Horizon Kinetics is headed by Murray Stahl (Trades, Portfolio) and Steven Bregman. These two investors have had a profound influence on the way I go about investing. Obviously, I keep an eye on their quarterly reports.
The duo is currently among the more bearish of value investors I follow and has increased the percentage of cash in their portfolios recently. They just released their vast second-quarter 2019 market commentary, which covers a range of topics including the state of the market, several attractive positions and historical context for the current bull market. I'm focusing here on a single topic in the commentary for two reasons: it will interest many investors as it pertains to one of the dominant companies of our time in Apple (AAPL, Financial), and it is fairly controversial (Horizon Kinetics has a bearish view).
Horizon Kinetics' are below in quotations. In between, I add commentary and context. Emphasis is also mine.
Here's what they think about Apple:
"Measuring the Valuation Risk of Today’s Internet Bubble The internet is so vast and so visible to the entire global investor base that it is inevitable that a dawning realization of its growth limits will be discounted in stock prices – meaning lower valuations – long before it actually occurs. Analysts have already begun to model a decline in Apple’s profits, partly due to saturation of the smartphone market and partly due to forecasting a commoditization of the smartphone in a manner similar to that of the laptop computer. In other words, the consensus view is evolving towards the idea that Apple will become a cyclical company within three years."
I did not realize the consensus on Apple has been changing in this way. It seemed counterintuitive, so I checked how earnings-per-share and revenue estimates changed over the past year. The consensus for revenue declined by roughly 1.5%, while earnings estimates dropped nearly 4%. That does seem to indicate that the consensus built in some profit decline for Apple.
"For Apple’s 2019 fiscal year, the consensus earnings estimate is $11.47 per share; although it rises for each of the next two years, it is only $11.36 for fiscal 2022. It is difficult to imagine that by the summer of 2021—roughly two years from now—Apple shares would trade at a P/E ratio much above 15x the lower year-forward estimate. This would be a price of about $170, some 10% below the current price."
Again, I intuitively agree that Apple trading at 20x earnings seems nonsensical. But I looked up its price-earnings multiple trajectory over the past 10 years, and it has traded between roughly 8x to 25x. The vast majority of the time it traded between 10x and 20x.
In addition, the only reason I can ever conjure to like Apple is the expansion of its services revenue. That's the revenue from apps, Apple pay and other software that comes with its devices. Statista's chart below shows how fast this segment is growing:
Services revenue now makes up nearly 20% of total revenue. As this piece of the pie keeps growing (which it does because of higher relative growth rates), it increasingly dominates the company's growth rate. Software revenue is generally perceived to be more valuable. That means this is a strong driver of multiple expansion in the coming years. The problem, of course, is that its services revenue is highly dependent on the hardware business. No devices sold means services will suffer as well.
"In reality, though, although the 2022 earnings estimate appears conservative, it is actually excessive, because the estimate is still steeped in bubble mentality. Here’s why. Apple earns an after-tax profit margin of 23.68%. This is extraordinarily high. The average profit margin of the S&P 500 on a look-through basis, inclusive of internet beneficiary companies, is 10.3%. Johnson & Johnson, the sixth largest company in the index, with patent protection on much of its product portfolio, has an 18.8% profit margin. ExxonMobil, number 10, has a 7.5% net margin. Bear in mind that these are – aside from the technology giants – among the most profitable companies in the world. For Apple, at a 10% margin and 15x the reduced profit, that would be $72 per share, a 65% decline."
There are several reasons Apple earns high margins: the service business has high margins (which is another reason its high growth rate is so important), and the company sells an enormous amount of devices with a limited product range. Horizon Kinetics has a point that Apple's margins are ultimately hard to sustain, but they are not necessary under near-term pressure.
"But wait, there’s more. Analysts’ projections of 2022 earnings of $11.36 per share implicitly assume that Apple will earn a 50% return on equity. That is, Apple’s book value is $23.02 per share, so $11.35 of earnings is a 50% return on equity – well, 49.3%, but why quibble? Which is even more extraordinarily high than a 24% net profit margin. Yet, even this figure understates the reality. That is because the book value figure is complicated, in part, by the company’s $225 billion of cash and marketable securities. These aren’t productive assets – they don’t produce a meaningful return and aren’t even necessary to the business. A more direct, undistorted measure of Apple’s profitability would compare its earnings to the operating assets that actually produce its revenues and earnings. These would be its property, plant and equipment, and one might add in its inventories. These amount to $44 billion, or $9.50 per share. Which means that Apple would earn, at analysts’ reduced 2022 earnings estimate, a 121% return on invested capital."
Although I am a huge fan of Horizon Kinetics' analysis, this seems a bit of a stretch. Yes, I agree there is high probability Apple won't sustain its current return on equity. But these financial metrics shouldn't be taken too seriously in isolation or without context. Accounting, Horizong Kinetics would be the first to agree, doesn't do a fantastic job of describing the value of a company's assets. Maybe it once did, but the world changed. Intangibles, like Apple's high customer loyalty, are not reflected in these figures, but they do play a role in determining future returns.
"A 20% return on capital, historically, is not generally sustainable by a large company. It is certainly not the sort of profitability earned by a company experiencing increased competition in a race to acquire customers among the poorer 40% of the world’s population. Because the competition would be exceedingly happy with a lower price for their goods and services, readily commoditizing the product if the outcome is a 20% return on capital. If Apple were to earn a 20% return on the higher, stated $23.02 book value recorded on the balance sheet, then its earnings would be $4.60 per share. At a P/E ratio of 15x, the share price would be $69, and that would be 66% lower than its recent $205 share price."
Apple is still extremely dependent on the iPhone. That's a vulnerability, and if it delivers several subpar iterations of the device, I fully agree the company could go the way of Nokia (NKIA) or BlackBerry (BB) faster than anyone would expect. But as long as Apple continues to deliver top-echelon products and keeps enforcing its ecosystem, it won't be easy to end the company's above-average returns on equity. That's probably why Warren Buffett is in it.
Disclosure: No positions.
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