Apple (AAPL) has long been a darling of Wall Street, owing to its status as a FAANG stock, and in 2018, it became the first publicly traded US company to ever achieve a $1 trillion market cap.
But when it joined the 13 digits club, some investors warned of the "market cap curse" meaning that in the past when companies achieved record high valuations that tended to signal a top, followed by an inevitable slide much lower.
At least in the short term, those bears appear to have been proven right with Apple closing down almost 40% from its all-time highs on Thursday, January 3rd, the day after management dropped a bombshell. One that rocked not just Apple, but sent numerous tech companies (and the entire market) crashing lower that day.
By Thursday's close, Apple's market cap had plummetted $425 billion from its peak. That's more than the entire market cap of fellow FAANG stock Facebook's (FB). As a result, Apple went from the most valuable US company to the fourth.
Given that I've long been a fan of Apple, and recently added it to my new Deep Value Dividend Growth Portfolio (which thus far has beaten the market by 10.6% since inception), many readers have been asking me whether now is a good time to "be greedy when others are fearful" or whether Apple's investment thesis just broke making it an IBM (IBM) style value trap to avoid.
So let's take a look at four things investors need to know, not just about Apple's recent bombshell guidance cut, but more importantly, how that warning affects the company's long-term investment thesis.
Most importantly, find out why Apple's heightened risk profile is likely more than offset by its attractive valuations (15% to 26% undervalued) which is why it's still likely to deliver long-term total returns of about 16% to 17% over the coming years.
That's ultimately why I used the latest Apple meltdown to double DVDGP's position in the company at about $142.
Today Apple investors are facing the perfect storm of negative factors have combined into a hurricane of negative sentiment that has sent Apple's shares plunging.
That includes the worst market correction since 2009 (a 19.8% fall in the S&P 500 at its recent lows), as well as a general tech meltdown due to fears of slowing global growth.
Apple's bear market began after its latest earnings showed very strong growth in fiscal Q4:
But the forward-looking market instead chose to focus on two things. The first was the announcement that Apple would no longer be reporting individual unit sales on hardware, including the iPhone which accounted for 59% of last quarter's sales.
“The number of units sold in any 90-day period is not necessarily representative of the underlying strength of our business….if you look at our revenue during the last three years, if you look at our net income during the last three years, if you look at our stock price in the last three years, there is no correlation to the units sold in any given period.” - Luca Maestri, CFO
While CFO Luca Maestri's explanation for the change in reporting policy makes sense, the market chose to take a more cynical view. Specifically that Apple was anticipating that iPhone demand had peaked and would either remain flat over time or possibly even begin declining.
iPhone Unit Volumes By Quarter
That's certainly possible because, due to improving technology and lengthening upgrade cycles, global smartphone sales have slowed to a snail's pace. Analyst firm IDC estimates that from 2017 to 2022 global smartphone volumes will grow 2.8% annually from 1.5 billion to 1.7 billion.
Not helping the typical rumors of "peak iPhone" was a slew of Apple supplier guidance cuts in recent weeks have fueled rampant speculation that Apple iPhone sales were weaker than expected, and the company was significantly cutting supply orders.
That's partially why analyst medium-term revenue growth forecasts for Apple were recently just 4%. That's a far cry from the company's 16% sales growth in 2017, an estimated 16% growth in 2018, and 9% 5-year CAGR. But those much weaker revenue growth forecasts came before the company made its first inter-quarter guidance warning in 15 years.
Now analysts expect just 1.6% CAGR revenue growth for Apple between 2019 and 2021, which has launched a further wave of analyst downgrades. What induced this massive cut in Apple's forward outlook?
In January 2nd's letter to investors, CEO Tim Cook slashed the company's fiscal Q1 2019 (the holiday quarter) sales guidance by 8%, from an already low 3% growth rate to -5%.
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...over 100 percent of our year-over-year worldwide revenue decline, occurred in Greater China across iPhone, Mac and iPad...The government-reported GDP growth during the September quarter was the second lowest in the last 25 years. We believe the economic environment in China has been further impacted by rising trade tensions with the United States...the effects appeared to reach consumers as well, with traffic to our retail stores and our channel partners in China declining as the quarter progressed. And market data has shown that the contraction in Greater China’s smartphone market has been particularly sharp." - Tim Cook, (emphasis added)
As Cook pointed out, China (which represents about 20% of company sales) is the principle reason for Apple's YOY revenues shrinking in Q1. That's likely due to three main factors. The first is that China's economy, already slowing due to both demographics (shrinking labor force since 2014), and the government's attempts to pull back on debt-fueled growth (now reversed), has seen its growth rate slow to the second worst level since 1993.
Its important manufacturing sector has also started contracting. A PMI of 50 is neutral and any number below 50 indicates a manufacturing recession. In November, China's manufacturing PMI dipped below 50 and has continued falling in December.
The second big blow to Apple from China is in supply chain disruption. Q1 is when Apple typically launches most of its new products for the next year and thanks to the US/China trade war semiconductors, in particular, are being hit with tariffs that are only adding to the usual supply constraints the company typically faces.
Finally, there's the one/two blow of falling Chinese consumer spending and the arrest of Huawei's CFO.
Chinese YOY Retail Sales Growth
In December, Chinese retail spending growth fell to a 15-year low, likely a combination of declining overall economic growth (less hiring, slower wage growth), and rising uncertainties surrounding the trade war. While the US and China are negotiating an end to that, given that NAFTA 2.0 negotiations took 15 months between three close allies, the market may be worried that negotiations may either break down entirely or drag on well into 2020.
That lower spending is apparently deeply impacting smartphone sales overall, but especially at the premium end of the market. With Apple recently choosing to focus on raising iPhone prices (to as high as $1,449 for its flagship model), it's not surprising that it's facing a sharp drop-off in sales.
What's more, as my fellow contributor Paul Santos recently pointed out, the US-induced Canadian arresting of Huawei's CFO (and daughter of its founder) may have induced nationalistic backlash against Apple.
Following a diplomatic incident in 2012 (with Japan), Japanese car makers, who usually do well in China, saw their sales crash.
This is because the Chinese people are intensely proud and often willing to change short-term purchasing habits to make a political point. Many investors are worried that with Huawei's latest flagships (which offer state of the art features at lower price points), this temporary trade fight might potentially result in a permanent loss of market share for Apple in China.
But China is hardly the only growth concern for Apple. In the Q4 conference call, Tim Cook mentioned that Apple was seeing weakening sales from key emerging markets.
“The emerging markets that we are seeing pressure in our markets like Turkey, India, Brazil, Russia. These are markets where currencies have weakened over the recent period, in some cases that resulted in us raising prices and those markets are not growing the way we would like to see.” - Tim Cook
The combination of a rising dollar (the US is the only major economy with a positive inflation-adjusted central bank interest rate) and slowing economic growth has caused emerging market sales to disappoint. With Apple's developed country market share now saturated, countries like India, Brazil and Turkey were seen as the key to maintaining strong long-term sales growth.
But with the world's economic growth rate now steadily falling, these key markets are proving to be a disappointment, at least in the short term. The market is likely worried that this slowing growth may continue long enough to trigger a global recession.
So with Apple now confirming the fears of so many bears, does that mean that Apple's investment thesis is broken? Is this former darling of Wall Street poised to fall into an IBM-like decline where revenues fall for years on end and the share price languishes in the toilet?
Actually, I don't think so, and here's why.
First, it's important to remember that while sales are important, ultimately, the bottom line is what matters most. That's not just because stock prices are a function of earnings and cash flow, but because dividends are paid out of free cash flow (I view Apple primarily as a dividend growth investment).
While analysts have slashed medium-term sales forecasts for Apple, they are still expecting 7.3% EPS growth from 2019 to 2021. What's more, Tim Cook said in his letter that thanks to share buybacks "We also expect to report a new all-time record for Apple’s earnings per share."
So where it matters most Apple is likely to continue delivering growth, thanks in large part to the largest net cash position (cash minus debt) in corporate America. In fact, management now forecasts that Apple's net cash position (which it eventually wants to take to zero), will hit $130 billion in Q1. That's up from $123 billion last quarter and enough to repurchase 18.4% of shares at its current price ($148).
To put that figure in context since it began its epic buyback program the company has repurchased $239 billion and reduced its share count by 28%. And thanks to generating $61 billion in annual free cash flow, Apple's buybacks are likely to continue at a rapid clip even after its net cash position hits zero.
But IBM too has spent a fortune on buybacks over the years (over $40 billion in fact), and that hasn't made that former tech darling a great investment. Now it's certainly true that financial engineering is no substitute for positive company fundamentals. Fortunately, Apple's fundamentals are far from broken.
For instance, while it's true that certain emerging markets (like China) are currently falling off a cliff others are still doing well.
And, while we saw challenges in some emerging markets, others set records, including Mexico, Poland, Malaysia and Vietnam." - Tim Cook
What about the common fear investors have that Apple is steadily losing market share to Chinese rivals like Huawei and Xiaomi (XI)? Well, the data actually shows that Apple's aspirational brand strategy (premium luxury pricing) hasn't been hurting it in that key growth market.
Chinese Smartphone Market Share
Yes, Apple's market share in Q4 2018 is going to fall. But note that over the past year, it has remained stable and Apple, despite having the most expensive phones in the country, has remained China's 5th biggest phone seller by volume (and #1 in profits).
But the biggest reason I don't consider Apple's investment thesis broken (just mildly impaired) is that Apple has a rich history of pivoting to new growth opportunities over time. It started out as a computer maker, then pivoted to iPods, then iPhones, then added iPads. Now the company is focused on non-iPhone sales growth and that strategy continues to go well.
Wearables grew by almost 50 percent year-over-year, as Apple Watch and AirPods were wildly popular among holiday shoppers; launches of MacBook Air and Mac mini powered the Mac to year-over-year revenue growth and the launch of the new iPad Pro drove iPad to year-over-year double-digit revenue growth." -Tim Cook (emphasis added)
In total non-iPhone sales for Q1 grew 19% YOY, which indicates that Apple is unlikely to be facing a Nokia/IBM-style value trap/secular decline.
More importantly, we can't forget that Apple's biggest growth catalyst isn't hardware at all, but monetizing its massive installed base (now up to 1.4 billion iOS devices according to Cook), by growing subscription service revenue.
Thanks to massive success in its shift from hardware to recurring services subscriptions (50% subscriber growth in the past 12 months), Apple's goal of doubling its service revenues from $25 billion in 2016 to $50 billion by 2020 continues to run slightly ahead of schedule.
Since 2015, Apple's service revenue has grown by an average of 19%, and that growth rate has been steadily accelerating. Note that adjusting for a one-time accounting artifact in Q3 service revenue growth was 27%.
According to management's new guidance, Q1 service revenue will come in at $10.8 billion, representing 28% sales growth. How is Apple's highest-margin business managing to accelerate growth (off a steadily larger base) in the face of all the challenges we just saw?
Our non-iPhone businesses have less exposure to emerging markets, and the vast majority of Services revenue is related to the size of the installed base, not current period sales." - Tim Cook
That would be the fact that service revenue is not driven by short-term hardware sales but the company's proven ability to monetize its installed base, which continues to rise over time. Unlike IBM, whose execution has been terrible, Apple's execution of its long-term strategic growth plans remains on track.
If Apple is able to maintain its long-term average service growth rate then its service revenue (more stable and higher margin than hardware) will grow to massive levels in the coming years.
Year (Fiscal Year)
Services Annual Revenue
$52.7 billion ($50 billion target)
(Source: earnings releases)
Analyst firm Macquarie estimates that Apple's service gross margins are 75%, compared to about 65% for the iPhone and 38% at the company level. In Q1, the company will begin reporting cost of goods allowing us to confirm the profitability of its most important, fastest-growing and most stable business segment. If service revenues are indeed more profitable than iPhones, then Apple's profitability will improve over time, making earnings, free cash flow, and dividend growth easier.
Thus, the key to Apple's long-term success is not in maintaining strong annual growth in iPhone volumes, but in growing the overall install base. That will rely on the company's industry-leading brand loyalty and maintaining (not necessarily growing) market share.
Fortunately, according to 451 Research, customer satisfaction for iPhones is 98%, literally the best of any smartphone. What's more among business users (who are the least price sensitive), 80% plan to purchase an iPhone. And according to analyst firm Fluent, 80% of iPhone owners planned to buy another iPhone with 70% of survey respondents saying they wouldn’t even consider another phone.
While it's always possible that Apple's wide moat and sticky ecosystem can degrade over time, thus far, there is no indication that the company's loyal customers are abandoning its premium products. In fact, the strong sales growth of the Apple Watch, AirPods, and HomePods indicates that most consumers are happy to become ever more ensnared in its ecosystem.
Ultimately, this means that, while I'll be monitoring Apple's results very closely in 2019, for now, I consider the majority of the evidence to point to weak China sales as a temporary event. One that is likely to eventually end when the trade war does (a sentiment shared by Paulo Santos and Morningstar's Abhinav Davuluri).
Basically, I consider Apple's long-term thesis not broken, but merely slightly impaired. That means that Apple remains a great long-term dividend growth investment at today's beaten down prices.
The most important part of analyzing any dividend stock is the payout profile which consists of three parts, yield, dividend safety, and long-term growth potential. Combined with valuation, this is what tends to drive total returns over time.
|Company||Yield||Simply Safe Dividend Score||FCF Payout Ratio||10-Year Projected Earnings Growth (Analyst Consensus)||10-Year Potential Annual Total Return (No Valuation Change)|
Valuation-Adjusted Total Returns
|Apple||2.0%||95/100 (Very Safe)||21%||11.8%||13.8%||15.5% to 16.9%|
|S&P 500||2.1%||NA||33%||6.4%||8.5%||5% to 9.5%|
(Sources: Simply Safe Dividends, Gurufocus, Fast Graphs, Yardeni Research, Multpl.com, Moneychimp, Vanguard, Gordon Dividend Growth Model, Dividend Yield Theory, Morningstar)
Apple's yield, despite the massive price crash, is not anything special, basically matching that of the S&P 500. However, that dividend is one of the safest on Wall Street thanks to a very low payout ratio and the company's fortress-like balance sheet.
|Company||Debt/EBITDA||Interest Coverage Ratio||S&P Credit Rating||Interest Rate|
(Sources: Morningstar, earnings releases, Gurufocus, Fast Graphs)
Apple's debt levels are actually immaterial since the company only took on that debt to institute its buyback program pre-tax reform when most of its cash was overseas and subject to a 35% repatriation tax. Post-tax reform, Apple is free to bring that cash home at much cheaper tax rates and thus its $130 billion net cash position is what investors need to focus on. Apple plans to eventually repay all its debt as it matures and get down to zero leverage.
Of course, the big question on everyone's mind is what the guidance cut means for Apple's long-term growth prospects. While 2019 is likely to prove a challenging year thanks to ongoing weakness in China (trade negotiations might take six to 12 months or even longer), thus far, the analyst consensus on the company's long-term (10-year) EPS growth has only fallen by 1.3% and remains firmly in the double digits.
In 2016, Tim Cook stated that Apple plans to grow its dividend every year, and in May 2018, its CFO reiterated that guidance. Specifically, Luca Maestri specifically said the company knows its dividend "is very important to our investors who value income... and plans for annual dividend increases going forward." Apple has now raised its dividend for six straight years at an 11.5% CAGR (16% in 2018). For context, the average and median dividend growth rate for the S&P 500 since 1990 has been 6.0% and 6.4%, respectively.
Thus, while Apple's payout may not be superior to the market's, its growth rate certainly is. What's more even assuming that Apple merely maintains its very low payout ratio, and chooses to funnel most of its FCF into buybacks to grow EPS (likely), then Apple should be able to continue delivering double-digit dividend growth for the foreseeable future.
Since 1956, a relatively accurate total return model has been yield + long-term earnings/cash flow/dividend growth. This is called the Gordon Dividend Growth Model and it's what Brookfield Asset Management (BAM) uses for its own long-term return targets (they also add a valuation adjustment).
The reason this model works so well is that total returns are driven both by income (yield) and capital gains. Stock prices are ultimately a function of earnings/free cash flow (from which dividends are paid). Thus, assuming a stable payout ratio and valuation changes that cancel out over time, yield + long-term earnings/FCF per share growth is a good estimate of total returns.
The GDGM currently estimates that Apple shares will deliver about 14% long-term returns assuming no changes in valuation. For context, the S&P 500's historical CAGR total return is 9.2% and the GDGM is currently estimating the market will deliver about 8.5% long-term returns. Adjusting for valuations, the S&P 500 is likely to deliver 9% to 9.5% returns though Vanguard is less optimistic (5% to 8% expected returns over the next few years).
In either case, Apple is likely to be a market-beater thanks to its safe but fast-growing yield. And when we consider Apple's current valuation, even in the context of its challenging short-term risk outlook, then the company appears capable of delivering even better 16% to 17% long-term returns over the next decade or roughly double that of the market.
Thanks to its nearly 40% crash, Apple is now underperforming the S&P 500 over the past year. However, value investors get excited when they see charts like this because it means that this quality blue-chip dividend growth stock is now on sale.
|Forward P/E Ratio||5-Year Average Forward P/E ratio||Implied 10-Year EPS Growth Rate|
Analyst Consensus 10-Year EPS Growth
Buyback Driven EPS Growth (Only Retained Annual FCF)
(Sources: Simply Safe Dividends, Fast Graphs, Benjamin Graham)
Apple's forward P/E is now just 12.3, far below its five-year average. Note that that average is itself low because slowing growth concerns are nothing new for Apple. That valuation currently bakes in just 2.5% long-term EPS growth. Even if you think analyst growth forecasts are going to fall off a cliff, Apple's retained annual FCF (FCF minus dividend) is capable of driving almost three times that EPS growth via buybacks in the coming years from its current valuation. And that ignores the $130 billion in net cash which could repurchase close to 20% of Apple's shares.
This means that Apple's shares are now pricing in all its risks and then some. In fact, the market's pessimism is so great on Apple that the company has to merely maintain stable revenue (zero sales growth for 10 years) and buybacks alone will likely result in significant multiple expansion and boost total returns above that predicted by the GDGM. For the current multiple to be justified, Apple's revenues would have to decline by 4.3% annually over the next decade.
Or to put it another way, Apple is still likely to beat the market's total returns on yield and dividend growth even if it becomes the next IBM, and its top line stagnates for the next 10 years. And if Apple is able to achieve even modest top line growth then it will see significant multiple expansion that will drive great returns. How much of a valuation boost are we talking about?
To answer that, we have to estimate how undervalued Apple currently is. My favorite method for this is called dividend yield theory or DYT. This is the exclusive valuation/investing strategy of asset manager/newsletter publisher Investment Quality Trends, who has been using it for 52 years to generate 10% market outperformance with 10% lower volatility.
DYT simply compares a stock's yield to its historical yield. Unless a company's thesis breaks, yields tend to be mean reverting and return to fairly stable levels over time that approximate fair value.
|Yield||5-year average yield||6-year median yield||6-Year Yield Range|
Estimated Fair Value Yield
|2.0%||1.7%||1.7%||0.4% to 2.8%||1.7%|
(Sources: Dividend Yield Theory, Simply Safe Dividend, Gurufocus)
Since reinstating the dividend, Apple's yield has fluctuated from 0.4% to 2.8%. But over the past five years, its average has been 1.7%. And over the past six years, the median yield (50% of the time the yield is higher and 50% lower) has also been 1.7%. So under DYT, a time-tested and highly effective valuation model for blue-chip dividend growth stocks like this, Apple's fair value yield appears to be 1.7% implying an intrinsic value of $172.
|Estimated Fair Value||Discount To Fair Value||Long-Term Valuation Return Boost||Expected Total Return (From Fair Value)|
Valuation Adjusted Total Return
(Sources: Dividend Yield Theory, Simply Safe Dividend, Gurufocus, Fast Graphs, Moneychimp, Gordon Dividend Growth Model)
That translates into a 15% discount to fair value or 18% upside from the current price. Over the next decade, assuming that Apple will be fairly valued in 2029, that means shares should outpace earnings/FCF/dividends by 1.7% per year. Add that to the GDGM's total return estimate and you get a 10-year total return potential of 15.5%. This is about 70% better than the S&P 500 (9% to 9.5%) is likely to deliver.
Of course, DYT is just one of many valuation methods you can use. To confirm whether or not Apple is as undervalued as DYT suggests, let's take a look at Morningstar's three-stage discounted cash flow analysis.
|Morningstar Fair Value||Discount To Fair Value||Valuation Boost|
Valuation Adjusted Total Return
Morningstar analysts are famous for a pure long-term fundamental focus, as well as conservative growth estimates that are usually far below that of most analysts (or even management guidance). Morningstar believes the guidance cut and 2019 weakness in China is a temporary event that will disappear when the trade war ends. Thus, it is maintaining its fair value estimate of $200, which implies Apple is actually 26% undervalued.
If Morningstar is right, then Apple is likely to actually generate close to 17% long-term total returns or roughly double that of the market over the coming decade.
The point is that Apple's massive sell-off has more than priced in its temporarily elevated risk profile. In fact, shares are now priced as if all its potential worst-case scenarios will come to pass and revenues will fall about 4% annually over the next decade.
If you believe, as I do, that Apple's non-iPhone businesses will allow it to generate even modest top line growth (and double-digit buyback fueled EPS growth) then today Apple is a very strong buy.
Don't get me wrong, I'm not a market timer and am NOT predicting that Apple has necessarily bottomed yet. It's possible shares still have lower to fall due to the worst growth scare in years. But what I do know is that the company's long-term investment thesis, while slightly dinged, has not been shattered as the recent plunge would have you believe.
Apple's long-term strategy of achieving modest top-line growth through strong non-iPhone hardware sales and even stronger high-margin service revenue growth remains firmly intact. And since the company's epic buybacks will be enough to grow its bottom line at a fast rate and likely deliver double-digit dividend growth for the foreseeable future I'm more than happy to place a "strong buy" on Apple today.
That's why the Deep Value Dividend Growth Portfolio took the opportunity to double its position in Apple on January 3rd. And in mid-February, if the stock continues to languish in the toilet, we'll boost our position by another 25% (assuming earnings results on January 29th aren't catastrophic).
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