Contents
Summary
- On January 3rd, AAPL’s share price sank ~10% after it announced on the 2nd a downward revision in its Q1 2019 guidance.
- AAPL is, by far, Berkshire Hathaway’s largest equity investment and ~73.3 million shares were purchased between in late 2017 and early 2018 when AAPL was trading in the $163 - $180 range.
- AAPL has generated between ~$45B - ~$70B in Free Cash Flow (FCF) on an annual basis between FY2013 – 2018.
- AAPL’s plan is to become net-cash neutral over time and its cash rich position and ability to generate ample FCF provides it with several options which should benefit shareholders.
- I acquired 300 shares for the FFJ Portfolio on January 3rd following the price plunge and will acquire additional shares if the share price falls further.
Introduction
Apple Inc. (NASDAQ: AAPL) certainly knows how to ring in the New Year!
On November 1, 2018 AAPL projected it would generate $89B - $93B in Q1 versus Wall Street consensus expectation of $92.74B.
On January 2, 2019 Tim Cook (AAPL’s CEO) informed the investment community that AAPL’s Q1 revenue will come in closer to ~$84B.
In his letter to AAPL investors, Cook indicates that tariffs imposed by the US and China on products from the opposite country have contributed to an economic slowdown in China; the Chinese economic slowdown decreases retail sales in the country and hurt Apple's overall business.
AAPL has acknowledged that the trade war is not solely the reason for its weaker results but it is definitely a significant factor. It has cited the strong US dollar, reduced battery replacement prices, and more as contributors to weaker than expected Q1 results.
AAPL faces more challenges on the trade front as current US tariffs on Chinese goods do not include many consumer electronics such as those manufactured by AAPL. In fact, some AAPL products were dropped from a preliminary list of goods that were subject to tariffs in September.
Trump (aka ‘Tariff Man’), however, stated in November that the iPhone and other Apple products could be hit by the next round of tariffs which would cover the $255B in Chinese products not currently involved in the trade war. AAPL has warned of further harm to the company if additional tariffs are imposed.
While the US and China agreed to a trade war truce at the start of December, this truce is only set to last until March 1. To make matters worse, Tariff Man’s lead trade negotiator reportedly wants to deploy additional tariffs to pressure the Chinese.
Despite reports of pain for American businesses and workers, Tariff Man has long said that the trade war is taking a much larger toll on China than the US. He argues that given the relative strength of the American economy (unemployment remains historically low, wage growth is picking up, consumer confidence is high, and Americans are still spending money at a solid clip), the US can afford to wait for the economic pain to force China into concessions.
In his line of thinking, the US can withstand blows from tariffs on $255B worth of Chinese goods (Beijing hit back with tariffs on $110B worth of American goods) because the underlying economic fundamentals are stronger than those in China.
The risk, however, is that Tariff Man underestimates the Chinese ability to withstand economic pain. Firstly, Chinese President Xi Jinping does not have to worry about an election anytime soon. Secondly, Beijing may still have the ability to prop up domestic firms in the event of protracted trade war.
Despite the risks of a protracted trade war, the White House believes the US has the upper hand in the trade battle with China, saying the declining earnings of companies in the country "puts a lot of pressure on China to make a deal."
Regardless of how this trade war plays out, it is very clear that AAPL and other companies are being hit hard. The head of aircraft manufacturer Airbus' China business, for example, recently stated that the trade war will have a "negative impact on China's aviation growth."
Let’s Put Things In Perspective
AAPL is not in the business of surprising the investment community with terrible news hence the January 2nd Letter to AAPL investors in which Tim Cook states:
‘While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China. In fact, most of our revenue shortfall to our guidance, and over 100% of our YoY worldwide revenue decline, occurred in Greater China across iPhone, Mac and iPad.’
I do not take the negative ramifications of the current trade war on AAPL’s performance lightly. I do, however, try to put things in perspective.
AAPL still expects the following for Q1:
- Revenue of ~$84B;
- Gross margin of ~38%;
- Operating expenses of ~$8.7B;
- Tax rate of approximately 16.5% before discrete items;
- The number of shares used in computing diluted EPS to be ~4.77B. For comparison purposes, the weighted-average diluted shares outstanding as recently as fiscal 2013 was ~6.522B.
It is times like this where I pay heed to Warren Buffett’s wise words…."Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble."
In this article I explain why I have acquired 300 AAPL shares for the FFJ Portfolio the morning of January 3rd even though it is entirely possible that AAPL’s share price could retrace further in the short-term.
Net Cash Neutral
If you read Tim Cook’s January 2nd Letter to Shareholders you may have noticed the following statement:
‘Our profitability and cash flow generation are strong, and we expect to exit the quarter with approximately $130B in net cash. As we have stated before, we plan to become net-cash neutral over time.’
AAPL has the good fortune of having a problem of having more cash than it knows what to do with and far more than it needs to operate.
Under the previous tax code, AAPL’s challenge was that most of this cash was held by foreign subsidiaries so as to avoid repatriation taxes. With the passing of the tax reform subsequent to Tariff Man becoming President, AAPL now has much greater access to those foreign reserves. This gives it many more options in terms of capital structure.
This enhanced flexibility, however, does not address the simple fact that AAPL has and generates too much cash.
In early February 2018, AAPL informed the investment community that AAPL has set a bold goal of bringing its net cash position to zero in the years ahead.
AAPL indicated that tax reform will allow it to pursue a more optimal capital structure. At the time, the net cash position was $163B. With the enhanced financial and operational flexibility from the access to foreign cash, a target has been set wherein AAPL will have an ‘an equal amount of cash and debt.’ Naturally, AAPL will need to retain billions of dollars in working capital just to operate.
Debt was once used as a temporary solution to avoid repatriation taxes but with the passing of tax reform, AAPL no longer needs to continue issuing paper for repatriation reasons. This suggests that AAPL may consider a sizable increase in its capital return program to reduce its gross cash position either in the form a special one-time cash dividend, a few special dividends over a few years, more aggressive increases in its annual dividend, or a significant boost in share repurchase authorization. Whatever method(s) AAPL elects to employ, it will take quite some time to deplete in excess of $100B.
AAPL could also decide to use its cash to reduce its existing debt. I draw to your attention the Term debt segment of AAPL’s 2018 10-K which starts on page 59 of 96. The bonds are callable so it could:
- choose to extinguish debt and the related interest expense;
- continuously roll over the current debt load with new issuances as tranches mature;
- plan on having sufficient cash on hand when those bonds mature to pay them off naturally as scheduled.
Whatever AAPL decides to do, we see that AAPL is under no time pressure as the debt structure includes bonds at highly attractive rates that mature as far out as 2047. Furthermore, interest expense is negligible since dividend and interest income covers debt servicing costs.
AAPL and Berkshire Hathaway (BRK)
If you look at the SEC website and perform a search on Berkshire Hathaway you can find a wealth of information.
This link provides the search results for all the 13F-HR filings. AAPL appears for the first time in the May 16, 2016 filing date for the period ending March 31, 2016.
Looking at the change in AAPL holdings on a quarterly basis we see that BRK definitely acquired a significant number of AAPL shares at prices lower than current levels. It did, however, also acquire millions of shares at prices higher than the current price.
Here is the total number of AAPL shares reported in the most recent filings.
Filing Date Shares Held
November 14, 2017 134,092,782
February 14, 2018 165,333,962
May 15, 2018 239,567,633
August 14, 2018 251,011,877
November 14, 2018 252,478,779
When BRK’s AAPL holdings jumped ~73.3 million shares between the February 14 and May 15, 2018 filing date, AAPL was trading in the $163 - $180 range. The fact Buffett, Munger, and their team members were prepared to acquire shares within this range suggests to me they viewed AAPL as reasonably valued relative to AAPL’s likely valuation several years into the future.
Credit Ratings
Moody’s has assigned a senior unsecured long-term debt credit rating of Aa1 and S&P Global has assigned a AA+ rating. Both ratings are one notch below the coveted AAA credit rating which is currently assigned solely to Johnson & Johnson (JNJ) and Microsoft (MSFT).
The ratings assigned to AAPL give me a high degree of comfort that it will not default on its obligations in the foreseeable future.
Valuation
We know that AAPL generated diluted EPS of $6.45, $9.22, $8.31, $9.21, and $11.91 in FY2014 – 2018. Furthermore, we know that in FY2009 – 2018, AAPL’s annual PE was 20.6, 18.0, 14.6, 12.1, 14.1, 17.1, 11.4, 13.9, 18.4, and 13.2.
I fully recognize the past several years have been wonderful for AAPL and until such time as the US/China trade dispute is resolved, AAPL is highly unlikely to generate results similar to recent years. So, let’s use a scenario in which it only generates EPS of $9.00 in FY2019.
I acquired 300 shares on January 3rd at $143.617. Using this purchase price and $9.00 in EPS we arrive at a forward PE of 15.96. This level is certainly within the PE range over the past several years.
Dividend, Dividend Yield, Dividend Payout Ratio
As noted earlier in this article, AAPL has ample liquidity which provides it with considerable flexibility in regards to its dividend growth.
The current $2.92 annual dividend ($0.73/share/quarter) provides investors with a current dividend yield of ~2% based on a ~$142 stock price. As previously noted, AAPL has the luxury of being extremely cash rich. If the plan is to become net-cash neutral, I anticipate AAPL will increase its quarterly dividend by at least 10% following the next $0.73/share quarterly dividend which will be distributed in February.
If we increase AAPL’s current $2.92/year dividend by 10% to ~$3.20/year, this is only a ~35.6% dividend payout ratio on the basis of $9.00 EPS.
The dividend payout ratio in 2013 – 2018 was ~27.4, ~28.5, 22.3, 24.8, 26.5, and 23.7. Despite the higher projected dividend payout ratio, AAPL would have absolutely no difficulty in servicing its dividend even if the payout ratio were to jump to the mid-30 level.
In FY2012, the weighted-average diluted shares outstanding amounted to 6,617 billion. In the January 2, 2019 Press Release, AAPL now expects the number of shares used in computing diluted EPS to be approximately 4.77 billion (down from 5 billion in FY2018).
The weighted-average diluted shares outstanding have been dropping at the rate of 250 million shares/year. I envision share repurchases will be ramped up if AAPL’s share price remains under pressure.
Final Thoughts
It is entirely possible that AAPL’s share price could retrace further especially if trade negotiations between the US/China fall off the rails. This would not only put pressure on AAPL but on many other US companies for which drastic action on their part may be necessary to ensure ongoing profitability (albeit at perhaps a slightly lower level than in recent years).
I think the current environment is far too risky to try and make a quick profit on AAPL and focus should be placed on its long-term growth potential; read Tim Cook’s January 2nd Letter to AAPL Investors if you have not already done so.
The fact AAPL is good enough to be BRK’s largest holding gives me a high degree of comfort that AAPL is good enough to be a member of the FFJ Portfolio.
I also like that AAPL has the luxury of having a very attractive balance sheet. With an objective of becoming net-cash neutral I fully expect AAPL to deploy its cash in an optimal manner so as to reward shareholders.
As noted earlier in this article, I initiated a position in AAPL on January 3rd. As I compose this article on January 4th I see that AAPL’s share price has bounced back somewhat. I fully expect further volatility in AAPL’s share price and am fully prepared to acquire additional shares if the share price retraces further.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long AAPL, JNJ, and MSFT.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
