Dividend Growth Stock of the Month, Bonus Edition: Apple Inc. (AAPL)

May 5, 2015
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In the Dividend Growth Stock of the Month (DGSM) series, I have been examining solid dividend growth stocks for long-term investors. Such companies are often large, old, blue-chip stocks. I also included a bonus article that warned against dividend growth stalwarts that are currently overvalued.

In this special bonus article, I want to break out of the mold by examining a stock that does not have much of a dividend growth streak. I think that Apple Inc. (AAPL) is the USA’s most widely held stock. It is the world’s largest publicly traded company by market capitalization.

I will adhere to the same analytical approach that I have used for the other dividend growth stocks, but the overall focus here is different.

We want to answer, first, whether Apple is a viable dividend growth stock, and second, if not, is it a promising investment for other reasons?

Apple’s Dividend Characteristics

Apple (AAPL)

As you can see, AAPL’s dividend resume is not what we are accustomed to seeing with really good dividend growth stocks. We usually see all green in the table above. But instead…

• At 1.7% (including the impact of the most recent 11% dividend increase on April 27), AAPL’s yield is below average for the best dividend growth stocks, and well below the average yield of all 690 Dividend Champions, Contenders, and Challengers (CCC), which stands at 2.8%. It is below my usual minimum dividend growth investing requirement of 2.7%.

• With only a 4-year streak of increasing dividends, it is difficult to label AAPL as a dividend growth stock at all. It is not a CCC member, which requires a 5-year streak of dividend increases. However, with its recent increase, Apple becomes a “near Challenger,” meaning that if it increases its dividend next year, it will enter the CCC as a Challenger. The 4-year streak is below my usual 5-year dividend growth requirement.

• Apple’s increase this year, announced on April 27, is 11%, compared to last year’s increase of 8%. The average most-recent increase for all CCC companies is 9.8%, so I rate the 11% bump as above average. It is not unusual for a “new” dividend company to have large or inconsistent increases in its early years of dividend growth.

• The company does not yet have a 5-year dividend growth rate.

Overall, Apple’s dividend resume is full of holes, and normally I would not research the company beyond this point. Clearly, paying and sustaining a rising dividend each year is not found in the company’s past, and it is not embedded in the company’s culture or practices.

But it is fair to ask, is APPL possibly a dividend growth stock of the future? Or, if we ignore dividend growth for a moment, is it a good investment outside of the dividend growth arena?

Company Quality

CaptureApple’s financials all look terrific. Its ROE (return on equity) is outstanding, and the company has been delivering great ROEs for more than 10 years, including straight through the Great Recession of 2007-2009.

Apple’s earnings growth is also very high, at 38% per year for the past 5 years.

Analysts believe that this will slow considerably, to 17% per year, but that is still quite a high rate of growth.

As we will see below, predicting earnings or revenue growth is hard in Apple’s line of business.

Consumer electronics is difficult to predict or for a company to dominate for any length of time.

Until a couple of years ago, AAPL had no debt. It has borrowed a little in the past couple of years, taking advantage of low interest rates to fund some of its stock buybacks and dividends. Apple’s D/E (debt to equity ratio) now stands at 0.3. That is below the norm for companies of its size, which is to the good side. Lower is better on this metric.

The company’s S&P credit rating is the same as the United States’ credit rating, which is to say that it is excellent.

However, S&P’s quality rating for Apple is only B+. Although B+ sounds high, on their scale it is defined as average.

Morningstar considers AAPL to have a narrow moat. They have 3 moat ratings: None, Narrow, and Wide. Just 266 stocks have a Wide moat rating, and another 949 have Narrow moats. Since Morningstar rates about 1700 stocks altogether, I consider the Narrow moat rating to be just OK rather than Good, since over half of the stocks that Morningstar rates have positive moat ratings.

So, everything is green except for two judgemental ratings. Why are the human judgements wavering when the financials look so good? Taking a look at Apple’s Story will help us understand the answer to that question.

Apple’s Story: How Does It Make Money?

We all know something about Apple. It is one of the most-discussed companies on the planet. Many of us know about Apple through its products. In my own family, my wife and I own 2 iPads, 4 iPhones, and several iPods. Two of the iPhones are off the grid, but we still use them as iPods.

Beyond that kind of personal familiarity, we need to dig down and see how Apple is as an investment proposition. A dry overview of Apple would look something like this:

Apple designs, produces, and sells consumer digital electronic devices that enjoy a premium image. Its products include PCs (brand = Mac), tablets (iPad), phones (iPhone), digital music players (iPod), and the new Apple Watch. Its services include a digital streaming music store (iTunes), an application distribution center (App Store), and iCloud. Apple designs and manufactures its own products. They run proprietary software (iOS), allowing a tight integration of hardware and software, and requiring third-party applications to conform to overall design specifications. Apple’s products and services are distributed online, through company-owned stores, and via third-party retailers.

What makes Apple so successful? Over the years, the company has introduced products that literally created new product/market categories.

• The iPod was the first successful digital “music in your pocket” portable device.
• The iPhone essentially created the smart-phone category and market.
• ITunes changed the music business.
• The iPad, when first introduced in 2010, was the fastest-selling electronic product ever.

Apple’s strengths lie in many areas, including not only elegant product design but also the ability to integrate hardware + software + services + third-party applications into user experiences that seem seamless. Apple’s nearly maniacal focus on product design and ease of use has become the stuff of legend.

The ease of use extends beyond each particular product. Apple has created what everyone calls an ecosystem. Its iPhones integrate, through its software, with older products like the iPad and newer ones like the Apple Watch, as well as with over 1 million third-party apps, creating a sort of “Apple-land” that envelopes users.

The unique combination and control over its systems have allowed Apple to become a golden brand and charge premium prices. Consumers have been willing to pay extra dollars to own Apple. This has been true even when competing products with better specs were available for less money.

However, Apple is in a tough business. Consumer electronics is characterized by short product life cycles, sudden obsolescence, and intense competition. The playing field evolves constantly. That is why Morningstar does not award a Wide moat rating to Apple. Can anyone ever say with confidence that a company has sustainable competitive advantages in consumer technology?

But sometimes, instead of thinking of Apple as a company that must constantly innovate, I think about it as a company that is established enough that it does not need to introduce a ground-breaking new product every year.

There are psychological and monetary switching costs involved in leaving the Apple ecosystem once customers are in it. IPhone users tend to want to get new iPhones when they need or want to upgrade, and the same is true of Mac users. Apple’s products are “sticky.”

The totality of customers’ positive product/service positive experiences tends to make them loyal customers. As the smartphone market matures, a greater proportion of purchases will come from previous smartphone owners. Customer loyalty thus becomes increasingly important as the years go by. With product life cycles in the 2-4 year range, repeat purchases by existing customers will become a larger part of the mix.

This is a two-edge sword. Product updates provide opportunities for Apple to attract new customers, but they also provide opportunities for customers to switch to other vendors. That is why the customer experience is so important with Apple.

Apple has constructed a web of convenience and “screen neutrality” (so long as it’s an Apple screen) that so far has not been matched by anyone else. Each new layer (as, for example, automobile systems and the new Watch) makes it less likely that users will want to leave the system.

Of course, as good as it has become, Apple must be considered vulnerable to the same kind of abandonment that befell other former leading electronic brands such as Nokia and Blackberry. That is why it cannot receive a superior grade for its business model. The company is on top now, but what about 10 years from now, or 20? Even now, iPad sales have been declining for 3 years, overtaken by other tablets and even by Apple’s own larger screen iPhones.

Beyond its current product/market/customer base, Apple clearly has growth opportunities in new markets not only for existing products but also with new products such as the Apple Watch. The Watch began shipping on April 24, so it is too early to evaluate its impact on the company. IPhone sales have been surprisingly strong in the company’s greater China region. Revenue soared 71% there as of the April 27 earnings release.

A couple of other factors are important in thinking about Apple: Its cash position and its buyback program.

Apple has more cash on hand than any other company on the planet. Per its April 27 earnings release, Apple has a cash + investment hoard of close to $200 Billion. That exceeds the gross domestic products of countries like New Zealand, Vietnam, Morocco, and Ecuador. [Source]

There is a catch. Most of Apple’s cash is overseas, and it would have to pay U.S. taxes on it if it were to repatriate it. That is one reason that Apple has recently started to issue bonds (debt), even while it has so much cash.

Capture[Source: Zero Hedge.]

The second additional factor is Apple’s stock buyback program. It has been retiring shares at a rapid rate. The company first initiated a buyback program in 2012, authorizing $10 billion to be spent on share repurchases. That authorization was increased to $60 billion in 2013, $90 billion in 2014, and $140 billion this year. Between dividends and buybacks, Apple has pledged to spend $200 billion by March, 2017.

Since 2012, Apple’s outstanding share count has been reduced from about 6.6 billion shares to about 5.8 billion. CEO Tim Cook recently stated that he feels that AAPL shares are undervalued, so we can expect the company’s buyback program to continue at a good clip.

CaptureApple’s cash hoard, borrowing, and share buybacks can all be placed under the umbrella of financial engineering. While often this phrase has a bad connotation, in Apple’s case I view the various pieces as positive and reinforcing Apple’s value to shareholders.

On the 15-point scale that I use, I give Apple 9 points for its Story. I would like to rate it higher, but the constant competition in technology businesses needs to be kept in the back of your mind.

CaptureStock Valuation

My process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation. Let’s walk through each of the 4 steps for AAPL.

FASTGraphs 1. The first step is to examine the stock’s current price to FASTGraphs’ default fair value. Apple differs here from the other companies we have looked at, because when a company has displayed a high rate of growth, FASTGraphs’ default fair value ratio is not the ususal 15. Rather it is equal to the company’s growth rate. That creates a high bar for a maturing company.

In Apple’s case, the software uses a default P/E of 16.9, based on Apple’s estimated forward growth rate that we saw earlier.

CaptureApple’s price has been rising toward that fair valuation (orange line), and it is now exactly at it. So on this firt metric, AAPL’s price rates as Fair.

FASTGraphs 2. The second valuation step is to compare AAPL’s price to its “normal” long-term average P/E ratio. For this step, I chose Apple’s valuation over the past 10 years, because the company has gone through extended periods of both over-valuation and under-valuation in the past. Therefore I think that the best comparison period is relatively short.

CaptureHere, we see that Apple’s valuation over the past 10 years has averaged 21.1 (blue line). Its current valuation at P/E = 16.6 suggests that the stock is undervalued. AAPL’s current price is about 20% under its fair value by this reckoning.

Morningstar. Morningstar uses a different approach , which is a comprehensive NPV (net present value) technique that many consider to be superior. The idea is to place a current value on all of the company’s future expected profits, discounted back to the present to reflect the time value of money.

CaptureOn Morningstar’s 5-star system, 3 stars indicates Fair value.

Current Yield vs. Historical Yield. My final step in valuation is to compare a stock’s current yield to its historical yield. It is better to be near the top of that range instead of the bottom.

CaptureThis view is not very helpful. Apple just started its dividend in 2012, so it has not paid a dividend long enough to establish a “normal” range. The gradual decline of its yield since its last increase in 2014 simply reflects AAPL/s rising price since then. You can see the jump at the end, reflecting its dividend announcement on April 27.

So we will ignore this metric in Apple’s case.

Valuation Summary:

CaptureOverall, I view Apple as fairly valued at the current time. I consider it to be a high-quality company that I would be willing to “pay up” for. And in fact, I recently added shares to my wife’s and my investments.

Miscellaneous Factors

There are a couple of factors that I like to look at that do not fall neatly into any of the earlier categories.

CaptureBeta measures a stock’s price volatility relative to the market as a whole. Most dividend growth investors like to own stocks with low volatility, because then you are less likely to become emotional.

AAPL’s beta is a little below the market’s beta, which is defined as 1.0. That’s OK.

The second miscellaneous factor is analysts’ recommendations. Most analysts are mainly interested in short-term price changes rather than dividend growth. Nevertheless, I like to see what the consensus ratings are, if for no other reason then to check for red flags that I somehow overlooked. As you can see, per the most recent S&P Capital IQ report, 50 analysts cover AAPL, and overall they score it 4.1 on a 5-point scale, where 1 = Strong Sell and 5 = Strong Buy. A rating of 4 is considered Buy.

Bottom Line

Apple has been one of the great success stories of the past generation.
It is not a classic dividend growth company. In fact I would not even call it a dividend growth company yet. It has only paid dividends since 2012.

But it may become a dividend growth stalwart of the future. In my opinion, whether it becomes that will depend as much or more on it becomng a consistently profitable operating company than on continuing to extend its astonishing string of technological consumer product introductions. The company certainly starts from a sound financial base.

My bet is that Apple will become a solid dividend growth growth company over the next decade or so. It is too soon to predict what its typical yield range will turn out to be. It is entirely possible that it will be a low-yield fast-growth company for quite a while. If that is the case, most of its investment value will come from its stock price, not its dividend.

The obvious risk in Apple is the highly competitive nature of its business. Many former tech leaders are now shells of their former selves or have gone out of business. But I think that Apple has built up a defensible position where it could remain dominant for years, much as has happened with Microsoft (MSFT) and Qualcomm (QCOM). I think that it has a good chance of retaining most of its current user base as well as expanding it. If that is the case, much of Apple’s future growth will come from selling services and upgrades to existing users. I think it has a viable business based on that alone, along with an occasional important new product introductions.

– Dave Van Knapp

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