Apple’s 3Q24 in Three Charts
Hello everyone.
While recording the podcast episode for yesterday’s update, it occurred to me that one part of our discussion could have benefited from a bit more explanation. While such explanation was added to the podcast, which does routinely happen when episodes are recorded, to ensure everyone received the explanation, the following passage was from yesterday’s update:
“Back in 2019, [Warren] Buffett trimmed a very small part of Berkshire’s Apple stake. When asked why, Buffett didn’t actually provide an answer other than to say Berkshire’s overall stake in Apple continues to move higher due to Apple's buyback program.”
Since Apple is retiring the shares that it repurchases, the overall number of shares outstanding has been declining. This means that each remaining outstanding share is entitled to a larger share of Apple’s future cash flow (and business). If Berkshire didn’t buy or sell any additional AAPL shares, their stake in Apple would gradually rise thanks to Apple’s buyback program.
If we assume that Buffett cuts Berkshire's AAPL stake so that it’s slightly larger than the next largest equity holding (say $30B fair value at 140M shares), that would equate to 0.9% of Apple. Over time, assuming Apple continues to buy back shares and Berkshire doesn’t sell any more shares, that Apple ownership percentage will rise. The buyback is a major reason why Buffett finds AAPL shares attractive.
We will continue our Apple 3Q24 earnings review. Let's jump in.
Apple’s 3Q24 in Three Charts
Last Friday, we went over how Apple’s 3Q24 earnings compared to my expectations. Results came in close to my estimates. Nearly every line item beat (HW gross margin was the only thing that missed).
We also discussed the largest takeaway from earnings: iPhone fundamentals continue to gradually improve and are becoming less of a drag on Apple's overall ecosystem growth.
Turning our attention to secondary themes from earnings, there were three:
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AAPL Valuation Metrics, Apple's Improving Valuation, Apple Close to $3 Trillion Market Cap (Again)
Hello everyone. The update kicks off with an examination of AAPL valuation metrics (forward P/E, EV/FCF, and free cash flow yield). We then go over Neil’s thoughts on why Apple’s valuation metrics have improved so dramatically in recent months. The discussion goes over Apple getting close to a $3 trillion market cap for the second time.
Let's jump into today's update.
AAPL Valuation Metrics
The AAPL roller coaster continues.
When we last talked about AAPL valuation at the beginning of the year, shares were on a down trend (-28% from all-time highs put in January 2022). Since that update was published, AAPL shares are up a whopping 45%. These are large, although not entirely unusual, moves for such a mega cap stock.
For today’s valuation exercise, it's prudent to run with a forward EPS estimate (earnings for the next 12 months) of approximately $6.00. With Apple shares trading at $189, the company’s forward price-to-earnings ratio (current stock price / forward EPS) is 32x. This is up significantly from the beginning of 2023 when shares were trading at a 20x forward multiple. It’s not the easiest exercise to compare the current forward multiple to historical averages given that we are relying on forward estimates and not reported figures. With that said, a 32x forward multiple would be close to all-time highs for Apple in the modern era. Shares had gotten close to the level in the summer of 2020 as shares made a major move higher prior to significant EPS growth which subsequently brought forward multiples down.
To put the 32x forward multiple in context, we compare Apple to various sectors and the overall market using the S&P 500 as a proxy.
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Apple’s Share Buyback: What Comes Next? (Above Avalon Report)
An examination of Apple’s buyback strategy in relation to its net cash neutral goal.
Written by Neil Cybart
Apple has the largest share buyback program in the world. With $90 billion put into buyback in just the past 12 months, the company’s buyback strategy continues to draw questions.
What is Apple’s ultimate objective in repurchasing shares?
What will happen to Apple’s buyback program once the company reaches its net cash neutral goal?
This report examines Apple’s share repurchase program, including the technical details and mechanisms behind buyback, the motivating factors for continued share repurchases, and the most likely path forward from a capital management perspective once Apple reaches its net cash neutral goal.
What Are Share Repurchases?
Share repurchases are the reverse mechanism of a company issuing stock. A company’s board of directors authorizes the use of cash on the balance sheet to buy back shares from existing shareholders. In most cases, repurchased shares are retired and taken out of circulation, thereby reducing a company’s share count.
Technical Details
There are three ways for a company to buy back shares:
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Apple Won the Share Buyback Debate
I receive many questions about Apple from Above Avalon readers, listeners, and members. In previous years, one topic has been far ahead of any other as a source of questions. Everyone wanted to know about Apple’s share buyback program.
Why is Apple buying back its shares?
Is Tim Cook trying to take Apple private?
Does buying back shares signal anything about Apple’s future product plans?
Why doesn’t Apple use cash to buy larger companies instead of buying back its shares?
Something interesting happened in 2020. I received far fewer questions about Apple’s share buyback program. To be precise, I didn’t receive an incoming question about buyback in nine months - from when the stock market put in a bottom in April 2020 to the start of 2021. What explains such a dramatic change? The Apple share buyback debate ended, and Apple was declared the winner.
How It Started
In the early 2010s, many on Wall Street viewed Apple as the iPhone company, and the iPhone was said to be “dead in the water.” A few activist hedge funds began circling around Apple shares due to their low valuation metrics relative to peers and the overall market. Apple was trading at a single digit forward price-to-earnings multiple – a valuation typically afforded to companies with little to no growth potential. On a free cash flow yield basis, Apple was priced like a junk bond.
In March 2012, after consultation with top shareholders, Apple announced it would begin paying a quarterly cash dividend and buying back shares. While Wall Street mostly applauded the move, Silicon Valley was convinced Apple had made a big mistake. Some thought Tim Cook was pressured into buying back Apple shares. Those who followed the “what would Steve Jobs do” doctrine were convinced that Cook had placed Apple on a path to ruin since Steve Jobs had famously viewed dividends and buyback as nothing more than distractions. At the time, none of Apple’s high-growth peers were buying back shares, which made Apple look even more like an outlier.
The primary concern held by those skeptical of Apple buying back shares was that by using cash to repurchase shares, Apple would have less cash to spend on capital expenditures (capex), research & development (R&D), and mergers & acquisitions (M&A). Said another way, some thought Apple was sacrificing its growth potential just to buy back shares.
Repurchase Pace
When looking back at Apple’s share buyback activity, one event stands out: passage of the Tax Cuts and Jobs Act of 2017. Prior to U.S. tax reform, Apple was constrained in terms of the amount of cash that could be spent on buyback. The company was penalized for bringing foreign cash back to the U.S. to fund share buyback. As shown in the exhibit below, Apple kept share buyback to a $30 billion to $45 billion per year pace despite having more than $150 billion of net cash on the balance sheet. Following U.S. tax reform, Apple was able to repatriate its foreign cash at more attractive tax rates. Apple’s share buyback pace shot higher and has been trending at $70 billion per year.
Exhibit 1: Apple Share Buyback Pace (Annual - FY)
Judging Apple’s Buyback Program
Since beginning to repurchase shares in 2013, Apple has spent $380 billion to buy back 10.6 billion shares at an average price of $35.80 per share. It’s tempting to think that Apple’s share buyback has been a success because Apple shares are trading 265% higher than the average price management paid to repurchase shares. However, one cannot judge buyback’s effectiveness or success by merely looking at the current stock price. Apple retires repurchased shares so there aren’t unrealized gains on the balance sheet from previously repurchased shares.
Share repurchases aren’t meant to boost stock prices even though some management teams may strive for such an outcome. Instead, share buyback is a tool for removing excess cash from balance sheets. In the process, a wealth transfer event is possible as ownership is shifted from shareholders willing to sell shares back to the company to those shareholders not selling shares. This is one reason why share buybacks are not created equally. Some companies incorrectly think buyback is a way to solve a problematic business model or lack of future growth while other companies see share buyback as a tool for balance sheet optimization.
The Above Avalon Report, “Share Buyback 101: An Examination of Apple’s Share Repurchase Strategy” contains much more detail on the wealth transfer dynamic found with share buyback. The report is available exclusively to Above Avalon members.
By repurchasing shares, a company doesn’t face brighter future prospects or even a higher stock price. The list of companies with stock prices that declined precipitously once share buyback concluded is long. Accordingly, a share buyback program’s effectiveness cannot and should not be judged by a company’s stock price.
End of Debate
Consensus agreed that Apple was holding on to too much cash on the balance sheet. However, there were differing opinions as to what Apple should do to remove the excess cash. Some thought that Apple should go on an M&A shopping spree. Twitter? Apple should buy it. Tesla? Apple should buy it. Netflix? Apple should buy it. Others thought Apple should ramp R&D so that as a percent of revenue, its R&D spending would be in line with that of its peers.
Instead of pursuing questionable expenditures such as large-scale M&A, paying special dividends, or simply saying “yes” to every R&D project imaginable, Apple instead saw an opportunity to both manage its balance sheet to a net cash neutral position (the amount of cash equals the amount of debt) and simultaneously invest in its future.
Apple’s share buyback debate didn’t end because Apple shares traded above a certain level, Apple repurchased shares below intrinsic value, or the company’s cash levels declined below a certain threshold. Instead, the buyback debate ended because Apple was able to successfully demonstrate that it can pile cash into buyback at record levels while also investing in its future at the same time. With Apple’s share buyback pace remaining at record levels, the company has been able to ramp up R&D to record levels while continuing to fund capex and pursue intelligent M&A.
What Did People Get Wrong?
Why did so many people underestimate Apple’s ability to both buy back shares and invest in its future at the same time?
People overestimated the amount of cash Apple actually needed to run the business and invest in the future.
People underestimated Apple’s ability to generate free cash flow.
As a percent of revenue, Apple’s R&D has historically been lower than that of its peers. Instead of this reflecting Apple underinvesting in R&D, the lower percentage reflects Apple’s unique culture and approach to product development. A better approach to take when judging Apple’s R&D spending is to compare current expenditures to historical totals. Apple spent more on R&D in FY2020 than the total it spent on R&D cumulatively from FY2010 to FY2014.
Apple’s capex needs are less than those of its peers. Apple has a capex-light business model because the company doesn’t offer free services to billions of people with a monetization strategy revolving around ads. This results in less property, plant, and equipment requirements.
Turning to M&A, Apple isn’t interested in buying products and users – a strategy that would likely be met with failure given the difficulty found with assimilating a target’s culture. Instead, Apple uses M&A to fill asset holes in the form of accessing technology and talent. This lends itself to Apple pursuing smaller deals involving companies with less in the way of thriving business models (and premium price tags).
Based on my estimates, Apple requires $10 billion to $15 billion per year to maintain and invest in property, plant, and equipment, and pursue intelligent M&A. Meanwhile, Apple’s business model predisposes the company to superior free cash flow generation. In FY2020, Apple generated a whopping $71 billion of free cash flow. The lack of significant capex requirements means that a high percentage of its operating cash flow ends up being free cash flow. As shown in Exhibit 2, Apple’s free cash flow has been increasing over time.
Exhibit 2: Apple Free Cash Flow (Annual - FY)
Apple’s superior free cash flow generation, combined with its investment run rate, allows the company to return tens of billions of dollars of excess cash to shareholders each year. This isn’t cash that would have been better suited for more R&D, capex, or M&A. Instead, the cash spent on buyback ends up keeping Apple management more disciplined and focused on proper and intelligent spending.
Big Picture
Apple has become a leader in corporate finance strategy. Following Apple, Google, Facebook, and Amazon have each subsequently announced their own share buyback program. Not surprisingly, none of them faced the kind of pushback that Apple faced during the last decade with its own buyback. Instead, Apple peers were applauded.
Consensus was convinced that Apple was buying back shares at the expense of its future growth potential. In reality, Apple’s growth potential has improved as its well-funded product strategy has allowed the company to pull away with the competition. In just the past five years, Apple has grown the iPhone installed base from 570 million to a billion users, and Apple’s ecosystem growth momentum is building. Apple’s wearables business has grown to the size of a Fortune 130 firm. Apple’s Services business went from a $20 billion to a $54 billion annual revenue run rate. In FY2020, Apple’s non-iPhone revenue growth, one of the best measures of ecosystem expansion, was 16%. Once consumers enter the Apple ecosystem via the iPhone, they proceed to buy additional Apple products and services.
There are still some questions worth asking regarding Apple’s share buyback. For example, with Apple shares trading at premium valuation multiples to the market, what is management’s approach to the buyback pace? However, when it’s a question of whether or not Apple management can buy back shares while also investing in its future, the debate has ended and Apple was declared the winner.
Listen to the corresponding Above Avalon podcast episode for this article here.
Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.
For additional discussion on this topic, check out the Above Avalon daily update from January 14th.
Above Avalon Podcast Episode 161: Apple's Spectacular Year on Wall Street
Something has clearly changed when it comes to the way Wall Street is treating AAPL. For the first time with Tim Cook as CEO, Apple shares are trading at a premium to the overall market. In episode 161, Neil discusses how changing behavior as it relates to passive versus active investing may be creating a type of perfect storm for AAPL shares. Additional discussion topics include Apple’s valuation, free cash flow, momentum shifting to passive investing, and Warren Buffett.
To listen to episode 161, go here.
The complete Above Avalon podcast episode archive is available here.
Apple's $500 Billion Year on Wall Street
Since the start of 2019, Apple’s market capitalization has increased by $500 billion or roughly the equivalent of Facebook’s market cap. For the first time with Tim Cook as CEO, Apple shares are trading at a premium to the overall market. Something has clearly changed when it comes to the way Wall Street is treating AAPL. However, the items that analysts, pundits, and the media positioned as catalysts for this dramatic change (Apple Services, iPhone sales rebound, 5G, improving U.S. / China trade sentiment) likely have little to nothing to do with Apple’s share price outperformance in 2019. Instead, changing behavior as it relates to passive versus active investing may be creating a type of perfect storm for AAPL shares.
Outperformance
It’s difficult to put a $500 billion market capitalization increase in context. Here are a few attempts:
Disney ($262B), Netflix ($146B), and three Spotifys ($78B) combined.
AT&T ($282B), Comcast ($196B), and a Spotify ($26B) combined.
Nearly two ExxonMobils ($588B).
Three Boeings ($558B).
Six Goldman Sachs ($498B).
Sixteen percent of the entire energy sector.
The market caps of the bottom 12% of the companies in the S&P 500 (60 companies in total).
When looking back over the past ten years of stock price performance, 2019 is on track to be the best one for Apple this decade (barring a stock market implosion in the next two weeks). Apple shares are up a whooping 77% in 2019. Comparing the S&P 500’s performance with that of AAPL, we reach Apple’s outperformance / underperformance relative to the broader market:
2010: 40%
2011: 26%
2012: 19%
2013: -22%
2014: 29%
2015: -2%
2016: 3%
2017: 29%
2018: 1%
2019: 50%
Apple shares have outperformed the market by 50% in 2019. For a company of Apple’s size, such outperformance is noteworthy.
Valuation
On a forward P/E multiple basis, Apple shares now trade at a 20% premium to the S&P 500. My preferred valuation metric for Apple is free cash flow yield, or the amount of free cash flow relative to enterprise value. Free cash flow is the amount of cash left over after management has paid all of the bills and maintained / funded capital investments. Enterprise value is market capitalization minus net cash (debt - cash).
In FY2019, Apple reported $58 billion of free cash flow. Apple is a free cash flow machine given its capex light business model. (More information on Apple’s free cash flow advantage is found in the Above Avalon daily update from March 13th available here.) While Apple’s free cash flow will fluctuate given the various moving parts, the combination of a stabilizing iPhone business and no major change in capex spending supports the idea of similar levels of free cash flow over the next 12 to 24 months. Accordingly, we can use $60 billion of free cash flow and Apple’s current enterprise value of $1.1 trillion. Apple is currently trading at a 5.2% free cash flow yield. The higher the yield, the lower the stock valuation.
One way of interpreting a 5.2% free cash flow yield is to compare it to other instruments such as government bonds and high-yield corporates. With those yields closer to 2.5%, a 5.2% yield suggests that Apple is still fairly attractive from a free cash flow yield basis. However, the days of Apple trading like a steel mill with just a few years left of operations are in the rear-view mirror. As recently as 2016, Apple was trading at a 17% free cash flow yield. For discussion purposes, AAPL would need to trade at $100 per share for free cash flow yield to once again be at a 17% yield.
What’s Driving AAPL?
Longtime Above Avalon readers and listeners will be familiar with my consistent stance on how to determine what is behind a stock price’s move. Unless every market participant is interviewed, we are unable to know the exact reason why a stock price behaves the way it does. Given the sheer difficulty found with such an exercise, the task of determining specific reasons behind a stock price move is ultimately a fool’s errand. The activity is nothing more than an attempt to add manufactured clarity to what is ultimately a lot of unknown. It is humans’ discomfort with the unknown that plays a role in the financial press’ never-ending quest to come up with exact reasons behind stock price moves.
When it comes to Apple, the list of “reasons” that analysts and reporters claim are behind the stock’s 77% move in 2019 continues to grow:
A stabilizing iPhone business.
Stronger services growth.
Apple management successfully navigating a tumultuous geopolitical landscape in both the U.S. and China.
Wearables momentum.
Continued ecosystem momentum with ongoing growth in terms of new users and the number of devices.
There is a rather glaring problem found with the preceding list of factors: None are significant enough on their own to justify a $500 billion increase in market capitalization.
Using a conservative measure as to what the iPhone business was previously valued at, Apple’s market cap increase would represent the iPhone business seeing its valuation double in just 11 months. That is unrealistic for a mature business like the iPhone. Expectations would have had to move from Wall Street thinking the iPhone was dead with just a few years of sales remaining (which was never the case) to the business demonstrating some kind of free cash flow bonanza (also not the case).
As for the idea that Services is somehow behind Apple’s spectacular rise, I’m skeptical. The problem with that theory is that there continues to be a lack of consensus as to what that narrative may even be. Apple isn’t becoming a services company, and there remains quite a bit of hesitation around that idea in terms of buy-side investors.
My suspicion is that Apple’s stock price run isn’t driven by any single business-related item. The move is simply too large. Instead, a $500 billion market capitalization increase points to a wide variety of investors wanting greater Apple exposure. This increased interest results in higher stock prices since a stock price is nothing more than the spot where demand for shares equals the supply of those shares.
Why do these investors want more Apple exposure? Instead of looking at Apple’s business for potential answers, we have to look at the multifaceted dynamic found with passive versus active investing.
Passive investing (index funds) are on the rise as investors are becoming increasingly disenchanted with mutual funds and active funds charging for underperforming the market. As more funds are poured into passive investment vehicles, all of the Wall Street giants (Apple, Microsoft, Amazon, Alphabet) benefit. By accounting for 4% of the S&P 500, 4% of every dollar put in an S&P 500 index fund is allocated to Apple. While this mechanism doesn’t necessarily lead to Apple’s share of the overall market increasing over time, it can lead to sustained demand for shares regardless of business fundamentals. This is key as active investors, and their constantly swinging perspectives on stocks, lose power to sway stock prices. While passive investing on its own doesn’t explain a $500 billion increase in Apple market cap in 2019, it likely is a contributing factor to what may be happening.
In a scenario where active investors (hedge funds, mutual funds, pension funds, etc.) were running with historically low exposure to Apple for whatever reason, a scenario in which Apple began to materially outperform the market would place pressure on these active investors given how they are often graded against a market benchmark. Given how Apple represents 4.3% of the overall S&P 500, a 77% move in the stock will likely make or break an active investor’s year depending on whether or not they own the stock.
The most likely explanation for Apple’s run up - however simplistic it may sound - is that active investors have been desperately trying to increase their exposure. The stronger demand for shares leads to higher stock prices in order for demand to match supply.
A crucial piece of evidence for my theory is found with Microsoft. The company is up 52% in 2019 with market cap gains of approximately $400 billion. We know Microsoft shares aren’t up that much because of iPhone sales. Instead, Microsoft is likely experiencing the same situation as Apple. Having shares of the two largest companies go up by 77% and 52% respectively means that active investors need to be overly exposed to these companies or risk underperforming benchmarks. For those active investors late to the party, the need for exposure only intensifies. Some may call this situation FOMO (fear of missing out). Others may call this forced buying - the opposite of forced selling.
Warren Buffett
Warren Buffett ends up being a symbol of this development. Back in 2016, Buffett began building his Apple stake after one of his portfolio managers introduced him to the idea. Buffett has been uncharacteristically quiet about his Apple investment. However, the past few Berkshire annual reports provide enough clues to suggest he is ultimately attracted by Apple’s robust free cash flow and balance sheet strategy in which free cash flow is poured into share buyback and dividends. Buffett took advantage of active investors shunning Apple to increase his own exposure. Buffett’s Apple stake is now worth $70 billion, marking an unrealized profit of approximately $34 billion (not including dividends).
During the period when Buffett was acquiring his Apple stake, the two largest Apple buyers in the market were Apple (via stock buyback) and Buffett. In some quarters, the buying from Apple and Buffett alone totaled as much as 10% of shares traded. That is astounding. As Apple and Buffett were buying shares, many other market observers remained on the sidelines for likely a variety of reasons (unease surrounding Apple’s business model, Apple’s exposure to China, and the list goes on).
What Next?
As for how this situation will end, no one knows. If someone proclaims to know, caution is needed. We can have much more confidence in saying that valuations will matter, eventually. It is also safe to assume that passive investment momentum will continue, which will likely only exacerbate current trends (both to the upside and downside).
Listen to the corresponding Above Avalon podcast episode for this article here.
Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.