For the past few years, Apple shares have been judged by one metric on Wall Street: iPhone unit sales. As iPhone growth has fluctuated, so has the stock price. Analysts have been infatuated with quarterly iPhone sales gyrations and the impact they may have on Apple earnings and the stock. However, things are changing. The iPhone’s influence over Apple’s stock is subsiding on Wall Street.
Over the past five years, Apple shares have been volatile. As seen in Exhibit 1, Apple's stock has experienced distinct stretches of severe underperformance and outperformance. For a company valued at more than $700B, a 70% move in a year is surprising, if not downright shocking.
Exhibit 1: Apple Stock Price Performance
Five years of Apple stock price performance can be broken into four distinct eras:
- Samsung competitive fears. The 2012 to 2013 period was symbolized by Samsung commercials mocking Apple users waiting in line to buy small screen iPhones. The market was beginning to demand larger smartphone screens, and Samsung was running fast to fill the need. There were growing fears of iPhone losing to smartphones running Android, resulting in lower iPhone ASP and margins. Apple shares dropped nearly 45% over this stretch.
- iPhone 6 and 6 Plus excitement. The iPhone launch at China Mobile, along with Apple's entry into large screen phones, drove a two-year stretch that saw Apple shares more than double in price. iPhone sales growth returned with a vengeance, with quarterly shipment growth up as high as 46% in late 2014.
- iPhone's first sales decline. Once the excitement surrounding the iPhone 6 and 6 Plus launch subsided, the new reality set in for the iPhone business. iPhone warning signs were appearing. The era of significant unit sales growth was coming to an end. The iPhone business registered its first quarterly sales decline in early 2016. During this period, Apple shares fell 30% from the previous high.
- Something new. Apple shares are now up nearly 70% from the low experienced in mid-2016.
Over the past year, AAPL shares have outperformed the overall market. There are now questions regarding what has driven a 53% increase in Apple's stock price from the bottom experienced in May 2016.
- Is Apple's services narrative finally catching on Wall Street?
- Are investors becoming increasingly optimistic about iPhone sales prospects?
Apple has become much more vocal in telling its services story. Management went so far as to provide a rare financial projection of doubling the Services business over the next four years. While Apple analysts have certainly been talking more about Apple services, it's not clear if new investors have actually bought into Apple's new messaging. At the same time, greater attention is being placed on the upcoming OLED iPhone, which may be the most significant iPhone update to date. Not only is Apple expected to announce a completely redesigned iPhone, but the device will likely include significant changes to the user experience. Some analysts have been adamant that the device will kick off a "mega upgrade cycle."
It may be easy to assume Apple services or new iPhones may have been responsible for much of Apple's latest stock outperformance. However, I don't think those factors alone were able to drive a 50% increase in Apple's share price.
Services represents less than 15% of Apple's overall revenue. Truly recurring services revenue in the form of subscription revenue occupies an even smaller portion of that total. It is a stretch to argue that such a small piece of the business can drive what amounts to nearly $250 billion of market capitalization gains in a little over a year. There would need to be a widespread change across Wall Street when it comes to investor attitude towards Apple services, and there just isn't any evidence of that occurring.
In terms of a new iPhone driving a mega upgrade cycle, consensus EPS estimates have barely budged for FY2018. This tells us there isn't widespread optimism flooding into the market. In fact, the trend has actually been for Apple EPS estimate cuts as talk of iPhone supply issues and potential delays grow louder.
Exhibit 2 takes Apple's stock price data from Exhibit 1 and superimposes iPhone unit sales growth (set on a three-month forward basis to account for investors' forward-looking tendencies). As clearly seen in Exhibit 2, Apple shares have skyrocketed over the past year despite a lack of iPhone sales growth. This represents a significant change from previous years. Something just doesn't add up.
Exhibit 2: iPhone Unit Sales Growth vs. Apple Stock Price Performance
One may look at Exhibit 2 and argue that Wall Street is taking a longer view of the iPhone business. Instead of just looking at the next quarter of iPhone sales, the focus is on 2018 and even 2019 sales. That could very well be true. However, it may not be that investors are necessarily expecting the iPhone business to return to some kind of sustainable growth. In what is the most telling sign that something unusual is occurring, rumors of iPhone supply issues and delays that would typically send Apple shares sliding now seemingly have no impact on the stock. Something major has changed regarding how Wall Street is thinking about Apple.
Balance Sheet Optimization
My theory is that the iPhone no longer has the same kind of influence over Apple shares as it once did. Instead, Apple has turned into a balance sheet optimization story on Wall Street. Apple's growing net cash balance (now standing at an all-time high of $158 billion) has taken the place of iPhone unit sales growth as the most influential variable impacting Apple shares.
The best way to lay out this theory is to compare Apple's stock price performance to the change in market capitalization. As seen in Exhibit 3, over the past five years, the two data points have increasingly been on a divergent path. Apple's stock price is up 74% while its market capitalization has increased just 35%. Apple's enterprise value (market cap + debt - cash) is up just 36%. Why is Apple's share price significantly outperforming the company's overall change in valuation on Wall Street? The share buyback program is impacting Apple's share price.
Exhibit 3: Apple Stock Price vs. Market Cap Performance
Apple management is using share repurchases to funnel excess cash from the balance sheet to shareholders selling their Apple shares. This not only reduced the number of Apple shares outstanding, but also gave each remaining share a larger ownership claim to Apple's future cash flows and earnings. It's not that share buyback is creating shareholder value with excess cash simply moving from the balance sheet to those selling their shares. Instead, investors are now willing to pay more for Apple's future cash flows and earnings.
There are a few reasons likely driving this higher valuation of future Apple cash flows.
- Higher ownership stake. As Apple uses excess cash to reduce the number of shares outstanding, each remaining Apple share has a higher ownership stake in a more optimized balance sheet and cash flows. This has led to a significant increase in EPS. Over the past five years, Apple's operating income has increased just 15%. However, Apple's EPS has increased 45%. As long as Apple continues to use excess cash and low-cost debt to buy back shares, this trend will continue indefinitely.
- Apple cash discount. While it may seem counterintuitive, it's actually not wise for a company to hold a significant amount of excess cash on the balance sheet. Apple was likely being penalized for holding so much cash. Another way of saying this is that investors were not fully valuing the $150B of net cash sitting on the balance sheet. This would materialize via below-average price-to-earnings (P/E) multiples. Investors just weren't interested in paying up for the full amount of cash on the balance sheet (technically, the amount of cash left over once Apple brought its foreign cash back to the U.S. at a lower tax rate). There is plenty of financial theory behind investors pricing excess cash at a discount, including fear of management misusing the cash on bad M&A or other improper uses.
- Expectations for additional capital management. Wall Street is forward-looking and with $240B of foreign cash and cash equivalents sitting on Apple's balance sheet, investors are increasingly contemplating various use cases for the cash if it is returned to the U.S. The most likely outcome would be a significant increase in the share buyback pace. At that point, a Dutch auction tender offer would even be a possibility. This would reduce the number of Apple shares outstanding by up to another 25% (which would boost EPS even higher).
- Shareholder base. Share repurchases are systemically shrinking Apple's shareholder base. Apple has reduced the number of outstanding shares by 20% since kicking off its buyback program. Apple investors who have done nothing but hold on to their shares over the past five years would have seen their ownership stake in Apple grow by 20%. As a result, long-term shareholders who have bought into the Apple story are gradually becoming larger Apple owners over time. While some of these holders may not be comfortable with their Apple stakes continuing to grow and represent an outsized portion of their portfolios, in theory, Apple is relying on fewer investors to buy into its narrative.
One unintended consequence of Apple's cash hoard gaining influence over Apple shares is that the iPhone no longer has the same kind influence it once did. This isn't to say that Wall Street ignores iPhone trends. The vast majority of free cash flow used for share buyback is coming from iPhone sales. The key difference is that Wall Street has grown less concerned about the quarterly gyration in iPhone sales. In the grand scheme of things, there is little difference between Apple selling 200M iPhones per year and 300M iPhones per year. It also doesn't matter if a new iPhone is delayed by a few months. These are relatively minor details that just don't matter in terms of the big picture. I suspect this is why ongoing iPhone delay rumors are having little impact on the stock. In addition, Apple's ongoing iPhone sales pressure and troubles in China and India are no longer viewed as significant hiccups that could derail the stock. Both countries combined represent approximately 20% of overall iPhone sales. U.S. and European sales strength would likely be enough to maintain the iPhone's current sales level.
Warren Buffett Symbolism
Warren Buffett's recent purchases of Apple shares over the span of less than a year (the stake is now worth $20 billion) symbolize how Wall Street is thinking differently about Apple. While Buffett is on record talking about how the iPhone is such a compelling consumer product, his comments regarding share buyback are quite telling.
Here's Buffett back in May on his Apple investment:
"Well the shares when we bought 'em, at least, were much more reasonable in relation to current earnings. Apple didn't have to do a lot better in the future than they were doing at the current time."
It's not that Buffett expects any significant change in Apple's business going forward. Instead, he viewed Apple's valuation as compelling given Apple's current performance. This begs the question, why now? Why didn't Buffett buy Apple years ago when the valuation was lower? Buffett claims he now understands the competitive landscape facing Apple. However, my suspicion is that Apple's balance sheet optimization story had simply become too hard for Buffett to ignore. Here's Buffett back in February responding to questions about Apple's market cap being too large to grow from here in any significant way:
"[Y]ou could have a lot fewer [Apple] shares outstanding at some time and still do very well on a per share basis. [Apple management] bought about 4 percent of the company last year. And they've been pretty, pretty aggressive on that. So my guess is they've got about 5.25 billion shares outstanding now, but my guess is that ten years from now they'll have substantially fewer."
Buffett is buying Apple because he has confidence that the iPhone business is a good cash generating machine that can fund aggressive share buyback. The Apple story on Wall Street now revolves just as much around the company's balance sheet and significant cash balances as it does around the iPhone business.
There are a number of implications related to Wall Street thinking differently about Apple.
1) Apple earnings will take on a different meaning. While quarterly earnings will still matter from the perspective of providing a window into Apple's current business trends, the way Wall Street responds to earnings will change. There will be less focus on weak/strong guidance or a beat/miss to iPhone or iPad sales. Instead, the focus will be on whether the overall Apple story has changed. This new reality will actually make it more important than ever for market observers to possess a longer view of Apple. Fresh and unique perspective will be needed to assess just how Apple's long-term competitive positioning is holding up.
2) Share buyback will continue to gain importance. The single biggest factor impacting Apple shares isn't the upcoming new iPhone or competition with Amazon or WeChat. Instead, it's the probability of Washington passing U.S. corporate tax reform, including a lower tax rate for bringing offshore cash back to the U.S. Apple is poised to spend a significant portion of its $240B of excess cash currently sitting in foreign subsidiaries on buyback, assuming it can be bought back at a lower tax rate.
3) A potential new long-term Apple story. Apple still lacks a compelling business narrative on Wall Street. For analysts and investors focused on modeling Apple's forward cash flows, a company that sells customer experiences comprised of hardware, software, and services isn't exactly the easiest company to forecast. Of course, there is also unknown found with companies like Amazon, Facebook, and Alphabet. However, those companies have easier (and simpler) narratives revolving around non-hardware revenue. There is no evidence to suggest that Apple is now viewed as a design company focused on something much larger than just selling hardware. Apple's R&D pipeline, an item that plays a critical part in the company's mission statement of coming up with future product that can improve people's lives, is still not valued on Wall Street.
This dynamic presents an interesting theory as to Apple's future as a public company. The notion of Apple being considered some kind of annuity with recurring hardware and software revenue may never catch on Wall Street. At the end of the day, Apple's future will always be focused on coming up with new products. This makes it incredibly difficult for investors to model Apple cash flows going forward. What if Apple were instead viewed as a balance sheet stock? The company would go through cycles based on a varying degree of share repurchases. These repurchases would be based on the company's ability to generate strong cash flows. For example, we are currently in the cycle in which iPhone is funding share repurchases. In the future, we may see Apple AR glasses or transportation initiatives fund share repurchases. Simply put, regardless of Apple's product line at any particular moment, investors will likely remain more focused on Apple's balance sheet and cash levels. As a result, Apple's future as a public company would be one of a cash generating machine supporting the largest share repurchase program in the world.
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