What Matters About Apple

There have been way too many articles about Apple (AAPL). Nevertheless none of them seem to cover the relevant issues but talk about the news and coming events. In this article I would like to talk about what's relevant (at least from my point of view).

Earnings and Accrual

Compared to many popular tech companies Apple has real earnings, earnings are huge, and it has them today. Not tomorrow, not planned, not speculated, but today.

Accrual is the probably the least used financial term when it comes to stocks. For interest bearing assets it comes almost naturally. For a stock like Apple who has real returns, the price targets of analysts without specifying a date is almost meaningless. If you think the fair value of Apple is X as of today and if your EPS projection for 2014 is $45, the fair value of the stock as end of 2014 is roughly X + 45. This means the earnings for 2014 are accruing over the year. This is a crucial difference between a company that has real returns vs. a company like Amazon (AMZN) who has promised returns. According to my calculations Apple has fair value of $650 as of today. This means we are looking at $695-700 as end of 2014 (of course dividends will be deducted, but it goes to shareholder's pocket so you can count them in as well). By the way we are talking about 8-9% earnings yield on AA+ rating. That's great risk/reward metric. Of course you are most welcome to buy Italian or Spanish sovereign bonds for 4-5% yield, but I can't promise you won't get a haircut down the road.

Japan and China

In the retail world, if you have a successful brand and well accepted products, penetrating into your under-tapped markets brings immediate success. There have been recent articles claiming that China Mobile is not such a big deal. Within a few quarters everybody will see that this is in fact a huge deal. Japanese DoCoMo deal is already a big success. The logic many analysts have is that per capita income in China is considerably lower than US or Japan. This is a fact. What they are wrong about is in developing countries products like iPhone are the only items people can differentiate themselves in society. They are symbols of status. Many people won't eat, but buy an iPhone. From this perspective Tim Cook is doing a tremendous job. In business management you should always take care of the quick-wins first, but not forget about the long run either.

Qui-Gon Jinn: Don't center on your anxieties, Obi-Wan. Keep your concentration here and now, where it belongs.

Obi-Wan Kenobi: But Master Yoda says I should be mindful of the future.

Qui-Gon Jinn: But not at the expense of the moment. Be mindful of the living Force, young Padawan.

- Star Wars Episode 1: The Phantom Menace

Innovation and Growth Issue

A lot of people are worried about the future of Apple and its ability to innovate. As Qui-Gon Jinn points out, don't miss the moment thinking about too much into the future. First of all, the amount of cash Apple has is tremendous. I think many people can't comprehend how much money $150 billion is. Apple may lose its innovation ability but as long as it maintains its business acumen, it is in great shape. When you have so much cash in your pocket you don't have to necessarily innovate yourself. You can buy both innovation and cash flow. Apple has been quietly acquiring technologies such as biometrics, motion tracking, and analytics. Instead of buying a dinosaur and having huge write-downs in the future it makes much more sense to acquire small but potential companies with interesting technologies. One thing the history shows us is that mega acquisitions pretty much all ended in loss of shareholder value.

And what if Apple cannot grow earnings? In that case Apple can also consider buying growth. For future I think Apple should consider reforming itself into a conglomerate. Conglomerates tend to underperform as they lose their focus in what they do best. Nevertheless Berkshire Hathaway (BRK.A) (BRK.B) has established itself in the business world with its strategic acquisitions. For Apple I speculate acquisitions in media, insurance, payment systems. Anything that can utilize the large customer base and create synergy.

Balance Sheet Management

In my Instablog I briefly mentioned about the bond issuance and buyback plan of Apple.

When Apple announced its buyback plan, there has been a lot of criticism regarding how this is just a financial gimmick and it takes Apple's focus away from what matters the most, innovation. Tim Cook was compared to Steve Jobs and commented as not visionary.

These criticisms are extremely off base. Balance sheet management is very important to every company. It is especially important if your balance sheet is as big as Apple's. A small mistake will be much more costly than not properly positioning products or lagging behind in innovation. This is a daily task of a company and it is as important as research and development. Criticizing Tim Cook for this is criticizing him for doing his job properly.

Coming back to the bond issuance, I repeatedly pointed out in my comments to other articles that borrowing at these artificially low interest rates is a no brainer. I believe tax repatriation issues are of second importance. By lowering interest rates FED, ECB, BOJ, and other central banks are basically stealing from people who have cash and giving(click to enlarge)it to people who have other assets (such as stocks, real estate). Issuing a bond and waiting for interest rates to tick up is a good gamble because if interest rates go up whoever bought those bonds will hold the bag. If they don't, the interest expense is still lower than the dividend payments for the bought back stocks. In any case, this is not just financial engineering; it is creating real value for shareholders, thanks to central banks causing misallocation in capital markets. Again, criticizing Tim Cook for taking advantage of this is criticizing him for doing his job.

In fact if you look at the below chart Apple's 30-year fixed rate bond is already down 18.5%, and whoever bought it is already holding the bag.

(Click to enlarge)

Source: Morningstar

This means Apple can buy back its debt from the market with discount. Unfortunately the bonds are not callable. Therefore it will be only possible to buy from sellers who will accept the losses at this point. Most of them will have to hold these for a long time in order not to incur capital losses. Nevertheless it is trading in the market and can be purchased to a certain extent. Now how is that not creating value? You have $100 debt and you can retire the debt for $81.5.

Conclusion

In addition to everything I discussed so far Apple is doing a tremendous job in supply chain management, production, and delivery of products in the scale of hundreds of millions per year. Even this is in itself a hidden value. Any new products introduced throughout 2014 and following years can bring huge upside if these products turn out to be innovative and disruptive. If not Apple is still a very healthy and well-managed company and can always buy both technology and cash flow.

Source: What Matters About Apple

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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