by Brian Green, 28th January 2020
APPLE PIE or APPLE CRUMBLE? AMAZON OR AMAZING?
On Tuesday evening Apple delighted Wall Street by beating estimates. This was due to the sparkling sales of its cheap iPhone XI and more favourable payment terms with which to buy it. There is also the issue of consumers willing to pay for privacy which Apple has emphasised. As a result, Smartphone sales popped above 60% of total revenue for the quarter ended 28th December 2019.Amazon, as we shall see in the second section,also delighted the markets by beating estimates.
Eighteen months ago, in the face of declining hardware sales, Apple remodelled itself, saying it was evolving into a services company from being solely a hardware company. However, the failure to grow the service side of the company as expected, shows that Apple is floundering, and, its future depends on cheaper Smartphones with lower margins.
This confusion over strategy has not prevented analysists projecting Apple to become the first two trillion Dollar company (current market cap is $1.422 trillion) or that it will be the first non-financial to achieve an annual profit of a hundred billion dollars. That may be so, but first Apple has to make as much profit as it did in earlier years.
In this article we will be using operating income as our data set. Operating Income is the best guide to the underlying profitability of a company. After it comes the frills, thrills and spills that distort the performance of a company. Operating income is sales less cost of sales and operating expenses (such as R&D and SGA or selling, general and administrative expenses). Graph 1 shows that while revenue peaked this quarter, operating income did not.
Profits as measured by operating income peaked in 2017 not 2019. When we adjust for inflation in Graphs 2 and 3 this will be clearer. The deflator used is the urban consumer price index which is the best metric to adjust for the fall in the purchasing value of the dollar over the period. (https://fred.stlouisfed.org/series/CPIAUCSL)
Graph 3 gives the clearer picture. From it we note that Q1 2019 revenue [equaled] that of 2017 but operating income was down 12%. On further analysis the following is found. The average adjusted profit for the five years is $23.577 billion. On this basis Apple’s profit in Q1 2019 of $23.588 billion is merely average. It was higher in two years, 2015 and 2017, and lower in two years 2016 and 2018.
The reason for this is the fall in margin. In 2017 Apple enjoyed a margin of 29.8% whereas in 2019 its margin has slipped by2% to 27.8% (revenue divided by gross margin). This slippage in margin represents a strategic problem for Apple as price pressures will intensify not abate. To maintain or increase its volumes Apple will continue to have to concentrate on price.
The purpose of this article is two-fold. Firstly, to demonstrate the Wall Street has “hype-induced amnesia”and secondly to demonstrate how this gives rise to a state of euphoria surrounding the world’s most “valuable” corporation. We have seen that Apple’s level of profitability is not soaring, instead it is stagnating. This however does not seem to have affected its market cap as Graph 5 shows. (Market Cap is at 31st December each year or closest date). To arrive at annual income, Q1 is multiplied by 3 as the final quarter of the year generally accounts for one third of revenue and profits. (Incidentally, Apple considers its first quarter to be the one ending at the end of December,which everyone else recognises to be the final or fourth quarter. It is confusing.)
Looking at the trends, we note that while the profit trend is flat,the trend for market cap has doubled over the five year period. Thus the fictious multiple is soaring above the actual multiple which is the amount of profit divided by circulating and fixed capital. it is of course difficult to obtain an actual rate of profit for Apple because so much of its production is outsourced,meaning that most of the fixed assets needed to produce the iPhone lies on the books of other companies like FoxCon which are based abroad. It also explains the limitations of a nationally based rate of profit.
Amazon is a unique monopoly. True,it is disrupter of the high street, but one that is not profiting from its monopoly position. Alone amongst the monopolies it continues to make a below average rate of profit. And had it not been for Amazon Web Services(AWS), Amazon could well be bankrupt by now. The table below contrasts the profits earned between the general segment (North America sales)and the AWS segment. All data in millions of Dollars covering the fourth quarters of 2018 and 2019.
Amazon’s profit on traditional sales fell between 2018 and 2019 resulting in a fall in its margin from 5.1%to 3.5%.On the other hand,AWS profits increased but only due to the increase in turnover. Its margin also fell by one tenth. However,despite this fall in margin, its contribution to total profits increased from below fifty percent to well above it.Total profits rose by only 1.5%.
This stagnation in operating income over the last two years is reflected in Amazons global performance which has occurred despite its steady growth in sales.
This has not stopped the exponential rise in its market cap. Despite operating profits stagnating,market cap rose by over $200 billion over the year. All data at year end.
Amazon may have a market cap approaching $ 1 trillion, but technically it is barely solvent. If we move the cost of leases from the asset to the liability side,which we should, and which amounts to over $25 billion, total assets exceed total liabilities by only $12 billion. This is less than the $14.8 billion of good will that inflates the asset side.Strip away the market’s view that Amazon is a perpetual growth machine and what you have is a barely profitable company that is unlikely to withstand a severe market shock.
Two corporations have been chosen. One is highly profitable, Apple, and one is barely profitable, Amazon. And yet Amazon’s current price to earnings ratio is 82.3 while Apple’s is only 25.6. In the frothy world of the markets,it appears that the Street places more emphasis on prospects rather than performance despite the fact that Amazon’s profit growth has been mediocre over the last five years. If that is the best profit performance both corporations could achieve in the frothy and unreal year of 2019, then the future is unlikely to beckon.
These two corporations belong to a small group of corporations, numbering less that ten, who have driven up the S&P 500 and the Nasdaq. Only Microsoft remains a true performer in terms of profits and potential. The others have generally presented stagnating profits. However, as long as the dead hand of ETF’s continue to bet on rising prices, because their previous bet caused prices to rise in the first place, and so long as the central banks juice the market, this will continue. But looking under the hood, the motor is covered in rust.
What applies to the leading corporations applies to the markets as a whole, though not to the same extent. The final graph is the latest from FactSet which shows that in every sector,current P/E ratios continue to exceed historical averages, even in those industries who are experiencing recessionary conditions in their industry.