Beware of the iPhone shrink.
On July 26, Apple aapl announced that its earnings and revenues narrowly beat Wall Street’s expectations. Investors, who’d been fretting that the sharp decline in iPhone sales that spooked the markets early this year would accelerate, cheered.
But here’s the thing: The surge isn’t supported by Apple’s financials; the iPhone seller’s fiscal third quarter numbers (for the 3 months ended June 25); or by its future prospects. Apple’s sales fell 14%, and net earnings declined 27%. CEO Tim Cook’s forecast for revenues of between $45.5 billion and $47.5 billion for the fourth quarter, are a bit better than what Apple had in the past three months, but far below the average of $56 billion a quarter pace for the last nine months, not to mention the $61 billion average over the first three quarters of fiscal 2015.
Bottom line: The most celebrated growth company of all-time is now shrinking. What’s worse, it’s highly uncertain that Apple can achieve the relatively robust growth it will need to reward investors ever again.
In recent years, Apple’s had a tough time finding any business worthy of feeding with its gigantic cash flows. Looking forward, Apple needs to not only find plenty of opportunities it’s not finding now, but exploit them skillfully by generating good returns. That dual challenge has enveloped Apple’s future in a fog of uncertainty.
Over the past four quarters, for instance, Apple has generated $50.1 billion in free cash flow, defined as cash from operations, minus the capital expenditures required to keep its plants and IT facilities in top condition. That’s a drop of 26% from the $69 billion in free cash flow it booked over the previous twelve months. As its cash flow fell, Apple couldn’t find significant investments to reverse the big shrink. Over the 12 months ended June 25, Apple used $49 billion of it free cash flow, or 97%, to pay dividends and repurchase shares. It had some funds left because of new long-term borrowings, but plowed that extra cash into “marketable securities,” i.e. short-term bonds, providing low single-digit returns.
But pocketing those dividends, and watching the share count dwindle, didn’t satisfy investors who pounded Apple’s shares roughly 20% over the past year, even including the new bounce.
So does the selloff make Apple genuinely cheap? You might think so from standard market metrics. It’s selling at 11 times free cash flow, based on its current market cap of around $560 billion. Based on that price, if Apple could simply grow with inflation, and keep returning all of its earnings to shareholders––its posture over the past year––that means it would yielding around 11% a year. That’s fabulous at a time when the market as a whole is up just 6% in 2016, and 10-year Treasury bonds are yielding 1.5%.
But keep in mind that Apple isn’t likely to stop shrinking anytime soon. It clearly sees its future as the great growth enterprise of legend. On the July 26 conference call, Tim Cook lauded Apple’s big expansion in services, stating that the franchise that includes its app store, iCloud, and AppleCare could grow to the size of a “Fortune 100 company” by next year all by itself, and predicted big things for the launch of the iPhone 6 in September.
So how fast must Apple grow to hand investors a decent return, say 8% per year––hardly fabulous given the stock’s volatile history? To make that happen, Apple could tolerate a continued fall in cash flows for awhile. But following that interlude, profits would need to rise at a strong, consistent pace.
Here’s the kind of scenario investors are betting on:
- Over the next year, Apple’s free cash flow falls from $50 billion to $34 billion.
- At that point, it would be selling at around 16.6 times cash flow, at a market cap of $600 billion.
- Apple pays a 2.2% dividend.
- So to generate a total return of 8%, it would need to grow cash flow regularly at 5.8% annually, from that base of $34 billion.
- Hence, by 2021, Apple’s cash flow would need to rise 33% to $45 billion, and keep rising $2.6 to $3 billion in the years that immediately follow.
Keep in mind that $45 billion in total cash flow is 84% more than what the second highest earner on the Fortune 500 list, J.P. Morgan Chase jpm , made in 2015, and that the $2.5 billion that needs to be added annually is equivalent to the total earnings of Aetna aet , as well as for Lowe’s low .
Can Apple do it? The bull case is that its cash flow will stabilize without dropping too much more, so growth will begin at a number far higher than $34 billion, and run from there. Indeed, if that happens, Apple at today’s prices would be an excellent buy.
But Cook’s forecast for the next quarter implies free cash flow in the $7 to $8 billion range for the quarter, or around $30 billion annualized. So let’s assume that Apple re-starts its growth from a much reduced base. To turn cash flows around, Apple will need to re-channel most of the money now going to buybacks and securities into high-yielding investments. “Apple keeps talking about their Big Future, but there’s no indication they’re putting their money where their mouth is,” says Jack Ciesielski, author of the Analyst’s Accounting Observer. “Any major investment plans appear to be a family secret.”
Among the possibilities are big acquisitions. So far, Apple has made lots of purchases of small tech companies, but each deal is typically tiny. In the conference call. Cook stated that Apple buys a company every three or four weeks, but gave no signal it would hunt for bigger targets. One Wall Street rumor gone viral is that Apple will get into driverless cars.
The rub is that the big investments need to move a gigantic needle, because even in the low-$30 billions, Apple’s cash flows are already super-gigantic. It would take another iPhone-like hit to do it. And the iPhone successors are more likely to stabilize its smart phone sales than to provide the big boost it will need to enrich investors. Apple is unlikely to repeat its history by always besting competitors with a constant flow of revolutionary products. Huge margins attract big, hungry competitors, the challenge Apple now faces with the likes of Samsung. Hence, it will probably have to buy companies and technologies.
Nobody knows how profitable those purchases will turn out to be. They’re unlikely to be in the original iPhone class. So the best conclusion is that Apple can’t find good stuff to invest in now, and that the chances it will find big enough ones in the future is just too low. So do the smart thing, when it comes to Apple’s shares, stay away.