Apple, Inc. (NASDAQ:AAPL) has done extremely well for itself over the last decade. Now, it stands as the most valuable company in the world, with a market capitalization over $600 billion. But are things likely to remain that way? Top-line growth has been slowing or even stalling due to market saturation, the end of carrier subsidies, and lengthening replacement rates of the devices (people holding onto their existing phones longer). Earnings have been pretty volatile since a peak in fiscal-year 2015, but appear to be setting up for a resurgence, thanks to strong sales of premium iPhone models in the U.S., Apple's biggest market.
While last quarter's results were encouraging with better-than-expected sales and EPS numbers, challenges remain. Given that, Apple's current capital return program, with its large share buybacks and growing dividend, is a steadying force, which should accrue to investor benefits over time. Its debt pile, used to finance such things, is growing, but remains only a fraction of the company's cash hoard. The firm is cash rich, and yet even continues to spend a healthy amount on R&D - that looks destined to continue unabated. Even if organic revenue growth going forward is going to be difficult to come by, AAPL possesses almost limitless financial resources to tap for its comparatively modest capital return program. I think that shareholder returns will continue to enjoy strong tailwinds, with significant upside from those things alone, even with potential disruptions in sales and profits. In the following article, I outline why I think investors can continue to enjoy healthy returns, even if the company itself experiences softening sales and revenue growth. While forward-looking analysis is paramount to investment success, I think it's also essential to put the company's current financial situation in proper context, so that we might better understand the underlying trends, and how management has evolved to address various challenges. This piece will attempt to give a bird's eye view of where things stand as of this writing, as well as where things are likely headed.
These Roots Run Deep
Apple has certainly gotten a lot of publicity recently (what else is new), as the fiscal 1st quarter of 2017 (the three months ending December 31, 2016), delighted investors and analysts alike. The company beat previous market forecasts for revenue ($78.3 billion), earnings ($17.9 billion), and especially earnings per share ($3.36). Considering the volatility in the stock over the last couple of years (yo-yoing from about $130 to $89, back to $130), it was certainly welcome news to current shareholders. The highlight of the quarter was the better-than-expected sales mix relating to the iPhone. Average selling prices (or ASPs) were slightly higher than forecast, thanks to a higher proportion of sales going to the more expensive iPhone 7Plus. While replacement rates remain longer than what the company experienced during the years of mobile carrier subsidization, it is encouraging to see customers upgrading to the company's more premium product offerings. And while iPad sales continue to decline (falling 22% quarter over quarter), the services segment has continued its strong growth (up 18% over the same period), and is helping to blunt the effect of falling iPad sales. Finally, Chinese sales did decline as expected (falling 12%), but Japanese sales, albeit a smaller market, still grew at a breathtaking 20%, which is very encouraging. Also, rather than tailing off with the end of carrier subsidies, Apple reasserted its dominance back home by growing sales in the Americas yet again. With all of that in mind, let's take a look at the overall trend in sales over the last few years:
Obviously, 2015 was a pretty astounding year, and certainly very difficult to top. In fact, investors have been pretty nervous for some time now that the company may have reached some sort of earnings plateau. I've heard the "law of large numbers" bandied about quite a lot, not to mention "market saturation" and "unsustainable margins." As with most things, there are some grains of truth to those dire predictions. Obviously, growth is increasingly hard to come by once sales have approached $250 billion per year, and talks of market capitalization near $1 trillion are within the realm of possibility. To me, that is more a testament to Apple's enduring and iconic brand the world over, rather than a portent of things to come. I know this; Apple has a cult-like following, extraordinary brand equity, remains best-of-breed with nearly all of its products, and is developing a service (which is growing in significance) and even financing arm to match. But, before I get too far ahead of myself, let's take a look at how much executives had to spend to make those lofty sales:
On the whole, the cost of goods sold has risen roughly in line with revenue numbers, while margins have remained relatively steady in recent years. Although, it is important to note, that net margin actually peaked out at close to 27% in 2012, which is pretty remarkable for a hardware-focused tech company. Still, despite a fall back to more normalized levels in recent years, net margin remains consistently healthy above 20%, and has essentially flat-lined. While this may appear concerning at first glance, it does at least indicate stability where profits are concerned, despite the fluctuation in device ASPs (average selling prices) constantly being discussed and dissected by analysts (which is understandable, given that the iPhone still accounts for over 60% of revenue and earnings).
Obviously, the most important number to really focus on is profit. Well, as mentioned above, Apple has been somewhat of a victim of its own success, in many respects. Fiscal-year 2015 was so incredibly profitable ($53.3 billion in profit; $9.22 EPS), thanks to the overwhelming market appeal and adoption of its flagship iPhone 6, that such momentum would be nearly impossible to continue, at least in the short term. The good news, is that there is some precedence for this very paradigm, as 2012 showed the same kind of success, followed by a bit of a slowdown in earnings, which was merely a pause before the succeeding run-up in profit once again. I think the most recent quarterly report released by Apple, seems to lend credence to the theory that the next year will be a similar story.
First of all, before we go much further into recent history. Can we just stop for a second, to marvel at the growth this company has experienced over the last decade? From $3.5 billion to a high of $53.4 billion in earnings in just 8 short years, is truly astounding. That is a compound annualized growth rate of 40.58%! That is one of the best testaments to the wealth-creating possibilities of equities as an investment class that I have ever witnessed.
Since net income is kind of pointless to discuss without per share numbers, let's also take a look at how earnings per share have grown during the same period. Please take note of two things in particular: 2012 and 2015 were banner years, followed by a pause, before another run-up (at last in 2012, we'll see what follows in 2017). Also, while overall earnings fell from fiscal-year 2016 to the following TTM period, EPS actually grew, reflecting a shrinking share count, to be discussed in more detail later.
I'd also like to provide a chart of the EPS growth, covering just full fiscal years (excluding the TTM period), and with the inclusion of a trend-line, showing the general trajectory I expect to more or less continue, albeit at slower rates of growth going forward.
Okay, back to present reality. Recent years have led to some investor concern over the apparent reversal, or at least pause, in the growth trend. That's not totally unwarranted, as the above chart shows. Still, this fact is due to a confluence of factors that need to be discussed. For one, growth in China had been rapid and impressive (I feel the recent slide is only temporary as well). The market there is massive, and the demographics are definitely on Apple's side. That growth has slowed somewhat, but remains robust. Despite the proliferation of copycats and other competitors, Apple's brand is highly sought-after in the country, and will likely remain an engine of sales growth for years to come, despite recent setbacks. Oddly enough, Chinese tastes are also somewhat high-end, compared to their western peers, and actually help to bolster overall ASPs. Japan's growth will likely continue as well, becoming an increasingly important piece to the overseas growth puzzle.
The end of mobile carrier subsidies from companies such as AT&T (NYSE:T), and Verizon (NYSE:VZ), have eaten into sales a bit, as customers initially balked at full-priced iPhones. That said, new payment plans, and fading sticker shock have helped to mute the effects of that shift. Another phenomenon, which is an ironic twist, is a lengthening replacement rate for its products, particularly the iPhone. That means that customers are keeping their existing phones longer and replacing them less frequently than in the past, partly due to the lack of carrier subsidies, but partly because of the high quality of the phones themselves and the modest incremental changes in each new iteration of the devices. What this also means, however, is that brand loyalty and customer retention are by far, the best in the business, and the firm continues to dominate mobile hardware. While the iPad has fallen in significance as a driver of profit over the last couple of years, the larger phone designs have largely replaced them as tablets, and cannibalized sales to a degree. That's not, on the whole, a bad development, as the phones themselves are actually more profitable than the smaller iPads tended to be.
Recent Quarterly Results Bode Well
While earnings have seemingly stagnated to a degree, last quarter's earnings release was very encouraging. Sales of the company's iPhone 7 and 7 Plus were strong, and ASPs were sufficiently high to drive better-than-expected profits. That is an encouraging sign to investors and analysts alike who had been concerned with margin compression and falling sales leading up to the quarter. Also, it's very important to note that while 1Q 2016 had overall higher earnings than 1Q 2017, the EPS figure actually grew in the recent quarter, thanks to the lower overall share count. This phenomenon reflects a significant effect of the share buyback plan, and should be duly noted by investors in the stock. While many analysts deride this sort of things as "financial engineering," the simple fact is that the shrinking share count gives existing shareholders a larger and larger piece of the Apple pie (pun intended), and therefore, access to greater earnings per share. The following chart tells the story:
So, while Q1 2016 saw overall earnings of $18.36 billion, compared to $17.89 billion in Q1 2017, a fall of 2.55%, EPS actually grew from $3.28 to $3.36 in the same period (a growth of 2.4%, quarter over quarter). That best illustrates the kind of power that a strong capital return program can have, in particular, a robust share buyback program. So, speaking of share buybacks, just how has the company done in that regard? Let's take a look:
You can clearly see that AAPL has made good on its promise to return money to shareholders in a big way. It has shrunk its overall outstanding share base from 6.6 billion shares in 2012, to 5.4 billion shares in the trailing twelve-month period. That is an average annual decline of 4.6%, or an overall decline of just over 18%. That gives EPS figures a very significant boost each year, and is a great way to help dampen volatility of earnings for existing shareholders. To put this program in even better perspective, let's look at how much money management has actually spent on retiring those shares as treasury stock in recent years:
In just four short years, management saw fit to plow $132.9 billion back into its own company, via share repurchases. One of the most encouraging thing about this, though, is that executives saw fit to make some of their biggest purchases, in large blocks, when Apple was trading at significant discounts to its normal P/E range. Regardless, this kind of commitment to returning capital to shareholders really helps put a kind of floor on the stock, and lowers its overall risk profile as an equity investment, at least compared to some of its less financially hefty peers.
It would seem that such enormous expenditures of cash would be absolutely unsustainable. Well, with any other company, you'd likely be right. However, Apple is truly in a unique position. Unbelievably, despite spending $187 billion on buybacks and dividends through the end of fiscal-year 2016, Apple has still managed to grow its enormous cash pile still further. The following two charts illustrate both the firm's short-term cash position, as well as its long-term cash (investments) portfolio.
What these two eye-popping graphs show is that Apple was sitting on a treasure chest of $237.6 billion as of the end of FY 2016. That is simply astounding, by any measure. Of course, as with any number, it's important to put it into proper context. First of all, how much of that cash hoard was derived from debt, and how has cash flow fared by taking on such debt, not to mention growing buybacks and dividends. First, let's take a look at the debt figures.
Okay, well, obviously short-term debt has grown a bit, but in comparison to nearly a quarter of a dollar trillion in cash on hand, this is hardly a distressing graphic. What about long-term obligations? Here's where things get a bit more interesting.
Undeniably, Apple has gone on a bit of a borrowing spree to finance some of its capital return program. Management has been very transparent about the reasons for this. It's pretty simple really. Apple, with its sterling credit rating, can borrow at rock-bottom rates, and chose to take advantage of the credit markets when corporate rates were at historic lows. At the same time, the U.S. corporate tax rate, up to 39.6%, was far too high a price to pay for the company to justify repatriating its cash from abroad. Instead, and thanks to the tax-deductible nature of interest on its debt, Apple realized it would be far cheaper to borrow the money to pay for its capital return program, rather than to pay those exorbitant corporate tax rates by bringing its cash home to the U.S.
This possibility of lower domestic taxes, by the way, is another potential catalyst for Apple investors to seriously consider: the salutary effect a lower corporate tax rate might have on shares of the stock. The Trump administration has been quite vocal about its support for a lower corporate tax rate, and such a move, to say, 20%, would greatly support the notion that Apple repatriate a significant portion of its profits back home. In such an instance, I wouldn't be shocked to see a very sizable special dividend, pay down of some debt, and an increase in R&D spending.
So, while debt has ballooned to a staggering $87 billion in FY 2016, it's important to keep that figure in context. The $237.6 billion in available cash leaves the balance sheet in pristine condition. Besides, Apple has one of the highest credit ratings of any company in the world, meaning its borrowing costs remain the envy of most of its corporate peers. Just to make sure, though, how is Apple's equity position? While the figure got a significant bump in 2015 along with earnings, it actually continued to climb even after that. This shows a strengthening balance sheet, despite the added debt.
So, the company is obviously very solvent, given its enormous cash hoard and rising equity. It may seem moot, but I'd also like to check out the firm's liquidity position, and I think free cash flow helps to clear that up. As you'll see below, the figure may have peaked in 2015 along with earnings, but remains extremely robust at over $50 billion.
At over $50 billion, Apple still throws off a staggering level of free cash flow, indicating an incredibly liquid company. The cash on hand only bolsters the notion that its overall solvency is stronger than ever, despite the rising pile of cheap debt. This company can pay it bills, that's for sure.
Another aspect of spending I like to look at, particularly with technology firms is research and development. Many Apple detractors bemoan the lack of any "revolutionary" products since Steve Jobs' death, and they do have a point. Most of the product launches since then have been evolutionary at best, and largely incremental in scope. So, does that mean the firm has given up on its R&D spending? Far from it, as the following chart can attest:
Growing from only $800 million in 2007 to $10 billion in 2016, represents a compound annual growth in R&D spending of 32.4%. This is roughly in line with the growth in sales, but at least shows the firm's continued commitment to upgrading existing product lines, developing new ones, and keeping up with consumer tastes and preferences. Apple may not have the same kind of visionary appeal it once did under the masterful direction of Steve Jobs, but the corporate culture he established is largely intact. Personally, I don't think it's necessary for continued investment success in the stock, but time will tell if Apple can revolutionize television with AppleTV or some other game changer.
It Can Pay to Wait
Meanwhile, as analysts ponder which new product will finally send the stock soaring to new heights, current investors in the stock are being paid a decent dividend that's only going to keep growing. At a mere 1.7% yield, it would appear that the firm is being a bit stingy with shareholders. But the good news is, dividend growth has been relatively steady around 10% the last few years, with plenty of room to run.
Remember, the firm just initiated its first ever dividend in 2012, so executives are still relatively new to the concept. Tim Cook has proven to be a very shareholder-friendly CEO, however, and is poised to continue such policies unabated well into the future. The cash is there, the earnings are there, and the balance sheet remains healthy. Finally, let's take a peek at the dividend payout ratio, just to make sure:
Fortunately for investors, concerned about the sustainability of the dividend, the payout ratio has remained consistently below 30% of earnings, averaging close to 25%. That is an extremely healthy number, and generally, anything below 50% is considered sustainable and healthy. So, Apple could essentially double its dividend, to a current yield of 3.4% (much to the delight of Icahn), and still be in fine shape. I like the two-pronged approach of a strong share buyback program along with a growing dividend, though, and think that existing shareholders have the best of all worlds (potential sales growth, multiple catalysts for EPS growth, rising dividend income, and the opportunity for multiple expansion).
Speaking of multiple expansion, let's also take a look at the stock's valuation relative to its peers, the market, and its own recent history. The below chart gives us a good sense for where things currently stand in that regard.
As can be seen above, Apple is trading slightly below the industry average, well below the S&P 500 (and consequently the Nasdaq), and only slightly above its own trailing 5-year average. I'd argue that Apple has traded at a significant discount to its intrinsic value over the last several years, given its earnings growth and EPS growth. I think the stock is reasonably priced right now, but still think it's one of the better deals around.
A Compelling Valuation
Here's something fascinating to really consider, if you are wondering about the relative safety of AAPL as an investment. While AAPL currently trades at a current P/E of 15.5, Microsoft (NASDAQ:MSFT) trades at nearly double that, standing at a P/E of 29.8. Additionally, if you factor in the cash the company had on hand at the end of FY 2016, repatriate all of it at a 20% tax rate (for simplicity's sake, I'm just going to apply a 20% rate to the entire cash pile, whether held domestically or abroad), then you come to a figure of $190.08 billion. If you were to subtract that cash from the company, then that's a deduction of $34.56 per share, leaving the current share price of $97.48 ($132.04-$34.56). That figure represents a current P/E ratio of 11.75 ex-cash (reflecting $8.29 of FY 2016 EPS). That is an extremely cheap stock by any measure, especially one with the kind of brand equity and loyal following that Apple has earned over the years.
What to Conclude
On the whole, Apple might still have some strong headwinds to navigate in its push to find new avenues for growth, and the continued reliance on one particular product to drive the bulk of sales and earnings is still somewhat concerning. That said, the iOS ecosystem the company has built, continues to strengthen, and opportunities remain on the horizon in a number of areas from TV to mobile payment platforms and beyond. The company is as financially sound as ever, despite management's recent appetite for debt, and buybacks and dividends should only enhance shareholder returns for years to come. I think Apple is reasonably priced at $132 as of this writing, but feel that initiating a new position, or adding to an existing one in the stock would be perfectly permissible. For the long run, I think the upward trajectory will only continue.
*All charts and graphs created courtesy of the author, with data exported from Morningstar Investment Service.
*All financial information data throughout the article also courtesy of Morningstar Investment Service.
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.
Additional disclosure: I have attached the Excel Workbook to this article, for clarity and transparency.