Written by the FALCON Team
Just recently, we published our monthly ‘Tech Stocks On Sale‘ series, exclusive for Seeking Alpha readers, in pursuit of attractive technology companies our quantitative screening process might reveal. After our prior article focusing on networking equipment giant Cisco (CSCO), we now move on with a deep-dive analysis on Apple (AAPL), to examine whether the tech juggernaut is worthy of today’s nosebleed-high valuation.
In light of Buffett’s teachings distilled from his 50+ years of shareholder letters, our analysis is based on the three dimensions that truly matter: operations, capital allocation, and valuation. Before we do that, however, let’s jump into what makes Apple an interesting candidate today.
So what’s the story with Apple?
If there is one company in the world where no introduction is needed, that would be the iconic consumer electronics giant Apple that still brings in ~55% of its revenue from the crown-jewel iPhone. Besides its smartphone franchise, the company’s computer and tablet product lines (Mac and iPad) make up for another ~18% of the top-line as of Q3 2020. Although the anticipated 5G iPhone launch and the pandemic-induced work-at-home environment might be a near-term catalyst for Apple, its “legacy” hardware business has entered a mature state, translating to low-single-digit top-line growth figures. Wearables and Accessories on the other hand (marked by the flagship Apple Watch and AirPods) are firing on all cylinders, sporting a ~27% year-over-year growth in the first three quarters of 2020, with an already sizable, ~9% contribution to Apple’s top-line. Since the company is currently estimated to ship 49 pairs of AirPods and 14 Apple Watches for every 100 iPhones sold, there appears to be significant room to keep on the dynamic growth in wearables for years to come.
The most staggering part of Apple’s story is, however, how the company succeeds in leveraging its enormous and loyal customer base (with active installed devices reaching 1.5 billion in 2019) amidst a continued push into adjacent service offerings. These already make up a significant, ~19% chunk of Apple’s top-line, coupled with healthy, double-digit growth rates. Moreover, the gross margin on services hovers above the stellar 60% mark, more than double that of the company’s consumer electronics product line. The recently announced “Apple One” offering (bundling various services like iCloud, Apple TV+ and Apple Music) could further solidify Apple’s subscription-based, recurring revenue streams. As the company plans to reach a target of 600 million paid subscriptions before the end of 2020, services continue to remain a positive catalyst for Apple’s bottom-line in years to come.
As a general rule of thumb, a company has authentic earnings power when it has both defensive and enterprising profits. Thus, when assessing a firm’s operations, we care about two fundamental aspects: it has to pass the cash flow-based stability test, and it must be a consistent shareholder value creator measured in the EVA framework.
Stability: Assessing Cash Flow Consistency
As Hewitt Heiserman writes in his book, “It’s Earnings That Count”: The most ruinous mistake you can make as a buyer of common stocks is to own a company that goes bankrupt. For this reason, the defensive investor judges the quality of a firm’s accrual profit based on its ability to self-fund. That is, whether it produces more cash from ongoing operations than it consumes, and not go deeper into debt or dilute current stockholders. When we look at the conventional financial statements, our primary concern, therefore, is the stability of the company’s cash generation.
As a result of exploding sales, Apple’s operating cash flow more than quadrupled over the past decade, with CapEx levels averaging a moderate ~16% of OCF during this timeframe. While at first glance, Apple’s operations seem fairly capital light (given the fact that most of its manufacturing footprint is outsourced), significant investments in R&D are also essential to ensure the company’s long-term survival (since it is operating in the rapidly changing, highly competitive consumer electronics field), thus the related spending should also be treated as capital expenditure. With that being said, Apple passes our first criteria regarding stability with flying colors, underpinned by its strong and steadily growing FCF generation capability. In the next step, we move on to the EVA framework, examining if the company can consistently create shareholder value, as EVA cuts through accounting distortions and charges for the use of capital.
Value Creation: What type of moat rating is warranted?
We tend to prefer companies whose businesses are protected by large and enduring economic moats, as buying those companies at the right price generally leads to outperformance, as outlined in our research article. In the EVA framework, the EVA Margin (EVA/Sales) will be our ratio to define a company’s moat. A 5% EVA Margin can be used as an indicator for a “good” company, whereas persistence of a 5%+ EVA Margin for 10 years makes a company great and thus “moaty”.
Let’s start by looking at the chart: Apple’s EVA Margin has been nothing but exceptional since the 2007 launch of the first iPhone. Numerically, Apple’s EVA Margin has averaged ~18% over the past decade, showcasing the company’s exceptional shareholder value creation capability, resting heavily on its robust pricing power and admirably loyal customer base. Due to its pronounced push into highly profitable service offerings, Apple’s EVA Margin has started to improve further in recent years, and will likely remain above the outstanding 15% mark despite intense competition in essentially all of its product segments. Thus, the company easily passes the quantitative wide-moat threshold.
Assessing incremental EVA returns
EVA Momentum measures the growth rate in EVA, scaled to the size of the business (measured by its sales). It is the EVA framework’s equivalent for Return On Incremental Invested Capital or ROIIC. Any positive EVA Momentum is good because it means EVA has increased, and it is an indication that it is worthwhile to reinvest capital in the underlying business. Instead of pinpointing any single-year performance, we prefer to look at the long-term trailing averages in EVA Momentum.
Over the past decade, Apple has generated an average EVA Momentum of 6.7%, showcasing a textbook example of profitable growth, as the company managed to increase sales while also maintaining an outstanding, double-digit EVA Margin level. It is worth noting that the EVA Momentum metric is skewed by the explosive sales trajectory of the early years of the decade, thus a more realistic picture of the company’s future growth characteristic can be painted by the past 5 years’ average EVA Momentum of a mediocre 0.7%. This performance stands in stark contrast to the common misperception that Apple still belongs to the ultra-high-growth basket, since that figure is barely better than the long-run average of 0.4% for the 50th percentile of the U.S. stock market (represented by the Russell 3000). That said, Apple is still an EVA-generating monster, where every reinvested dollar leads to incremental EVA generation for the company’s shareholders.
Our take on the moat
The EVA framework enabled us so far to prove from a rearview-mirror perspective, whether the company has an economic moat based on its historical consistency of shareholder value creation. From a qualitative standpoint, Apple derives moat sources from the combination of its sterling brand reputation as an intangible asset and the switching costs associated with its sticky ecosystem. Although the very nature of the business implies an inherent risk, namely that brand equity could wane if a firm’s products were technologically inferior to competitors over an extended period (look no further than Nokia (NOK)), we argue that there is a reason why Warren Buffett calls Apple “probably the best business I know in the world”.
The EVA Margin figures illustrate how enormously successful Apple is at leveraging brand value to apply premium pricing to its products, dominating the global handset market by capturing 66% of industry profits and 32% of the overall handset revenue. Its loyal customer base is showcased by multiple surveys, citing that over 90% of U.S.-based iPhone users intend to buy another iPhone when they next upgrade. Furthermore, the firm’s accessory and service offerings (e.g. Apple Watch, AirPods, or Apple Card) amplify Apple’s sphere of influence on the consumer, thus creating high switching costs to leave the company’s iOS ecosystem.
As a conclusion, we argue that a wide moat rating seems warranted for Apple from a qualitative standpoint, as the company’s tremendous R&D resources will allow it to remain competitive from a technological point of view, while its devoted customer base (willing to pay a handsome premium for Apple’s design and brand) will enable the company to outearn its WACC for decades to come.
Taking a brief snapshot at the company’s debt profile, Apple has an excellent S&P Credit Rating of AA+ coupled with long-term debt to capital of 52%. The company’s ability to generate monstrous levels of cash flow, coupled with its substantial amount of cash reserves gives it ample room to keep up its lengthy record of successful product innovation, while also performing tuck-in deals to extend its portfolio of complementary offerings.
Summary of operations – the Quality Score
The EVA framework’s Quality Score is a comprehensive way to assess a company’s overall quality, by combining its EVA-based Performance (EVA Margin and Trend) and Risk (e.g. Volatility and Vulnerability) metrics into a single score, measured against the broader market. In the case of extraordinary companies, we would like to see a Quality Score consistently above 80 over a long period. As outlined in our research article, the upper quintile tends to outperform the market historically.
In the case of Apple, the company’s Quality Score has been nothing but exceptional for the past decade (averaging 84 over the period), stabilizing above the 80 mark following a drop in the company’s EVA Margin in 2012-2013, after its early-mover advantage started to fade among intensified smartphone competition. That being said, Apple’s recent push into high-margin services moved the needle again, resulting in a first-rate, 97th percentile Profitability Score against all global companies, coupled with a 37th percentile Risk Score, resting on its fortress financial stability. All that combines for an outstanding composite Quality Score of 94 as of today.
As a final assessment, Apple is a highly profitable business with exceptional pricing power underscored by its premium brand reputation and extremely loyal user base. The company passes our operational criteria without a hitch, and Apple’s wide-moat rating seems fully warranted both from a quantitative and a qualitative standpoint.
After looking at the operations dimension, we continue investigating the company through the capital allocation lens. Remember, the incremental return on invested capital (measured by EVA Momentum) is a crucial element when it comes to the assessment of successful capital allocation by management. If the company can earn a positive EVA by reinvesting all the cash generated by the underlying business, shareholders are better off if the firm retains most of its earnings. In the table below, we have dissected all the possible uses of cash for Apple for the past decade.
As outlined earlier, Apple reinvests relatively low levels of capital to keep the business running and growing, with CapEx amounting to ~16% of OCF on average over the past decade, while significant R&D expenses (6% of sales in 2019) are also necessary for the company to keep its competitive position. With Apple’s EVA Momentum coming in at 0.7% in the last 5 years, the current level of reinvestment seems justified, since it translates to incremental shareholder value creation going forward. Yet, we must note that the trend of the EVA Momentum has abated meaningfully in recent years, showcasing the fact that Apple has become a huge and maturing business (marked especially by the iPhone). Although still capable of profitable, incremental EVA generating growth, the business has gotten so big and so lucrative that investors must carefully consider whether the expectations for abnormal growth are still reasonable. The focus on service-related revenues could further boost Apple’s fundamentals in the future, but when both growth drivers (increase in sales and the EVA Margin) are stretched to extreme levels, it is not easy to capture additional gains. Nevertheless, the company’s priorities regarding capital deployment remain the same:
With regard to capital allocation, our approach remains unchanged. We continue to invest confidently in our future while also returning value to our shareholders.”
Source: Luca Maestri, CFO, Q2 2020 Earnings Call
As visible on the chart above, Apple returns all the available free cash to its owners. Between 2013 (when repurchases became a regular practice) and 2019, the company generated an aggregate of $390 billion in free cash flow, while buybacks and dividend payments amounted to $387 billion, or 99% of FCF.
Apple regularly returns cash to its owners through share buybacks, and continues to do so amid the pandemic:
We returned over $21 billion to shareholders during the June quarter, including […] $10 billion through open market repurchases of 31.3 million Apple shares. We also began a $6 billion accelerated share repurchase program in May, resulting in the initial delivery and retirement of 15.2 million shares. And finally, we retired an additional 4.8 million shares in the final settlement of our 15th ASR.”
Source: Luca Maestri, CFO, Q3 2020 Earnings Call
Previous repurchase programs have been fully completed by the time of expiration, making us confident that Apple not only makes rosy promises but also delivers on repurchases. Buybacks amounted to $301 billion during the last 7 years, reducing the share count by a massive ~32%. In terms of shareholder value creation, it is always crucial to assess whether share repurchases are executed in an opportunistic manner. While share buybacks can provide much value to shareholders, it is important to examine when these purchases are taking place, since if these happen at a premium to the intrinsic value of a business, they are actually value-destructive, not value-enhancing.
The repurchase activity is somewhat of a mixed bag at Apple. There were some promising attempts to carry out accelerated buybacks when it was opportunistic to do so, like when the market correction happened in December 2018 and management ramped up the program. However, at other times like in 2014 or early 2018, buybacks happened at historically elevated valuation levels, measured by the Future Growth Reliance metric. We feel that the enormous amount of cash generated by Apple’s operations each quarter sometimes burns a hole in management’s pocket. They feel an insatiable need to put that money somewhere, buybacks being an obvious choice, but as we can see, this action is value-destructive for shareholders, if it is carried out at the wrong time. Overall, we believe that the repurchase activity is rather automatic and could be more opportunistic at Apple.
Apple initiated a dividend in 2012 and has grown its payout for eight consecutive years at a double-digit compound rate. Back in 2018, CFO Luca Maestri has stated that the company plans on raising its dividend every year, although the once impressive initial growth rates have tapered-off into the mid-single-digit territory in recent years. Nevertheless, dividend payments remain an important cornerstone of the company’s capital allocation policy and the usual increase came like clockwork at the beginning of May:
As a testament to the confidence we have in our business today and into the future […] our Board has authorized a 6% increase in our quarterly dividend”
Source: Luca Maestri, CFO, Q2 2020 Earnings Call
That being said, the current entry yield of 0.7% is anything but enticing in historical terms, sitting at one of the lowest levels ever recorded. The stock provided a lower than 1.0% entry yield only 9.5% of the time in the last 5 years, signaling a significant overvaluation based on this metric. Although Apple will not find it easy to grow EVA at double-digit rates in the future, this is one of the most bullet-proof dividends out there, considering a payout ratio averaging ~20% of FCF in recent years, accentuated by the company’s superb financial health and immense cash reserves. Income investors can likely count on Apple delivering high-single-digit dividend increases in the years ahead.
In general, Apple’s growth has been almost entirely organic which is a significant positive in our view. The firm remained laser-focused on smaller, bolt-on type acquisitions (which carry significantly less integration risk) along with a strong commitment to in-house development, staying away from questionable deals like Google’s (GOOGL) endeavor with Motorola (MSI) or Microsoft’s (MSFT) purchase of Nokia’s phone business.
Apple’s only noteworthy acquisition was the $3 billion deal to purchase Beats Music and Beats Electronics in 2015, but even that represented only a tiny portion of the firm’s total cash balance. That venture has already paid for itself, as Apple successfully turned the music streaming service called Beats Music into Apple Music, which has more than 68 million paid subscribers worldwide.
Anyhow, we have got to mention that in case Apple struggles to find organic growth opportunities in the coming decade, the risk of management feeling pressured to buy its way to growth via larger acquisitions would increase considerably.
Future Growth Reliance
Our prime historical valuation indicator in the EVA world is the Future Growth Reliance (FGR), which is the percent proportion of the firm’s market value that is derived from, and depends on, growth in EVA. As outlined in our research article, it is the best-of-breed sentiment indicator that addresses accounting distortions, thus gives us a true picture of which companies seem attractively valued in historical terms.
Looking at the chart of Apple, the dark side of the story becomes immediately obvious, namely the exuberant valuation level the company is currently trading at. Numerically, the FGR ratio stands at 55% as of today, which means that more than half of Apple’s current (nearly $2 trillion) market cap is derived from future expectations for growth. This indicates how utterly exaggerated the current sentiment is regarding Apple’s future EVA growth potential. When we put the numbers into our discounted EVA model (based on the reasonable assumption that EVA will grow 5% annually for the next 10 years), we arrive at a fair value estimate of $67. The current market price implies a 13.5% CAGR in EVA for the next decade, which is absolutely mind-boggling. To put that into perspective, the company was able to achieve such growth only when the iPhone was still a sexy new thing. Examining the intrinsic value of the company from another perspective, we think Apple’s current fundamentals (including decent but tapering top-line growth and a slight margin expansion forecast due to a pronounced focus on recurring revenues) paired with a 20% FGR scenario would also lead to a price that is near “fair value”. Be aware though that the long-term FGR averages are somewhere between 10% and 25%, so this is not an overly conservative assumption. This base case would translate to a share price of $64, underscoring the gross overvaluation of Apple today, no matter what valuation tool we use.
As a second step, we use Morningstar’s valuation system, where analysts create industry and company-specific assumptions, and then all the inputs are used in a discounted cash flow model. In order to reflect all moving parts within the business, the analyst firm also evaluates the level of uncertainty with all the stocks they cover. Morningstar assigns Apple a high uncertainty rating with a $71 fair value. The thresholds between the different star ratings are illustrated below:
With the stock currently trading at $116.97 as of October 12, a 1-star rating is warranted, implying that Apple’s shares are grossly overvalued based on Morningstar’s estimate, in line with our previous analysis relying on EVA fundamentals. It is worth noting that our $64-$67 EVA-based fair value estimate falls roughly in line with Morningstar’s 3-star rated, fair value band.
Summary of the investment thesis
PRVit score – heat map vs. market
After all our due diligence, we turn to the PRVit model for a final judgment of the overall attractiveness of a stock. The PRVit is a multifactor quantitative stock selection model based on EVA-centric measures of Performance, Risk, and Valuation. Combining a company’s Quality Score with its actual Valuation Score can be visualized on a heat map like the one below, where the gradient diagonal line signals fair value. We want to see a stock in the upper-right hand corner of this heat map, but we are more concerned with the Quality Score, as we believe that over the long-run, we are better off with a truly exceptional business bought at a fair price, rather than a fair company bought at an exceptionally attractive price.
As visible on the above heat map, Apple seems to offer a fair trade-off between quality and price, but we must note that in this quantitative framework, if a company scores near 100 on the Quality dimension, it basically cannot get expensive enough to deem it as overvalued. While Apple’s top-notch quality remains unquestionable, it is currently paired with a valuation that is impossible to justify. To conclude, no matter from which angle we look at it, it should not come as a surprise that we wouldn’t touch Apple with a ten-foot pole at today’s nosebleed-high valuation levels. On the contrary, we argue that profits are ripe for harvesting for existing Apple shareholders, as baked-in expectations are so high that it might be very easy to surprise on the downside. (That said, one of our analysts is still holding his Apple position that he bought at a split-adjusted price of $24.) However hard we tried, it was nearly impossible to come up with a positive(!) total return potential, meaning that shares of Apple could easily turn out to be dead money for at least the next 3-5 years. Investors who are eager to be owners of this exceptional company should stay on the sidelines until valuation returns to a more down-to-earth range, leading to an entry price of $60-70.
One more thing
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Disclosure: I am/we are 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.
Originally published on Seeking Alpha