Apple: We Are Near Peak Sentiment

Apple's recent growth bump, primarily caused by COVID-induced demand drivers, has sent the stock and multiple soaring.

The current valuation is pricing in higher growth for longer. This seems unlikely.

Trimming shares or selling calls here to reduce downside seems attractive, given the extended multiples.

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For those who haven't been paying attention, Apple (AAPL) stock has recently been on quite the run. In the last 16 months since COVID lows, shares have climbed over 190%, from a post split price of ~$50, to the current price around $150. Underlying this explosion in value has been strong, increasing revenue and net income growth over the last few quarters, combined with rapidly increasing sales and earnings multiples. Put simply, we think that growth expectations for the stock have peaked, and the company's equity is set to produce a period of entirely uninteresting returns. Selling some shares or selling covered calls to increase yield seems like an attractive alternative to continuing to sit idly in a position.

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While there probably aren't many people on earth who don't know what Apple does, we will give an overview anyway. If you're one of the few who are unaware, Apple Inc. sells mostly consumer electronics - iPhones, iPads, iMacs, MacBooks and Apple Watches, in addition to a robust set of accessories for said hardware. The company also operates a digital marketplace for games and software apps that is built into its devices, in combination with it's own subscription music, TV, workout, news, and cloud storage subscription offerings. 

Over the last decade, the company has gone from a smartphone contender to the consumer electronics market dominator, earning an unbelievable brand premium and printing cash hand over fist.

Since 2011, the company has kept gross and net income margins almost completely unchanged, which is a result of the unbelievable operating leverage the company possesses. Additionally, The regularity with which the company has been able to pump out free cash flow has delighted investors, and the company has grown to become the most valuable company on earth.

However, if you look more closely at the income statement, Apple has actually had a hard time increasing net income since 2015, which coincided with the launch of the iPhone 6; the last truly 'game changing' Apple product release. Since then, the company has produced a slate of mostly same-y feeling and looking iPhones, Macbooks, and iPads, which has resulted in slowing sales growth, as consumers have struggled to understand the value proposition. Anecdotally, "If it ain't broke, don't fix it", is a common response people give when asked about if they are thinking about upgrading their Apple device.

In fact, you can see how the company's revenues are now in the habit of dipping post an important iPhone launch year. The total addressable market has been, for the most part, completely saturated. Pretty much everyone who wants a smartphone / computer has one. While there's still incremental growth to be had in large developing economies like India, China, and eventually, Africa, the company has largely exhausted it's hardware growth levers.

The company's multiple has historically reflected this. As the 2010's wore on, Apple was no longer priced for growth. Trading between a 12-18x TTM Price / earnings ratio over the last decade, the market more or less gave up on the growth story, and settled for the operational excellence and consistent cash flow.

Under pressure to continue growing, and sensing this problem, in 2019, Apple began looking for ways to re-ignite growth and investor interest, while smoothing out revenues over time.

Increasing the purchasing power parity of the rest of the world was out of their reach, and so Tim Cook and the C-Suite began looking towards monetizing the install base already in place. Having built incredible brand trust, selling Apple branded services was a viable option, and so that's exactly what they did. In 2019, Apple announced a slew of Apple device-native subscription services in payments, media, fitness, and gaming, branded as Apple Card, News, TV+, Fitness, and Arcade, respectively. This was in addition to the already existing products of iCloud and Apple Music.

Then came along a global pandemic.

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Far from having a negative impact on the company, COVID-19 provided Apple with the perfect set of conditions to increase revenues. People stuck working from home began to invest in better personal computer hardware, and barred from other forms of entertainment, people stuck inside began signing up for Apple TV+ and Arcade in droves. This is reflected in the numbers.

In the 12 months trailing December 2020, we can see Revenue beginning to rise rapidly, reaching 26% YoY growth in the TTM to now. This is a level of growth that the company hasn't seen in over a decade. And, with the stability of the company from an operational standpoint, every dollar dropped straight to the bottom line. Net Income has increased 48% YoY, and EPS has gone from $3.32 to $5.15.

Apple's analysts, who have been hungry for growth, heaped praise on the company for these results, and institutions and individuals alike have bid the stock up.

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However, the market is forever forward looking, and so one must begin to wonder how well the company will continue to do on an ongoing basis. As was mentioned previously, the increase in the stock price over the last year has been a combination of improved results and multiple expansion. In fact, the majority of the stock appreciation has been due to the increased growth expectations that show up in the multiples.

Since mid 2019, Apple's TTM EV/EBITDA ratio has nearly tripled, from a long term average near 8, to the current value at 22.10. The P/E has similarly doubled from an average near 15, to just shy of 30.

The question for the future is whether or not Apple's current growth has been sustainable. At Discordia, we certainly don't think so. Looking at the big picture, the last few quarters of growth signal more of a demand bump from COVID, than a substantial broadening of the TAM. An exterior event forcing hardware upgrades can hardly be counted on in the future. Sure, services income will continue to grow over time, but increasing competition in the space also means that an open growth runway like Netflix (NFLX) had over the last decade for subscription revenue isn't really in the cards. We expect TTM growth rates to drop to the mid to low teens over the next 4 quarters. Apple provided sparse info and no Revenue guides on their last call. I wonder why that may be?

The bottom line is this - If growth is going to mean revert lower after COVID is past us, which, again, we think is highly possible, then why is the company trading at 30x earnings? The stock is also trading at a 60% premium to it's 5 year average Price / Sales. A multiple like that in large cap companies is typically reserved for software-like firms with long growth runways, not consumer hardware companies with saturated, competitive markets. Yes, the Apple brand commands a premium, both with consumers and investors, but at 30x earnings, at the scale Apple operates, traders are simply pricing in too much future growth. 

Despite this, on Wednesday the stock made all time highs, as investors continue to be net bidders. To us, this looks like peak sentiment. Sure, Apple may continue to trade higher over the very long term, but in the short and medium term, the stock has gotten over its skis, and a 30 year payback period seems like a hell of a lot to pay for what is currently on offer.

We are aware that most ardent investors will likely write this off as another article in a long string of bears being wrong on Apple, but our gripe is with the valuation, not with the company. Shareholders have been rewarded for the company's COVID-induced performance bump, but from this price, the risk looks skewed to the downside. Selling Calls, or shares, seems like the best course of action.