Hole Story

Adam M. Grossman

IS APPLE the greatest company ever? On the surface, it certainly appears that way. The company sells more than 450,000 iPhones every day. Customers love them: According to surveys, iPhone customer satisfaction stands at 98%. Last year, Apple’s revenues topped $250 billion, and in its most recent quarter the company saw profits jump 41% from a year earlier. Not surprisingly, the company’s share price reflects this success. Having gained 33% over the past year, the company recently reached $1 trillion in market value—the first company ever to achieve that milestone.

What’s not to like?

I have nothing against Apple. The iPhone is a great product. 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 41% over the past year. But can we accept that figure at face value? It’s worth looking under the covers. Let’s begin with a quick tour through Apple’s fourth quarter profit and loss statement. There are a few things to learn.

The starting point on a profit and loss statement is revenue. By that measure, Apple grew at a healthy 20% rate. Pre-tax profits grew a little more slowly, at 18%. But here’s where things get interesting. Somehow, Apple was able to convert that gain of 18% in pre-tax profits into an increase of 41% in after-tax earnings per share, which is the key driver of stock prices.

How did it manage that? First, Apple benefitted from the recently enacted corporate tax cut. As a result, even though profits increased by 18%, its tax bill decreased by 28%. 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 $70 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 41% 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 29%, the number of phones sold increased only fractionally—0.5%, to be exact. In other words, virtually all of that 29% revenue increase came from higher prices. Over the past year, the average price of an iPhone has increased from about $620 to nearly $800, with several topping $1,000.

Why am I harping on this? Aren’t these price increases just more proof of Apple’s dominance, its customers’ loyalty and the immortal magic of Steve Jobs?

In some ways, yes. But I’m focusing on it because I see three cautionary lessons for individual investors:

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 benefitted from a set of unusual circumstances: a 29% price increase, a huge corporate tax cut and a onetime “amnesty” on cash repatriation that enabled gargantuan buybacks. These events are unlikely to repeat. As any high school student can tell you, you can’t draw a trend line through a single data point. 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’s 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, just as 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.

Adam M. Grossman’s previous articles include Seeking ZeroGarbage In and All Too Human. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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