Upsetting the Apple cart – is it still right to hold?
By Karl Hunt
We have held Apple for some time believing it to be too lowly rated given its growth and potential. Apple has always been relatively lowly rated compared to other “tech” stocks. There is a good reason for this. Unlike a company like Microsoft that has recurring revenues and an in-built user base given the fact that there is a significant inertia (the hassle factor) in moving away from a product like Microsoft Office, Apple is different. There is the view that Apple must reinvent its main product every year – the iPhone – one bad product update and the company is sunk.
It’s not quite as extreme as that. Companies like Apple or Samsung manage this risk by incremental improvements to their products, tweaking each aspect of the phone rather than making too many radical changes.
One of the current concerns for Apple investors is that handset volumes are likely to be fairly flat over the next year. The average replacement for a smartphone is 31-32 months in the USA (smartphone performance tends to fall off after 30 months) and people have been hanging on to their phones a bit longer – partly because they don’t see any significant step up changes in technology and the costs of new replacement handsets have risen significantly. It is rumoured that Apple is likely to help this process along somewhat with a few more affordable handsets to broaden the product range. AppleCare – an extended and more comprehensive after sale warranty has been growing at circa 20% a year – could also be a significant aide to growth if people are holding on to smartphones for longer.
Apple is a tremendous brand known for its quality, styling and innovation. It has a large, loyal customer base which grows yearly. There is clearly scope to extend that brand to other categories. It has already done so with the Apple Watch. There were strong expectations for an Apple TV however this appears to have died down.
What Apple is working on is always difficult to establish. One of Apple’s challenges is that it such a big company at U$915bn that only very big markets, such as transportation and healthcare, will really make a significant difference to its sales and earnings. It has been rumoured for some time that Apple was working on a car, apparently known as the Titan project. Now according to an interview with Tim Cook, CEO of Apple, this development has taken a path more focused on autonomous driving systems and mobile entertainment given Apple’s expertise in software and entertainment.
In 2014 Apple launched HomeKit which essentially is a device that enables you to control more of your “things” (Internet of Things, IoT) from your smartphone. For example, you could check your house security cameras from your phone whilst away, set the oven, adjust heating and lighting. So far over 50 branded device manufacturers have signed up to provide more devices to work with HomeKit. Apple is currently focusing on the enabling technology for IoT rather than branding devices under the Apple name. That may change over time and become an additional revenue source.
Apple certainly has vast financial resources. It is the biggest cash machine on the planet, generating over U$50bn a year. It now has net cash on its balance sheet of U$163bn – equating to just under 20% of its market value. With low current interest rate levels, the return on this cash is low. However over 90% of this cash is overseas, as bringing this cash back to the USA would in the past have left it with a large tax bill. However, with the new tax laws introduced in the USA this is set to change. Apple is to announce in April what it is planning to do with this cash given its stated aim to be cash net neutral.
Apple has been rather reluctant to make big acquisitions. Its preference is to buy tech companies early and integrate them in to the Apple culture rather than deal with big culture clashes. So far this appears to have worked. A big acquisition is unlikely. There is always speculation from time to time that Apple could make a big acquisition in entertainment such as Netflix, Walt Disney or Electronic Arts. Although we still would bet against this strategic move, Electronic Arts, the big computer gaming company, would perhaps fit best. Primarily as Apple is known to have done a lot of research and development in the Augmented Reality (AR) field, so Electronic Arts would make the most logical sense.
Apple does have a reputation of buying back its shares with excess cash. With Apple’s relatively low rating and the low yield on its cash pile, any further announced buy back plans will enhance earnings per share. If you net off all its cash against is market value and deduct earnings it makes from its cash, Apple’s PE ratio falls from 15.5x for 2018 to 13.5x. This compares to a PE ratio of around 18x for the US market.
Apple could also decide to increase its dividend payout without even touching the cash. Currently it pays out just over a fifth of its earnings in dividends. At the current share price, this yields a rather low 1.5%. Unfortunately withholding tax on dividends in the USA is rather high at 30% so we as foreign investors would be less enthused by that idea.
So, we most likely expect Apple to announce that they will do a bit of everything with the cash in April – enhance earnings per share through a share buy-back of around 10% of the shares ($90bn), continue to make relatively small in-fill acquisitions to enable more product development in diversifying areas and increase the dividend.
In 2017 Apple shares rose 49%, significantly outperforming the S&P 500 which did close its PE discount to the market. Although most of the re-rating is likely complete we believe that Apple is still being undervalued by the market. This is due to its vast financial resources which it can use to enhance shareholder returns by raising earnings per share through new products, acquisitions and share buy backs.