MorningWord 9/29/15: $AAPL Turnover

by Dan September 29, 2015 9:37 am • Commentary

Shares of Apple (AAPL), showed decent relative strength yesterday. On a day when the S&P 500 (SPX) closed down 2.5% and the Nasdaq Composite down 3% Apple shares were down just 2%. Investors seemed to be pleased with the first weekend iPhone sales record of 13 million for the 6s & 6s+. That record comes with an asterisk because last year’s 10 million first weekend units sold did not include China. This year’s does.

Last night I had a discussion with a sophisticated high net worth investor who is a long time AAPL holder. He made the same statement I often hear from long time holders, “I’d rather own Apple than the S&P 500”. But that was followed this question, “why is AAPL no longer working?”

For answers to that question I’ll start with an anecdotal observation and then move on to fundamentals . First the anecdotal. I’m a guy who loves their products (most of them) and has great admiration for the company and their brand. I have bought every iPhone since its introduction in 2007.  After messing around with my new iPhone 6s on Friday, I packed it up and returned it to Cupertino the next day. It’s simply not worth the $750 to upgrade from an iPhone 6 to the 6s . It’s a great phone. iPhone 5s users will be extremely happy with it as the larger size from 5 to 6 is still a major differentiation, and I suspect most Samsung Galaxy users tempted by the AAPL ecosystem will be too. Just not for my money when I already own the 6. Yes this is anecdotal, but it’s important. Apple is the iPhone company. iOS accounts for 70% of their earnings. Therefore upgrade cycles must do much more than just marginally improve the previous device with refinements.

Now to the fundamentals. Simply put, AAPL is no longer a no brainer of an investment. At least for the next year or two. Here’s why:

  1. iPhone Unit Growth: The iPhone 6 & 6 plus’s increase in size caused a massive upgrade cycle.  Size was the thing iPhone was lacking in most markets outside the U.S. Comparisons to last year’s unit growth of 25% will be tough off of such a large base with what appears to be a very incremental upgrade. So the big fear is that iPhone unit growth will slow at a time where new iPad, wearables and services have shown little signs to pick up the slack.
  2. Buybacks and dividends: 80 some percent of the company’s $203 billion in cash is overseas, to increase and continue to fund capital return to the tune of their existing $200 billion commitment, they will need to continue to add to their $55 billion debt load, and are in dire need of an offshore tax amnesty (which Carl Icahn discussed last night in his video Danger Ahead).  Tim Cook may need to get behind a Trump candidacy to grow their capital return beyond 2016.
  3. Earnings and Sales Growth: Even with these buybacks, AAPL is only expected to grow earnings 7% year over year next year in fiscal 2016 (with expected sales growth of 6%).
  4. U.S. Dollar: 60% of AAPL’s sales last year came from outside the U.S., this is only increasing, while China represents about 25% of total iPhone sales. Its our view that dollar strength is here to stay in the global economic environment we are in.

So what do you pay for a company that remains universally loved in both products and the stock but is challenged by the law of large numbers of being the largest market cap company in the world? AAPL is expected to grow sales in fiscal 2015 (completed tomorrow) 28% from $183 billion last year to $233 billion this year. This eye-popping growth was the result of the larges upgrade cycle and the largest geographic expansion of the iPhone since its inception.

It feels like Tim Cook has placed AAPL’s future on the growing middle class in China.  But while China remains a long term growth opportunity, in the near term, it could be a stumbling block if Chinese consumption takes a hit. The fact that an iPhone costs nearly 14% of the annual household income in China means iPhones can go from the aspirational product they’ve become, back into a luxury product they were a few years ago.

It’s been our view for months that AAPL stock is dead money. In a post on Friday (here) we detailed an options strategy for AAPL holders to protect their long stock during this market uncertainty. This is how we defined dead money in that post:

the stock was incorporating a lot of good news and positive sentiment and in the best case scenario was likely to go sideways (read here from June 23rd), but also ran the risk of a correction if the company did not deliver on new innovative products (despite their increasing dominance with the iPhone)

So that’s the bear case for AAPL.  With the stock down 16% from the all time highs made in April, and up about 19% from its August 24th panic opening, the range is probably in for the stock (barring a market crash) for 2015. We think new highs are very UNLIKELY in 2015, and $100 should serve as fairly important technical and valuation support.

But the question remains. What do you pay for a company of this size who does not appear to be innovating the way it had prior to 2010. One that will struggle mightily to get back to double digit earnings and sales growth anytime soon??

The balance sheet is rock solid, but using it to do accelerated buybacks to defend the stock the way they have in the last couple years will become more challenging.

Could there be surprises with wearables and services? No doubt about it, but not to the tune of tens of billions of dollars in the next year, which will be what it will take to offset any decline in growth of iPhone and spur high single digit growth.

Oh and one more thing. That little business of CEO Tim Cook putting himself out there on China growth in his August email to CNBC’s Jim Cramer? Well, that’s the sort of thing that could dog him for quarters, if not years.

Nike’s reported results and futures orders (last week) reflected a fairly strong picture for Chinese consumption, which many analysts/investors/pundits were quick to extrapolate to AAPL.  We will see if this is the case when AAPL reports fiscal Q4 on October 27th and more importantly offers Q1 guidance.  As of last night’s close the options market was implying about a $11 move in either direction (or about 10%) between now and the close on Friday October 30th.  On the day of AAPL’s Q3 earnings on July 22nd the implied move for that report was about 5%.  This will be interesting to track of the next few weeks as we get reports from those in AAPL supply chain and their competition, and the generally mood in the market.

So would I still rather own AAPL than the S&P 500 here? Probably, but I don’t expect either to be at new highs anytime soon. If you want to stay long AAPL I like the idea of slapping on some disaster protection (although I most prefer cash for the time being).  Few thought AAPL’s 45% peak to trough decline from Sept 2012 to June 2013 was likely in a bull market. It’s certainly a distinct possibility in what could be an emerging bear market.