What has the street so spooked?  The earnings report didn’t look too bad, at least on the surface. Sales and earnings both topped estimates.  But there may appear to be issues, operating income shrunk from the same quarter last year and net income was up a minuscule .11% .  This is despite an Q1/Q1 annualized 18% rise in sales.  Did Apple just become a broken growth, value stock, should we speak about them in the same breath as Research in Motion?  Not so fast, this quarter was only 13 weeks versus a 14 week comparable from last year.  Extending another week may have given Apple another $4bln in sales and $1.2bln in profit.  26.6% revenue growth, but still only 9% income growth.  Perhaps there is something amiss in the supply chain?

One issue for Apple looks to be input costs.  Labor costs are likely rising over seas, at least in dollars.  Is this earnings report about margins?  Investors may be wondering if Apple is losing market power in the supply chain?

If negative sentiment is margins, perhaps the bar was set too high.  Last year’s out-sized margins were off the chart.  Maybe the street thinks that margins will continue to contract, perhaps back into the mid 20’s, but this is not a sure thing.

 

So this brings us to unit sales.  Pricing power is intact, but units sold were lower than expectations.  Lower unit sales may be a symptom of the macro economic environment, a combination of rising prices and slow job and wage growth.  Also, Mac sales were 20% below expectations.  As Apple builds out the cloud (cost), volumes on their high price tag item suffer.

So Apple just sold 10 iOS devices every second for the past three months.  Sales are up 29% Y/Y. They sold every iPad mini they could make and they have a backlog of orders. Profits are up 26% Y/Y.  And the stock is down 12.5% in a day.

Here’s a pessimistic scenario for you.  Ebit margins just dropped from 39% to 31%; let’s consider a further drop to 25%.  The loyal user base remains intact and continues to buy Apple’s newest devices, but the base does not grow.  TTM earnings are $44.1/share and drop to $36, and free cash flow drops to $36bln/yr.  With no prospects for growth, they pay out their balance sheet cash and short term investments of ($144/shr).  The market cap drops to $300bln, or $317 a share.  Apple is now giving a 12% cash yield, an investor gets his money back in 8.5 years.

I believe Apple will still be selling products in a decade.  Apple looks like a good investment to me, even in the pessimistic scenario.

The final question centers on the CEO, is Tim Cook failing?  Has the street lost confidence? Perhaps Tim Cook is patient and smart.  Today’s economy is certainly not the healthiest. The cash gives Apple options, perhaps the option to buy something in the future at a bargain price.  Apple can use the cash to further innovate, at their preferred pace and keep iterative sales intact for at least a decade, probably more.  Today,  Apple spends only about 1/2 what Google spends on R&D, and 25% less than AMZN.  But, with $137bln liquid, Apple could buy AMZN for cash and 1 year later they would still have more cash than Google.

Apple continues to be a core holding and we would look to add to the position before we would consider selling.

Disclaimer: The information, data, analyses and opinions contained herein (1) include the confidential and proprietary information of Alhambra Investment Partners LLC, do not constitute investment advice offered by Alhambra,  are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and are not warranted to be correct, complete or accurate. Except as otherwise required by law, Alhambra shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, this information, data, analyses or opinions or their use.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Douglas R. Terry, CFA is reachable at: dterry@4kb.d43.myftpupload.com