this stated shift, Apple guidance is often seen as somewhat conservative just not as outrageously so.
The question investors have to ask is whether or not Apple is being somewhat conservative with its target or is offering a truly realistic assessment of the next quarter. For the just reported quarter, Apple had guided to $55-$58 billion and delivered $57.6 billion in sales, right near the top end. With this in mind, I would look for results to be near the top end of this guidance of $43-$44 billion, which is still over $2 billion light. Given the deal with China Mobile, which admittedly will take some time to pay dividends due to the iPhone's price, for revenue to be this light is disappointing. Frankly with its current product portfolio, Apple appears to be reaching saturation, particularly in the United States. To generate double digit growth in revenue once again, Apple will need to expand its portfolio into TVs, wearable technology, or payments. Otherwise, slow growth is likely to persist. Interestingly, R&D spending was up 32% year over year, which suggests that developers are working on new products, which hopefully could be launched before the end of 2014.
Now just because Apple's current products are driving less growth does not mean the stock isn't worth buying. After all, 6% growth in the quarter is still a respectable figure, and Apple remains immensely profitable. Last year, Apple generated $40 in EPS and should generate at least $47 in 2014. Shares are trading at only 10.7x 2014 earnings. If Apple can launch another innovative product that reaccelerates growth, shares could move dramatically higher.
Importantly, shares are a lot cheaper than they appear due to the massive cash hoard, which now stands at $159 billion, which is up $12 billion sequentially. Now, 78% of that sum is overseas, and the company carries $17 billion in debt. If you deducted 35% from Apple's overseas cash total due to repatriation, the company has a net cash position of $99 billion. On a net-cash basis, Apple is trading at 8.4x 2014 earnings. At this valuation, I find Apple to be an attractive investment even without accelerating growth especially as Apple is unlikely to pay this sum of repatriation taxes as it continues to generate over $40 billion of cash flow and at some point the U.S. may pass corporate tax reform.
This brings us to Carl Icahn's thesis that Apple is a "no-brainer." One could view a no-brainer as a stock with significant upside potential and little long term downside risk. It should be noted that being a no-brainer does not mean a stock won't fall in the next day, week, or month as the immediate term is all but impossible to predict. That is why it is unfair to criticize Icahn for calling Apple a no-brainer before this drop. He sees a stock with significant upside if the company develops innovative products and that should produce a solid long-term rate of return without these products thanks to the very low valuation. With an ex-cash earnings yield of 11.9%, there is a significant margin of safety.
In fact with Icahn adding to his stake, he probably welcomes the opportunity to buy shares at a lower price. Further, a lower price means Apple can buy back more shares under the authorization, which makes the repurchase plan even more accretive for shareholders. Of course, Icahn is pushing for an even larger buyback of at least $50 billion this year. With growth still slow, more investors may be getting onboard with this plan. There is really no need for this company to hold over $100 billion in cash. Even with the current capital plan, its cash hoard continues to grow.
Apple could afford to do a buyback in excess of its cash flow to normalize its balance sheet. Rather than repatriate offshore cash, Apple could continue to sell debt and use that to fund a buyback. Apple should repurchase at least $50 billion in 2014, which could add $4 to EPS. The Icahn plan makes complete sense, and I expect Icahn to continue to push forcefully for this. More investors may be getting on board with this plan after the disappointing guidance to engineer EPS growth. With shares trading at a discount to the broader market and historical valuations, a sizable buyback would be a very accretive use of funds.
All in all, Apple reported a decent quarter though guidance was troubling. It is starting to appear that Apple is saturating its markets, especially in the United States. China offers tremendous long term growth, though Apple will need to offer a phone at a much lower price in order to gain meaningful market share. China could boost numbers 3-5% in 2014, but there is the potential for a much bigger presence as the nation's middle class continues to develop. Even if Apple is never able to innovate again, something I doubt consider the company's history, AAPL is an attractive investment thanks to its incredibly low valuation and extremely strong cash generation. Even an ex-cash multiple of 12x would push shares above $660 or 30% higher than here.
Investors are justified to feel frustrated after this quarter because it seems like Apple has been stuck in neutral for the past two years. Under $515, shares are pricing in the failure of Apple ever to innovate again, and to be honest, shares look attractive even absent revenue growth. For investors with a time horizon of over 12 months, I agree with Carl Icahn that Apple is a "no-brainer." If the company's increased R&D pays off, shares will move dramatically higher. Even without growth, shares are very cheap and sport an earnings yield of nearly 12%. I would buy on this dip.
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.