The Apple In Wall Street’s Manic Eye—Why Price Discovery Is Deader Than A Doornail, Part 1

Actually, what was to like about last night’s big earnings announcement?

After all, compared to prior year, revenues were down 5.1%, gross profit was lower by 6.8% and operating expenses were up by 11.7%. That meant, in turn, that the company’s operating margin slid from 26.0% to 23.2%, causing pre-tax profits to drop by 14.7% and net income to fall by 16.3%.

That’s the very picture of a company experiencing negative operating leverage and deteriorating performance fundamentals and fixing to take a drubbing in the casino from the “growth” momos.

It’s also the very metrics that Apple Inc. reported last night, but a drubbing is not what happened upon their release. Instead, the stock has ripped higher by 5%, thereby adding a round $45 billion to its market cap and putting its nose just at the entry line for the trillion dollar club.

OK, there’s the “beat” thing, the “guidance” ruse and the “story” meme about services coming to the rescue of the iPhone’s nose dive.

As to the latter, it was exactly that: March quarter iPhone sales of $31.1 billion were down by $6.5 billion or 17.3% from the year ago figure. So the $1.6 billion gain in its services revenues made up barely 25% of the slack.

Likewise, the “beat” thing is a patented Wall Street scam, but this one was especially ludicrous. Apparently, the consensus projected a sales decline of $3.77 billion or 6.2% compared to prior year, but the actual drop came in at $3.12 billion or 5.1%.

Whoopee—a tad less down!

So hit the “buy” key and slather on another $45 billion of market cap.

Then there is the “guidance” ruse which bubblevision pitched as, “Apple stock spikes after reporting strong guidance.

In fact, the company’s guidance for the June quarter was the following:

  • revenue between $52.5 billion and $54.5 billion
  • gross margin between 37 percent and 38 percent
  • operating expenses between $8.7 billion and $8.8 billion
  • other income/(expense) of $250 million
  • tax rate of approximately 16.5 percent

If we take the mid-point of each we get revenues of $53.5 billion which compares to $53.3 billion in last year’s June quarter and a gross margin of 37.5% compared to 38.3% last year.

Of course, even part way down the income statement, this math does not  bespeak of “strong”. The implied gross profit of $20.1 billion in the up-coming quarter is actually “down” from $20.4 billion last year.

To be sure, the guidance for operating expense of $8.75 billion is indeed strong—it’s up by 12.1% over last year!

Alas, that means that the implied operating income guidance of $11.35 billion (mid-point) does not stack up well at all to last year’s $12.61 billion. To paraphrase the Donald, any more of this kind of “strong” 10% decline in operating profits and someone’s liable to say we can’t stand all this strong.

But the seemingly odorless skunk in the woodpile comes on the bottom line. Apply the other income/expense and tax rate guidance and you get net income of $9.69 billion.

Perhaps not inadvertently, the company did not spell out the net income math in its press release—since last year during the June quarter net income posted at $11.52 billion.

That’s right, the company confessed that its next quarter earnings are going to be down by 16%, and the morons on Wall Street genuflected “strong” and raced off for the buy key.

In fact, its “strong” guidance of 16% down for June is exactly equal to the 16% net income decline reported for the March quarter last night. In effect, the company projected no progress at all next quarter in turning the mighty ship of Apple Inc., but the boys & girls and robo-readers down in the casino apparently bought first and did the math later, if at all.

Of course, they actually did do the math, Wall Street style. That is, the talking heads claim Apple always sandbags its guidance—meaning that the projected 16% down next quarter is actually “strong” on a sandbag-adjusted basis. Apparently.

But here’s the thing. After the most amazing outbreak of product innovation and sales and profits growth in corporate history triggered by the iPhone launch a decade ago, Apple reached a financial performance peak in its 2015 fiscal year; and it has been struggling to stabilize, revamp its product mix and re-set its financial course ever since.

But it’s simply not happened because Apple’s current guidance implies that its LTM results next quarter will be still way below the it’s peak level three-and-one-half years ago.

Thus, if we take the last three quarters of actuals plus the June quarter guidance we get the following LTM comparisons with the company’s fiscal 2015 results (September). On revenues, the June LTM number would be $258.7 billion—up 11% from 2015. But the income statement is a downhill slalom thereafter.

To wit, the LTM gross margin would be 37.9% compared to 40.1% in 2015. Accordingly, actual LTM gross profit of $98.0 billion would represent only a 4.7% gain from 2015, which isn’t much to write home about given Apple’s exploding operating costs for R&D and SG&A.

Based on the last three quarters of actuals plus the company’s guidance for the June quarter, LTM operating expense pencils out to $33.85 billion—compared to just $22.4 billion in 2015. That’s a 51% eruption of operating expense on the back of a 4.7% gain in gross margin dollars.

Needless to say, it doesn’t pencil out. The LTM operating income figure would be just $64.2 billion, down 10% from the peak 2015 level of $71.2 billion.

Stated differently, Apples’ business model is changing substantially and it’s dragging down its fabled profit margins. That is, with gross margin down by more than 200 basis points in the LTM model and operating costs up from 9.6% of sales to 13.1%, the implied LTM operating income margin is a wholly different kettle of fish: It drops from 30.5% of sales at the once-in-history iPhone peak to 24.8% in our June LTM estimate.

Again, it needs to be recalled that our LTM estimate reflects three quarters of actuals and one quarter which is already one-third over. So we don’t think anybody is sandbagging anything.

And we also don’t think Apples’ projected pre-tax income of $65.72 billion is anything to sneeze about. It represents truly barn-burning profitability on sales, and an even more prodigious return on capital (which, as we show below, is likely the Achilles Heel in the whole Apple story). Still, it’s not close to the $72.5 billion of pre-tax profits Apple reported back at its 2015 peak.

In short, Apple’s true profitability looks to be off by 10% from it peak, and at this point of the repositioning game its operating leverage seems to be falling faster than gains from its Wearables, Accessories and Services can be harvested.

Moreover, that’s to say nothing of the big Red Hole called China, where its six months’ sales have declined by a thumping 25% and we are talking about real money here: Sales of $31 billion in last year’s first half have fallen to $23.4 billion this year.

Yes, the Donald and Emperor Xi Jinping may bury the hatchet next month. Sort of.

But what is percolating through the current trans-Pacific negotiating shuttle looks increasingly like a Rube Goldberg contraption where most of the tough issues–including mutual removal of the existing 10-25% tariffs—will be punted into the foggy future. There they will presumably be sorted out under the auspices of a K-Street special of milestones, performance tests, compliance assessments and penalty imposition and appeal procedures, which will make even the pointy heads of the beltway lawyers spin.

So we have no idea whether China is coming back or not, or whether Services and Wearables will win the day or whether the ferocious competition—Huawei, Samsung etc.– in the smart phone space will not continue to erode Apples’ vaunted margins on its proprietary devices.

The latter does not look especially promising. Just during the quarter reported last night, its gross margin on Products–principally iPhones, iPads, Mac’s and Wearables—fell from 33.8% last year to 31.2% this year; and Products still account for 80% of sales.

In all, the only two bright spots in the outlook actually go right to the heart of the Apple problem per se, and the reason why the Fed’s destruction of honest price discovery is so foreboding with respect to what’s coming down the macro-economic and financial pike.

To wit, the 10% decline in pre-tax profits in our LTM model compared to the 2015 peak represents the real economics. But thanks to the Trumpite/GOP’s corporate tax slashing, the company’s LTM tax rate will be just 15.9% compared to 26.7% in 2015.  Still, that’s just a one-time gift, not growth, and it’s already anniversaried out.

Likewise,  thanks to the Fed’s endless coddling of Wall Street and its defacto subsidization of rampant financial engineering in the C-suites, Apple’s share count has been reduced by nearly one billion or 16% since the 2015 peak. So on an after-tax per share basis, net income under our LTM model is a tad higher than 2015.

But here’s the thing. The Bank of Apple has been running down its vaunted net cash reserves, and its operating free cash flow is seriously falling. With respect to the latter, free cash flow during the last six months was down by 12% versus prior year; and the comparison with the 2015 peak is even more telling.

Back in 2015, the company generated $81.3 billion of cash from operations, which was reduced by $11.4 billion for CapEx, thereby generating operating free cash flow of $69.8 billion.

By contrast, the figures for March LTM are $71.6 billion of cash from operations (down 12%), which was reduced by $12.0 billion of CapEx (up 5%), thereby generating operating free cash flow of just $59.6 billion.  

The truth of corporate finance for a mature monster of the midway like Apple Inc, of course, is that operating free cash flow is the ultimate measure of profitability and value, and it’s now down 14.6% from it 3.5 years’ ago peak.

In fact, the company’s weakening free cash flow gets to another key “internal” in the March quarter report. To wit, Apple spent the incredible sum of $27.1 billion on stock buybacks ($23.7 billion) and dividends ($3.4 billion) against only $11.6 billion of net income and $8.8 billion of operating free cash flow.

Needless to say, the math eventually gives out when you distribute to shareholders 2.3X your net income and 3.1X your free cash flow. Those ratios, of course, explain why Apple’s stock came roaring back during the first four months of this year, thereby leading the overall cap-weighted S&P 500 and NASDAQ-100 in their V-shaped rebound from the Christmas Eve interim lows.

The bid from Cupertino was Mighty indeed—-even if it does mean that Apple’s net cash position at the end of March at $122 billion ($225 billion of cash and liquid investment netted by $104 billion of debt) has already come down substantially from the $142 billion net cash hoard ($217 billion of cash netted by $75 billion of debt) it had posted at the end of 2015.

In this respect, the company did announce an increase in its dividend and a new $75 billion buyback authorization, which apparently got the headline reading robo-machines lathered up for the buy.

Then again, in Q1 the company pumped into Wall Street $18.3 billion in excess of its operating free cash flow. At that rate, its net cash hoard would be gone in seven quarters, and it would then become a plain old debtor like the rest of corporate America.

Undoubtedly, in future years Apple would distribute less back into the casino or borrow even more or maybe even find some way to reduce the 14.6% plunge of its free cash flow since the 2015 peak.

As to the latter, it’s a matter of faith that what is now a $45 billion annual Services business can replace the continued run-off of its $215 billion gadgets business. Naturally, Jim Cramer thinks so because Services currently have a higher gross margin than gadgets.

Then again, the unique peak profitability of Apple in 2015 reflected the perfect storm of selling premium products to affluent Americans and Europeans that were made with the deeply discounted labor supplied by Foxconn’s 1 million plus nimble young fingers and backs spread among the former rice paddies of China’s interior industrial centers.

It was that massive arbitrage which created the Bank of Apple, and it is a bank. At the end of Q1 it had  $342 billion of assets on its balance sheet, but $225 billion or 66% of that consisted of the aforementioned cash.

At the same time, the mightiest gadget seller in the world of extremely exacting and technologically advanced products had net PP&E of only $39 billion and operating working capital of negative $38 billion (payables and other current liabilities less inventories and trade receivables).

That’s right. Aside from it cash, which in today’s Fed-world generates only rounding error interest income, the mighty profit machines called Apple Inc. has only $1 billion of net operating capital employed behind its $260 billion business!

That’s your trans-Pacific arbitrage at work: All the capital is over there in Foxconn and the rest of Apples’ massive and intricate global supply chain.

So the real question is whether the greatest arbitrage in history will hold; whether other smart phone makers will compete down its massive iPhone margins; whether anything remotely as profitable as its peak gadgets business( iPhone) can be created in services, where there is huge competition and no proprietary manufacturing farm in China; and whether its shrinking free cash flow trend can be arrested and reversed in the face of the self-evident decline (per above) in its operating leverage.

These are huge imponderables, and that’s what honest free market price discovery was supposed to suss-out as the future unfolds.

But in the Fed’s hyped-up casino, there is apparently no time for sussing. That is to say, back at its peak in September 2015, Apple’s market cap weighed in at $625 billion, meaning that it was being valued at 8.9X operating free cash flow.

And that’s not exactly unreasonable for a company sitting at the tippy-top of an historic and aberrant run of profitability attributable overwhelmingly to the (unsustainable) first mover advantage of the iPhone.

Now 42 months later with all of the aforementioned headwinds and the deteriorating financial results itemized above, and with free cash flow down by 15% for the LTM period we have modeled, the Apple stock closed today after its post-earnings rip at a $992 billion market cap.

That means, in turn, that it is now being valued at 16.6X free cash flow.

You could call that multiple expansion with a vengeance.

And you could also say that in in the manic eye of  Wall Street, Apple is simply the poster boy for momentum and liquidity driven speculation run wild, as we will further address in Part 2.