This is from the AMM Dividend Letter released January 31, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
Dividend oriented investors often focus too much on current yield (i.e. how much the company pays the investor today), which, by extension, leads to a portfolio of mature slower growth businesses like regulated utilities or telecommunications service companies. These companies may offer relatively high current yields, yet their growth prospects are low. We aren’t against investing in these industries; however we don’t think an investor seeking long-term wealth creation should necessarily overweight their portfolio in these kinds of businesses.
When we developed the AMM Dividend Strategy we decided to focus on overcoming the current yield dilemma (high payout, low growth) in dividend investing. To build a more growth oriented dividend portfolio we focus on three core types of dividend payers as the building blocks of our portfolios.
1) Dividend Stalwarts: Companies that have strong dependable market positions, that pay a reasonable dividend (~2-3%), and have shown an ability to grow their dividends over a long period of time at a pace far faster than inflation. While the current yield is modest, we expect the growth in the dividend payout to provide a more robust yield (on original cost) in the future.
2) Restructuring/Special Situations: Companies undergoing a restructuring, spin-off, or other special situation. Volume 1 of the AMM Dividend Letter highlighted such an investment, the upcoming spin-off of SLM Corp. (SLM) into two companies. If we see value in the restructuring and the parent company pays a reasonable dividend we will invest. Our initial time frame for these investments is one year but if, after the restructuring, one of the companies’ appears to offer good odds of becoming a dividend stalwart we may hold our investment for a longer time frame.
3) New Dividend Payers: Companies that have recently initiated a dividend policy. While these companies do not have the long history of paying and growing their dividend like the stalwarts, they do have a strong market position and the cash flow to become a stalwart in the future. And sometimes they’re just so cheap that you have to buy them like the subject of our latest letter, Apple Inc. (AAPL).
Dividend Stock in Focus
Apple, Inc. (AAPL): $500.60*
At the turn of the millennium, before the iPad and iPhone revolutions, Apple was in the early stages of a business turnaround. The key people that would help drive Apple’s future growth, like founder Steve Jobs and lead designer Jony Ive, were already in place. The candy colored iMac was out and people were talking about Apple again. The iMacs were a start but they weren’t the blockbuster Apple needed.
Then came 2001.
The introduction of the iPod represented more than just another high tech, high priced gadget. In reality the iPod represented three products: the iPod (the device), iTunes (personal data manager), and the iTunes store (the digital store). The beginning of Apple’s closed ecosystem.
Apple became extremely successful with its closed ecosystem. Ironically Apple’s success might not have happened were not for the critical decision to open up iTunes to the PC market. While Steve jobs wanted to keep the iTunes software solely on apple devices, Senior Vice President’s Phil Schiller and Jon Rubinstein saw the value in opening up iTunes to PCs. From Design Crazy
by Max Chafkin:
“We argued with Steve a bunch [about putting iTunes on Windows], and he said no. Finally, Phil Schiller and I said ‘we’re going to do it.’ And Steve said, ‘F*** you guys, do whatever you want. You’re responsible.’ And he stormed out of the room. In October 2003, iTunes was introduced for Windows. Apple would sell two million iPods that year. The following year, with the release of the iPod Mini, the figure would increase five fold. Once it was on the PC, that’s when it took off”.
The majority of computer users had PCs and they could finally buy an iPod. Their first iPods turned into their first iPhones. Their first iPhones turned into their first iPads. They saw how easy it was to upgrade the software and how well the software worked with the hardware. They soon realized how much easier it would be to be fully a part of the Apple ecosystem propelling Apple past Coca-Cola and being awarded Interbrands’ title as World’s Most Valuable Brand for “revolutionizing the way we work, play, and communicate”.
Dividend History:
At first blush Apple may appear an unusual choice for a strategy focused on dividend growth; however Apple is a great example of the “New Dividend Payer” concept discussed earlier. The company initiated a $2.65 quarterly dividend in 2012, in part due to pressure from shareholders who argued that the company should return a portion of their fast growing cash hoard to shareholders. Last year Apple increased the quarterly payout by 15% to 3.02 per share. This represents a current yield of approximately 2.4% at current price levels. The payout ratio stands at 30%. Given the firm’s leading position, rock solid balance sheet, and an ever-growing activist shareholder base, we expect the dividend hikes to continue.
Chart from S&P Capital IQ.
Catalysts for Dividend Growth and Price Appreciation:
Aspiration Brand:
“But the bottom Line is that there are people who can afford iPhones and iPads, and people who can’t” – John Gruber of Daring Fireball
A lot of digital ink has been spilled lately about how Apple needs to introduce a cheaper iPhone or face market share loss to Android based smart phones. Competing for market share with cheaper phones is a surefire way to destroy margins and free cash flow.
Apple is a luxury brand. Apple builds its smart phones and other hardware at relatively the same cost as its competitors, however because of its brand recognition and the quality it infers, Apple can charge a higher price. Think Rolexes not Timexes.
Apple is hyper focused on elegant designs and operating systems that are known for simplicity, intuitiveness, and reliability. Focusing on quality products for their customers is what drives Apple. Not market share. A market will build around highly-desirable high-quality products. As a luxury brand, Apple can charge more for its products, maintain higher operating margins, and generate excess cash per sale.
China:
Over 80% of cell phones in China are still connecting to a 2G network. China is still in the early stages of growth for its 3G and 4G networks. It wasn’t until faster and more robust wireless networks like 3G came along in the U.S. that smartphone use took off. We have a similar situation developing in China.
Smart phones sales in China have reached an all-time high. About 9 of every 10 handsets sold in China is a smartphone and the Chinese consumer tends to buy a new phone every 15 months.
Chart courtesy of Counterpoint Technology Market Research.
While it was expected to happen, it was crucial that Apple gain a larger exposure to China. China Mobile, the largest Chinese wireless network operator, started carrying the iPhone this year because they were losing subscribers to competitors who did. Apple now has access to China Mobile’s 760+ million customers.
China has the largest growing group of people that can afford iPhones and iPads.
iTunes:
In June 2013 Apple reached 575 million iTunes accounts. According to Horace Dediu of Asymco, that averages out to 500,000 new iTunes accounts per day. With year-over-year revenue growth of 38% and 25% for 2012 and 2013 respectively, iTunes is growing into another major source of revenue for Apple. With over $16 billion in sales in fiscal year 2013, iTunes accounts for 9.4% of total sales.
Per account, Apple generates more revenue per user than even Amazon.
Chart courtesy of Morgan Stanley Research.
And not surprising Apple produces more free cash flow per account than each company mentioned in the graph above.
There is a lot of leverage in iTunes. The more Apple devices in consumers hands the more iTunes accounts. This leads to more purchases of apps, music, movies, books, software, and a lot more revenue and cash flow for Apple. Content purchases, like music and movies, also keeps people tied to Apple’s ecosystem.
Looking to the future every iTunes account is linked to a credit card or debit card and it’s easy to see how Apple could lead the way in digital wallets.
Cash Flow:
For the trailing twelve months Apple (AAPL) has generated about $40 billion in normalized free cash flow. Without factoring in any growth or margin expansion/contraction in 12 years Apple could buyback all of its shares outstanding just using existing free cash flow. This is a very basic example and doesn’t account for items like repatriation taxes on the large amount of cash that is being generated overseas. Nevertheless, it shows that Apple is a cash flow machine. Apple’s cash flow yield, essentially what would be your cash return if investing today, is over 8%.
Return of Capital:
Amidst the push by activist investors like David Einhorn of Greenlight Capital and Carl Icahn, Apple has initiated a $100 billion plan to return more capital to shareholders. $60 billion has been earmarked for share buybacks. As of Apple’s most recent 10-K, $23 billion has been used leaving $37 billion left to buy more shares. At Apple’s current share price over 8% of their shares outstanding could be bought back under the plan.
Of the remaining $40 billion of capital to return to shareholders $10 billion was used to increase Apple’s quarterly dividend to $3.05, providing another $30 billion of capital to be returned to shareholders on top of the $37 billion in share buybacks.
Conclusion:
Apple exists at the crossroads of technology and industrial design. Two categories that are highly dependent on the changing tastes of its customer base. Due to this inherent risk in their business model, we use a higher discount rate (12.5%) than we would typically use for a company of this size and financial strength when valuing Apple. We also built out our cash flow model using a 25% operating margin (below Apple’s trailing twelve month operating margin of 28%), estimated growth over the next five years at 6% vs. the average analyst estimate of 16%, and excluded share buybacks. Even with our modest assumptions we arrive at a fair value of $605 per share for Apple.
* Price as of the close January 31, 2014
Chart courtesy of Stockcharts.com.
