thinking about Apple (AAPL)

setting the stage

(I should say at the outset that, although at one time I owned AAPL for years, I don’t hold it now and haven’t for a long while (except for a couple of days in January).

Q:  What does AAPL do for a living?

A:  It makes smartphones and other mobile computing/consumer electronics devices targeted at affluent consumers willing to pay a premium price for the perceived superior aesthetics and more user-friendly software.

A mouthful.

in other words, a niche player…

If my definition is correct, AAPL has decided to carve out a niche for itself in the high end of the mobile device market.  It’s a very desirable and lucrative niche, one it dominates.  But AAPL is a niche player, nonetheless.  It’s a little like TIF or WYNN.

Like any market strategy, this one has its pluses and minuses.  Anyone listening to the AAPL earnings calls over the past few years can’t help having heard the persistent questioning from Bernstein about what the company would do once everyone who can afford a $600 smartphone already has one.

Move downmarket?  Unlikely.  TIF is the only company I’m aware of who has taken this path and not completely destroyed its brand image–thereby losing its original customers.  Better to lose low-margin sales in the mass market than to kill the goose.

Absent new blockbuster products, however, the price of maintaining the upmarket strategy for AAPL is that sales slow as volume-oriented manufacturers ride down the cost curve and churn out smartphones that retail for $100-$300.

That’s where we are now.

Tons of publicly-available-for-free data has been available for years showing where the smartphone marke, and AAPL, have been heading.  So this outcome can’t have been a surprise.

…with an “ecosystem”

Another characteristic of AAPL devices is the “ecosystem,”  which has tended to make customers more sticky.  All AAPL devices work well together.  All reside in a “walled garden” created by AAPL software–reminiscent of the way AOL worked back in the infancy of the internet.

on this description…

…the current PE of 10.8x–8.0x, after adjusting for cash on the balance sheet–seems crazy low.  It’s less than INTC’s, for instance.

is there more to the story?

There’s an obvious risk in securities analysis of taking the current stock price as the truth and trying to come up with reasons why  it is what it is, rather than taking out a clean sheet of paper and trying to imagine what the future will be like.  The Efficient Markets hypothesis taught in business schools despite overwhelming evidence that emotional storms of greed and fear that routinely roil financial markets, encourages this thinking.

Admittedly possibly being influenced by the recent swoon in the AAPL share price, I’ve been asking myself recently whether the conventional wisdom about AAPL, which is my description above, is correct.

I have two questions.  No answers, but questions anyway.

my questions

1.  Is the high-end niche defensible?

In most luxury retail it is.  In consumer electronics, it clearly isn’t.  Think: Sony.  Based on the (small) number of entrants in the mobile appliance market and the (small) number of products sold, AAPL may be closer to Sony than to Hermès.

2.  Is the “walled garden” a mixed blessing?

It certainly worked for AOL for a long while. But then the Wild West of the early internet was gradually tamed and customers discovered there was a much more interesting world outside the garden.

I don’t think AAPL aficionados have any intention of tunneling out–at least not yet.  But the inaccessibility of AAPL customers to GOOG has prompted the latter to introduce the “hero phone” later in the year through its Motorola Mobility subsidiary.  The idea seems to be to create an attractive, user-friendly, high-end smartphone, load it with GOOG software and sell it at cost.

The “Made in USA” label and the management description of the “hero” seem to me to indicate it’s targeted directly at the large concentration of AAPL customers here in the US.  It’s an open question whether GOOG/Motorola can create a smartphone that’s attractive to iPhone users, or whether they’ll consider switching.  But a technologically inferior PC sure did undermine the Mac with consumers in the 1980s almost solely because it was a lot cheaper (btw, the Mac lost out to IBM with corporate customers because it had no clue how to sell to them).  And the wireless carriers will certainly welcome the “hero,” assuming it works well.

AAPL’s 2Q13–some answers, still some questions

the report

After the New York close yesterday AAPL reported its 2Q13 earnings results (AAPL’s fiscal year ends in September).  Revenues were $43.6 billion, up 9% year-on-year.  EPS, however, were down 18% yoy, at $10.09.   The latter figure was slightly ahead of the Wall Street analyst consensus of $9.97, a number that been ratcheting down in recent weeks.

The company guided to flattish sales in 3Q13, with mild margin contraction.

It announced a 15% increase in the quarterly dividend to $3.05 a share, meaning a current dividend yield of just over 3%.

APPL also intends to buy back $60 billion in stock before the end of calendar 2015.  That would be 15% of the company at current prices.  AAPL now has $147 billion in cash, of which $104 billion is held outside the US.  It won’t touch the foreign holdings for the buyback.  Instead, it will issue bonds in the US to get the money it needs.

This piece of financial engineering will have two impacts.  It will boost the growth rate of EPS by at least an additional 5 percentage points per year.    And the financial leverage will increase AAPL’s return on equity from its already heady 25%+.

The stock was initially up about 5% on this news.  Then, during the conference call, AAPL management said it won’t have its next new product launch until fall.  The gains evaporated and were replaced by a slight loss.

what’s going on

Two factors:

margin erosion

1. smartphones

As I see it (remember, AAPL is pretty opaque), the emergence of Samsung as a competitor in the high end of the smartphone market,where AAPL makes its biggest profits, has caused that segment to mature faster than AAPL had expected.  Unit volume growth is now coming mainly from emerging markets, where the price of AAPL’s cutting-edge phones is too high.  The company is selling older models (iPhone4s) there, at discount prices–and therefore reduced margins.

2. tablets

A year ago, it looked to me like 2/3 of AAPL’s tablet volume was from its newest model iPads.  Today, unit volumes are much higher, but less than a quarter are the newest 10″ iPads.  The rest is a combination of iPad minis (a runaway success) and bulk sales of iPad2s to institutions.   Both of the latter are at lower margins.

My guess is that we’re at or near a gross margin low point now.

continuing PE multiple contraction

The maturing of the smartphone market has been actively discussed in the financial community for a couple of years.  In my view, worry about this possibility is the main reason that, despite booming sales and earnings, the price earnings multiple on AAPL’s stock had contracted from the high teens to around 12 by the second half of last year.  Relative to the market, the multiple went from a premium of 25% to a discount of 25% over the same time period.

Unpleasant for holders, maybe, but understandable.

Over the past 6-8 months, however, the multiple has contracted further, both in absolute terms (to under 10) and relative (to a discount of more than 40%).  In fact, yesterday’s Wall Street Journal had an article comparing AAPL with HWP and DELL.  That’s kind of like comparing night and day–the single thing I can see that ties AAPL to these two truly terrible companies is the similarity of their price earnings multiples.

Yes, when fast growers begin to slow down, the PE contracts, often violently.  And because a good portion of the contraction is an emotional thing, the multiple shrinkage is usually greater than one would expect.  But even seeing this process over and over, I didn’t imagine that a fundamentally sound company like AAPL could be trading at 9x in a market trading at 15x.

where to from here?

Note, first, that I’ve been wrong about the stock for a while.

I think the stock buyback makes economic sense, and it will probably at least stabilize the AAPL stock price.  I don’t think the addition of debt to the capital structure will have any effect.

It may be a big stretch, but to me the 15% dividend increase says that’s what AAPL’s board expects its earnings growth rate over the next few years to be, financial engineering aside.  I think that’s a reasonable assumption, and could be conservative.

AAPL management would do the most for its stock by being more forthright with investors about current business challenges and how it plans to deal with them.  That’s not likely, however, if the 2Q13 earnings call is any indication.

That leaves holders waiting for new product announcements–and subsequent earnings acceleration–at summer’s end.


what do gold and AAPL have in common?

common factors

–they’re both large positive bets (large holdings) of hedge funds–and of many retail investors

–both have delivered weak performance over the past year, after extended periods of substantial gains.  And the losses have occurred during a time of generally stable conditions for the world economy, with ample liquidity and strong inflows of money into financial products

–recent trading in both seems to me to be giving signs of forced or distressed selling

are these factors connected?  

It’s hard to know, since global hedge fund disclosure is incomplete–and there’s ample evidence that what disclosure there is can’t be relied on.  However, I think it’s reasonable to assume they are.

if so, what does this imply?

In my experience, a professional investor goes through a three-step process as he realizes he’s made a mistake–or that his previously good idea is no longer working.  He:

–stops adding to the position when new money comes in, effectively shrinking its relative size,

–begins to sell, to further lessen the negative effect of the position on performance, and

–accelerates the selling when the position is small enough the extra visibility and extra downward pressure on price make little difference.

A professional investor can go through these states in the blink of an eye, or it can take a long period of time. A lot depends on style, self-awareness and how ugly the underperformance is.  Anyone who operates on margin may also get additional feedback from his lenders.

Many retail investors, in my experience, just panic–very close to the bottom.

Recent price action in gold and in AAPL strike me as Stage-Three end-game activity–some combination of panic, response to margin calls and/or dumping of the remainders of positions being sold over long periods.

is this an opportunity to buy?


For me, the answer here is easy.  It’s “No.”  The key supply-demand issue is whether central banks in emerging markets will continue to buy gold in the aggressive way they have done over the past several years.  I have no idea.  So I’m clearly the “dumb money” in this arena–the strongest reason there is to stay away.


We’ll have more information tomorrow, after AAPL reports its latest quarterly earnings.

The stock is now trading at less than 9x historic earnings and yielding 2.7%.  The shares have underperformed the S&P 500 by more than 50 percentage points since last September.

The company has no debt and its cash holdings are approaching almost half the market cap.

If there’s anything “wrong” with the stock, it’s that its fall from grace has been so extreme.  That prompts the question, “What must sellers know that I don’t?”

How do you overcome aversion, based on an extended decline, to a stock that looks like a $100 bill lying on the street?  The first step, I think, is to look for signs that the waves of selling that have pummeled AAPL are over.   This means having AAPL announce bad news and have the stock go up, rather than sell of further.  That’s why tomorrow’s earnings report may be important.


Einhorn stops Apple (APPL) shareholder vote on preferred stock


Hedge fund manager David Einhorn has been urging AAPL for some time to adopt his pet idea of issuing preferred stock that would basically be backed by the company’s gigantic accumulated cash position.

APPL isn’t interested.

In the Steve Jobs days, I think the AAPL CEO would have told Mr. Einhorn, either directly or through the press, that his answer was “No!!,” and that Einhorn should stop trying to interfere with the running of AAPL’s business.  This probably would have been the end of the matter.

The current AAPL management didn’t do that.  Instead, it put on the agenda at the company’s annual meeting this week a shareholder vote to change the company’s charter in a way that would forbid the kind of perpetual preferred Einhorn is championing (see my analysis of the preferred idea).

Not only that, but AAPL wrapped this proposal in a package of others and asked for a single vote on the whole bundle.

last week

Mr. Einhorn sued, saying in effect that the bundling violates both common sense and SEC rules.  On Friday, a federal judge agreed–and barred a vote on “Proposal #2” at this annual meeting.

According to the Financial Timesby the time of the court ruling AAPL had received ballots representing 40% of the outstanding shares.  Of them, 97.5% had voted for the company and, by implication, against Mr. Einhorn.

the voting results are no surprise

In my experience, individual shareholders vote with management no matter whether it’s in their economic interest or not.  Hard for me to understand, but easy to predict.

For almost two decades, the SEC has been pushing the compliance departments of professional money managers on proxy voting.  The regulator wants them to take seriously their fiduciary obligation to vote the shares under their stewardship in the best interests of their customers–or else.  This pressure has resulted in the rise of third-party firms like ISS and Glass Lewis, which have set themselves up as independent experts in proxy analysis and making shareholder-friendly voting recommendations.  The path of least resistance for institutional investors seems to me to be to subscribe to  one of these firms’ services and vote accordingly.

Both ISS and GL recommended voting for AAPL in this matter.

In other words, all the individuals and all the traditional institutions were going to vote against Einhorn.

why a vote at all?   …and why this vote?

Mr. Einhorn points out on the Greenlight Capital website that because no one has tried his preferred suggestion, that doesn’t mean it’s a bad idea.  Of course, it doesn’t mean it’s a good one either  …or a good one for AAPL.

What’s clear, however, is that AAPL doesn’t want to discuss the idea publicly–even to say that it’s a thought, but one that won’t work for AAPL.  I think this is a mistake.

I think I understand why AAPL set up the vote as a bundle, though, rather than a straight yes-or-no on the preferred issue alone.  From my common sense viewpoint, as well as from an SEC perspective, grouping a bunch of disparate proposals together just doesn’t seem fair.  (In addition, for what it’s worth, I don’t see how narrowing the scope of possible future preferred issues serves shareholders interests.  It just makes Mr. Einhorn go away.)

Why bundle?  AAPL must know that institutions pretty much vote whatever way ISS tells them.  I think AAPL presented the preferred proposal to the advisory service in a package that it simply couldn’t recommend voting against.  It thereby also avoided the risk that if the preferred ban were offered separately ISS would recommend a “no” vote, which a ton of institutional holders would then cast.

AAPL management hasn’t done itself any favors, 

…in my view.

The company’s unwillingness to lay out reasons–like that the preferreds might constrain needed US-sourced cash flow–for opposing the Einhorn proposal make management look weak.

The bundling makes the company look like it has something to hide.

AAPL’s odd behavior suggests there’s considerably more to this story than meets the eye.

David Einhorn’s preferred stock proposal for Apple (AAPL)

Yesterday hedge fund manager David Einhorn made public an open letter to AAPL shareholders, publicizing his suggestion that the company issue perpetual preferred stock to shareholders.

mechanics of the issue

AAPL has no debt and $137 billion of cash on its balance sheet.  It is generating cash flow at the rate of about $40 billion a year.

Einhorn proposes that AAPL issue a new security for free to shareholders that would pay a total yearly dividend of $2 billion.

The new security would:

–be perpetual, meaning it would go on forever (or until AAPL goes out of business).  This also means the preferred would have no redemption value, that is, it could/would never be returned to AAPL in exchange for a cash payment

–be cumulative, meaning any unpaid dividends would continue to be obligations of AAPL, rather than simply lost, as is the case with dividends on common stock

–have a dividend preference over the common, meaning the preferred dividend–and any accumulated unpaid ones–would have to be paid before a common could be.


In round numbers, AAPL has a billion shares outstanding.  One way of implementing the Einhorn proposal would be to distribute one share of preferred for each common share held.  If so, the preferred would pay an annual dividend of $2.

How much would you pay for a potentially infinite stream of $2 annual payments?  Einhorn tried to frame the issue psychologically by saying this is “$50 billion” worth of stock, or $50 a share if the issue were constructed as I describe.  This would also be a 4% yield.

Especially for the first issue of this type, $50 could be low.  Yes, it represents 25 years of undiscounted dividend payments.  But AAPL is a pristine credit.  The yield is a huge premium to the 30-year Treasury.  There are tons of AAPL fans who might like a “cheap” way of owning an AAPL security–AAPL has (foolishly, in my view) chosen so far not to tap this base of support by splitting its common.  And the preferred issue would have novelty value.

an investor’s view

–The proposed preferred has no claim on AAPL’s assets and represents only a tiny fraction of the company’s cash flow.  It wouldn’t have voting rights under normal circumstances.  So it isn’t equity in any practical sense.  Arguably, therefore, its issuance might have no effect on the price of AAPL common.  In all likelihood, any negative effect would be tiny.  There’s even a (lottery ticketholder’s) chance that the effect would be positive.  

So the Einhorn proposal is like creating free money, as I wrote yesterday.

–Einhorn’s hedge fund clients hold about $500 million worth of AAPL.  Einhorn himself gets some percentage, say, 20%, of the profits they make on his investment choices.  An AAPL preferred issuance could represent a $10 million payday for him.

-The preferred is not a one-and-done story.  There’s no reason why this magic trick can’t be repeated at least several more times, each one giving a $50 billion boost to aggregate shareholder wealth.

–What’s not being said is that the pledge of future cash flows puts handcuffs on management, for good or for ill.  Each $2 billion in cash flow dedicated to preferred dividends means less that management is free to use for capital expenditure, acquisitions or other uses. The preferred can be regarded as a prudent safety measure.  Look at Hewlett-Packard–a once-great company that has squandered an enormous amount of its shareholders’ money through a decade of lunatic, management- and board-approved acquisitions.


–Q:  Who are these guys to tell us what to do?  They don’t work here.

A: They’re the owners.  You work for them.

Reply:  That can’t be right.

–About 3/4 of AAPL’s cash is held outside the US, so it’s only available to pay preferred dividends if it’s repatriated.  That would mean paying income tax at 35% on anything that’s brought back.

–If we assume AAPL generates its global cash flow in the same proportions as its cash holdings, then only $40 billion annually is available to pay dividends of any type.  $10 billion+ already goes to pay the common dividend.

If shareholders say they think Einhorn has a good idea (which he does), then management has potentially got to focus a lot more on earning money in the US.

my 2¢

There’s a tipping point out there somewhere, after which the Einhorn trick will no longer work.  Not a current worry, though.

There’s also a legitimate concern that at some point the diversion of cash flow away from reinvestment in the firm will hamstring management and hamper growth.  With $137 billion in the bank, not a concern, either.

weird stuff from the AAPL high command

In the old days, Steve Jobs would have thrown Einhorn out of his office and that would have been case closed.

IN contrast, current management is seeking to change the company’s charter to outlaw preferreds like Einhorn’s.  Not only that, it’s taking a page from Congress’s book, wrapping the change inside a bunch of others that are supposed to be voted on as a group.  So the owners don’t get a say so on the Einhorn idea alone.

These action has, predictably, had the opposite of the intended effect.  It’s publicized the Einhorn proposal like nothing else ever has.  It makes management look weak.  And it makes AAPL look like it has something to hide.  (My candidates:  the small amount of cash flow generated in the US; the dilutive effect of management stock options, which are obscured by stock buybacks out of US-held cash.)

what would I do?

I’m not a current holder–to my regret, although I did buy AAPL for my clients (including me) in 2004.  But if I were, I’d back Einhorn.

David Einhorn and Apple (AAPL)

It’s been a long day and I’ve gotten off to a late start.

the proposal

Hedge fund manager David Einhorn, who owns on behalf of his clients (so the internet tells me) over a million AAPL shares, has proposed to the company that it issue a perpetual (meaning it never comes due, and is therefore never redeemed) preferred stock with a total face value of $50 billion, paying a dividend of $2 per year.  The stock would be distributed for free to existing AAPL shareholders.

He’s apparently been discussing this idea with AAPL management since last May.

The proposal is a clever, novel twist on a finance truism   …namely, that if a security is a composite of disparate elements, like growth businesses and value ones, separating the two will increase the valuation of each.

The idea is that if a firm is composed of, say, mobile semiconductor design and cement mixing, growth investors will love the first and hate the second.  The opposite with value investors.  So either group will demand payment, in the form of a lower price earnings multiple, for being forced to take the part they don’t like or want.  Therefore, if you split the two parts up, the multiple on both will rise.

In the AAPL case, the potential split is between a security with earnings growth potential and one solely dependent on income/cash flow generation.

AAPL’s reaction to Einhorn

AAPL’s reaction has been to ask shareholders to vote at the next general meeting to change the company charter to explicitly ban the kind of preferred Einhorn wants.


Einhorn’s reaction to that has been to sue, to seek publicity and to take his own case to shareholders.

my take

The story is nowhere as simple as this.  There’s lots of stuff going on behind the scenes.  Details tomorrow.

Apple(AAPL)’s 1Q13 earnings

the report

After the close yesterday AAPL announced its 1Q13 earnings results (the company’s fiscal year ends in October).  AAPL earned $13.81 per share on revenues of $54.5 billion, both all-time records.  Sales were up 18% year on year, EPS were down by $.06.  EPS exceeded the Wall Street consensus by a little.  Revenues were a tiny bit lower.

Note that 1Q13 had 13 weeks in it, 1Q12 had 14.  On an apples to apples basis, sales would have been up by about 25% and eps would have shown a gain of 10%+, I think.

new guidance

AAPL also announced it was changing the way it would give forward-looking earnings guidance–and provided the first figures using the new method.  Under Steve Jobs, the company gave what inevitably proved ludicrously low single-number suggestions about what its sales, margins and EPS for the following quarter would be.  I’m not positive AAPL intended its “guidance” to be funny, but the process ended up being almost a parody of the way most other companies proceed.  My strong impression is that AAPL knew the figures it suggested were wildly inaccurate.

Under Tim Cook, AAPL has decided to become a bit more conventional.  During the conference call the CFO said that 2Q13 revenue will likely be $41 billion – $43 billion.  Gross margin will be between 37.5% and 38.5%, operating expenses $3.8 billion – $3.9 billion.  Other income will be about $350 million and the tax rate will be around 26%.  Unlike the past, no EPS figure was given.

All that would imply EPS of around $10 for 2Q13–a figure substantially below the brokerage house consensus of $11.50.  Of course, until we have actuals to compare with we won’t know whether the new company guidance protocol is intended to be any more accurate than the old.

Nothing on the call thrilled Wall Street.  As I’m writing this in mid-afternoon, AAPL shares are down about 12% in an otherwise flat market.


The iPhone is fine.  Units were up 29% yoy (30%+, apples to apples), revenues up 28%.   iPhone 5 was capacity constrained for most of the quarter, iPhone 4 for the entire period.  So sales could have been higher.  Despite this, sales were in line with the growth of the smartphone industry. Remember, too, that smartphones are AAPL’s main business, comprising 60% of revenues and more than 2/3 of operating profit.  So this is the business that counts.

two points of weakness

Macs (10% of sales)

AAPL was capacity constrained with new iMacs.  AAPL’s PC unit volume was down 22% yoy (-15% is probably a better apples to apples number), in a market that declined by 6%, however. So having more iMacs on the shelves would have affected the degree of market underperformance, not the fact.   Higher unit selling prices meant that revenue declined by about 10% ata.

iPads (20% of sales)

Units were up 48% yoy (60% ata). That’s good.   But revenues were up only 22% (30%? ata).  That’s bad.

Yoy the average selling price of iPads in total (minis, iPad 2s and the newest models) dropped from $568 in 1Q12 to $467 during 1Q13.  In other words, during the year AAPL saw a massive move away from its flagship tablet offering toward cheaper models.  My back of the envelope guess is that the company sold around 13 million newest model iPads during the 2011 holiday season   …and only about half as many this time around.


A while ago, AAPL decided to move its computer line upmarket.  My guess is that it’s now suffering from a cyclical falloff in demand caused by macroeconomic weakness–and made somewhat worse by the high price points.

The iPad numbers say to me that the tablet market is already quickly evolving away from the original high profit margin format of the original iPad, either toward a $400 price point for corporate/ education use and a $200-$300 price for consumers.  If I’m correct, the tablet market may end up being much bigger than previously thought, but it won’t follow anything like the high profit trajectory of the smartphone.  Note, too, that mini production was capacity constrained during the quarter.  The average unit price might have even been lower if AAPL had been able to satisfy all its potential mini customers.

my take

The tablet numbers are the only disturbing thing I found in the APPL quarterly information.  From what I’ve read, I’m not sure anyone else has noticed, however.  But both in tablets and Macs, AAPL has given the first hints that even it can be subject to business cycle forces.  That’s another way of saying that the company’s peak earnings acceleration phase may be behind it.

From a stock market point of view, however, investors have been discounting the arrival of this day (incorrectly, until now) for a half-decade.  AAPL has $137 billion in cash, about a third of its market capitalization, and no debt.  If we assume the company can earn $50 a share this year, it’s trading a 9x earnings, while growing at a bit less than 15% in weak economic times.  Better economic times should move that growth rate north.  Ex cash, AAPL shares are trading at 6x.  That’s crazy low.

where will the buyers come from?

I’ve read somewhere recently that over 3/4 of all equity mutual funds in the US have AAPL as one of their top few positions.  Equity oriented hedge funds have been up to their ears in the stock for a long time.

Two reasons why:

–it’s been a great stock to own for almost ten years, and

–at its peak, AAPL represented 10% of the IT sector’s market cap and 5% of the S&P 500’s.  Therefore, any professional concerned with outperforming an index would be forced to establish at least a market weighting in the stock in his portfolio, if for no other reason than to protect himself from losing ground to a surging AAPL stock price.

So, who’s left to buy?  No one.

What I’ve just written sounds pretty stupid, but it’s a situation that occurs often in smaller markets where one or two stocks dominate the index.  We just haven’t seen it in the US during my lifetime.

A common strategy in these markets is to neutralize the whales (have a market weighting) and try to achieve outperformance elsewhere. So virtually everyone already owns all the stock he ever intends to own.   The result is that surprisingly small amounts of buying and selling can move the giants a long way.

This may be happening with AAPL.  Certainly, in my opinion, the fundamentals don’t warrant the current low price.  But it’s anyone’s guess how long the current malaise may last.


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