Thesis Summary

Apple Inc. (AAPL) has enjoyed one of the largest rallies in its history since the market bottomed in March. While this has been supported somewhat by strong quarterly growth, the company now faces a wide array of challenges that will surely set it back in the years to come. Geopolitics, increasing legislation and a slowdown in demand for its products brought about by a global recession are some of the threats I have identified. The article also features a 5-year DCF valuation which yields a potential 30% downside.

(Source: Pinterest)

Latest Quarter

Despite the pandemic, the latest quarterly results have yielded above-average growth for Apple. Below, we can see an extract from the latest quarterly report:

(Source: 10-Q)

Apple’s revenues have increased by around 6.6% over the last 6 months. However, EPS has increased by a whopping 15%. This can be attributed to the higher revenues coming from services, rather than products, a segment which carries a higher margin. Overall, Apple has done well at keeping a lid on costs.

Apple is a quality company with a strong balance sheet and some great products and services. However, today’s lofty valuation seems to disregard some very material threats that the company is and will be facing over the next 5-10 years.

Triple threat

It is undeniable that Apple is an amazing company. It has managed to become one of the biggest players in the smartphone industry and has not only created a unique brand but also a unique ecosystem. However, the company will face a triple threat in the next few years, which should make many investors question pouring any more money into this stock.

Geopolitical Threat

First and foremost, Apple stands to suffer a lot from the current geopolitical climate. The latest idea to come from the White House, banning the use of WeChat, will only be the beginning of increasing tension between the world’s superpowers. If Apple were to lose the ability to offer WeChat in its AppStore, some investors estimate that we could see sales for iPhones and related hardware fall by 15-25%. Of course, Apple is not the only one that could potentially suffer, since this ban could also apply to Alphabet Inc. (GOOGL) and its Android phones.

The problem, though, goes much beyond this WeChat hiccup. The U.S. and China have been engaged in a trade war for the better part of the last three years. Although it seems like a truce has been reached, there are unavoidable facts that will eventually force Trump to push his mercantilist agenda forward – issues like Debt/GDP and the balance of payments.

Most investors today, underestimate the effects that geopolitics and trade wars can have on the economy. For the most part, we have enjoyed a slow and steady process of globalization over the last 20 years. However, this is beginning to change in the U.S. and abroad. When push comes to shove, countries will look out for themselves and further nationalization could be on the cards. This would mean very bad news for Apple, because it relies on international markets to sell and produce its products.

Legislation

At this point, you may think that the point made above is moot as the November elections approach. However, Trump can’t be written off yet, and even if Biden wins, the company will have to face a whole other set of challenges. Namely, these will be higher taxes and a higher regulatory environment.

The most obvious headwind Apple will face will be a higher corporate tax, although this would affect all U.S. companies equally. However, what Apple and the other tech companies will have to face, regardless of the outcome of the election, will be much higher scrutiny on their activity. Apple has already been at the short end of the proverbial stick when it comes to lawsuits. The latest of these features Fortnite creator Epic Games, which has sued Google and Apple for removing the game from their platforms. Apple also had to pay a fine of around $500 million after being found guilty of deliberately slowing down the older versions of the iPhone.

Overall, the idea I am trying to transmit is captured quite well in Epic’s 60-page document. The bottom line is that companies like Apple and Google are “too big” and “too powerful”. While there is certainly nothing wrong with being powerful, I do think that Apple is losing that which once made it unique. The company became a success thanks to its great marketing efforts which defined it as a unique firm. But consumers and legislators are now realizing this is no longer the case. Apple is just another tech giant pushing its weight around. Ultimately, this erodes consumer confidence and exposes the company to the legislative threat.

A global recession

Again, a global recession would hurt all companies, but I will make a case here as to why I think we could soon face a global recession and why I think that Apple and other high-flying tech companies could be disproportionally hurt.

First off, and despite what the stock market is saying, we are facing a recession. The U.S. and Europe may very well be approaching a 1990s Japanese-style lost decade. There is no more room for monetary stimulus as long as interest rates are nailed to the ground. Further fiscal stimulus, which is surely on the cards, will only serve to increase the level of unproductive debt and weaken international trust in the euro and dollar. The same could be said of China, which is now approaching a demographic stagnation and is also very heavily indebted. The result will be a prolonged stage of low to no growth. Furthermore, if the economy is hit with another shock like the coronavirus, there is little the Fed, the ECB or the IMF will be able to do to salvage the situation.

While there are a few ways this could play out, the bottom line is that low growth and loss of income are on the cards, and a company like Apple needs people to have disposable income. Smartphones are necessities, as important today as a washing machine, but iPhones are luxury products. Apple relies on having a huge middle class with a substantial amount of disposable income to spend on iPhones. Its growth prospects also rely on foreign countries increasing the size of their middle and upper societal echelons. A global recession would halt Apple’s expansions in a moment where smartphone growth is already slowing down. Furthermore, we would see the lofty valuation of Apple and most of its tech peers come crashing down.

Valuation

Even under the best of circumstances, at this point, it is hard to justify Apple’s valuation. Even assuming a CAGR of 5% over the next 5 years, the company still has a potential downside of 30%.

(Source: Finbox.io)

The above projection estimates a revenue CAGR of 5.4% for the period and an EBITDA margin of 28.4%. Given these assumptions, the target price for Apple comes out to $318.79, which implies a 30.5% downside. To even begin to justify its current price, Apple would have to grow revenues at double digits and further increase its profitability over the next 5 years.

Takeaway

Don’t get me wrong, Apple is a great company, and I would not argue with anyone who continues to hold the stock. The company has a proven track record, and the scenarios explained above are only some of many possibilities. Apple will serve well as a low-income paying stock – just don’t expect the returns it has delivered over the past 20 years, and accept that Apple, just like any other investment, carries some risk.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Read More

LEAVE A REPLY

Please enter your comment!
Please enter your name here