A simple way of expressing the markets new view is to say, “what is the change in stock price implying about EPS estimates?”
The price change in stock is therefore equal to the change in earnings estimates.
So the market is essentially pricing in a China impact of at least 11.7% to earnings. Is that reasonable? That could be from a 10% tariff or a retaliation against a US producer like Apple.
After skimming AAPL’s filings, I found that China represents ~20% of sales. Assuming this business is of similar margin to the whole company, that means that ~$10.8BN of net income comes from China, or $2.4 / share. Since the market is implying the earnings estimates need to come down by ~$1.5 / share, one could simply say that the market is implying 62% of AAPL’s China earnings are gone ($1.50 out of $2.40).
Obviously, it isn’t that simple (for example, the market could price in some slowdown in AAPL’s other regions due to a slowing global economy).
I will say though that this seems bold considering what Apple had said on its latest earnings call:
Fortunately for Apple, they’ll be able to grow EPS in a lot of different environments due to their cash hoard. Here is a snapshot of their capitalization.
I think people often forget that Apple has a lot of long-term investments in marketable securities on its balance sheet. I would consider that cash for all intents and purposes because the company can (and does) sell some securities for attractive investments or to buy back stock.
Therefore, ~24% of Apple’s market cap is in cash right now. Let’s assume they use all that to buy back stock, but it comes at a premium. Let’s use ~30% premium which is around $250 / share.
At $250 / share, they can repurchase 842 million shares, which is a little less than 20% of the outstanding amount. If I assume net income is unchanged for 2020 (roughly $58BN), then EPS should go from $12.78 to $15.71. A 15x multiple on $15.71 is a $236 stock price, or 22% upside. A 17x multiple foots to 38% upside to $267. At 17x, this is ~1x above the S&Ps P/E multiple, but well deserved in my view given I think AAPL is an above-average company.
At this point, it seems like Apple is well positioned to either return capital to shareholders or invest cash for new projects. Tariffs on Apple are a negative, but not a deal breaker. While others are concerned about the company and what lies ahead for its future, I think having so much cash at this point provides for a significant margin of safety.
Investors are notoriously short sighted. But how often have you capitulated at the wrong time on an investment simply because (a) the headlines get worse and worse and/or (b) your losses are mounting (or your gains are shrinking)?
Any experienced investor has these cases. Equally as bad is not acting when your diligence and work suggests the value of the company is not impaired or that the news is bad, but they will make it through.
I wanted to highlight a few examples I’ve taken note of over the years and are hopefully recent enough to be relevant. My goal is for us to remind ourselves of these cases and to profit from similar cases if they are to occur again in the future, which they always do.
Case Study 1: Facebook IPO
I remember the Facebook IPO well. Mostly because it was one of those where I knew the business would be fine and had large run way ahead of it, but yours truly talked themselves out of buying it.
It was 2012, so not too long ago, and this was going to be one of the largest IPOs in recent history of a large tech company. The IPO was also extremely over-hyped. Yelp had IPO’d just recently and popped 64% on the first day of trading. Everyone I talked to that was outside of the finance realm was going to buy into Facebook (which scared me, since if everyone is a buyer, what value is there to be had) and they knew nothing about how the company made money (which scared me again). The stock IPO’d at $38 (after a technical snafu delayed trading). The stock traded poorly and the underwriters on the deal actually downgraded their growth estimates for the company.
Then, the lock-up period on the stock ended a few months later that released 133MM shares, which was a large increase in float compared to the 180MM that had been sold in the IPO. Fear began to build around this “technical” factor, as 1.2BN shares were going to free up thereafter. With so much supply and tepid demand, who would support the stock??
People were concerned about these short term factors, but completely missed the point. FB filed the IPO with $4BN in LTM Revenue and actually was very profitable – with 24% net income margins. The stock bottomed at $19 / share, which foots 9.5x estimates of EBITDA over the next 12 months. The thing about that multiple is that FB would go on to grow EBITDA from ~$1.2BN to $27.4BN in the LTM period.
Let’s say you bout in the IPO and sat through the pain… you would have experienced a ~50% loss, but would’ve turned into a 325% gain up to now.
Case Study 2: Apple and the death of Steve Jobs
This one will be quick because I think everyone knows the story. Apple had essentially made a comeback of a life time when Steve Jobs came back, after being on the verge of bankruptcy. Now, everyone knows it as the $1 trillion dollar company that has a well entrenched customer base that refuse to change phones, even when the prices exceed $1,000 per phone.
But there were several times in which people thought that the death of Steve Jobs would again impair Apple’s business model. What people forget is that men and women can have lasting impacts on firm culture, even after their deaths or departures.
Steve Jobs dies in late 2011, but it wasn’t until 2013 really that people became concerned about innovation. The company was still launching iPhones and iPods, but it wasn’t launching the NEXT thing (I guess people were expecting microchips in their heads). And that brought about serious fear in the company’s outlook and led people to anchor on quotes like this one from Larry Ellison, the CEO of Oracle.
“Well, we already know. We saw — we conducted the experiment. I mean, it’s been done. We saw Apple with Steve Jobs. We saw Apple without Steve Jobs. We saw Apple with Steve Jobs. Now, we’re gonna see Apple without Steve Jobs.”
As shown in the chart above, the stock fell 40% from its highs. But you already know what happened next. Customers didn’t frantically leave, Apple kept improving and innovating, and is still a dominant player in the space.
What actually came to be was an interesting cycle. Apple had an upgrade cycle that was becoming evident every 2 or so years. In the lulls of those cycles (i.e. the low periods when less people decided to upgrade), the headlines would be overly negative. Again, we would hear about the lack of innovation in the company and actually, despite seeing a rebound in 2014-2015, the headlines came back in 2016 and Apple’s stock got crushed again. Articles like these, appropriately titled, “Apple’s Core Problem Is That It Can No Longer Innovate“, were so proliferate it was hard not to buy in.
Again, that turned out to be a lot of noise and Apple’s stock today sits at ~$230 a share.
The question is, now that we are in the next lull cycle, will the market learn from these last mistakes?
Case Study 3: Intrepid Potash
I wanted to provide another example of overly negative sentiment, but this time related to cyclical downturn + headlines of bankruptcy risk. There were plenty of examples of this with the 2016 oil downturn and there are actually even a few I had the choice from related to just overly concerned bankruptcy risk, but I wanted an example that maybe you haven’t heard about.
Intrepid Potash (ticker:IPI) is a US potash producer, which is used as a fertilizer for crops. IPI’s capacity was relatively high on the cost curve, meaning there were mines in the world out there that could produce the same commodity for cheaper, giving those producers an advantage if prices fell.
Well, prices did indeed fall. By a lot. Back when corn was $8/bushel in 2010/2011 time frame, fertilizer prices also benefited. Farmer incomes were solid allowing them to spend more on fertilizer and other inputs. When corn supply caught up with demand (driven by higher ethanol demands), the price collapsed and potash has fallen with it, as shown in the chart below.
All the potash and other fertilizer producers stocks fell as well. This obviously makes sense because the earnings of these companies looked to be significantly impacted, at least in the near term. To make things worse, in the “good times” several major potash producers announced they would be adding capacity. Well, it takes about 5 years for that capacity to come online and guess what… it came on right at the worst time.
In my opinion, this is a classic example of a cyclical (not secular) downturn in a commodity. Demand for food should move up +/- 2% each year with a rise in population, which will in turn increase demand for corn. Increased demand for corn, in turn, will increase demand for inputs, like potash. In the short term though, the price of commodities can be highly volatile due to mismatches between supply and demand and could be low for awhile before the new supply is absorbed by slowly increasing demand.
Being higher up on the cost curve was a problem for Intrepid. IPI’s realized potash prices went from a peak of $541 / ton to $200 / ton. While the company was able to take some costs out, its COGS / ton moved from ~$225 / ton to $175 / ton. Obviously, that means margins earned on each ton sold were squeezed significantly and that’s before S,G&A and capex are taken into account as well.
That’s when the negative headlines came out. You see, fundamentals were bad and there was no sign of a turn around. Worse still, the company was about 6.5x levered and the company was in breach of its covenants. Headlines at that point came out about the company filing for bankruptcy. However, all you had to do is go to the filings and see that the lenders to IPI were a group of Agricultural focused banks. These banks understand that Ag has cycles, though it may not cycle with the general economy, and they likely wouldn’t want to force bankruptcy on IPI and take the keys. IPI after all was still in an OK liquidity position at the depths of a pretty bad cycle (and it was clear the banks were issuing extensions to help the company). I also liked that the CEO of the company was buying stock en masse during these times. Lastly, the company was public, so it could issue stock if it needed.
And that’s actually what the company did. I found it surprising, but instead of pressuring the stock further, it put liquidity / bankruptcy concerns at rest and stock went from $1 to over $3 on the news. The company issued $58MM of equity and moved on and instead of the stock falling from dilution, it shot up 300%.
The stock still has well to go before it recovers to the levels seen before, but keep in mind we’re still what I would call trough fundamentals, given where potash and corn prices are.
Case Study 4: Lululemon
The last case study is Lululemon, the athletic wear retailer, ran into a few PR snafus during 2014. First, the company’s leggings were found to be shear and even at some points see through. Instead of the CEO saying, “mea culpa… we’re working to fix these quality issues and will provide refunds to those who purchased products not up to our standards,” he blamed it on customers being too “big” to fit in the products.
The CEO and founder then stepped down. Lululemon at the time seemed to be in peril. Retail is littered with companies who have been left behind as consumer tastes changed.
But that is the thing. Customer perception of the product remained favorable. In addition, it was a brand focused mainly on women at the time and has now started to gain entry into men’s fashion as well. That would mean an untapped market for the company to provide extra growth. Lastly, at the end of 2013, the company had 254 locations in the US and Canada. Compare that to a more mature company, like the Gap, which had 3,700 locations at the time and you can see there was a long roadway ahead before the brand matured. Lululemon now has 415 locations and is still growing.
Holding on, or buying in, to the stock would’ve been the right call as the company has continued to have positive momentum and the stock chart below shows that.
My goal of this post was for you to read these case studies and see if they apply to any other companies you can think of now. Hopefully you take note of these situations as well, so you can apply these scenarios to future ones. The goal is to profit from lessons learned, especially regarding mismatches in negative sentiment and actual fundamentals. Some of these sentiment changes occur over and over with the same companies (Apple and Facebook), but I’ve recently seen these examples in other companies as well.
Any companies you follow now that seem to be on this trend?
As the news media has reported, Apple reached $1 TRILLION market cap on August 2nd. This is almost unfathomable to think of, despite other players such as Amazon on the heals of this feat as well. It means that if I owned $50 BILLION of Apple, I’d still only own 5% of the company. Imagine an activist trying to take a stake to do something. Buying even 1% of the company would take a lot of cash (and be highly risky).
So now that we sit at $1 trillion, is that a sign of the top for Apple? Phone growth has slowed and competitors like Samsung have moved in.
However, I don’t think this is the end for Apple. The brand and ecosystem it has should almost be thought of a subscription based business model. Yes, there is an iPhone cycle, but the fact that they are charging a $1,000 per phone should speak to the brand power here. The brand is proving to be a tough moat to break. Samsungs commercials even point to what features they had before Apple, yet recently it was reported that their high priced phones were struggling at a time when Apple raised price tremendously.
The interesting thing is that I think Apple still has room to run here and the stock actually looks cheap, even if we set aside the premium we should ascribe to the brand value.
Below, I share my analysis of cash today + cash I expect them to generate over the next 12 months less their total debt (as the company has said they will remain net debt zero). That means they have $190BN of cash available for repurchases. Let’s assume they use that cash to purchase stock at a price of $247 ( I arrive there by ascribing a 20% premium to today’s price, as the stock will move up with that much additional shares bought).
Apple can repurchase ~770MM shares of the company, or ~15% of the total amount outstanding.
Then, I compare this new sharecount to net income estimates over the next few years. If I assign just the S&P500s multiple to Apple (even though I could argue Apple deserves a premium given business quality), I see 30% upside including dividends over the next 12 months!
The stock is not dead yet, just because it hit a high watermark.