Why Did Buffett Buy More Apple? – Apple Inc. (NASDAQ:AAPL … – Seeking Alpha
Much has been said as of late about Berkshire Hathaway’s (NYSE: BRK.A, BRK.B recent buying of Apple Inc. (NASDAQ: AAPL) – see here, here, and here) – many investors and commentators are surprised by Uncle Warren’s Berkshire investment in Apple. What’s more, it seems to go against his “no tech stock” mantra.
In this article we will see that by applying Berkshire Hathaway’s own investment framework, buying Apple isn’t such a stretch. What’s more, upon further reflection, Apple appears to be a classical Buffett-type investment.
Just prior to the bursting of the 1999 internet bubble, Warren Buffett wrote an article that was published in Fortune Magazine that outlined his thesis for sitting on the sidelines. Essentially, it boils down to the following points:
- Investor expectations for the “information revolution” of the internet were high, based on the revolutionary effect the internet would have on all facets of our lives.
- With such high expectations came extraordinary stock valuations that were based on future events that had yet to materialize.
- It was not possible, based on the information at hand, to successfully predict the winners from the losers.
- Many of these internet companies had no identifiable competitive advantage (MOAT).
Buffett goes on to cite the automotive and airline industries as examples, which also revolutionized society but led to poor investor returns. Interestingly, at present, Berkshire has investments in both sectors, but that is a topic for another day.
Berkshire seemed to change its mind with IBM (NYSE:IBM) in 2011, and in 2016, with its subsequent purchase of Apple.
What has changed since Buffett first expressed his apprehension of tech stocks in 1999?
The Four Pillars of Berkshire’s Investments.
In 2012, Charlie Munger gave an interview to BBC in which he discussed a wide range of topics. Of those topics discussed also commented on the four criteria him and Warren employ when thinking about investing in a business. In summary, they are:
1) We have to deal with what we are capable of understanding.
2) We look for businesses that have a durable competitive advantage.
3) We prefer a management with integrity and talent.
4) We need to pay a price that makes sense and gives us a margin of safety.
Given this, let’s drill deeper into Apple.
Capable of Understanding the Business?
For most of you reading this, I don’t need to tell you how Apple makes its money. Essentially, it’s a consumer electronic hardware company with the majority of its revenue coming from sales of the iPhone.
Source: Apple Q1 2017 Earnings Release
What is talked about less is the services component of Apple. Currently accounting for 13% of revenue, basically, this is the revenue generated from services provided by the App Store, Apple Pay and Apple music. The revenue generated is high margin and is rapidly growing (18% year over year, as shown above)
In essence, Apple sells you a hardware product and then uses its ecosystem of services to generate recurring revenue as you use the hardware product. I think most would agree they are capable of understanding the business.
Durable Competitive Advantage?
There is no doubt that the consumer electronics space is a fiercely competitive space – if you don’t destroy your own product by updating it and releasing a new version on a frequent basis, you can be sure one of your competitors will. Furthermore, one could think of consumer electronics as a commodity – generally consumers go where they get the most bang for their buck and so often the lowest cost producer will win.
How does a company build a moat in this space? The first way is via brand. I think Apple has done a great job building its brand as consumers often associate the brand with quality, design and innovation. Many Apple users are fiercely loyal to the company to the point where they sometimes become borderline annoying. Furthermore, the brand is also considered a premium product, one that confers wealth and status. Brand strength allows Apple to charge higher prices and enjoy higher margins for its “premium” product.
The astute reader will point out that margins have come under fire as of late, which implies consumers are willing to pay less of a premium. This suggests the brand moat is eroding.
Despite this, Apple has another trick up its sleeve – its services. Its services not only provide attractive business economics (low capital requirements; high margins), but they also create a switching cost for the consumer. Think about it – if you are familiar and comfortable with the App Store, subscribe to iCloud for data storage, have an Apple Music subscription, and use Apple Car Play in your daily driver, how likely are you to switch from an iPhone to an Android phone with your next purchase?
As hardware sales continue, more consumers use Apple services (driving service revenue growth) and in turn the Apple products work their way into your life. What’s more, the more Apple products you use, the more these services harmonize across different platforms and the switching costs increase. Finally, the more hardware Apple sells, the greater the incentive for developers and third parties to create software for that hardware (i.e. downloadable apps via the App Store), which in turn creates greater incentive for consumers to buy the product. This virtuous cycle creates a network effect.
We can see these moats in action by looking at the historical trends of earnings growth and cash flow growth at Apple – over the last 10 years, earnings have grown 28%. This is fairly impressive, considering the cutthroat nature of the consumer electronics business.
It is also important to recognize that cash flow has also been growing as well, averaging just shy of 25% over the last 10 years.
The astute reader will recognize that buybacks do contribute to earnings per share/cash flow per share growth. This is true, and will be discussed more below.
Thus I believe, qualitatively and quantitatively, that Apple does have a durable competitive advantage. Moreover, as long as service revenue continues to grow this moat is increasing with time.
Does Management Have Integrity and Talent?
Admittedly, this is the most difficult question for investors to answer, as you need an understanding of the managers as people to come to a conclusion. As I do not know Tim Cook, or any of the directors personally and because I am not privy to the inside workings of Apple, I must take a different approach to answering this question.
As owners of the business, investors look for stewards that act in their best interest – I would say this constitutes integrity. One way to assess this would be to examine how shareholder friendly Apple’s management is. At present, Apple does pay a small dividend (currently yielding 1.4% at the time of writing) which is relatively new as it was instituted in 2012. Although young, this dividend has grown by just over 40% over the last 5 years, which is quite impressive dividend growth.
Additionally, Apple does have a buyback program, spending $144 billion on share repurchases since 2012.
Source: Apple Return of Capital Timeline Q1 2017
Management also has an eye for value when doing buybacks, as buybacks are really only value creating for shareholders if the shares are bought back while undervalued – in essence, management is buying $1.00 for less than $1.00. Alternatively, when a stock is overvalued and management initiates a buyback, management destroys value as it buys $1.00 for more than $1.00. Apple has a history of being opportunistic and acting swiftly when management views its shares as being undervalued.
Overall, these substantial buybacks have also led to a significant decrease in the total share count outstanding. Said another way, each investor’s piece of the pie is increasing, thanks to management.
Of note is that Apple also has $246 billion in cash on the books, with ~$230 billion held in overseas, tax sheltered accounts. Any repatriation of these funds could lead to a substantial value creation event for shareholders.
Does management have talent? I think the easiest way to assess this is to examine how management is incentivized and see if they met these incentives, as a strong business can compensate for a poor manager.
After failing to meet internal 2016 goals, Tim Cook, CEO of Apple, made ~20% less than he made in 2015. This failure of execution so far appears to be a one-off event, but nonetheless it bears discussing.
Thus, I think management has integrity and very likely has talent.
Price That Makes Sense, with a Margin of Safety?
This, in essence, is the valuation of Apple – as Munger says in the interview above, a wonderful company is not worth an infinite price. Using S&P Capital IQ data, a DCF yields a fair price of about $125.
From a multiple point of view, today Apple is trading at a P/E multiple of 16.22 which is at about its 10-year median of 15.38. This equates to a present earnings yield of about 6%.
From a cash flow perspective, today Apple is trading at a P/FCF multiple of 14, which is also close to its 10-year median of 12.61. This equates to a present free cash flow yield of 7%.
It is worth mentioning that Berkshire first purchased Apple shares in May of 2016, and Apple shares have appreciated by about 30% since then. The second addition – when Berkshire quadrupled its position – presumably occurred somewhere between share prices of $100-$120, in which case, Apple shares would have been slightly undervalued to fully valued. I think this purchase price makes sense, although at first glance, I do not think there is a meaningful margin of safety at these levels.
However, thinking about it more, the cash on the books accounts for about ~34% of the market cap of Apple. Perhaps this is Berkshire Hathaway’s margin of safety, as this money does not generate any meaningful return for Apple or its shareholders by sitting in the bank. Said another way, if you were to buy the whole company and somehow unlock the cash in the bank, you would immediately get just over 1/3 of your money back, without having to rely on the continued operations of the company. Perhaps this is Berkshire Hathaway’s margin of safety.
Putting It All Together
Thus, we can see that since Buffett wrote on tech stocks in 1999, things have changed. Apple has an easily understandable business model that has historically shown to be a winner. It can be valued based on fundamentals. It has a moat that is increasing with time. It has a management in place that appears competent with integrity.
Furthermore, the company is a cash flow machine with a ridiculous amount of cash on the books (~$46/share) that, if unlocked, would generate a tremendous return for shareholders.
Given this, with the power of hindsight, it appears that Berkshire’s investment in Apple is a no-brainer.
Please feel free to let me know what you think about Berkshire’s investment in Apple in the comments section below.
Thank you for reading!
Disclosure: I am/we are long AAPL, BRK.B, IBM.
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.