Apple is in the midst of its weakest growth period in 15 years. Despite deteriorating financial trends, Apple's stock has held up remarkably well in 2016. There are a number of clues that suggest we are in the latter stages of a major Apple expectations reset on Wall Street. The implications are significant not just for AAPL, but also for the amount of leeway given to Tim Cook and Luca Maestri over the next two to three years.
AAPL: The Growth Stock
On May 22nd, 2015, Apple's prospects were running high. AAPL shares had just closed at an all-time high of $132.54, giving the company a $769 billion market cap. Excluding the cash and cash equivalents on the balance sheet, Apple's enterprise value was $619 billion. Three weeks earlier, Apple had reported record 2Q15 earnings. The iPhone 6 and 6 Plus drove strong 40% year-over-year growth in iPhone unit sales. In addition, Apple had just experienced its largest product category launch ever with Apple Watch. Expectations were that the Watch would quickly become a key Apple revenue driver.
While a few analysts voiced concerns about Apple's dependency on the iPhone for revenue and profits, there were others projecting Apple would become the first trillion dollar market cap company. Apple financial expectations were quite high as many analysts and investors were modeling 20%+ EPS growth in 2016 and 2017. Apple was the largest growth stock on Wall Street.
The Apple Reset
Over the subsequent three months following AAPL's record-high close in May 2015, AAPL shares declined 20%. The Chinese stock market had crashed, and fears began to grow that there could be a spillover effect on iPhone demand. Wall Street eventually began to doubt whether or not Apple would be able to maintain its revenue and earnings growth rates given China's slowing economy.
In October 2015, only a few weeks after the iPhone 6s and 6s Plus launch, reports surfaced that the new iPhones were not selling as strongly as expected. While the iPhone business had contained so much promise just a few months earlier, things were beginning to look much more fragile. Analysts began to cut their iPhone sales estimates on growing fear that the iPhone business was headed into a rough patch.
Apple's 1Q16 earnings report back in January confirmed that fear. Apple was able to grow iPhone sales by a mere 311,000 units year-over-year, and management's 2Q16 guidance implied Apple would report its first year-over-year decline in iPhone sales. Meanwhile, Apple Watch sales were not living up to Wall Street's lofty expectations.
In the days following Apple's miserable 2Q16 earnings report this past April, expectations took another step down, resulting in AAPL shares bottoming at $90.34 on May 12th, 2016. During the twelve-month span ranging from May 2015 to May 2016, AAPL shares had declined by 32%, wiping out $271 billion of market cap. Excluding cash and cash equivalents, Apple's enterprise value had declined by $274 billion. Apple had just gone through a year-long expectations reset concluding with Apple no longer being considered a growth stock.
The Expectations Game
Apple's reset over the past year has been guided by Wall Street's expectations game. Analysts and investors make projections about a company's future stream of cash flows and earnings. These expectations help explain how one company's stock can perform poorly the day after reporting strong earnings while another company's stock can outperform the market after posting a weak earnings report.
Apple suffered from two primary problems pertaining to the expectations game. Management never had a cohesive narrative for how investors and analysts should judge Apple's financial success. In addition, there was evidence that Apple management was caught off guard by slowing iPhone 6s and 6s Plus sales, which made it difficult to communicate clarity with top Apple shareholders and analysts.
Establishing a Narrative. A narrative provides a management team an avenue to explain its business to analysts and investors. Companies can use everything from SEC filings to the prepared remarks found in the beginning of a quarterly earnings conference call to help establish and then nurture a narrative. The strongest Wall Street narratives are those that are easiest to explain and understand. Examples of well-received narratives include Facebook owning the most attractive mobile properties for advertisers or Amazon forgoing near-term profits in order to invest in long-term investments and bets. For each narrative, investors monitor certain financial metrics in order to judge how a management team is performing in comparison to benchmarks.
When it came to Apple, the company has never had a functioning narrative on Wall Street. Instead, the only way investors have come to judge Apple's success has been to look at whatever hardware product was the top seller at any given moment. In the early 2000s, it was the Mac and iPod. Eventually, the focus turned to the iPhone, and soon, iPad. Once the iPad ran into sales trouble, the iPhone then became the center of attention. Nothing else mattered but iPhone unit sales growth. This was a recipe for disaster considering how Apple's business model is based on profit share, not market share. Once iPhone unit sales growth slowed, the closest thing Apple had to a Wall Street narrative fell apart.
Managing Financial Expectations. Companies have additional tools at their disposal to help guide investor's near-term expectations. Providing financial guidance is one of the more common methods used to establish an adequate framework for expectations. Management teams can issue estimate ranges for what they think is achievable in terms of revenue, income, or metrics such as monthly users. Another option that is less talked about, but at times far more effective, is for management teams to keep open communication channels with top shareholders and financial analysts.
Even though Tim Cook and Luca Maestri have been providing quarterly guidance as well as communicating with top shareholders, the two were not able to adequately manage financial expectations surrounding the iPhone business. There is evidence that even Apple management themselves were caught off guard by slowing iPhone sales and that this contributed to the lack of proper messaging and explanation.
AAPL: The Value Stock
After a year-long expectations reset that saw a 30% drop in Apple's stock price, there is evidence that AAPL is now considered a value stock on Wall Street. This new distinction is likely playing a big role in Apple's resilient stock price in the face of deteriorating financial trends. As AAPL shares declined over the past year, Apple's shareholder base underwent significant changes. Investors focused on earnings growth sold their shares to investors primarily focused on value. This shareholder rotation has led to the average Apple investor now holding very different opinions about Apple and how to judge financial success.
In what will likely end up serving as a symbol of Apple's newly appointed value stock distinction, Todd Combs and Ted Weschler of Berkshire Hathaway bought a $1 billion stake in Apple in 1Q16. To have such value-oriented investors take a stake in Apple is quite telling.
There are three key implications related to AAPL now being considered a value stock.
Different Expectations. Given shareholder rotation, Apple now faces different expectations when it comes to its financial performance. Wall Street has become much more accepting of what was once unimaginable only a few months ago, iPhone sales declines. This change in expectations will play a role in Apple's earnings release next week as the company is expected to report the weakest quarter for iPhone sales performance since the product launched in 2007. (My complete Apple 3Q16 earnings preview is available here.)
Management Flexibility. Given the amount of shareholder rotation and reduced expectations surrounding growth, Tim Cook and Luca Maestri have been given additional time by Wall Street to position Apple for a post-iPhone era. It remains in Apple's best interest to come up with a long-term narrative that includes some aspect of hardware but is not based on unit sales.
Capital Management. Apple's capital management strategy will play an increasingly important role for value-oriented investors. Apple's announcements surrounding annual dividend increases and share buyback authorization changes will likely garner much more interest.
The Big Picture
Apple's stock has hit rough stretches in the past. However, this most recent drop and the resulting expectations reset stands out from the rest. For the first time, Wall Street is dealing with an Apple with declining revenue. In the past, Apple revenue declines were only discussed as worst-case scenarios. The reality of what is taking place in the iPhone business has likely shaken the AAPL investor base much more than any other event over the past 15 years.
While it may seem like this kind of expectations reset should have resulted in more than a 30% drop in Apple's stock price over the past year, I suspect Apple's share buyback program will provide some much-needed answers. Management has been buying back approximately $30 billion of AAPL shares per year. This is an unprecedented amount of buyback. Since 2012, Apple has bought back 16% of its shares outstanding. These were shares formerly held by investors with expectations of Apple as a growth stock. Accordingly, Apple's buyback program played a role in rotating Apple's shareholder base by removing shares that would have otherwise been sold to other investors in the marketplace.
One sign that a company's expectations have truly been reset is that company's stock price increases on negative news. This serves as an indicator that the investor base has likely been flushed out and expectations have been reset. We will be able to test this theory when Apple releases its 3Q16 earnings report.
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