Apple – Rotting At The Core

Blasphemy! You say. No one questions the mighty Apple Inc.’s (AAPL) financial dynasty. The stock has grown on a split adjusted basis from under $2.00 in the year 2002 to its present level of $166 per share on October 30, 2017. And as the price chart shows, over the past year the shares have increased steadily from $100 to the present trading range. Any dips in the share price move up have been good buying opportunities.

Why should anyone worry given the company’s stellar brand position and cash on hand?

Count me as an investor that lives by the adage, “Bulls make money, Bears make money, and Pigs get slaughtered.” And the persistent move higher and higher in the Apple share price on lower and lower share volume, flat net income growth, and a tired product line, creates plenty of reasons for shareholders to start to question the valuation.

Certainly No Signs Liquidity will be an Issue any time Soon

But wait, the mighty Apple balance sheet is a fortress of cash, and continues to grow every quarter.

At $50 per share in cash, Apple does indeed have formidable staying power, and therefore, is unlikely to suffer any liquidity based concerns in the near future. But the question that begs to be asked at this juncture is whether the company is actually going to grow its earnings base in the future, or simple harvest its iPhone dominant market position?

Main Problem – CFO, Not Steve Jobs Now Running the Company

Where I come down on the important question of whether Apple can actually grow substantially in the future, at least enough to justify its present stock valuation, is a definite no.

First, you need look no further than the past 4 years of earnings to see that the company is muddling through time without any clear new dominant product entering its portfolio to allow it to expand earnings. The iPhone’s big earnings growth hit took place from 2010 through 2012. Since that time, the company has been in an earnings growth rut.

To energize growth, Apple is now trying to make ever more sensational new iPhone launch announcements. But the latest product launch announcement in my assessment is shear product line confusion. The company launches the iPhone 8, and then creates an immediate wait by introducing the iPhone X. Not to mention that putting an X in a product name is usually the “kiss of death”, Apple without question is struggling to find the next big hit after the phenomenal run Steve Jobs had with the iPod and then the iPhone. Having been in the network technology business for many years, I understand that tech product visionaries always work many years out on the curve in order to grab the next wave. Apple, however, is now seemingly stuck on the same wave, with no clear new product vision coming forward to drive the imagination of the “feed me now” generation beyond the iPhone.

Enter the Apple CFO and Tim Cook to save the company’s stock from being hammered into oblivion. And the financial engineering that has been used by many tech companies over the last 8 years (OTCPK:MFST) (ORCL) (CSCO) (IBM) is also being used at Apple to pump up a slow growth financial situation. The stock buyback program at Apple, Inc. is a financial “beauty.” Back in 2012 the company had 6.6B fully diluted share on the books. As of July 2017, the share number had dwindled to 5.2B.

To finance the buy-backs the company has entered the debt market to raise capital, not wishing to pluck the feathers from its overseas cash stash to buy-back the shares thereby incurring a large tax bill. The huge imbalance created by this financial engineering exercise is noteworthy. First, in 2012 Apple Inc, like many tech companies, did virtually no borrowing, and for very good reason. Most tech executives know that the half life of their best products are 7 years or shorter. Borrow against the future when the product line needs to turn over that quickly, and you are destined to be owned by the debt-holders sooner or later.

In Apple’s case, however, they have taken the share buy-back solution one step further. Apple’s CFO is borrowing against its mega-cash balance held overseas, and running a levered bond fund inside the corporation to make this numbers work for Wall Street. Currently the company sits on $261B in cash and equivalent investments, and has borrowed long-term about $90B to fund the buy-backs. Assuming the tech business in Apple in normal market circumstances would maintain very low leverage, this makes the bond investment portfolio levered at about 35%. Margin regulations on funds and investors in the market are limited to 40%. In my opinion, the Apple CFO definitely is running a risky financial operation, and one that could bite unknowing shareholders very hard in the near future, particularly if interest rates continue to increase.

What Happens When the Financial Engineering Begins to Unravel

Leverage is a double edge sword, and in the case where a CFO starts to use it to buy-back company shares at an increasing pace, shareholders need to pay close attention to the risks involved. In the current Apple situation, the biggest loser with the increasingly leveraged balance sheet is, and probably has been for several years now, new product investment. I am not talking about revitalizing the iPhone. The company has already proven there are multiple competing contenders to be the next star, neither of which is likely to solve the earnings growth required to justify the current nosebleed stock price level. This circumstance, in my assessment, is a symptom of a growing problem.

The simple fact that Apple is buying back shares at such a rapid pace to prop up the share price is just the tip of the iceberg when it comes to the risk being taken on. Apple is generating sufficiently large levels of cash flow to support an on-going buyback program. However, the company has chosen instead to borrow money to fund the buy-back, some long-term, but much of it short-term. Meanwhile they have chosen to keep a large bond fund on their balance sheet, sitting mostly overseas to dodge US taxes. This bond fund, by the way, has $150B (about 60%) invest in the bonds of other corporations – not risk-free US Treasuries.

What happens as the interest rate mess created by the Federal Reserve, and followed by the ECB and the BOJ starts to unravel and the market begins to demand a real interest rate as a return for risky investments? Apple loses in multiple ways. One, the bond portfolio takes a hit. A 10% hit on a $261B portfolio, which could happen if rates rose 100 basis points, would translate to a substantial $26B unrealized loss in the securities portfolio that would flow through as an equity reduction on the balance sheet. Likewise, the short-term debt that was being borrowed to lever up the business to buy-back the shares would need to be refinanced at higher rates. The interest expense line at Apple is currently running at $2.4B (annualized 3Q 2017 level). This value could easily double if rates rise 100 basis points or more.

And lastly there is the unknown chain reaction that these events will have on Board Room decisions as the balance sheet losses start to mount and the CFO wakes up to see the risk for Apple’s future his structured finance play in the financial markets, rather than focusing on Apple’s core business. The most likely reaction by the Board will be a “belt-tightening” maneuver inside the company, which will end up hitting future product investment for some period of time. At that point, it will definitely be time to sell Apple shares and find better risk reward opportunities for your investment dollar.

Bottom Line –Tech Castles Surrounded by a Debt Moat Can Quickly Crumble

The underlying challenge in maintaining a fortress tech company is that the castle is always built out of sand. Tech product half lives are usually 7 years or less. If Apple does not soon produce a revolutionary product, the tech fortune it has amassed will crumble and the sand castle will be washed away.

With so much emphasis today on the Apple stock buyback program and whether they can successfully re-vitalize an aging iPhone product line as the basis for the stock valuation, odds are high that Apple will be the bellweather indicator of the next big stock market failure in the future. Plenty of other tech companies are using the same buyback playbook. (OTCPK:MFST) (CSCO) (ORCL) (IBM) Buyers beware when the tech market finally reaches a top as interest rates continue to climb. The crashing sound you will hear will likely be similar to the pull-back experienced in year 2000, but this time for a very different reason.

Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.

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.

Carol Humphreys