By Brian Nelson, CFA
We have a few regrets for not “lightening up” more on the position in Apple (AAPL) in the newsletter portfolios during the past few weeks, “Looking to Trim Apple…” and while our lack of action may cost the newsletter portfolios a few basis points in the near term, we’re not too concerned. For one, in this “type” of market, we want to stick with quality, and Apple fits that bill quite well, particularly with the cushion that its balance sheet provides. The iPhone giant’s equity price may go lower as some sell the “headlines” around its fiscal 2016 performance, but the company’s financial health puts it in a class by itself, in our view.
The Journal hit the wires with some pretty nasty headlines, noting that “Apple said iPhone sales grew at the slowest pace since its introduction in 2007 and forecast that revenue in the current quarter will decline at the steepest rate in 15 years…” Quarterly revenue missed consensus expectations by more than $700 million, with sales of iPhones, iPads, and Macs all coming in below expectations in the quarter. Reported operating income and cash flow from operations also dropped from the year-ago period. Apple issued fiscal second-quarter revenue guidance of $50-$53 billion, below a consensus mark of $55.6 billion. If this weren’t enough to disappoint, the executive team said it has started to see “some signs of economic softness” in China. We don’t think the quarter and outlook could have been set up any worse for the stock.
That said, we still think Apple will be a relative outperformer in a weak equity market, something that we’re expecting during 2016. Though a disappointment relative to expectations it was, Apple’s quarter still witnessed record revenue of $75.9 billion, record income of $18.4 billion, and an impressive gross margin, up from the year-ago period. Despite coming in lower than expectations, Apple also delivered “all-time record sales of iPhone, Apple Watch and Apple TV” in the period, as it noted that the growth of its Services businesses accelerated. These were all good things, but the question — “is this quarter the peak?” – will in our opinion continue to weigh on shares. Fundamentally, we’re most concerned that reported operating income barely budged from last year’s period, perhaps the greatest indication that a performance “ceiling” has been hit. Free cash flow generation in the period also waned considerably.
As we expect shares to inevitably face some weakness in coming months, we would expect pressures to continue to mount on what CEO Tim Cook and the executive team should do with its considerable cash balance, which on a net basis, reached $160 billion at the end of the quarter ($215.7 billion gross). Buying back stock isn’t offering much “bang for the buck” in light of the paltry multiple on earnings-per-share numbers, and while ongoing increases in the dividend will be nice, the yield will serve mostly to act as support for the equity, in our view, not as a catalyst for new heights, at least in the near term. Repatriating the cash to the US in order to foot a large tax bill simply isn’t going to happen, and why should it? Apple generates more than two thirds of its business overseas anyway.
On the basis of our valuation process, Apple is not getting sufficient credit for its large cash balance. As a result, we would expect the executive team, if pressured by a weak stock price, to eventually be “forced” into some deal-making to translate such cash into an earnings stream, most likely by picking up a non-US target such that earnings growth can be had and US taxes can be circumvented. We think M&A will become of considerable more importance to the Apple “story” in 2016, far more than it has ever been in the past.
Recent news that has stated Apple is unhappy with its car progress may make California-based Tesla (TSLA) a take-out candidate (~$25 billion market capitalization), but it’s more likely a foreign car maker with forward-looking technology may fit the bill as Apple will seek to put its foreign reserves to work tax-free, should it go in that direction. Apple will likely not bother with a GoPro (GPRO) or a Pandora (P), nor do we think a deal with undervalued Qualcomm (QCOM) is likely, even if it is possible, but scooping up non-US-based entities in its supply chain does make a lot of sense, in our opinion. Apple has ~60 percentage points of margin (1 less the gross margin) it could effectively “buy” in coming years to grow earnings and pave the way for higher returns.
As share pressures mount and Apple gets even less credit for its overseas cash balance, look for the company to start shopping around, if it hasn’t already started to build a list of takeout candidates. There may be nothing more straightforward than vertical integration and cutting costs from the system to bolster returns, and the market may soon “force” it to start making such deals. CEO Tim Cook will be tested in 2016, and the executive team will soon have to start sorting good targets from bad. Carl Icahn may also make a return visit.
A large deal could already be in the works…we wouldn’t be surprised.