Apple (NASDAQ:AAPL) is heavily exposed to political outcomes coming out of this election cycle, but that doesn't make it an uncompelling investment, as much of the arguments against a Trump presidency hinged on whether it would in fact derail trade relationships with China via a tariff.
Upon weighing the possible outcomes and putting together a detailed article explaining the various methods in which Trump could improve the trade deficit without relying on domestic manufacturing, I get the impression that Trump won't levy a trade tariff. Furthermore, Wilbur Ross (Trump's Commerce Secretary) mentioned that the tariff would be a last resort. I believe negative catalysts in the form of trade and on-shoring of manufacturing while a legitimate risk factor has been weighed too heavily in comparison to the upcoming iPhone replacement cycle (iPhone 8).
Addressing the elephant in the room
I'm less concerned about the negative headwinds already priced into the stock from the incoming presidency, and more concerned with multi-year sales/earnings drivers as a result of product execution, and whether Apple can productively utilize cash from overseas accounts after removing the "indefinitely reinvested cash classification," which would result in a cash repatriation event, resulting in a headwind to GAAP earnings, unless if tax impacts were reclassified for the accompanying fiscal years in which earnings were actually generated.
Apple specifies in its 10-K 2016 Annual Filing the amount of cash held in foreign subsidiaries (page 55):
"As of September 24, 2016, and September 26, 2015, $216.0 billion and $186.9 billion, respectively, of the Company's cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S."
With the corporate tax holiday reported at 10%, the negative headwind would amount to $21.6 billion in taxes paid in a single fiscal year on $216 billion in cash retrieved from foreign accounts.
So, unless if those taxes are redistributed over the course of five to seven years, the diluted EPS figure could experience a one-time headwind in the form of Apple's looming $21.6 billion tax bill. However, Apple would (most likely) put the cash to great use in the form of share buybacks/dividend increase, accelerated development into new technologies (autonomous driving, AR displays, and battery technology), and some big corporate acquisitions.
That being the case, I've conducted a thorough overview of the European Union tax situation in a separate article several months ago, and have come away with the impression that if Apple's tax rate were to move to the Irish tax code, the impact would not just extend to EU earnings, but perhaps the remainder of the world. Japan is the only major geographic reporting segment that Apple pays the standard corporate tax rate due to Japan's "Anti-Tax Haven Measure Act."
Furthermore, the United States provides a corporate tax credit up to the U.S. corporate tax rate, which means that Apple will pay at most 10%, and would not suffer double taxation, so any excess taxes paid to foreign government would not factor in the calculated taxes owed to the IRS.
I estimate Apple's foreign tax rate (excl. Japan) was 0.8%. However, upon including Japan, Apple's foreign tax payments were $2.98 billion on $52.664 billion in international operating income, which translates into an international tax rate of approx. 5.65% (based on FY'15 numbers).
So, what's the most realistic scenario?
Source: Raymond James
In a scenario in which AAPL were to experience a 15% U.S. tax rate, it would still lower the corporate average tax rate, as the imposed increases of EU taxes to 12.5% are still below the reduced tax rate of the United States. Therefore, Apple would likely gain the benefit of an international tax credit, limiting the average corporate tax rate to just 15%. That implies that Apple's current 25.5% tax rate in FY'16 would be lowered a full 10.5 percentage points regardless of whether the EU successfully imposes a 12.5% corporate tax rate based on Irish tax code.
I find it highly unlikely that Apple will negotiate its way out of the imposed 12.5% tax rate the EU Commissioner is after, but the company could at least mitigate the back-owed taxes. In other words, there's a high possibility that it could settle the tax issue by keeping the tax benefits from the Irish loophole from past tax reporting years, and instead phase in the 12.5% (standard corporate Irish tax rate) in future tax reporting years, as a potential compromise.
Apple could come up with some great legal arguments, but one would be dubious to assume that the EU would allow a member state to leverage the trade treaties of the EU while also permitting a less than 1% corporate average tax rate on EU region earnings.
Therefore, I walk away with the impression that of the above scenarios suggested by Raymond James, the 15% U.S. tax rate, cash repatriation holiday, shift towards U.S. manufacturing, and 12.5% Euro tax rate to be the most realistic scenario when combined.
Of course, I don't necessarily agree with the modeled impact of those events, as the 15% corporate tax rate would sufficiently negate the earnings headwind of a Euro tax increase to 12.5%, as the two taxes wouldn't stack on top of each other. Furthermore, Apple would likely shift international earnings back to the United States, as there would be a very marginal difference in diluted EPS if it were to keep the cash abroad.
In other words, assuming the U.S. corporate tax rate reaches near parity with Ireland and the EU successfully imposes the 12.5% rate, it's likely that Apple would repatriate all foreign earnings back to the United States in future years, and would pay an average corporate tax rate of around 15%.
But what about manufacturing?
The increase to manufacturing costs by shifting production to the United States would be a headwind to earnings, but a trade war with China still seems unlikely. It's likely that Apple would mitigate risks of a trade war via on-shoring of production should the need materialize.
Here's what Raymond James mentioned in its latest note regarding on-shoring of Apple's manufacturing:
"Labor expense is a bit of a rounding error for most consumer electronics products, maybe 2-4% of COGS for final assembly/test/QA based on companies we surveyed, so we suspect the added costs would be much more around regulatory costs, less labor productivity, increased capital spending, and lower yields rather than higher wages."
A modest increase to bill of materials seems probable, but the financial impact could easily be mitigated in future years where Apple's service/app store revenues comprise a much higher percentage of corporate earnings/sales. Therefore, I don't anticipate the gross margin figure to decline assuming a continued ramp in higher gross margin categories, as service/app store net revenue is estimated to be a 90%+ gross margin business.
I come away with the impression that Apple is still in the "exploration phase," and has yet to make serious moves to build iPhone, MacBook and iPad assembly lines. Of course, that could always change if Apple and other tech companies could get Congress to pass a budget to help incentivize large companies to develop manufacturing capabilities in the United States.
Furthermore, Apple could produce a higher return on capital from repatriated cash than what investors may anticipate in future years, and may go on a flurry of acquisitions to build upon its high-margin service/software business.
The EU tax situation is still years away from resolution, and a reduction to the U.S. corporate tax rate is unlikely to materialize within the first year of Trump's presidency. Therefore, I'd hold off on adjusting financial models to reflect the impact from shifts in corporate tax rates globally. Furthermore, I'd be skeptical of U.S. and Chinese trade relations worsening too significantly.
Therefore, I anticipate the impact to Apple in FY'17 to be limited to F/X volatility, which will reduce sales/earnings as opposed to any material changes in taxes.
I'll implement the impact from future tax changes in my financial model when an appropriate moment materializes. For now, I reiterate my bullish view on Apple and still view it as a long-term buy.
Disclosure: I/we 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.