Apple's Cheaper Stock Buyback
It is becoming cheaper for Apple to buy back its shares. Since Apple reported 3Q15 earnings, AAPL shares have been down by as much as 30%. Looking ahead, AAPL volatility will continue as the market continues to worry about slowing revenue growth in China. With $50 billion of share repurchase authorization remaining, Apple is in prime position to take advantage of stock market volatility and buy back its stock at a 15% discount to all-time highs resulting in up to $4 billion of "savings" over the next six months.
Apple Valuation
Stock valuation is a complicated subject. While finance textbooks explain how to take a series of numbers and assumptions and arrive at a stock's intrinsic value, the truth is market participants determine a stock's true worth. A stock price is merely the point at which a buyer and seller agree to exchange shares. Emotion and psychology play just as important of a role in determining a stock price as sales, earnings, and growth potential.
Apple is currently trading at a 11x forward earnings multiple (20% EPS growth), a 40% discount to the overall market's 18x forward earnings multiple. If excluding $35 of cash per share, Apple is trading at a 7x forward earnings multiple, a 60% discount to the overall market. If Apple traded with a 18x forward earnings multiple ex-cash, shares would trade at $225, a 100% premium to the current market price.
Growth Concerns
Many look at the valuation discrepancy as evidence that Apple is being penalized by Wall Street due to the lack of confidence in its ability to grow. However, nearly every sell-side Apple analyst is relying on higher earnings multiples, despite slowing operating income growth, to arrive at target prices that are well above the current market price. This doesn't strike me as overly pessimistic.
Instead, Apple continues to suffer from a lack of confidence and conviction on the part of current and prospective shareholders. Since growth concerns are a bit generic, more specific issues plaguing Apple continue to include doubt that strong Apple customer loyalty will continue and a business model that makes it difficult to forecast earnings.
Apple Customer Loyalty Doubt. It is no secret that Apple is the iPhone company. With the product representing 60% of revenue and 80% of operating income, the iPhone deserves the attention it is receiving on Wall Street. However, there continues to be a general lack of understanding over the dynamics underlying iPhones sales, including the impact that Apple customer loyalty has on sales.
Approximately 75%-80% of iPhones sold each year are to previous iPhone owners. Many on Wall Street look at the fact that Apple is relying on its existing user base to drive sales as a negative. Not only do repeat customers make up a significant amount of iPhone sales, but this actually describes Apple's business model. A company that sells not just products, but experiences, relies on repeat customers to offset any negative implications from the decision to not chase market share. This is one reason why Apple management has a tendency to focus on customer satisfaction rates whenever possible. High satisfaction is suspected to eventually turn into loyalty and repeat customers.
When thinking about iPhone sales growth in 2016, having approximately 75-80% of unit sales come from the 525 million iPhone user base is an indication that the Apple machine is functioning properly. The iPhone upgrade cycle is dependent on evolutionary features that do not over serve the customer base but instead entice upgrades. A high percentage of repeat iPhone customers is actually a strength for Apple, not a weakness. Apple would then need to focus on bringing in approximately 40 million new users to the iOS ecosystem annually in order to report ongoing iPhone growth. When considering the large market opportunity in China and ongoing troubles with Samsung, this 40 million new user target is achievable.
One of the concerns Wall Street has with Apple's customer loyalty is questions about how long the trend can continue. The ongoing debate over smartphone "subsidies" going away (they aren't), not to mention cheaper smartphone alternatives from China, are continuously positioned as factors that may cause iPhone owners to look elsewhere for their next smartphone.
A few Apple analysts have attempted to tackle this customer loyalty issue indirectly by coming at it from an ecosystem angle. By attaching a certain amount of revenue (and profit) to each iOS user over time, one can start to look at the iOS user base as a large annuity that will kick off profits each year. While the idea doesn't exactly rely on the most politically-correct analogy, the general idea is a fair one to make. The problem is that it does little to drive increased confidence that Apple's high customer loyalty will continue in the future.
Difficult Business Model to Forecast Trends. Apple has a business model that makes it very difficult to forecast financial trends 3-5 years out. While some of this is born from the company's thoughts on secrecy and surprise, the reasoning actually goes much deeper. Apple's business model is built on the belief that things will not remain steady over the long-run. Management is constantly looking to break itself, only enjoying key sales milestones for a short while before looking to do something else. In recent years that may have meant cannibalizing existing products, while in the future, it may be moving from its comfort zone into new industries. Compare this to something like Google's search business which had never been thought of to be in trouble by many on Wall Street until only recently or Facebook's recent announcement that 1 billion people went to Facebook in a single day. These businesses, while inherently more complex and confusing than Apple, are thought of as more sustainable over the long-run, while Apple's business comes across as more susceptible to market forces.
This lack of business model visibility boils all the way down to granular features found in Apple products. When Apple introduces a new user interface for iPhones next week, it will be difficult for many to envision such a feature becoming a crucial feature across the iPhone line one day, opening the door to significant design changes. Apple is well aware of the 3-5 year plan with features and products, often introducing certain features just to serve as a stepping stone to future revisions. Extend this exercise to nearly every Apple action, and the end result is Wall Street placing heavy reliance on short-term actions with little to no value attached to the long-term. It is tough to value something that will happen in the future when it is not obvious it will occur.
Even though this model of constantly looking to change the equation plays a key role in Apple's goal of remaining relevant over the long-term (what if Apple never moved past the iPod?), from Wall Street's perspective, such never-ending change is difficult to measure and value. Moving from counting iPod profits to iPhone margins, and soon financials behind monthly automobile leases, is not easy and results in low conviction. The end result is lower valuation multiples to compensate for this unknown. I suspect this has been one of the primary reasons over the years for Apple's valuation discount to the market.
Google and Amazon continue to stand out to investors as both companies share some similarities with Apple in terms of unknown futures. The difference is that while Apple is reporting strong profits on very disciplined expense management, Google and Amazon are considered founder-led companies that keep profits artificially low due to excess expenses and investment. As a result, Google and Amazon are rewarded with higher valuation multiples on what appear to be more mediocre profit and growth trends compared to Apple. Some may disagree with this treatment, but the thing to keep in mind is Wall Street will continue to think a certain way until it no longer wants to. It is impossible to predict when that moment will arrive.
Apple's Share Buyback Program
I continue to view Apple buying back its shares as the most appropriate use of excess cash that is not needed for organic growth and M&A.
As of June 27, 2015, Apple had $50 billion of share buyback authorization remaining out of a total of $140 billion of authorization. Theoretically, Apple could repurchase 8% of itself without any additional authorization from the board of directors. However, when looking at cash available for buyback, it becomes clear that Apple is not in a position to buy back that many shares at this time.
Apple is only able to use U.S. cash on hand to repurchase shares and as of June 27, 2015, Apple had $22 billion of domestic cash ($181 billion is held offshore). When forecasting earnings through the second half of CY2015 and taking into consideration debt issuance and U.S. free cash flow generation, Apple will have approximately $50 billion of domestic cash available by year-end. After adjusting for routine cash needs, including cash dividends, as well as the need for a cash buffer, Apple will likely be in a position to spend $20-$25 billion on buyback over the next six months (July to December 2015).
Apple management can make a dollar worth of share buyback go much further when Apple's stock price is depressed. With shares down 15% from all-time highs, Apple could theoretically buy back 15% additional Apple shares with the same amount of cash resulting in a "savings" of close to $4 billion over the next six months.
There are three likely strategies Apple can take in regards to its buyback:
1) Scheduled Share Repurchases. Apple could follow a very strict schedule as to when excess cash is spent on buyback. It would be equivalent to an investor buying an index fund the same day each month to gain market exposure, regardless of whether the market was up or down. As each quarter comes and goes, Apple will spend the same amount on buyback, resulting in additional shares being bought if the share price decreases. There is evidence of Apple following this type of repurchase schedule with $5 billion spend on share buyback in 4Q13, 1Q14, 3Q14, and 1Q15.
2) Opportunistic Share Repurchases. Instead of simply following a schedule, Tim Cook and Luca Maestri could take stock valuation and timing into greater consideration, resulting in an ebb and flow to the pace of buyback. Apple has shown the tendency of being opportunistic, such as in February 2014, when Tim Cook announced Apple had repurchased close $14 billion of shares over the span of two weeks (shares were trading around $70 at the time).
Beginning in 3Q15, Apple initiated a new accelerated share repurchase arrangement (ASR). The mechanics of such a program may at first seem a bit opaque, but they are actually relatively straightforward. The investment bank(s) handling the ASR borrow AAPL shares in order to deliver a large number of shares to Apple up-front. The banks then proceed to buy back shares over the span of weeks and months to cover their borrow. With AAPL shares having been weak since 3Q15 earnings, Apple will actually be able to take full advantage of its lower stock price by receiving cash back from the investment bank(s) in charge of the ASR.
3) Hybrid Strategy. Apple can combine the two strategies, and have both a scheduled buyback plan in place in addition to buying more shares during times of market weakness. Judging from historical trends, Apple management is following this strategy, suggesting there may be increased motivation to increase the pace of buyback during times of market weakness.
In reality, few companies take aggressive, bold moves with buyback programs during periods of market turmoil. Instead, capital management strategies tend to become more conservative as companies prepare for adverse capital market conditions. There had been a noticeable decline in the pace of Apple buyback recently, but it's difficult to know if it was due to a rising stock price, depleted U.S. cash reserves, or a combination of the two factors. Year-to-date, Apple spent $17 billion on buyback, 26% less than the $23 billion spent during the same time period in 2014. It will be important to see if this pace changes in the face of market volatility and lower share prices.
Volatility Will Continue
There is no evidence to suggest that AAPL volatility will decline anytime soon. The market will focus on slowing EPS growth in 2016 while in reality, there will be much deeper issues at play. Customer loyalty and Apple's eventual embrace of new product categories will likely continue to be ignored by Wall Street. One of the primary ways for a $640 billion market cap company to grow in terms of valuation multiples is for current shareholders to become more comfortable owning a greater share of the company. As long as there are still basic misunderstandings about how Apple thinks about the future, valuation multiples will remain range bound, and management will rely on the share buyback program to take advantage of any perceived market dislocation.
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