- Apple's ~3% and ~5% top and bottom line miss, respectively, was not the only concerning part of its latest earnings call.
- The most concerning part was Apple's choice to deploy cash towards financial engineering instead of new products or accretive acquisitions.
- This article presents the pros and cons of Apple's decision and the way forward for its shareholders.
AppleInc's (NSDQ:AAPL) stock price declined by ~10% in the last 3 trading sessions. This was after the company reported, on April 26, revenues of $50.6 billion and earnings of $1.90 per share. Analysts were looking for $52 billion and $1.99, respectively, implying ~3% and ~5% miss on both the top and the bottom line.
But missing estimates was not the only concerning part about Apple's earnings call. The company's use of cash raised more questions. One would wonder why Apple decided to deploy cash towards financial engineering and not acquisitions or on new products. Now, it is possible that Apple is also investing in new products since the company stated that "our products pipeline has amazing innovations in store." But Apple did not mention any products in store. Meaning that it is only logical for investors to wonder whether this is Apple's optimal use of cash.
Apple's decision can be viewed from two main angles: Bear and bull. In this article, I will start with the bear case and conclude with the bull case.
Is Innovation Drying Up At Apple?
Did Apple decide to increase its capital return program by $50 billion because their innovative pipeline is dry?
In a competitive technology market, innovation is key to remaining relevant. Therefore, Apple's continued share repurchases might be a sign that the company is running out of great ideas to invest in and hence, is using its cash for financial engineering. Since 2012, Apple has used over $163 billion of its capital return program. That includes $117 billion in share repurchases.
"We have now completed over $163 billion of the current $200 billion capital return program, including $117 billion in share repurchases." - Luca Maestri - Chief Financial Officer & Senior Vice President
The 10% dividend hike and the $50 billion increase in share repurchases are good for short-term price appreciation but they might destroy long-term shareholder value. This is because they are not cash-generating ventures.
Apple needs to use its cash on valuable, cash-generating assets. For instance, Apple has been known to steal Tesla employees. Elon Musk told Bloomberg that Apple is "offering $250,000 signing bonuses and 60% salary increases" to Tesla's employees to move to Apple. But instead of trying to re-invent the wheel, Apple can attempt to buy Tesla (Tesla's market capitalization is ~$33 billion) and improve on what has been done instead of starting from scratch.
Besides Tesla Motors Inc. (Tesla (NSDQ:TSLA), Apple has the potential to become the dominant player in the wearables market. They can do this by acquiring Fitbit Inc (Fitbit Inc (NYSE:FIT). Fitbit currently has a market capitalization of ~$3.74 billion. Fitbit is a clear market leader in the worldwide wearable device market, according to research by IDC.
"According to IDC's Q4 report, Fitbit dominated the market with 8.1 million shipments. Apple trailed the champion by four million, less than half of Fitbit shipments. Xiaomi came in third with 2.7 million and was the only Chinese company among the top five vendors." - IDC Research for Q4 2015
Therefore, one would argue that using cash for financial engineering instead of acquiring a company that can be a growth catalyst for Apple, is a short-term strategy and does not increase long-term shareholder value.
On the positive side
Apple's revenue miss is probably already priced in. The investor community was already expecting Apple to disappoint this quarter. This could be why Apple's stock price is already ~20% below its 52-week high.
Secondly, Apple is already trading at undemanding valuations and the 10% post-earnings decline continues to make the stock cheaper. Apple is not an overpriced technology company. On the contrary, Apple has always been an undervalued $578.58 billion company. It is no surprise that a survey by Thomson found that based on 38 broker ratings, Apple still has a mean price target of $133.87/share. Using Apple's latest stock price (April 29 close price) , Apple is now trading at ~30% below its mean price target. Meaning that the recent stock price decline will only make Apple's valuation even more attractive.
Third, maybe Apple just has a shareholder friendly management. Long-term investors who seek dividend stocks understand the importance of getting paid while waiting (only applies to companies you believe in). This is why the 10% dividend hike and the $50 billion increase in share buybacks are critical. Maybe Apple's pipeline is not dry, maybe this is a shareholder friendly management that wants to ensure that they mitigate shareholder losses from now until the fall when they unveil new products.
With regards to acquisitions, Tim Cook did mention that Apple is "always on the lookout for companies with great technology, talent, and strategic fit." Meaning that maybe the company might surprise investors with an accretive acquisition moving forward.
What makes Apple a good dividend play is the fact that it still has great margins. Apple still has margins that are the envy of technology giants. This provides a solution to a sustainable dividend growth story, moving forward.
This might not be the best time to buy into Apple stock. We need to observe the impact of Apple's political risks in China. Apple's major growth frontier ("China") has a lot of political risk. The Chinese government recently shut-down iTunes and iBooks in China, making growth in China a challenge. The next challenge might be ApplePay. ApplePay holds a lot of sensitive data for Chinese citizens.
Secondly, the future is in services and not hardware. Apple's highest grossing product, the iPhone, is likely going to face strong competition if Apple fails to innovate. Apple needs to create an enticing value proposition for customers to stand-out from the likes of Samsung, Xiaomi and Huawei. It also needs to improve its service offerings.
As we approach the fall, rumors will emerge of what might be in Apple's pipeline. We will have a clear understanding of Apple's growth in emerging markets, the potential upgrade cycle for the new iPhone and the number of people switching from android. More information will help investors make a better decision on what price point will be optimal. For now, the stock is likely to be very volatile as the market tries to figure out Apple's way forward. Furthermore, there is likely to be an ocean of downgrades or price-target cuts from analysts as they try to modify their models.
Lastly, Apple might initiate a huge chunk of its buyback program in the next few weeks once its stock price declines further. Therefore, the next few weeks will likely create great entry opportunities. But in the near-term, we need to see how the market will price in the news and wait for investors who will overreact to sell. We need to see Apple's next move.