Apple & China: Still growing strong

Posted on Posted in Newsletters

After the market closed last Wednesday, Apple Inc. (NASDAQ: AAPL) reported its 2nd quarter earnings to much delight. Apple addressed a number of issues in its earnings report, including:

(1)   Revenue and net income (“earnings”) per share as well as earnings forecasts for next quarter
(2)   The status of its share repurchase program
(3)   The announcement of a cash dividend
(4)   The announcement of a 7-for-1 stock split

When a company reports earnings, they hold a public conference call where key members of management (CEO, CFO, etc.) discuss operating results for the quarter and offer guidance (projections) for the future, while simultaneously releasing materials on their website. They also use the conference call to make important announcements about the company that are of interest to shareholders and analysts. Afterwards, there’s a Q&A when management attempts to answer pesky analysts’ questions, which is typically the most entertaining part.

Owing to Apple being such a popular stock and company, and to the fact that so many issues were addressed in one earnings release, some of you may be confused as to what this barrage of financial jargon means. We think it makes sense to clear up some of the confusion and explain these topics in non-technical English.

Earnings measures

At the very top of the income (profit & loss) statement we have revenue (or sales)—how much money Apple brought in during the last quarter from selling its stuff. Going from revenue to net income (aka “earnings,” which we divide by the number of outstanding shares to get “earnings per share”) is a tedious, mind-numbing process from which we will spare you. The quick explanation is that we subtract cost of goods sold, operating expenses, depreciation, interest, taxes, etc. to arrive at net income—the amount shareholders actually have left after paying everybody else.

Long before the actual numbers become public, analysts have already provided revenue and earnings per share estimates, and the stock price at any given time before the earnings release factors in the consensus levels from analysts who cover the stock. If earnings come in better than expected, the stock typically jumps; conversely, if earnings are worse than expected, the stock price typically sags.

But Wall Street is not always so straightforward. There are times when earnings for a company are stronger than expected but some other announcement casts doubt on the future, and the stock falls despite better-than-expected earnings. Similarly, unexpectedly low earnings can be offset by an announcement that makes analysts more excited about the company’s future prospects, causing the stock to rise despite disappointing earnings.

“Capital Return Activities”: Dividends and Share Repurchases

Apple executed about $21 billion worth of capital return activities during the March quarter, including $2.7 billion in dividend payments and roughly $18 billion in share repurchases.

Dividends, the most common form of capital return, are cash payments distributed by the company to shareholders. They are more likely to be paid by mature companies (those that have passed the rapid growth phase) and companies with predictable cash flows, as well as those with hoards of cash. Apple fits into all of these categories. A young biotech firm will need all of its capital to reinvest in future growth, but a company like Apple has more than enough cash to fund current operations and future projects; thus, its shareholders prefer to have a portion of their investment returned via a dividend. You can read more about dividends in our blog post from 2012.

When a company buys back (repurchases) its own shares, this is also a form of “capital return.” Instead of paying cash directly to shareholders, the company purchases its own stock (in the case of Apple, purchases in Q2 were made both on the open market and via an investment bank through two rounds of “Accelerated Share Repurchase” programs). By reducing the number of shares outstanding, the company has effectively increased each shareholder’s piece of the company pie.

A company typically buys back its own shares when it believes that its market price is low relative to its intrinsic (true) value. If Apple believes each share is actually worth, say, $1,000, it can add value for existing shareholders by buying shares back in the low-$500 range (where Apple stock was trading pre-earnings release).

Stock Splits: Don’t be misled by the numbers

Apple also announced that its shares will undergo a 7-to-1 stock split, meaning that each shareholder will receive 6 additional shares of AAPL for every 1 share currently owned. The net impact of a stock split on the value of your investment in Apple or any other company is exactly zero. Instead of having 1 Apple share worth $590.09, you will have 7 shares of Apple stock worth about $84.30 each. This assumes, of course, that the price of the stock doesn’t change between the announcement of the split and when it actually occurs.

A company like Apple splits expensive shares to increase the number of potential buyers of the stock—both institutional buyers who may have rules limiting the maximum price of shares they can hold, and individual investors who are scared off by stocks selling for much over $100/share. Also, there is speculation that Apple may be paving the way for potential inclusion in the Dow Jones Industrial Average (DJIA), the popular price-weighted index composed of 30 large-cap US companies.

We always tell people not to compare stock prices to one another, as these numbers don’t mean anything. A share of Coca-Cola Company (NYSE: KO) trades at $40.79, while PepsiCo, Inc. (NYSE: PEP) stock is priced at $85.89, more than twice the price of a share of Coke. However, Coke’s market capitalization (the total market value of its equity) is almost $180 billion, while Pepsi’s is barely over $130 billion. In other words, the price of one share tells you nothing about the overall value of a company, nor whether the shares are “cheap” or “expensive” relative to other companies’ stocks.

China Loves Apple

As many of you know, Ken just returned from a trip to China. We’ll be including some of the highlights of that trip that are relevant to finance and investing in our next few eNewsletters, starting with this one. As the trip included the Forbes Investment Cruise, Ken listened to and spoke with several prominent investment professionals and other experts, and we’ll share some of those insights with you as well.

So speaking of Apple, are they doing well in China? The dry statistics tell you something: in the most recent quarter, Apple’s China sales were up +13%, and China now accounts for 20% of Apple’s total sales. China is now Apple’s 3rd biggest market, and will soon pass Europe to take second place to the US. Talk about growth!

On the ground, Apple’s presence is obvious. Stores selling Apple products are everywhere—primarily licensed dealers but also a dozen company-owned Apple stores. There are iPhones everywhere as well, including lots of iPhone 5S models, which are supposedly too expensive for the Chinese. There are quite a few Androids as well, but the iPhone seems to be the smartphone of choice for the Chinese.

Apple products aren’t the only Western “luxury goods” in China. There are designer stores on almost every corner, many stuffed into huge, modern malls with dozens or even hundreds of stores. Want a Rolls Royce or Aston Martin? No problem. There are currently 22 Rolls Royce and 14 Aston Martin dealerships in China. Gucci, Prada, Louis Vuitton? The number of stores selling these designer brands in China number in the hundreds.

From Out of Nowhere, an Economic Juggernaut

From a communist backwater with little wealth and well over 1 billion subsistence farmers, China has recently become the second largest consumer economy after the US, surpassing Japan in 2013. The Chinese love Western luxury goods, from Rolls Royce cars to Chateau Lafite Rothschild wine. But this obsession by the wealthiest Chinese masks far greater increases in consumption (on an aggregate basis) by the 300 million Chinese who are now considered “middle class.” They make a lot less than the US middle class, and they can’t afford a Rolls Royce, but a Toyota Yaris or iPhone 5C is well within their grasp.

Note that the size of the middle class in China is roughly equal to the entire US population. By 2022, it’s estimated that China’s middle class will number 630 million—nearly twice the population of the US. They won’t yet be spending as much on average as US consumers, but their sheer numbers mean that China will be a voracious buyer of all sorts of goods and services. 2022 is also the year in which it is predicted that China’s GDP will surpass that of the US. We shall see.

The transformation of China is from backwater to world economic power is nothing short of astounding. Take Pudong, for example, which is an area in Shanghai on the east bank of the river (“pu dong” means “east bank”). Prior to 1993, when the Chinese government designated it as a “Special Economic Zone,” it was entirely farmland, with a population of just a few thousand. Today, Pudong has over 5 million inhabitants and dozens of skyscrapers, including the Shanghai World Financial Center, the tallest building in China at 101 floors and 492 meters. (Shanghai overall has 24 million people.)

And the construction continues at breakneck pace (if this is a “slowdown” I can’t imagine what it was like during the peak). Just across the street from the World Financial Center is the nearly finished Shanghai Tower. At 632 meters and 121 floors, it will be the new tallest building in China and the second tallest in the world after the Burj Khalifa tower in Dubai that was featured in the last Mission Impossible movie.

We’ll be posting photos of our trip to the web so that you can get some idea of the scale of the new China. (There will also be pictures of the old China, such as the Great Wall and the Forbidden City.) In future eNewsletters we’ll write more about the people and culture of China, as well as about investment opportunities there. If nothing else, it will be fascinating to watch how China continues to grow and evolve.

Zai hui (Until we meet again),

       Adam

Dr. Ken Waltzer MD, MPH, AIF®, CFA, CFP®
Founder and President – Kenfield Capital Strategies (KCS)

Adam Bragman
Director of Business Development – Kenfield Capital Strategies (KCS)

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