AAPL has had a rough two months. The shares are down nearly 20% from all-time highs, shedding $275 billion of market cap in eight weeks. Unprecedented does a good job of describing the fall’s magnitude and speed.
Apple’s dramatic stock price drop is now leading to a surge in pessimism towards the company. An increasing number of Apple management’s actions are being questioned while criticism is being thrown at various Apple products. In reality, most of this criticism is nothing more than a byproduct of a declining stock price. This has happened before, and a closer examination of previous stock price drops suggest Apple management will use the lower AAPL share price to its advantage by leveraging its share buyback program.
Why Is AAPL Down?
Surfing through Twitter over the long Thanksgiving weekend led to some Apple-related observations. There was no shortage of reasons being passed around for why the company’s stock price was in free fall:
Apparently, no one is buying the newest iPhones because they are too expensive.
Management must want to hide something really bad by no longer disclosing unit sales data.
Apple’s fortunes in China continue to sour.
In essence, there was a surge in fear, doubt, uncertainty, and overreaction.
People love to come up with reasons for why a particular stock or market index is up or down on any given day. Much of this is due to the human desire to add clarity to what is an inherently unknown process. Unfortunately, the only way to figure out why Apple’s stock price dropped more than 20% would be to poll every market participant as to why he or she sold or bought shares. Obviously, this isn’t feasible.
We know a few developments took place in recent weeks:
Apple provided slightly weaker-than-expected 1Q19 revenue guidance and cautious commentary. Management cited uncertainty around supply for some of the new products, slowing demand in emerging markets (India, Turkey, Brazil, and Russia), and foreign currency headwinds.
Apple announced it would no longer provide unit sales data, which came as a shock to Wall Street, who as a collective body relied on unit sales as a financial crutch. While consensus has been negative on the move, management’s decision makes sense given how unit sales have been telling us less about business fundamentals over time.
Apple EPS estimates are being revised lower. While every analyst is guided by different motivations, many have cited Apple’s 1Q19 guidance and weaker demand for flagship iPhones as driving their lower estimates. Over the past month, FY2019 EPS estimates have been cut by 2% although many analysts have yet to update numbers. My FY2019 EPS estimate was cut by 7% due to a higher tax rate going forward and lower revenue attributed to a number of product categories. Above Avalon members have access to my current earnings model here.
The broader stock market has been in disarray. The four largest companies saw nearly $800 billion of market cap wiped away in less than two months. On a combined basis, Apple and Amazon saw more than $500 billion in market cap evaporate.
While some market participants may have been swayed by one or more of the preceding developments, others may have been guided by unrelated matters. Accordingly, the most accurate explanation for why Apple shares lost $275 billion in market cap is because Apple shares were down. Selling pressure begets more selling pressure.
We’ve Heard This Song Before
Apple’s stock price has never been immune from rough patches. Prior to 2018, the most recent downturn occurred in 2015 and 2016. Over the course of a year, the stock traded down 30% from an adjusted $124 to $87. There was even a two-month span from November 2015 to January 2016 in which shares fell nearly 20%, reminiscent of AAPL’s recent downturn.
The 2015 and 2016 stock price decline was set within an environment of slowing iPhone sales. In November 2015, Apple provided weak 1Q16 revenue guidance. The implication was that iPhone unit sales growth would soon evaporate despite Apple having just reported 37% unit sales growth in FY2015. Wall Street quickly turned its attention to 2Q16 guidance to determine if iPhone sales weakness would be temporary or a longer-term trend.
Three months later, Apple’s 2Q16 guidance not only implied even weaker iPhone sales, but also an overall year-over-year decline in revenue. Many market observers became concerned about the long-term health of the iPhone business. Analysts fumbled over each other in a rush to cut estimates. AAPL shares ended up bottoming three months later and then went on to see two years of gains totaling 150%. Apple added $600 billion of market cap during this time period as its forward P/E multiple increased from less than 10x to 15x.
Apple went through an even steeper stock price decline in 2012 and 2013 when shares fell 37% from an adjusted $69 to $44. However, the circumstances around that decline were quite a bit different. Apple’s gross margins were evaporating due to the iPad mini launch. Apple’s revenue growth then began to slow as iPad sales imploded. There were also genuine fears in the marketplace that the iPhone would lose at the hands of Android smartphone manufacturers. In summary, the worry was that Apple’s long-term gross margin picture would deteriorate, resulting in less profits and cash flow.
Looking back at previous AAPL downturns, a few takeaways become apparent:
Expectations reset. AAPL shares faced an earnings expectations reset. Either gross margin projections were dialed back or the company’s revenue growth projections were cut. Both changes had a negative impact on earnings expectations.
Negative sentiment. The broader narrative around Apple had turned remarkably negative. In 2012 and 2013 it was about competition driving lower margins while in 2015 and 2016, it was based more on a slowing iPhone upgrade cycle.
Bottoming process. AAPL shares put in a trough once market commenters and analysts stopped trying to call a bottom and instead assumed the stock would keep falling. In essence, once people stopping paying attention to AAPL and expectations had been reset, the shares were in a better position to begin outperforming.
It shouldn’t come as a surprise that the most recent AAPL stock price move is taking place during an earnings expectation reset. Analysts are cutting estimates due Apple’s 1Q19 revenue guidance and fears of slowing iPhone sales although it is debatable if overall iPhone demand is actually that much different from that of previous quarters. In my view, fears of an iPhone demand implosion are off-the-mark.
Similar to previous stock price downturns, AAPL stock weakness is also leading to a rise in criticism facing the company. Some people are convinced that Apple is getting greedy by charging higher prices for iPhones, iPads, and Apple Watches. Gross margin data, which Apple will break out between Services and hardware for the first time, will shine much light on the issue. My expectation is that margin data would show higher product prices are primarily to reflect the additional technology included in the latest flagships. Add in worries about slowing emerging markets growth and the U.S. / China trade tension boogeyman, and the result is a toxic brew of Apple revenue growth concerns.
The Buyback Wild Factor
Instead of going on the PR offense to calm fears about business and product demand, Apple management is in a prime position to stay quiet and take advantage of AAPL share weakness. Given the lower stock price, Apple can leverage its share buyback program to repurchase additional shares for the same amount of cash.
Apple began buying back shares at the end of 2012. Over the span of six years, Apple has spent $239 billion buying back 2.1 billion shares at an average price of $115 per share. As seen in Exhibit 1, Apple’s total number of shares outstanding has been on a steady decline and is now 25% below peak levels. This is another way of saying Apple has repurchased 25% of itself over the past six years.
Exhibit 1: Apple Shares Outstanding
Breaking out Apple’s buyback by quarter, it’s easy to see management’s decision to ramp its buyback pace following U.S. tax reform. Apple no longer has an excess cash dilemma with cash “stuck” in foreign subsidiaries.
Exhibit 2: Apple Share Buyback ($)
As Apple’s stock price increased, it took much more cash to repurchase the same number of shares. In essence, the share buyback became more expensive. For example, Apple repurchased 92 million shares via open market transactions last quarter to the tune of $19 billion. This total ended up being a little more than double the number of shares repurchased in 2Q16 (41M) via open market transactions, for which Apple spent just $4 billion on open market repurchases. Apple paid an average of $210 per share with its repurchase activity last quarter versus $98 in 2Q16.
Apple is currently spending $20B on buyback per quarter. As shown in Exhibit 3, assuming AAPL shares remain near $180, Apple will be able to buy back 330M additional shares over the next two years versus if Apple shares were trading at $230+. An additional 330M shares amounts to buying back seven percent of the company in just two years. This exercise assumes Apple spends the same $20B per quarter.
Exhibit 3: A Cheaper Apple Stock Buyback
If Apple shares trade down to $160, management would be in a position to buy back nine percent of the company in two years. This amounts to 30% more than what can be repurchased at $180, assuming the same $20B is spent on buyback every quarter.
For every $10 price drop in AAPL shares, management can repurchase an additional one percent of the company over two years, assuming Apple spends the same $20B per quarter on buyback. This produces an interesting dynamic as it is in Apple management’s best interest, from the perspective of the share buyback, for AAPL shares to decline in price.
Share buyback is not created equal. For some companies, buying back shares is a mistake and nothing more than a ploy to distract shareholders from mismanagement. For other companies, share buyback is a very attractive way to return excess cash to shareholders.
From Apple management’s perspective, as long as AAPL shares trade at an appropriate valuation, the buyback is an attractive way to return excess cash to shareholders. Apple is generating more than $50 billion of free cash flow per year, all of which can be returned to shareholders. Free cash flow is the cash left over after investing in the business and organic growth opportunities. Given Apple’s balance sheet, the company has about $125 billion of excess cash that can be returned to shareholders. Combining the excess cash with free cash flow generation, Apple is in a position to continue the current $20B of buyback per quarter for the foreseeable future.
The key ingredient required for Apple to properly leverage its share buyback is maintaining the buyback pace even in the face of market volatility and dislocation. This is where Apple management has a significant advantage over the market.
Tim Cook and Jony Ive are overseeing a design company tasked with coming up with tools for people. Given how Apple is a toolmaker, the market has had a very difficult time valuing the company’s future cash flows. Revenue and profits are the result of a successful product strategy built on intense collaboration and focus. Once a product ships, the Apple machine keeps churning, pushing out iteration after iteration in a process that is hard for competitors to match.
A consequence of this product strategy is that at any given moment, by just looking at the products Apple is currently selling, one is seeing only a snapshot of the Apple machine. Most of Apple’s long-term value is found with the process used to come up with future products. The market is not in a good position to value this process.
During periods of severe market dislocation, Apple’s market value can swing by hundreds of billions of dollars. For example, Apple’s enterprise value is currently $750 billion, down from $975 billion at the beginning of October. Apple management has an advantage when it comes to determining whether Apple shares are under or overvalued given the unannounced product pipeline. In addition, management is in a good position to judge how effective the Apple machine is in coming up with new ideas for future growth.
By capitalizing on the market’s worry, anxiety, and unease, Apple management can leverage the share buyback program to buy additional shares when Apple shares come under pressure. Given the magnitude of the buyback program and Apple’s free cash flow generation, no other public company is in as good of a position as Apple to benefit from stock market turmoil.
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