Interactive Investor

Stockwatch: Don't turn your back on Apple

3rd August 2018 09:02

Edmond Jackson from interactive investor


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Apple is one of the stockmarket's great success stories and now trades at record highs, but it may still be worth buying, argues companies analyst Edmond Jackson. Here's why.

Do you recall the late Jim Slater's maxim: "Elephants don't gallop?"  As if arithmetic law guarantees the bigger a company becomes, the harder to achieve growth, i.e. portfolios should prioritise quality small caps.  

Maybe 20-30 years when Slater's advice reigned, his metaphor was true because big cap stocks tended to reflect traditional industries, whereas those emerging – especially technology – were small cap or AIM equivalent.  

Nowadays, however, constituents of the Dow Jones Industrial Average are regarded as yester-year stocks whereas Nasdaq has tech-firms whose capabilities have only strengthened with size, especially where global branding is involved.  

Extensive innovation by one of the world’s biggest firms 

Exactly five years ago I drew attention to Apple Inc at $71, then out-of-favour amid scepticism about whether it could innovate sufficiently in a post Steve Jobs era, hence its stock languishing on 12.5 times earnings.  

On a contrarian view, however, a major refreshment of Apple products was underway and by April 2015 "Apple still has plenty of juice" I could draw attention to 27.1% quarterly revenue growth with earnings per share (EPS) up 40.1%, updating various thereafter, e.g. at $172 last November - citing Apple as a potential major beneficiary of the US tax reform bill, to repatriate and return to shareholders, its capital held abroad.  

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"This stock could become a $1 trillion company on tax reform alone, putting a target near $200." 

Well it's just passed that, testing $207 after latest Q3 results (to end-June) have beaten expectations, market value representing about 20 times historic earnings and a dividend yield just over 1.5%.  

That doesn't look overly demanding despite the need for iPhone and growth in other new product/service sales, to offset modest declines in Mac/iPad revenues (see table).  

"Giffen goods" theory may help explain iPhone demand

An interesting aspect of these results is a 20% advance in iPhone revenues versus 1% growth in their units (i.e. higher sales prices achieved), propelling Apple to its best-ever revenue for its weakest quarter ahead of new iPhone launches in Q4, with guidance also raised for this period to end-September.  

Group revenue was $53.3 billion versus consensus for $52.3 billion, and EPS $2.34 versus $2.16 expected; helped by a higher average iPhone selling price of $724 versus expectations for $693.  This is one example, besides ongoing enthusiasm by Apple customers for new iPhone launches, overcoming doubts Apple is significantly a "one product company".  

Care is still needed to watch underlying progress given the iPhone represents only about 12% of global smartphone sales versus leader Samsung with 21%, and lately China's Huawei passing Apple to second position with 16%.  Yet it shows "Giffen good" aspects: an economic theory where demand actually rises with price, for select goods or services. With the iPhone, it’s as if the personal financial sacrifice conveys a mental high at buying/owning a perceived, must-have device.  

Last November, I suggested a near-term bull case for Apple at $172 after resurgent global hysteria for the launch of iPhone X with people queuing around city streets.

"Social psychologists may draw a link with a seemingly global epidemic in narcissism, fuelled e.g. by social media for which a smartphone is ideal, the iPhone also conveying a personal sense of perfection." 

Since then, the stock is up around 20%, partly as the market tries to factor this behavioural aspect into the stock price.  

Price rises and self-reinforcing growth

Year-on-year, Apple has raise the average selling price of an iPhone by 20%, and analysts are re-working expectations to project rises over 5% in 2019.  One estimate is every 2% rise in average selling price means a 1% gain in group revenue and 12 cents to EPS.

Furthermore, management claims new products such as Apple Watches and AirPods both appeal to iPhone users and attract new users to iPhones, in a self-reinforcing way, potentially supportive of revenue growth even if price growth slips.

There's also scope for the equity valuation to better reflect growth in annuity-type revenues from Apple’s services side - e.g. Apple Music, the App Store and iCloud - which are up 31% in the latest quarter despite China - the biggest market for App Store - slowing the process of new app approvals (though which have improved in recent weeks).  

Chinese sales are actually enjoying a rebound, up from $8 billion to $9.6 billion like-for-like in Q3, and Apple does not appear to be in the direct firing line of China/US trade tariff frictions, its chief executive’s concern is more how trade tensions/tariffs may bear on consumer confidence generally.  The stock has continued to rise in the last day despite the US market hit by an escalation in tariffs with China. 

Apple Inc - Product Summary                
  Q3 2018 Q2 2018 Q3 2017 Year on Year
  Units Revenue Units Revenue Units Revenue Units Revenue
    $   $   $    
iPhone 41,300 29,906 52,217 38,032 41,026 24,846 1% 20%
iPad 11,553 4,741 9,113 4,113 11,424 4,969 1% -5%
Mac 3,720 5,330 4,078 5,848 4,292 5,592 -13% -5%
Services   9,548   9,190   7,266   31%
Other Products   3,740   3,954   2,735   37%
Total Apple   $53,265   $61,137   $45,408   17%

 25% boost to equity value from US tax reform?

Discussion of Apple tends to focus on products, yet it's important to appreciate the scope for this huge cash-rich beast of a company to influence shareholder value with buybacks.  The end-June near-cash hoard was down 8.8% to $233.7 billion as returns escalated (it's estimated) to around $50 billion in the last two quarters; yet there’s a replenishing aspect as Apple repatriates cash held abroad, in the wake of President Trump's tax reform.  

This will enhance already very strong cash generation – $57.9 billion for the 9 months to end-June, up 19.4% like-for-like - such that Apple could buy back around 25% of its equity over the next three years.  Such a move would directly enhance EPS making it possible to anticipate 25% upside in the stock simply if the price/earnings (PE) multiple can remain at least 20 times – i.e. before considering what growth in product/service revenues.

Thus, so long as iPhone revenues remain reasonably stable and growth from other products/services at least offsets decline in Mac/iPad revenues, current levels of cash generation look sustainable and the stock rise as an effect of buybacks alone.

 Add, according to price opportunities

Apple is thus a uniquely modern "elephant": product appeal and relative freedom to price; self-reinforcing demand within the Apple universe; and phenomenal cash resources.  

Obviously, a recession is liable to hit discretionary consumer spending to some degree, possibly to the benefit of more keenly-priced rivals, and Apple's success has put it perception-wise in the "FANG" collection of stocks, exposed to a sentiment hit if trade tensions and other challenges in the global economy prompt a de-risking by investors.  

But, if this was to happen anytime in the next year, Apple shares would be a prime candidate to buy on weakness, assuming it does fall back.  Presently, the stock continues to rise, testing $207 despite another fall in the US market over China.  Near-term volatility aside, the objective stance is: Add.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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