Monday, May 23, 2016

Taking a Bite Out of Apple

Warren Buffett likely gave a nod of approval before Berkshire decided to invest $1 billion in Apple

To the surprise of many who figured Buffett and his Berkshire Hathaway investment company always steer far from investments that sound and smell “technology,” the group announced in May it would invest $1 billion in Apple stock. 

In the days before the announcement, Apple’s stock had tumbled a bit following what it deemed a lackluster first-quarter performance (a slight decline in revenues for a company that had hardly experienced bad-news earnings the past decade). In the moments after the announcement, its stock price bounced upward. A Buffett stock-purchase gesture will do that for you. 

Some analysts responded in the media this signaled a step toward retirement for Buffett, now 85--a hint that he is allowing others to lead the company’s investment decisions and that might have spurred the decision behind the Apple stake.

On the other hand, no matter how many detect Buffett is permitting others to make investment decisions, a billion-dollar investment in Apple or Coca Cola or any major company likely required Buffett’s nod of approval. The next generation of decision-makers at Berkshire will likely have sought Buffett’s input and sign-off. He might have not have come up with the idea or might not have immersed himself in the research that usually accompanies a Berkshire stake. Others performed the analysis and industry research and presented a legitimate case to invest; Buffett, no doubt, okayed it.

What did they see, as they researched and reached a decision that must have conformed to the company’s decades-long investment principles? The  principles form the backbone of investments in companies that will show consistent, stable and sustainable performance for a long time. 

Buffett and his Omaha crew for ages have preached investments in

(a) businesses they know and understand and businesses with readily understood operating models,

(b) industries that will be important for a long time to a large buying market, 

(c) companies that have groomed leaders to be astute, shrewd business managers, 

(d) companies that hit certain measurable objectives: good, stable returns on equity (book value), most notably, 

(e) companies that have “intrinsic” values that far exceed the values calculated by emotion-swamped and flighty short-term shareholders, 

(f) companies that have cost control and exhibit some signs of growth (after a modest amount of tweaking by the same experienced management team), 

(g) companies that may occasionally experience downturns or slumps, but will be granted time to recover and even soar.

And yes, companies that pay steady dividends from predictable streams of cash flow, aren’t burdened with too much debt and aren’t daring to venture into non-core, exotic activities or activities that appear to be CEO “hobbies.” 

Does Apple qualify? What could have swayed them, beyond Apple’s decades-long performance of stunning levels of operating cash flow? 

Take a peek. 

a) Market values that fall shy over “intrinsic” values, even if Apple hasn’t yet unveiled the next gadget of the decade.

Apple now has a market value that now exceeds $510 billion, even after the stock price cascaded downward from above $130/share to the mid-90’s today. Berkshire analysts may have concluded after a slight downturn in earnings (“down” to $10 billion in the first quarter), equity markets might have over-reacted. Has the market been too concerned about Apple's product line, uncertainties about an Apple watch product and slippage in revenues warrant declining values? 

A recent P-E ratio computed to 10, for a company operating in a still-growing industry where normal P-E’s range above 15. A P-E ratio hovering about 10 suggests markets aren’t willing to give value to uncertain levels of growth. 

The Omaha team may have concluded the market is under-estimating future growth. They are confident Apple management (under Tim Cook, as CEO) can still crank out operating cash flows continually in a $10-15 billion range each quarter. 

b) Cash reserves, which rest visibly on its balance sheet. 

Apple still sits on billions in cash, even if in recent years, the company has elected to reward shareholders with dividends and not hoard it all. Beyond dividend pay-outs and stock repurchases, it still has about $40 billion to “play with”—for new investments, new projects, an occasional acquisition. (Another $30-40 billion resides in operating units overseas and unconsolidated subsidiaries, targets for many who claim the company keeps that cash there to avoid tax obligations.)

A few years ago, shareholder activists protested that some of the cash reserves should be siphoned off to equity-holders in the form of dividends, if only to boost an already astounding ROE’s (returns on equity). 

Apple complied, started paying dividends for the first time and instituted a stock-buy program. It replenished much of the stockpile from new cash from operations and from proceeds of new debt. (Apple continues to pay out about 15% of operating cash flow in dividends.) 

Activists pushed for stock buy-backs, too, and begged for a capital structure that welcomed cheap debt, less equity. A little financial engineering, so to speak. Apple has obliged and has conducted occasional stock repurchases the past three years or so. 

c) Operating cash flow 

Even if it claims it experienced a “bad” first quarter (unsuitable for its standards), the company is still generating sustainable (predictable) cash flow (after capital expenditures) from operations of about $15 billion a quarter, over $60 billion a year, reliable streams that get Berkshire analysts excited.

Berkshire analysts could have concluded that operating cash flow won’t surge to $80 billion a year soon, but the market may be under-valuing a company that will likely continue to generate at least $40-50 billion cash from profits, even in the toughest years. 

d) Book-value returns. 

Buffett has often said they assess performance based on a company’s ability to generate earnings on book value. Apple produced an ROE of 44% last year (31% last quarter). Getting comfortable with low-cost debt (as it has done the past few years) has enhanced returns. High profit margins (22% ROS) on products peddled to consumer public has helped. (Remember, iPhones have $500-plus price tags affixed to them.)

Buffet is attached to companies with operations that result in returns (ROE) that exceed expectations and cost-of-capital requirements. 

In the end, the team of analysts concluded sustainable cash flows and sound returns on capital offset the label of Apple being a “technology” company. They crunched the numbers and felt comfortable the right management is in place for a long time. And Cook and his corps of product creators will develop new products that will keep piles of cash flooding its doorsteps. 

Buffett and team are less worried about whether Apple’s watch didn’t usurp the iPhone in popularity, not too concerned because one or two quarters fell short of fabulous earnings in previous years. They may have beamed they could swoon in and grab a piece of a $500 billion company they think—with cash flows and predictable streams and a business culture that finds a way of producing the next new thing—is really worth $600-700 billion. 

Tracy Williams

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