A New York Times article I read in early January discussed how Apple (NASDAQ:AAPL) CEO Tim Cook was going to have a really tough time in the year ahead, possibly his toughest test since taking over as CEO, putting doubts about Apple stock in the heads of investors.
The author (Jack Nicas) provided five reasons why this could be Cook’s toughest year yet: China’s not nearly as lucrative as once thought; people own phones longer; President Trump can’t stand Chinese-made products; Apple’s become defensive about iPhone sales; and innovation is slowing in Cupertino.
In the words of Judge Chamberlain Holler (Fred Gwynne) from the movie My Cousin Vinny, the author’s arguments are very lucid, intelligent, and well-thought out.
Indeed,Tim Cook’s ability to drive Apple stock higher is not a slam dunk, but it’s important to remember that the pace of innovation at most of the smartphone companies, not just Apple, appears to be slowing as new ideas get harder and harder to deliver.
While I understand why people think that Apple is not going to have an easy time in the years ahead, I believe that Warren Buffett’s big bet on AAPL stock is a good one that will continue to be positive for Berkshire Hathaway’s (NYSE:BRK.A,NYSE:BRK.B) shareholders for years to come.
Unlike Buffett’s IBM (NYSE:IBM) investment, his investment in Apple stock will turn out to be one of his best moves in a long, illustrious career.
Here are seven reasons why.
Reasons Why Berkshire Will Benefit From Apple Stock: Buffett Himself
It’s become a cottage industry of sorts to second-guess Warren Buffett’s stock picks in recent years, but the fact is, he and his team are still very good at making long-term bets on stocks and riding them to big profits.
The Jan. 3 headline on CNN Business said it all.
Apple’s plunge has cost Warren Buffett nearly $4 billion today.
Berkshire Hathaway owns almost 253 million shares of Apple, making the holding company Cupertino’s third-largest shareholder behind BlackRock (NYSE:BLK) and Vanguard. It’s also Berkshire Hathaway’s largest equity holding, accounting for 26% of the company’s stock portfolio.
Buffett wouldn’t risk so much on Apple stock if he wasn’t certain that the long-term upside is much greater than the short-term pain created by the slump of AAPL stock.
Warren Buffett is the type of person who’s very good at seeing the big picture. If he sees a good future for AAPL, I do, too.
Reasons Why Berkshire Will Benefit From Apple Stock: Huge Free Cash Flow
Anytime I see an article about Apple’s free cash flow, I need to read it. Apple might be suffering a crisis of innovation – at least if you believe the detractors – but it’s not suffering from a shortage of cash.
Seeking Alpha contributor Robert Riesen recently detailed five reasons why Apple stock is a good buy at current prices. High atop his list was the company’s ability to generate cash, not to mention its huge cash stockpile.
In 2018, AAPL repurchased $73.1 billion of Apple stock, more than it repurchased in the two previous years combined. The company paid $180.25 per share on average, about $10 less than the midpoint between the high ($233.47) and low ($142.00) of Apple stock over the past 52 weeks.
Most companies tend to pay more than the 52-week midpoint price, so from that perspective AAPL is effectively repurchasing its shares. Apple finished its last fiscal year with $71 billion left on its share repurchase authorization. With Apple stock trading lower than the midpoint between its 52-week high and its 52-week low, expect AAPL to buy a lot of shares in the first half of 2019.
As Riesen stated in his Seeking Alpha article, AAPL produces at least double the amount of free cash flow of other companies on the market, yet AAPL stock has a similar enterprise value to other tech companies.
Apple’s cash flow generation should be worth more to investors.
Reasons Why Berkshire Will Benefit From Apple Stock: Valuation
One of the valuation metrics I like to use when analyzing any company is free-cash-flow yield, defined as free-cash-flow per share divided by market cap plus long-term debt less cash. That metric tells you not only that the company is generating significant free cash flow, but also that it’s trading at a reasonable valuation.
Currently, Apple’s enterprise value is 11.72 times its free cash flow of $67.4 billion. To get the free cash flow yield, you divide $67.4 billion into the company’s enterprise value of $789.6 billion. The result is a free-cash-flow yield of 8.5%, above the 8% minimum for which most value investors look.
Riesen compares nine other tech companies to Apple. Only IBM (barely) has a lower enterprise value to free-cash-flow ratio, which suggests that investors continue to underestimate the value of its free-cash- flow generation.
That’s okay.
When a recession hits, AAPL will have more cash than almost any other company, putting it in a great position to weather the storm. That’s got to be worth more than 11.7 times free cash flow.
Reasons Why Berkshire Will Benefit From Apple Stock: Services
RBC Capital Markets recently warned that the company’s services revenue slowed to about 18% growth last quarter, well below the 27% growth that analysts were expecting. According to the firm, fewer purchases of AppleCare due to a lack of hardware upgrades were the main culprit.
Despite this warning, RBC remains confident about the ability of Apple’s services business to move the needle for AAPL stock.
“We think investors are better off remaining positive here given attractive valuation and high probability for services to re-accelerate later in 2019 via new offerings,” RBC said on Jan. 14.
One theory is that big companies like Netflix (NASDAQ:NFLX) are starting to require new subscribers to sign up directly with them. By doing so, the companies no longer have to pay large fees to Apple and Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) to sell their products and services in the Apple and Google app stores .
I don’t know how much water this argument holds, but I do know that Apple’s services revenue is not going to go up in a straight line. There are going to be quarters when consumers throttle back spending, and this quarter appears to be one of them.
Tim Cook’s argument is that AAPL wants its customers to enjoy their phones, and that services such as iTunes and the App Store help them do that.
I couldn’t agree more.
In the future, AAPL will focus not just on selling phones, but on generating ancillary revenue from phone owners. The company’s recurring revenue will more than offset the impact to its top line of declining phone sales.
Over the long-term, that will be a winning plan for owners of AAPL stock.
Reasons Why Berkshire Will Benefit From Apple Stock: China
In what’s become a broken record, analysts are recommending that Apple lower the price of its phones in China because the high prices of iPhones puts the company at a severe disadvantage to other phone providers in the country.
“Apple needs to make sure that over the next few quarters they do not lose any current iPhone customers, and thus speaks to the more significant price reductions on the way in China, in our opinion,” Wedbush analyst Dan Ives stated on Jan. 14. “This is a smart and necessary strategy.”
Ives believes that Apple needs to cut the price of its iPhone XR by 20% in China to stop hemorrhaging customers, many of whom are flocking to cheaper phones.
In December, I wrote that AAPL shouldn’t cave in to pressure to lower its phone prices in India; I have the same viewpoint about China. iPh0ne isn’t supposed to be everybody’s phone; it’s supposed to appeal to people who don’t want to spend a lot of time figuring out how to use phones.
Apple’s products have generally been easy to use, and its customers have to pay for that privilege. By cutting its prices, AAPL would not only cut into its margins, but destroy its brand power.
I understand that AAPL is not selling enough phones in China, but if the price of the iPhones was the only thing holding it back, I’m pretty sure it would have acted a long time ago.
If Apple wants to be an important part of the Chinese smartphone market, it needs to remain the premium option for the country’s consumers.
It must have patience.
Reasons Why Berkshire Will Benefit From Apple Stock: Privacy
Did you see the bold, amusing ad that Apple placed on the side of a hotel in Las Vegas during CES 2019? It read, “What happens on your iPhone, stays on your iPhone.”
It was meant as a dig against the Facebooks (NASDAQ:FB) of the world who will gladly sell your information to the highest bidder, even if that bidder happens to be a Russian named Vladimir Putin.
While Apple’s iPhone isn’t free of privacy issues caused by third-party apps downloaded on the App Store, AAPL does not release its customers’ data and information to anyone who wants it. That’s because it doesn’t use this information for advertising purposes.
That’s what makes AAPL so much more attractive than many of its competitors and peers.
“Apple needs to sell privacy with as much marketing skill as it does its ‘super-Retina screens’ and ‘precision-machined, surgical-grade stainless steel,’” wrote 9to5 Mac contributor Ben Lovejoy in December. “Long-term, I’d guess privacy promotion will do more to sell iPhones than any number of trade-in deals. And it will enhance the company’s image, not damage it.”
That strategy, in my opinion, is far smarter than dropping the price of an iPhone in China by 20%. It’s harder to do but worth far more to the brand in the long run.
Reasons Why Berkshire Will Benefit From Apple Stock: Tim Cook
Tim Cook took an impossible task – succeeding Steve Jobs as CEO – and made it look easy. I don’t know the man, but he seems like a very genuine person, who puts his pants on one leg at a time, just like the rest of us.
Among the issues that he’s had to face since becoming chief executive:
- A slowdown of iPad sales
- A slowdown of iPhone sales
- Too much cash
- Too small of a dividend
- No great product innovations
I could add another five issues, maybe ten, to the list.
Yet, since Cook was named CEO in August 2011, Apple stock is up almost 200%, which includes a 30% drop over the last three-and-a-half months.
Owners of Apple stock were spitting nails when Steve Jobs got sick and then died because they were worried that Jobs’s replacement would be some number cruncher with no clue about innovation.
That’s what many of them thought about Cook, but he’s proven to be far more technologically adept than most people gave him credit when he first became CEO.
I’m not going to say much about Cook other than to note that Warren Buffett’s said a lot of good things about the man. If you haven’t noticed, Buffett knows a thing or two about sizing up a person.
Cook’s a keeper.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
