Is Apple the greatest company ever? On the surface, it certainly appears that way. They sell more than 450,000 iPhones per day, every day. And customers love them: According to surveys, iPhone customer satisfaction stands at 98%. Last year Apple’s revenue topped $200 billion, and in its most recent quarter the company saw profits jump by 40%. Not surprisingly, the company’s share price reflects this success. Having gained 38% over the past year, the company is now worth more than $1 trillion — the first company ever to reach that milestone.
So what’s not to like?
I have nothing against Apple. The iPhone is a great product, and I have a lot of respect for the way CEO Tim Cook runs the company. As an investor, though, I’m not sure these numbers tell the whole story.
Yes, Apple’s profits grew by 40% over the past year, but can we accept that figure at face value? It’s worth taking a look under the covers. If you’ll bear with me, let’s take a quick tour through Apple’s third quarter Profit & Loss statement, where they reported that number. There may be a few things to learn.
The starting point on a Profit & Loss statement is revenue. By that measure, Apple grew at a healthy 17% rate, and pre-tax profits grew at a similar rate. But here’s where things get interesting. Somehow Apple was able to convert that gain of 17% in pre-tax profits into a gain of 40% in after-tax earnings per share, which is the key driver of stock prices. Let’s see how they did that, and what it might tell us:
First, Apple benefited from the recently-enacted corporate tax cut. As a result, even though profits increased by 17%, their tax bill decreased by 32%. In addition, and also as part of the new tax rules, the company was able to repatriate hundreds of billions of dollars that essentially had been stranded overseas. From this cash hoard, Apple was able to buy back more than $60 billion of its own shares. This had the effect of substantially reducing Apple’s share count, thereby increasing the profits allocated to each remaining share. Taken together, the result was a 40% increase in earnings on a per-share basis.
So what’s not to like? Apple management is doing everything they can to delight customers and shareholders alike.
The problem, in my view, can be found in a supplementary disclosure document provided by Apple. If you look at the most recent one, you’ll see that iPhone sales seem to have plateaued. While iPhone revenue grew by 20%, the number of phones sold increased only fractionally — 0.7%, to be exact. In other words, virtually all of that 20% revenue increase came from higher prices. Over the past year, the average price of an iPhone has increased from about $600 to more than $700, with several topping $1,000.
Why am I harping on this? Aren’t these price increases just more proof of Apple’s dominance, their customers’ loyalty, and the immortal magic of Steve Jobs?
In some ways, yes, this is all true. But I’m focusing on it because I see three cautionary lessons for you, as an individual investor:
1. Always look at the numbers behind the numbers. Whenever you’re looking at economic or financial data, don’t settle for simple summaries. Keep your hand on your wallet until you know what’s really going on.
2. Be wary of short-term data. This year, Apple benefited from a set of unusual circumstances: a 20% price increase, a huge corporate tax cut and a one-time “amnesty” on cash repatriation that enabled gargantuan buybacks. Realistically, these events are unlikely to repeat. As any high school student could tell you, you can’t draw a trend line through a single data point. So always, always look at long-term data before making a decision.
3. Remember that trees don’t grow to the sky. In defending the slowdown in iPhone unit sales, Tim Cook stated, “I don’t buy the view that the market is saturated.” I’m sure he is sincere in making that statement, but I’m also sure that the CEOs of General Motors or Sears or IBM — or BlackBerry — would have said the same thing when their companies were on top of the world the way Apple is today. To be clear, I’m not saying that Apple is over the hill; I’m just saying it’s important to avoid loving an investment so much that you lose objectivity.