Things to keep in mind after Apple reported earnings yesterday:
I. Apple Sits On $237 Billion in Cash
Cue the Rodney Dangerfield because, for the last ten years, cash hasn’t been getting any respect. During a business cycle in which we see interest rates rise by at least three points, people are going to start talking about corporate balance sheets much more than they do now. If the AT&T-Time Warner merger goes through, you are going to read a lot of “Is the dividend safe?” articles about AT&T stock as it deals with $160 billion in debt in a higher rate environment (right now, AT&T’s debt is at $126 billion.)
Firms like Alphabet, Johnson & Johnson, Cisco, Berkshire Hathaway, and yes, Apple are often praised for their operating results but are rarely praised for their excellent balance sheets. This ought to come into focus more during the next business cycle.
Imagine, for example, if Apple were able to earn 3% on its $237 billion cash hoard. That’s over $7 billion that would get tacked on to operating profits from the core business. Apple is making around a $45 billion profit, so the aggregate effect is that higher interest rates would add on 15% to earnings.
Of course, Apple has $84 billion in debt, and the future refinancings / additional borrowing would also come in at a higher rate, but Apple’s cash holdings could instantly roll over to reap the benefits of higher rates while its pre-existing debt is locked in at 1% or 2%.
Apart from the effect of higher rates on cash balances, there is also a question of mergers and acquisitions. If Apple has the ability to make acquisitions at 25x earnings, it has a cash balance capable of adding about $10 billion in net profits to its current $45 billion base. I don’t know the identity of the target company or when it will happen, but the fertile soil is there. And if not, each additional percentage point increase in interest rates will add $2.37 billion to Apple’s net income.
II. Buybacks and Dividends Raise The Floor
When stock repurchases and buybacks are well supported by profits, it gives you an attractive baseline of “automatic returns.” By that, I mean that you are receiving a minimal threshold of returns even if the business operations stagnate.
At Apple, you get 2% dividends and 3% stock repurchases each year. Together, they comprise about 60% of profits. This gives you a baseline return of 5% per year even if the earnings flatline and the P/E valuation remains constant.
This is where it is helpful that the stock trades at a P/E ratio of 12-13x earnings. It doesn’t cost nearly as much to buy out the existing owners because the valuation is so low. Meanwhile, the buyback programs at companies like Visa tilt at windmills a bit because it literally requires three times as much cash to buy out 1% of the existing ownership.
The high buybacks and so-so initial dividend yield mean that you only need about 5% core earnings per share growth over the life of your holding to get returns that match the historical pace of the stock market.
III. India Is The Key To 5% Operating Growth
Apple sold around 200 million iPhones of various editions last year. That is a very, very difficult base to improve upon. One of the reasons why Apple stock came down 4% in post-market trading after earnings is because iPhone growth in China fell by almost a third after a five-year stretch of almost 30% annual growth in the region. The Chinese population either: (1) has a smartphone already, (2) is in the poor rural area and can’t afford one, or (3) participates in the black market and buys knock-off smartphones. The saturation in the United States, and the backwards step in China, showcase the difficulty of moving the needle when you’re a $200+ billion revenue business. To experience growth in the iPhone market that advances net profits in a noticeable way, Apple needs to grow in India.
Right now, Apple has $2 billion in sales and only a 2% market share in India. If it can capture half the Indian market within ten years, and assuming the Indian smartphone market grows at 7%, it can bring in $80 billion annually in India. The net profit margins at Apple hover around 20%, so a matured end-game smartphone presence in India could add about $16 billion to the profit base.
IV. The Typical Investor Has 3% Of Their Wealth in Apple Stock
Apple is widely owned in mutual funds across America and is the top holding in the S&P 500 Index with a 3.3% weighting as of last quarter. Every $10,000 that you invest means that you are statistically putting about $330 into Apple stock.
Is this a net positive for the average American? I think so. The 20% net profit margins, the untapped international market potential, the enormous cash balance, and the ongoing commitment to share repurchases and dividends that is funded by profits and serves as a 5% return threshold are all elements that indicate Apple’s returns should be competitive with the returns of the 20th century American stock market.
The demerits are the reliance on smartphones which means that Apple must be perpetually “building a better mousetrap” with this product offering to maintain relevancy. Also, it remains to be seen whether profits in India can earn a net profit margin analogous to the American consumer. Usually, the last places you visit in terms of international expansion are the last places for a reason.
My expectation is that Apple will grow core earnings at a rate of 3-6% annually, repurchase about 3% of its stock each year, and of course, you know about the 2% dividend. It is possible that the current price of $115 per share signals slight undervaluation, but I don’t think it is so undervalued that you can bake P/E expansion into your projected returns for the stock. When you purchase Apple stock, you are buying a tech giant with a likely performance range of 8-11%. It is very attractive compared to where the S&P 500 is at right now, but its long-term results will probably mirror what a typical American large-cap stock index did over the 20th century.
Originally posted 2016-10-26 11:50:00.