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Brian Nelson is the president of Valuentum, an independent financial publishing firm that serves individuals and financial advisers.

valuentumbrian 12:19 PM May 03, 2016 at 12:19 PM

Apple: Nowhere To Run, Nowhere To Hide

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The iPhone giant disappoints.

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Valuentum (val∙u∙n∙tum) [val-yoo-en-tuh-m] Securities Inc. is an independent investment research provider, offering premium equity reports and dividend reports, as well as commentary across all sectors/companies, a Best Ideas Newsletter (spanning market caps, asset classes), a Dividend Growth Newsletter, business/investing book reviews pre-public release, modeling tools/products, and more. Independence and integrity remain our core, and we strive to be a champion of the investor. Valuentum is based in the Chicagoland area.

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By Brian Nelson, CFA

Today’s stock market is a difficult one. That Apple (AAPL) is selling off after disappointing fiscal second-quarter results is unfortunately no surprise to us, “Apple Will Go Lower… And It Will Be ‘Forced’ Into Acquisitions(January 2016).” There may be “nowhere to run, nowhere to hide” for market participants seeking full exposure to equities.

Unfortunately, it’s no consolation to the reader that missed our profit-taking alert in Apple a few months ago, and our discussion to take even more shares off the table “Looking To Trim Apple… (December 2015).” In August 2015, we removed one third of the position in Apple from the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio at $108.92 for a very large gain. For those that may not be familiar with what the form of a transaction email alert can sometimes look like, it can be found here. We’re working to make such alerts more prominent in your inbox. Obviously having the good sense to take a little off the table many months ago is not completely mitigating the pain of the sell-off following Apple’s fiscal second quarter report, released April 26.

We think it’s worth reminding readers of what we think of Apple: it is a fantastic company that generates a tremendous amount of free cash flow and truly showcases a fortress balance sheet. During the quarter ending March 26, 2016, the iPhone maker recorded revenue of $50.6 billion and quarterly net income of $10.5 billion, or $1.90 per diluted share, staggering levels of profitability for perhaps any other company…but Apple. The performance wasn’t nearly as strong as that of the year-ago period or what consensus was looking for, but we think it’s far too early to sound the alarm bell on Apple’s fundamentals. From what we could tell, the FBI was a major distraction in the period, “…FBI Says Can Hack iPhone,” and US tax reform continues to be a hotbed issue, absorbing much of the executive suite’s time as it navigates these political topics. CEO Tim Cook may be getting pulled in far too many different directions.

Apple’s capital-return program has taken on new proportions. For starters, in the fiscal second quarter press release, management announced that the board has authorized an additional $50 billion to return to shareholders, with the company now planning to spend a total of $250 billion of cash under the program by the end of March 2018. Though for any other company we’d be applauding in a big way the buyback program because undervalued shares are being scooped up, Apple is simply not getting credit for the savvy repurchases, as shares continue to tumble from highs set many months ago. The market believes mid-cycle expectations are much lower than today’s levels, and bolstering earnings-per-share with more share repurchases may just be absorbing cash that otherwise could be used to thwart off any competitive threat, or facilitate even greater dominance in wearables by buying Fitbit (FIT) or Garmin (GRMN). Apple could also use this cash to improve its gross margin, which fell 140 basis points in the quarter, by integrating costlier aspects of its supply chain.

Instead of spending cash on buybacks, which seemingly vanishes as Apple’s stock price and earnings per share decline, we would have preferred an increase in the dividend at a pace much higher than what Apple’s board decided. Certainly a 10% hike in the quarterly dividend, as that announced, is nothing to be ashamed of (now $0.57 per share, was $0.52 per share), but this is Apple. The company has a cash balance of $232.9 billion and a net cash position of $161 billion at the end of March as it hauled in $33.1 billion in free cash flow during the trailing six-month period. Over that same six-month period, Apple’s dividend obligations were just $5.87 billion – meaning in free cash flow generation alone it covered its dividend obligations nearly 6 times.Where’s the real growth? Tim Cook and team should refocus on tangible capital returns in the form of a higher dividend, or save excess cash for a war chest.

What might happen in 20 years, for example, if Apple uses most all excess cash to buy back stock, and its business faces the declines that we’ve seen from the likes of the Palm Pilot, Motorola’s Moto Razr (MSI) and Blackberry’s (BBRY) flagship, “…Weighed Down By ‘Palm Pilot,’ ‘Moto Razr,’ and ‘Blackberry’ Memories.” Its fundamentals and earnings would be eroded, and it wouldn’t have much of a balance sheet to offer investors value. This is how companies can fall from grace in a big way. Technology changes fast, and we don’t want Apple to waste one of its “moat-iest” characteristics, its cash hoard, just to bolster accounting earnings per share. We want the executive suite at Apple to really think about the long haul – not only the next product iteration, but building an enterprise over the next couple decades. Excess cash can come in handy in a big way, and we think the finance team at Apple should do an analysis immediately of the tangible benefits of its buyback program thus far.

Apple’s internal metrics weren’t great in the quarter ending in March either. On a year-over-year basis, unit sales of the iPhone dropped 16%, unit sales of the iPad dropped 19%, while unit sales of the Mac dropped 12%. Last year offered difficult year-over-year comparisons (there were very strong iPhone 6 sales in last year’s period), but we expect these internal numbers to spark selling pressure in the equity as sell-side analysts raise a word of caution in light of macroeconomic concerns, particularly in China (FXI), and global competitive pressures. On a year-over-year basis, revenue from Greater China dropped 26%, and we’re viewing this as yet another red flag that the country’s pace of economic growth in the mid-to-high-single digits may not be reflective of actual sovereign health. The read-through on other consumer-oriented equities, including Baidu (BIDU) and Alibaba (BABA) is limited, in our view, given the separate verticals.

One poor quarter a trend does not make, and we’re not panicking at all. Apple remains a core holding in the newsletter portfolios, and while we wanted more, the company will ebb and flow with the product cycle. We think the executive suite should be wiser with its share buyback program and lay out a 10-20 year plan to focus on sustainability for long-term dividend holders, and of course, we would have liked to see a dividend increase in the magnitude of greater than 10%. On the trailing six-month relationship between free cash flow and cash dividends paid, Apple can raise its dividend at a 10% compound annual growth rate for the next 18 years, and that doesn’t assume any improvement in free cash flow generation on the basis of the current six-month run rate or consider its $161 billion net cash position, which covers current annual dividend payments nearly 14 times by itself.

Apple is going to be raising its dividend for a very, very long time.

Like our line of thinking? View more of our work at www.valuentum.com. Thank you for reading!

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