Upsetting the Apple cart - is it still right to hold?

With the chatter questioning whether it is time to trim the FAANG stocks growing, Karl Hunt of the TAMIM Global Equity High Conviction IMA takes a look at portfolio holding Apple (AAPL.NASDAQ) through this lens.

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 for example that has recurring revenues and an in-built user base and the fact that there is a significant inertia ( hassle factor) in moving away from a product like Microsoft Office, Apple is different. There is the view that Apple has to reinvent its main product every year – the iPhone – one bad product and the company is sunk. It’s not quite as extreme as that – a company 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 near term 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 – and this 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. So 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 – but that appears to have died down. What Apple is working on is always difficult to establish. One of Apple’s problems is that it such a big company at U$915bn that only very big markets will really make a significant difference to its sales and earnings – transportation, healthcare, etc. It has been rumoured for some time that it was working on a car – known apparently as the Titan project. Now according to an interview with Tim Cook, CEO of Apple, this has taken a path more focused on autonomous driving systems and entertainment on the move given Apple’s expertise in software and entertainment. 

In 2014 Apple launched HomeKit which is basically a device that enables you to control more of your “things” (Internet of Things) from your smartphone. So for example you could check your house security cameras from your phone whilst away, set the oven, heating, lighting, etc. So far over 50 branded device manufacturers have signed up to provide more devices to work with HomeKit. At the moment, Apple is focusing on the enabling technology for IoT rather than branding devices under the Apple name, but that may change and be 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 – and with low interest rates 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. So, 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 given that Apple is known to have done a lot of research and development in the area of Augmented Reality (AR), so Electronic Arts would make the most logical sense.

It 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 then Apple’s PE ratio falls from 15.5x for 2018 to 13.5x – which compares to a PE ratio of around 18x for the US market.
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It could also decide to increase its dividend payout without even touching the cash. Currently it pays just over a fifth of its earnings out in dividends which at the current share prices 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 should most likely expect Apple to announce that they will do a bit of everything with the cash in April – buy back say 10% of the shares ($90bn) which will enhance earnings per share, continue to make relatively small in-fill acquisitions which enable more product development in diversifying areas, and increase the dividend.
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In 2017 Apple shares rose 49%, significantly outperforming the S&P 500 which did close the PE discount to the index. Although most of the re-rating is likely complete we still feel that Apple is still being undervalued by the market given its vast financial resources which it can use to enhance shareholder return by raising earnings per share through new products, acquisitions and share buy backs.

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