Unless you manage every dime in your portfolio, you likely have very serious exposure to Apple (AAPL). In fact, passive investors who use one of the many S&P 500 index ETFs have as much as 2.65% of their entire retirement funds invested in this one tech company.
Apple's influence on the market can't be ignored. It's a part of a plethora of indexes, in virtually every single mutual fund, and as the second-largest company on the American stock markets, its performance can make or break the results of a whole trading day.
Apple released its latest earnings numbers on Tuesday in what has to have been one of the most closely followed earnings releases in history. So let's take a look at the creature from Cupertino.
What's Up With Apple Stock?
The last time I talked about Apple here at The College Investor it was August 2012, the markets were in love with the stock, but I wrote about my worries of oncoming margin compression. The new iPad Mini was only a rumor at the time, but it was a signal to the market that Apple was soon to give up profit margin and high price points for increased sales. Margins and competitive advantage go hand in hand. When a company has no fear for competition, its margins should stay relatively high. When gross margins dip, Wall Street worries.
Since then, that fear has played out. Apple is keeping its iPhone devices on the market longer, with its iPhone 4, 4S and 5 now on store shelves all at the same time at various price points. (The 4 is available for the subsidized price of $0.99 at mobile phone stores and Tim Cook, Apple's CEO, recently mentioned the plan to continue this practice in China's growing cell phone market.) It also developed a $329 iPad Mini as an alternative to its higher priced full-size iPad.
Apple's latest earnings report confirmed fears of lower margins and lower selling prices. Gross margins in at a very respectable 37.5%, with expectations of 36% going forward.
Several Trends Have Worked Against Apple in Recent Months:
- Technology Upgrades Aren't a Necessity – There were very large distinguishing differences between the first and second iPhones and iPads. Faster processors, better screens, higher-quality cameras, improved performance and battery life were just part of the next upgrade cycle. However, as technology gets better and faster than what consumers really need in an electronic device, another iDevice isn't so much of a necessity.
- Tech Prices Fall Over Time – Maintaining a high per-unit price point on a product that only becomes less expensive to produce in a competitive market is like trying to fight gravity. What more can mobile phone and tablet makers throw into a device to justify a $599 unsubsidized price? GPS, multi-touch screens, accelerometers, and processors fast enough for casual browsing existed long before the last iPhone and iPad – and their actual input costs fall by the day.
- Price Competition is Hot – Android mobile devices are launching with subsidized prices at $0. Android-based tablets like Amazon's Kindle Fire, Samsung Galaxy tab, and others are available on store shelves at a steep discount to an entry-level Apple iPad Mini. A 7″ Galaxy tab is available for $199, a $130 discount to the iPad Mini.
- Product Costs are Becoming More Visible – T-Mobile plans to stir up the mobile phone model with its “Uncarrier” marketing schtick. The short story is this: new T-Mobile customers can choose a plan priced without a subsidy for a new device. Customers who want a new iPhone can either pay for the device up front (which would set them back $599) or pay only $199 and finance the remainder with monthly installment payments of $20. This model, if it becomes a staple in American mobile markets, would expose the true cost of an iPhone, potentially leading customers away from more frequent upgrades.
Of course, none of these issues would matter if investors knew what was next. Most homes have a smartphone, a tablet, a laptop, and maybe also a desktop computer. What more could Apple make that consumers don't already have? That's up for you to predict – I have no insight into the next big thing – but I do know that it will be nearly impossible to replicate the runaway success of the iPhone with a funky watch or new way to watch television. The market seems to agree.
The Bull Case for Apple Stock
Hardware prices are falling, Apple is giving into price wars, and growth at the top and bottom line is slowing. What could possibly be working in Apple's favor?
A lot, actually. Here's where we pivot.
For one, the company is ridiculously cheap assuming it neither grows nor shrinks. At 9 times last year's earnings and with $145 billion in cash in the bank, Apple trades at a P/E ratio less cash of 5.6. Repeat: 5.6 times earnings less cash for one of the largest companies in the world.
Secondly, the company also – FINALLY – has a plan for what it will do with its cash stockpile. The press release announced a disappointing dividend increase of 15% alongside another $50 billion increase to its repurchase program. (I figured that Apple would ultimately shoot to become one of the highest yielding firms in tech; its new 3% dividend yield lags Intel's 3.85%, Cisco's 3.25%, and merely matches Microsoft's current dividend yield.)
The repurchase program is no lightweight. Assuming Apple buys back shares at the current market value, it would cut shares outstanding by 15.7% by the end of 2015. The company plans to borrow against pre-tax foreign cash overseas to fund its dividend and repurchase expansion. Other tech companies do something similar; when Google needed domestic cash it sold three different maturities with post-tax interest costs lower than 1%. Apple should be able to do the same.
Finally, Apple has a strong ecosystem which is only further strengthened by the fact it attracts the spendiest and most tech-addicted users. Despite lagging in mobile market share, iOS tops Android in application installs, application revenue, and online internet traffic.
What's the Trade?
The next move for Apple stock is sure to make many new millionaires and billionaires, as well as widows.
On one hand, stabilization in free cash flow generation at roughly $45 billion per year would make Apple one of the cheapest large cap stocks on the public stock market – a true bargain at just over 8x free cash flow and nearly two-fifths of its market cap in cash. A low priced stock with excellent capital allocation plans is a setup for a runaway winner.
On the other hand, a combination of a modest decline in gross margins, slipping market share, and a lengthier upgrade cycle could bring about a perpetual decline in earnings. A combination of a 5% drop in margins, 10% drop in average selling prices, and a 20% longer upgrade cycle for its average user wouldn't make Apple the clear value it looks to be at current market prices.
If you believe Apple can simply hold on to what it has, it is, by far, the most compelling value you'll ever find in a liquid large cap. However, its recent trajectory suggests its just another falling tech titan.
I want to hear from you. Tech is a dartboard, but predictions are free.
In which camp do you find yourself?
Is Apple the next multibagger after it shocks the market after showing stabilization in its business? Or is it just another tech company running into the end of its life or turning into Microsoft, a perpetual cash register with no growth?