In July of last year, I wrote an article on Apple (AAPL) pleading that Apple increases the dividend by 25%. After all, Apple's cash flow is high enough to cover that dividend and then some. Future capital spending, including acquisitions, also are well funded by Apple's current cash - so I argued - why not increase the dividend?
Nine months later and the dividend has increased, but only about 10% from the $2.23 it paid back then. At $2.46 over the last 12 months and $2.52 looking forward - at least we're getting there… slowly. In the meantime, investors have been happy with total returns. But now what?
After a total return of 48% in 2017, Apple declined more than the market earlier this year and has recovered along with the broader market to get back to a 3% positive return. Yes, Apple moved along with the rest of the market. I repeat that because I've read quite a few comments on how Apple should be considered a safe haven asset and that investors should load up on Apple to protect against a market decline. I agree that a pullback in the market, and Apple stock, can present an attractive buying opportunity - but a safe haven asset? What? Really?
Apple's stock has provided investors with spectacular returns over the years but to call it a safe haven asset brings to light how Apple is the poster child for several investor biases commonly known in the world of behavioral finance. In a book titled "Behavioral Finance and Wealth Management," Michael Pompian addresses 20 investor biases and puts them into context for the four types of investors he classifies: Preservers, Followers, Independents, and Accumulators.
One type of investor specifically stands out regarding the decision-making process for Apple, and many other stocks with seemingly "cult-like" fanatics. For example, investors considered Followers follow the lead of their friends and colleagues in investment decisions, and want to be in the latest, most popular investments without regard to a long-term plan. We know these people by the conversations we have with them about a specific stock they recently bought or have made a lot of money on. They bought it from a tip from a friend or it came up in conversation at a dinner party that led to a buy the following day. What I often notice during these conversations is that there's very little thought given to a portfolio strategy, or a long-term plan, as Pompian states.
There are several other biases that are relevant to Apple as well. Like Conservatism Bias, which is when people cling to a prior view or forecast at the expense of acknowledging new information. Like when a decline in unit sales for Apple is dismissed as not relevant anymore because the installed base is now more important. While I acknowledge the fact that a 1.3 billion installed base is impressive, Apple still has to successfully monetize it. Investors who dismiss poor unit sales too easily could be guilty of Conservatism bias.
Confirmation bias is another investor behavior I see quite often with Apple investors. Confirmation bias causes investors to seek out only information that confirms their beliefs about an investment, and not seek out information that may contradict their beliefs. I have personally been criticized for writing articles that resulted in a negative opinion of a stock and for wasting my readers' time outlining reasons why they shouldn't invest. Forgive me if I thought self-directed investors would like to hear conflicting opinions about a stock before making their own decisions - instead of reading only positive articles that ignore or omit relevant and material information that might be viewed as negative. The same is true of Apple investors/readers - articles with positive spin on Apple have more readers while negative articles result in personal negative attacks on the author. In my humble opinion, readers should make sure to read articles and reports that are critical of Apple stock just as enthusiastically as positive articles, so they can get a well-rounded view of a company before determining whether or not to invest.
What's the negative news people are ignoring?
Nikkei reported that unnamed supply-chain sources have been notified by Apple that production targets will be reduced to 20M from 40M units in the first quarter. The same report goes on to say that production of the iPhone 7/Plus and 8/Plus will stay at around 30M units for the quarter.
So far Apple has not made a statement confirming the report and many articles have come up questioning the validity of this "news." Is it unfathomable? No. Is it blasphemy? Many Apple fans would say so. You see, most Apple fans can spin both stock price appreciation and declines as a good thing. For example,
If the stock goes up, my shares are worth more," but if the stock goes down, Apple will buy the stock and it will stop going down - and I will be able to buy more shares too
another recent comment on an Apple article was,
Hopefully, these buybacks will continue to support the price while the rest of the market continues its slow-motion crash.
Yet another article was titled
The Dip Apple Wants
- referring again to the potential for more buybacks.
Lastly, there's the Affinity bias, which refers to an individual's tendency to make irrationally uneconomical consumer choices or investment decisions based on how they believe a certain product or service will reflect their values. iPhone, Apple Watch, Apple TV, you name it. Everyone I know that owns an Apple product are highly critical of all other products and would be very satisfied if all other products fall off the face of the earth.
It's a common investment concept to invest in the stocks of companies whose products one loves, but there should be some level of analysis and evaluation before doing so. I know that most SA readers don't take their investing lightly but we all know individuals that bought Apple stock solely because they love their iPhone and without regard for whether the stock was fairly valued at the time.
Recent results indicate that Apple is still firing on all cylinders. It hit an all-time record revenue in several countries and the highest September quarter revenue ever - and then followed that up with $88B in revenues in Q1 2018. Gross margins also were solid at the high end of guidance at 38% and the company guidance for 2018 gross margins was for 38% to 38.5%. It was the first time Apple had launched three phones concurrently so there might have been some concerns of cannibalization. But iPhone 8 and 8 Plus became the most popular iPhone models shortly after launch and iPhone X has been the top selling phone since it launched in November.
In the most recent quarter, international sales made up 65% of total sales so enthusiasm for Apple products is certainly not limited to the US, and in fact, the better growth opportunities are probably abroad. And while consumers were rewarded with innovative new features on the iPhone X, investors were rewarded with $14.5B that was returned to them through the capital return program consisting of dividends and repurchases.
Even with the return of capital, however, Apple still has a lot of cash. In the latest quarterly report, management reported cash and equivalents of $285B.
Source: Apple 10-Q - Q1 2018
With a market cap of $769B, that's more than a 33% ratio of cash to market cap - so if Apple used its cash to buy back $285B worth of shares, it would certainly prop up the price as some folks have commented.
But there are other companies with just as much cash on their balance sheet as a percent of market cap. If it were that easy to navigate a volatile market with a 10% correction, then some of these companies also would be sound investment candidates under the thesis that they would buy back their own stock if it declined. For investors interested in that strategy, I compiled a list of companies with a cash/market cap greater than 25%, based on the same balance sheet figures used by Apple in its calculation of $285B. However, word of warning, I have not done any further research to determine if the investments being reported are highly liquid and considered cash.
There are some household names on the list that also could use buybacks to prop up their stock - if anyone is interested in that approach.
A deeper dive into Apple
Despite all the misplaced enthusiasm for Apple stock, it does seem like a compelling opportunity. A company of its size that can still generate 24% EPS growth even as unit sales decline is intriguing. That means there's still considerable pricing power there.
It currently trades at just 18.4 times earnings - higher than its three- and five-year average multiples of 14.5x and 14x, respectively - but lower than the PE multiple of the S&P 500. It's worth a look and here are some highlights that signal Buy.
The company's service business has grown to $8.5B per quarter - a higher revenue level than most companies in the Fortune 100. It grew at 18% in the most recent quarter compared to the same quarter last year. The Other Products category, including Apple TV, Apple Watch, Beats products, iPod touch, and other Apple-branded third-party products had revenues of $5.5B, a growth rate of 36%. The table below shows the results of the latest quarter by geography and product.
Source: Apple 10-Q - Q1 2018
Even though unit sales were flat or declined for the company's Big 3 products, Apple still has pricing power, as evidenced by the average sale price of its iPhone increasing from $695 to $796. And despite unit sales declining on iPhones, Apple watch had unit sales growth of 50% for the third consecutive quarter. In fact, Apple now ships more watches than Switzerland.
Sales also are growing faster outside the US than they are within the US, with Japan revenues growing at 26% off a low base. The weaker dollar helps too. Revenue from emerging markets outside of China was up 40% year-over-year - evidence that markets that a few years ago were thought to be too price sensitive are finding ways to buy Apple products - in addition to Apple making lower cost versions available in these markets.
The next big thing could be augmented reality and Apple already is positioning itself to be a leader in the space. According to Cook, there are now more than 2,000 AR Kit enabled apps in the App Store. Apple is enabling developers to leverage the "most advanced operating system" to create the most advanced AR tools and we have witnessed the effects of this ecosystem approach before - it works.
The Balance Sheet
There isn't much to say about Apple's balance sheet, it's solid - particularly when 33% of the company's market cap is held in cash. But there were some shifts this quarter due to the tax reforms passed in 2017. There was a substantial tax benefit last quarter of $33B which was balanced by a sharp increase in liabilities.
Source: Apple 10-Q - Q1 2018
As a result of the deemed repatriation tax, which is based on the company's total post-1986 deferred foreign income, the company replaced $36.1 billion of its U.S. deferred tax liability with a provisional tax payable of $38.0 billion. Other than that, not much jumped out at me in their financials.
- Second quarter guidance of $60 to $62B is well below the most recent quarter's $88B but well above the Q2 2017 revenues of $53B.
- Service and Other Products had the greatest amount of growth and is expected to continue to outpace its more traditional products. Services net sales alone increased 18% and outpaced iPhone, iPad, and Mac sales.
- And Other Products, led by wearables, were the second largest contributor to revenue growth after iPhone.
There are some risks that investors should be wary of. Besides the 10 pages of risk factors listed on the company's 10-Q, we highlight a few mentioned and other risks we are mindful of.
- The average selling price for iPhones was $796 compared to $695 a year ago. That was an excellent result but a surprise, in my opinion, and I wonder how much higher prices can go before consumers start skipping an upgrade or two.
- The upgrade rate is slowing. Analysts questioned management on the latest call but Cook thinks it's a natural tendency for people to upgrade while there are others that prefer to own a used iPhone. That said, I personally started upgrading less frequently. The new features are attractive but they don't draw my attention as much as a $1,000 price would warrant. Other consumers may have a higher threshold than me on price but the fact is, they will eventually reach that limit.
- The better battery also will prolong upgrades. Cook mentioned that the company decided to "do the right thing" than to continue to inflict pain on users caused by upgrades that slowed down the phones and drained the batteries.
- The company expects a negative impact from memory pricing in the March quarter due to a lack of supply that has driven prices up. I'm sure Apple will still get its fair share of memory chips but margins may be a bit more unpredictable.
- I mentioned the higher installed base earlier but with lower unit sale growth - it implies longer replacement cycles or upgrade rates that will trend down - or battery replacement in lieu of upgrades could hurt future sales. The challenge will be to monetize the installed base. We saw Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR) fumble trying to monetize their users so it's not a given that Apple will find the right model immediately.
One thing for sure is that the company has done a fantastic job of returning cash to shareholders, even if the dividend increases I called for haven't quite been reached. Over the last six years, Apple has returned over $248 billion to shareholders in the form dividends and share buybacks.
Source: Apple 10-Q - Q1 2018
As of the date of this article, another $34B remains on the company's long-term stock purchase plan as well.
So what now?
The stock price is currently hovering near its 52-week high and is trading at a PE of 18 and a price/book of 6.3x. Its five-year average PE multiple is 14 so on a relative basis the stock looks a bit lofty. Unlike the years before 2016, when the stock traded below its five-year average, it has been above the five-year average for almost all of the last year.
Earnings for the next few quarters are expected to continue their growth trajectory but a big chunk of next year's earnings are slated for Q1 2019 when EPS is forecast by analysts to reach $4.65, more than 20% above Q1 2018 levels. As the chart below indicates, analyst estimates are fairly close to actual results - a result of the amount of coverage the company receives and the information available on the company.
The forward PE ratio, therefore, can be a good indicator of the company's valuation level, and a PE of 15 is much more attractive than a PE of 18.
It would have been nice to have bought at the recent low of $154, but unfortunately, we were not finished with our analysis and had not published this report. The stock has recovered to $179 and as per our custom to take a look at technical for possible entry points, we do see a missed opportunity but recognize that it may not be too late to jump in at these levels. The stock price has a series of higher highs and higher lows and is on a steady upward trend. I would feel comfortable buying at these levels and watching for a price spike past $180 as confirmation of further upside in the short term, and any pullback from $180 as an imminent pullback that could present another buying opportunity.
That said, Apple stock is NOT a safe-haven and it should not be treated as such.
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Source : https://seekingalpha.com/article/4156859-apple-bias-aside-time-take-bite