Apple Part 1

Apple Inc. (AAPL) Part 1

Today I want to share with you my research on Apple. I discovered that Apple could be a good investment according to the principles of Compound Investing, while writing my Bachelor’s Thesis. My topic was to write about the overvaluation of the US stock market, especially analyzing Tesla. While doing research on the big Tech companies that are massively overvalued in relation to their earnings, I found that Apple was different. Their P/E-ratio at the time was around 14 while all the others had P/E-ratios of 100 or more. This gave me the impulse to do further research on Apple.

1.1 Quantitative Analysis

Return on Equity

Apple’s average ROE for the past ten years has been 35.55%. It is also important to mention, that the ROE didn’t fluctuate much and the lowest value during this period was 26.28% in 2009.

Earnings

As you can see in the graphic below the earnings per share over the past ten years show a strong upward trend. Although EPS decreased in the years from 2012 to 2013 and 2015 to 2016 Apple was able to get back quickly and the upward trend in earnings was not broken. Also the EPS are not fluctuating much, which is a good sign of stable and predictable growth. The rate at which EPS have been compounding (CAGR) over the last ten years is 24%, which is an exceptional value and also shows the strength of Apple’s business model.

Debt

Up until 2013 Apple didn’t have any long term debt. Since 2013 they have started building up long term debt, but for our analysis we have to look at the ratio of long term debt to net income (displayed in the second graphic). This ratio built up to 2.0 in 2017, but we can see that it has been going down to 1.6 in 2018. Not just the ratio went down, but also the absolute long term debt. This is a good sign and we will see if this development can continue for the year 2019. Normally the threshold for the long term debt to net income ratio would be 1 and all companies with a higher ratio would be eliminated. Because Apple is moving in the right direction I will continue with the analysis. Still it is definitely an important aspect to consider when making the investment decision and we will have to monitor the future development of long term debt closely. 

1.2 Qualitative Analysis

1.2.1 Business Model

In terms of the business model Apple has big changes ahead. They stand at a point of transforming their entire core business. Hence the following analysis will be presented in two separate parts.

Business Model during the last ten years

The last ten years the iPhone has been Apple’s most valuable product making up around 70% of total revenue. Apple had the advantage of inventing the smartphone, so when the iPhone first came out there was no competition at all. When competing products were introduced to the market, Apple was able to profit from having positioned their products in the luxury segment. Because of this positioning and Apple’s strong brand name they were able to realize high profit margins. Additionally, because Apple produces both hardware and software, it is difficult for users to switch to competitors without negative repercussions. For example someone who has bought apps with his Apple account would have to buy them again when switching to android. This ‘digital prison’ strategy together with the iPhone as a new, transformative technology has worked really well for Apple in the past. 

Future Business Model

The saturation of the smartphone market and cheap competing products are a threat to Apple’s business model. Even though they will be able to make lots of money with the iPhone in the future, it is likely that we won’t see any substantial growth in this area. Apple’s strategy, in order to secure future growth, has been to transition to a services business. They have been working on it for many years, but in the recent past it has become more obvious. New services offered by Apple are for example the Apple Credit Card, Apple TV and Apple news. They all have the goal in common to bind customers to the company and generate further revenue. 

1.2.2 Further Qualitative aspects

Type of Business

Apple is definitely a monopoly type business as they have a strong brand name and are positioned in the luxury segment. Customers are willing to pay huge premiums for Apple products.

Capital Requirements

On the one hand Apple has to use a lot of capital for research and development in order to stay competitive. On the other hand they don’t have to maintain factories and their products won’t become obsolete for a long time. Also Apple’s transition to a services business will lead to less capital requirements. 

Retainment of Earnings

In the graphic below you can see how much of the earnings Apple retained each year. With Compound Investing we are looking for a high percentage of retained earnings, because we want to invest in companies that can compound their earnings within the business at high rates of return. First of all we see that Apple started paying a dividend in 2012 and that the percentage of retained earnings since then has been in the mid 70% range. That is definitely a good sign, because it means that Apple still reinvests about three quarters of their earnings back into the business. The other aspect we have to test is, if Apple can reach a high enough rate of return on the retained earnings to justify an investment in them. In order to calculate the rate of return on retained earnings we compare the absolute amount of retained earnings to the growth of EPS over a period of time. In the bottom right of the table below you can see that Apple retained 42.69$ per share from 2009 to 2017. That means this amount per share has been reinvested into the business in order to realize an EPS in 2018 of 12.01$. The growth of EPS therefore is 12.01$ – 1.32$ = 10.69$. The rate of return can be calculated by dividing the growth of EPS by the sum of retained earnings: 10.69$ / 42.69$ = 25%. That means Apple realized a rate of return of 25% by reinvesting their earnings back into the business. This rate of return meets our minimum requirement so that from a standpoint of earnings retainment Apple looks like a good investment.

 

Conclusion

The goal of this article was to look deeper into the financials and the business model of Apple. Before I started this analysis I was convinced that Apple was a great company to invest in. Now I am not so sure. I wasn’t aware of the long term debt Apple has built up over the past years, even though, if the declining trend continues, this factor might not be so important. What will determine the future success is the transition to a services business. On the one hand such a dramatic change in the business model is always risky and more a speculation than an investment. On the other hand the business model of the past ten years is still working at this time and we shouldn’t anticipate a deterioration of it, but just acknowledge the possibility. I did invest in Apple myself on the basis of the old business model, without being fully aware of the future challenges Apple will have to face. However I will stick with the investment for now, as the business model still works and because I was able to get the stock at  a very good price. My strategy with this investment is to be cautious as to how Apple will face the future and only sell if their financials deteriorate. I hope you enjoyed reading!

 

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