A couple of weeks ago, I applauded Apple (AAPL) for doing the right thing by using its buyback to cushion a fall in its shares after the latest earnings report. When Apple's fiscal Q2 guidance did not impress, shares slid from $550 (and a high of $575) to under $495. The news of Apple's buyback inspired some confidence in the short-term, and shares quickly bounced back to $551. The rally didn't last long, as a couple of analyst downgrades knocked down the stock, and Apple closed Tuesday at $522.
The fear about guidance was valid because current analyst estimates call for a small decline in Apple's fiscal Q2 revenues over the prior year period. Investors have become concerned about Apple's growth, and flat or declining revenues are a big issue. The stock will have a hard time rallying and keeping a decent valuation without growth. In today's market, names like Google (GOOG), Facebook (FB), and Tesla Motors (TSLA) keep rallying to new highs, because they have growth potential.
That's why it is so important for Apple to deliver now. The company needs to come out with something new, and rather soon. Even if it is just a new iPad or larger screen iPhone, Apple cannot wait until September or October to start launching products. Yes, the China Mobile (CHL) deal will help, but it may not be enough. Today, I'll explain why Apple needs to make a move, and what that will mean for the stock going forward.
Q3 - a repeat of January?
A couple of weeks ago, I stated that Apple really could not solve its biggest problem, and that was the analyst problem. There were some analysts out there with crazy estimates. For example, one analyst called for nearly 30% revenue growth in fiscal Q3. Currently, the high estimate on the street still calls for about 25% revenue growth in the quarter. While I favor Apple as a long-term investment, I cannot honestly say that Apple will come anywhere close to 25% year-over-year revenue growth for the quarter. The following image shows a shot of Apple's estimates page on Yahoo! Finance, linked in my opening.
Right now, Apple is expected to show 9.5% revenue growth in Q3, a rise of $3.37 billion. Here's a quick reminder of Apple's revenues generated in Q3 last year:
- 31.24 million iPhones at $581.10 each.
- 14.62 million iPads at $436.07 each.
- 3.75 million Macs at $1,303.41 each.
- 4.57 million iPods at $160.43 each.
- $5.169 billion in other revenues (iTunes store, accessories, etc.)
Do those numbers make it impossible for Apple to achieve nearly $3.4 billion in revenue growth? No. However, you also have to consider that the iPod will probably show a $200 million to $300 million (maybe even more) decline in revenues. Factor that in, and Apple needs about $3.6 billion in growth to meet current estimates.
In fiscal Q1, Apple reported decent unit growth for the Mac, iPhone, and iPad, but revenue growth for all three was lower than unit growth due to a decline in selling prices. Mac revenue growth was up 15.9%, iPhone revenue growth was up 6.0%, and iPad revenue growth was up 7.4%. Combine that with Apple's guidance (and current estimates) for basically flat total revenue growth in fiscal Q2, and you can see why the Q3 numbers seem hard to achieve at current. Don't forget, the current Q2 quarter includes the launch of China Mobile for Apple, and yet revenue guidance was still very light.
Not worried as much about earnings:
Apple analysts are looking for a little more than 15% earnings per share growth in fiscal Q3, a bit more than the revenue growth rate currently. However, I'm not as worried about this number for two reasons. The first is rather simple. Apple doesn't provide earnings per share guidance anymore. Yes, Apple provides enough guidance where you can calculate earnings per share. However, there are items like the share count that you could play with and so I might have one number for EPS and another person might have a different one. You don't have that with revenues because Apple provides a concrete range. There's a different feel with earnings per share.
The other reason to not worry about earnings per share so much is the buyback. In fiscal Q3 last year, Apple's diluted share count (which is used to determine EPS) was 924.265 million. In fiscal Q1 of this year, it was down to 901.452 million. We know that Apple has bought back at least $14 billion in stock this quarter, and I assume the company will buy back some in fiscal Q3 as well. Just getting the share count down improves EPS, and that assumes zero growth from net income. Add in some net income growth and earnings per share can really take off. As a reminder, analysts are currently looking for $8.61 in Q3 this year after $7.47 last year.
So for example, a 5% increase in Q3 net income and a 5% decrease in the share count gets EPS to jump to $8.25 for the quarter, a rise of 10.53%. A 7% rise in net income and 7% decline in the share count gets Apple to $8.59 in earnings per share, just two cents from the current analyst average. I expect the Q3 diluted share count to be down somewhere in the 6% to 7% range right now. So Apple would need to increase net income by about 8.5% (with a 6% share count reduction) to meet current EPS estimates. That's less than the current revenue growth rate, meaning an overall decline in net margins. Of course, this also assumes no change in analyst estimates. If analyst estimates come down some more, the math gets a bit easier for Apple. That's why I am not as concerned with earnings per share. It's revenues that could be the issue.
What can Apple do about this?
I'm guessing that analyst estimates will come down further for Q3, because analysts probably don't want to see another huge revenue "miss" on the guidance front. However, Apple really should try to avoid putting its stock in the hands of analysts again. How can the company do that? Well, any sort of product launch would help. I'm guessing that some analysts may have a product launch included in their current numbers, so the average might not move up tremendously. A product launch would also help inspire some investor confidence for those who say Apple lacks growth.
What could Apple launch? Well, here are the usual suspects that many have been talking about:
- Larger screen iPhone (potentially 4.7 and 5.5 inch versions).
- Larger screen iPad.
- Update to Apple TV.
The larger iPhones are probably out for Q3, and are most likely part of Apple's iPhone 6 rollout in August or September. The update to Apple TV may not be enough to move the needle, unless Apple actually launches a whole television set. The smartwatch is interesting, although at a lower price point might be a tough sell early on. If Apple averaged $250 a watch, it would need 4 million watches for a billion in revenues. That might be tough for something completely new, as Apple could be plagued by its usual supply issues at launch.
That's why I personally like the idea of the larger screen iPad, and rumors have been saying 13 inches for it. Apple used to launch new iPads in the spring, so a March/April launch might work. Apple could launch the large version in April, and then update the regular version and mini in the fall like it normally does. On a larger screen iPad, Apple could generate a higher average selling price than the regular and mini iPads. Does that take away from sales of the smaller models? Sure, but in this case, Apple is moving you towards the higher priced (and hopefully higher margin eventually after launch) model. The potential risk here is if laptop sales were to be impacted, but I don't think that's as big of an issue as the iPad mini issue was. When Apple launched the mini, it hurt total revenues because people switched to the smaller and cheaper model. This would be the opposite of that, and would certainly help revenues. Apple would also benefit from the sales of new accessories for the new model, as well as the normal revenue boost to iTunes and other items.
One other item to consider:
When it comes to Apple, what's the first non-product item that most people think about? If you guessed Apple's cash pile, you would be correct. Apple's balance of cash, short-term investments, and long-term investments has skyrocketed in recent years. Unfortunately, most of that cash is located outside the US, so it can't be used for dividends and buybacks. Apple doesn't want to repatriate the funds and pay a large tax bill. Instead, the company in 2013 chose to borrow against those funds with a large debt offering.
At some point though, and that time is getting closer, I believe that Apple will do something with its international cash pile. As you can see in the chart below, Apple's foreign cash resources have grown tremendously in recent years. The growth in the foreign balance is higher than the growth in the domestic balance due to Apple using domestic funds for the dividend and buyback.
In the latest 10-Q filing, Apple stated that it had approximately $124.4 billion of its cash pile held by foreign subsidiaries. That was up about $30 billion in the past year, and just under $90 billion in the past three years. Apple's foreign cash balance right now is slightly above the market cap of both Intel (INTC) and Cisco Systems (CSCO).
By the end of calendar 2014, Apple's international cash pile will top $150 billion if the current growth rate continues. The company is going to do something with this cash eventually. One key question is will it be a large international acquisition, like when Microsoft (MSFT) used its foreign cash to buy Nokia's devices and services unit? I don't think the US tax code will change anytime soon, so repatriation remains only a slight possibility at this point. One thing is clear. Apple will not just let this cash balance grow indefinitely. The company did not do that with the domestic cash balance. For now, investors are left to ponder what will Apple use the money for, and when will that happen?
Growth and valuation comparisons:
Apple needs to do something because the company needs to have some level of growth. When you have quarters with no growth, or investors perceive no growth, you're not going to get a strong valuation. Just look at the table below comparing Apple to other technology sector giants. These are the current analyst estimates from Yahoo! Finance, taken from the estimates page linked above.
*EPS Growth and P/E values are non-GAAP.
Apple has more growth than Intel, and Intel has had two straight years of declining revenues and plunging earnings. But investors perceive Intel as having a "growth opportunity" because Intel is starting to move into mobile. Despite two plus years of failures for Intel, the stock still fetches a 9% premium to Apple just because of perception. Cisco is also having a terrible year with declining revenues and earnings, and yet fetches a similar valuation to Apple when Cisco's earnings are converted to GAAP.
The other factors involved here are dividends versus buybacks. Intel and Cisco both have much higher dividend yields than Apple. Investors seem to like that. Apple has a much more powerful buyback, one that is significantly reducing Apple's share count right now. Intel's diluted share count actually rose in its most recent quarter as Intel slashed its buyback in 2013. Intel has not raised its dividend in nearly two years, and yet investors still bid up the stock in relation to Apple. In regards to Cisco, the company needed to buy back a tremendous amount of stock in its most recent quarter just to get the diluted share count down from the prior year period. But due to the rise in the share count during Cisco's prior quarter, the first half of Cisco's fiscal year still saw a nearly 1% rise in the diluted share count. Apple will probably get its share count down by about 6% year over year, but that doesn't seem to matter right now.
I'm not saying here that Apple has to rival Google in terms of growth potential. With Apple's revenues as high as they are currently, 20% a year growth just isn't possible without a ton of acquisitions or new products that could compromise other areas of the business. But Apple can't have quarters like the current one with basically zero growth if it wants even a market-average valuation. Right now, Apple having Intel's valuation would put the stock at $570.
Apple protected its stock when shares fell post-earnings by buying back $14 billion worth of stock. Now it is time for Apple to launch some new products and get the growth story back on track. Apple may need a launch in the next few months to meet current Q3 estimates. If not, Apple's guidance will probably be weak again in April, and regardless of the Q2 numbers, the stock will drop again. If Apple can launch some new versions of current products, and maybe some completely new products as well, growth will return. That should get the stock moving again, and maybe Apple stock will start to rally like it did in the second half of 2013. But until Apple proves some aspect of growth, the stock won't command the valuation of other tech names, even if Apple offers more overall. It's time for Apple to deliver, and the sooner, the better. Until then, investors should use pullbacks to accumulate Apple shares, like the pullback that took shares under $500 a few weeks ago.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.