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Overview

Apple's (NASDAQ:AAPL) most recent earnings report featured some interesting information for shareholders and interested onlookers, among which I count myself. The earnings report itself has been debated here on SA time and again at this point so I won't be talking about the quarter, specifically. I'm more interested in the broader implications for what has become a trend at Apple since Tim Cook took over; disappointing financial results and a lack of any catalysts for it to get better.

Lessons from the quarter

Apple managed to increase EPS in the quarter but only due to the decreased share count of the company's robust buyback program. I'm a big fan of buybacks, particularly on beaten down shares, but the fact remains that Apple has been struggling to grow earnings over the past several quarters and we saw more of that this week. The same is true for revenue; the days of Apple producing blowout revenue growth have long since gone. At this point, shareholders are lucky to get 5% on a regular basis. While this quarter's revenue number came in with a small beat, the guidance for FQ2 was horrendous. At the midpoint of the quarter's guidance, Apple's revenue number is light by $3 billion. This is now somewhat normal in the Tim Cook era and nobody should be surprised when these things happen; I suspect this is not the only disappointing guidance we'll receive from Apple this year.

Margins have also been deteriorating for some time now and are settling in at the ~38% level. Hopefully, that is the bottom in gross margins as it has been a long, sickening slide from the out-of-this-world margins Apple used to post. Pricing pressure and intense competition have disallowed Apple to continue to rake in the cash it used to on a unit basis as it is now just another smartphone company instead of the smartphone company.

Mismanagement and lack of growth catalysts

I mentioned in the open that Tim Cook's reign at Apple has been marked by a distinct lack of innovation and I still think we keep seeing that. Understanding that he hasn't been at the helm for a long time, he still has produced nothing in the way of new products. All we see from Apple is new iterations of products that have been around for years; iPhones with little discernible upgrades, iPads that are nice but way too expensive given offerings from competitors, and Macs that are still a tiny piece of the business with no growth catalysts in sight. The fact is that iPhone and iPad were revolutionary when they came out and Apple has made tens of billions of dollars resting on its laurels. However, in the hardware business, you cannot simply keep reproducing the same product over and over again and simply give it a new moniker each time; at some point, people will grow tired of the iPhone and iPad, at which point shareholders will be begging for 5% revenue growth. I'm not debating that Apple's products are great, because they are; I'm simply saying that continuously "introducing" the same product over and over again will begin to wear on consumers at some point. The fact is that Apple needs a new product to jumpstart growth and I have very little confidence at this point that we'll see something transformative from Apple again. The company has unequivocally lost its innovative spirit and is now just another phone company.

Not only has Apple ceased to innovate, it can't even make the right amount of products it has now. On the conference call, CFO Oppenheimer mentioned that iPhone 5S sales were hurt by supply constraints. This isn't the first time that Apple has made too many or too few of its key product and I think it's downright pathetic that a company with the resources of Apple would allow sales to pass by due to a lack of inventory. Not only are they apparently not particularly good at forecasting demand, but they are unwilling to invest in inventory for their biggest selling product and the one that made it the $450 billion company it is today. This reeks of mismanagement to me and there is no excuse for it. So what if Apple spends another billion dollars on inventory of 5S'; is anyone going to care the company has a little too much inventory if it means additional sales are reaped? The company is just sitting on the biggest cash hoard in the history of business and is yet unwilling to make enough iPhones. I don't get it. If the manufacturing base is too small, find more manufacturers or make them yourself. Money clearly isn't the problem so make the investment to avoid another string of embarrassing quarters that cost your shareholders money. There is no excuse for this and shareholders should be outraged.

Despite my scathing remarks to this point, there are still reasons to own this stock for certain investors. It pays a nice dividend, currently yielding 2.5%, and I suspect this number will increase as shareholders continue to demand more cash be returned instead of sitting in foreign bank accounts. In addition, Apple's is one of the safest dividends I've ever seen given Apple's ability to generate cash and what it's already got on its balance sheet. For a dividend investor, this can be a great situation.

Apple is also returning tens of billions of dollars through buybacks, a move which I applaud. This makes it easier for Apple to raise the dividend in the future as there are fewer shares outstanding, and it means EPS will be higher, all else equal. I love both of these things about Apple and my only complaint here is that both programs are too small; Apple can afford a much larger dividend and a much larger buyback program and I'd like to see them both increased.

Valuation

In order to figure out a value for Apple's shares, I like to use a DCF-type model that you can read more about here. I used my own estimates regarding dividend growth and the discount rate of 10%. I then figured out what earnings growth rates are being priced into shares right now given those estimates. In other words, I took the current value of Apple shares and worked backwards to see what kind of expectations are built into the price right now in order to determine if shares are worth a look.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$39.75

$42.93

$46.36

$49.61

$53.08

$56.80

x(1+Forecasted earnings growth)

8.00%

8.00%

7.00%

7.00%

7.00%

7.00%

=Forecasted earnings per share

$42.93

$46.36

$49.61

$53.08

$56.80

$60.77

Equity Book Value Forecasts

Equity book value at beginning of year

$137.40

$168.13

$200.83

$235.14

$271.08

$308.68

Earnings per share

$42.93

$46.36

$49.61

$53.08

$56.80

$60.77

-Dividends per share

$12.20

$13.66

$15.30

$17.14

$19.20

$21.50

=Equity book value at EOY

$137.40

$168.13

$200.83

$235.14

$271.08

$308.68

$347.95

Abnormal earnings

Equity book value at begin of year

$137.40

$168.13

$200.83

$235.14

$271.08

$308.68

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

$13.74

$16.81

$20.08

$23.51

$27.11

$30.87

Forecasted EPS

$42.93

$46.36

$49.61

$53.08

$56.80

$60.77

-Normal earnings

$13.74

$16.81

$20.08

$23.51

$27.11

$30.87

=Abnormal earnings

$29.19

$29.55

$29.53

$29.57

$29.69

$29.91

Valuation

Future abnormal earnings

$29.19

$29.55

$29.53

$29.57

$29.69

$29.91

x discount factor(0.1)

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

$26.54

$24.42

$22.18

$20.20

$18.44

$16.88

Abnormal earnings in year +6

$29.91

Assumed long-term growth rate

3.00%

Value of terminal year

$427.23

Estimated share price

Sum of discounted AE over horizon

$111.77

+PV of terminal year AE

$241.16

=PV of all AE

$352.94

+Current equity book value

$137.40

=Estimated current share price

$490.34

As you can see, my model shows that current expectations are for about 7% earnings growth per year. While that doesn't sound like much, consider for a moment that when I first wrote about Apple, expectations for 2013 EPS were $49.28. In fact, 2013 EPS came in at $39.75 and keep in mind, we're only talking about a one year time period here where things went very wrong for Apple's EPS. Going from $49 to $40 in EPS is a radical swing and it helps explain why shares briefly saw $700 before crashing back down to Earth.

The point of this is to say that while Apple looks "cheap" now, it looked similarly "cheap" at $700, then $650, then $600 and now at $500. Apple's earnings estimates have done one thing in the past year or so and that is get cut. This is why I think even seven percent earnings growth is likely out of the question considering Apple only made the same amount of money in FQ1 2014 as it did in the same quarter last year. The only reason EPS increased is because of the buyback program and while that is going to persist, Apple is going to have to figure out a way to actually grow its profits or seven percent EPS growth is an unattainable goal. With the market pricing in $60 in EPS in 2019, I think the chance for disappointment is extremely high and the risk for shares is to the downside. There is simply no reason to think Apple can grow its profits at this point given the sorry state that Tim Cook has left its business in. While still a world class operation, it is merely the rubble of what Jobs built during his life and the heart and soul of the company was lost when he was.

The bottom line

I'm afraid that Apple shareholders are expecting massive growth from a company that is incapable of providing it. Apple's niche is high end smartphones but the problem with that is a niche is, by definition, not the largest part of the market. Samsung (OTC:SSNGY) has twice the market share of Apple and the reason is that it sells devices with larger screens that are cheaper than iPhone. I know Apple is steadfastly opposed to diluting its formula with iPhone but maybe that time has arrived. The 5C is a bust as it doesn't provide a cheap enough alternative and still has the signature tiny screen Apple clings to for some reason; thus the slow, disappointing sales. Apple needs to either stop being so stubborn about leaving iPhone in its original, ancient form or create a new product that is transformational like iPhone and iPad were when they came out. Otherwise, where is the growth coming from? The company's market is too small at this point to provide meaningful growth as many people, particularly in the developing world, cannot afford a $650 phone. Carrier subsidies are also under pressure, making it even more expensive to buy a smartphone for many consumers.

Apart from the dividend, I simply don't see any reason to own this stock. Unless you just want to hold Apple in the hopes the dividend is increased, which I think is a distinct possibility, you are kidding yourself if you think Apple is still a growth stock. That ceased to exist several quarters ago and appears, under Tim Cook, to be an elusive status. Cook's Apple is focused on trying to tread water instead of innovate and create. While shares certainly look cheap at $500, beware falling EPS estimates. We've seen in the past year Apple's earnings estimates come down from $49 to $40 and I think we'll see similar cuts in the coming quarters.

Source: Apple's Sell-Off Is An Opportunity... To Sell