Epic v. Apple (AAPL)

Apple logo

If Fortnite-maker Epic Games’ Australian legal challenge against Apple is successful, the tech giant may be forced to loosen its grip on its valuable mobile app ecosystem, with Epic arguing that competition law obliges Apple to allow rival stores and payment processing mechanisms on its devices.

Currently, the Apple-controlled App Store is the only way to get apps to consumers on iPhones, which make up more than half of all in-use smartphones in Australia. And all payments for digital goods, in-app purchases and subscriptions must use Apple’s payment mechanism, from which, in most cases, Apple takes a 30 per cent commission.

ACCC: Rod Sims
ACCC chair Rod Sims

Australian Competition and Consumer Commission chair Rod Sims said the Epic case was a well-timed test of the current competition laws, which were recently revised to better prevent misuses of market power

“Apple, as one of the two main app stores, is in a very strong position. It would seem like they have quite a lot of market power and can set the terms and conditions under which various apps operate,” Sims said. (from Tim Biggs at The Age)

Epic Games lawsuit

Epic Games filed suit against Apple in the US District Court for the Northern District of California, on August 2020, challenging Apple’s restrictions on apps from having other in-app purchasing methods outside of the App Store. Founder Tim Sweeney had previously challenged the 30% revenue cut that Apple takes on each purchase made in the App Store. Epic made changes in Fortnite intentionally to bypass the App Store payment system, prompting Apple to block the game from the App Store and leading to the Epic lawsuit.

Epic also filed another lawsuit against Google (GOOGL) the same day, which challenges Google’s similar practices on the Google Play app store for Android, after Google pulled Fortnite following the same update. (Wikipedia)

Apple Segments

Apple Inc. AAPL Segments

Services only account for 20% of revenue (FY20) but gross margins (66.0%) are more than double that of products (31.5%). The contribution towards overall operating profit of $66.3 billion is likely to be disproportionately high.

Conclusion

Apple would take a significant profit hit if its monopoly hold over app registration (via its App store) and processing of digital payments was removed. The company is already backing off from its former uncompromising stance, offering to halve commissions on sales via the App store (including In-App purchases), but only for developers with sales of less than $1 million. Allowing free competition from competing app stores and digital payment processors would compress margins even further.

Disclosure

Staff of The Patient Investor do not directly or indirectly own shares in the above company.

Apple Inc (AAPL)

Stock: Apple Inc
Exchange: NASDAQ Symbol: AAPL
Date: 7-May-20 Latest price: $300.63
Market Cap: $1.3 Tn Fair Value: $181.52
Forward P/E: 25.06 FV Payback (Years): 11
Forward Dividend Yield: 1.10% Debt/FCF: 2.1
Financial Y/E: 28-Sep-20 Rating: HOLD
Sector: Technology Industry: Consumer Electronics
Investment Theme: LT Growth Structural Trends: Growth of online services

Summary

We consider Apple (AAPL) to be priced above fair value, but the technical outlook is bullish.

We rate the stock as a HOLD but have not included it in our model portfolio because of declining long-term revenue growth.

Valuation

We project annual revenue to fall 15% in the next 12 months, recovering to 7% growth in the long-term. Estimated fair value is $181.52 with a payback period of 11 years.

The payback period recognizes AAPL’s strong market position but also its reliance on continuing sales of devices (as opposed to services).

Technical Analysis

AAPL continues in a primary up-trend, but expect strong resistance at its Feb high of 325. A Declining Trend Index warns of secondary selling pressure. Respect of resistance at 325 would suggest another test of primary support at 230.

Twiggs Trend Index & Twiggs Momentum (13-week)

Company Profile

Apple was a pioneer of the personal computer revolution, introducing the Macintosh in 1984. Today, Apple is a world leader in five areas of consumer electronics:

  • iPhone smart phones;
  • iPad tablets;
  • Mac computers;
  • Apple Watch; and
  • Apple TV.

Apple devices run internally developed semiconductors and software platforms — iOS, iPadOS, macOS, watchOS, and tvOS — with an enviable reputation for connectivity across all Apple devices.

Products are sold online, through company-owned stores, and through third-party retailers. Apart from device sales, about 20% of revenue is derived from services, including:

  • the App Store;
  • Apple Music;
  • Apple Pay; and
  • iCloud.

Apple’s headquarters are in Cupertino, California and the corporation employs more than 100,000 people.

Competitors

Morningstar sums up Apple’s competitive strengths:

We assign a narrow economic moat rating for Apple that stems from the combination of switching costs and intangible assets. We think the firm’s primary moat source is customer switching costs, as Apple bolsters the user experience with a cohort of auxiliary products…….

Regarding intangible assets, Apple’s differentiated user experience via iOS coupled with its expertise in both hardware and software design allows the firm to more seamlessly build integrated products.

….Recent survey data shows that iPhone customers are not even contemplating switching brands today. In a December 2018 survey by Kantar, 90% of U.S.-based iPhone users said they planned to remain loyal to future Apple devices. Also, users of ancillary products (especially the Watch and AirPods) lose significant functionality when paired with a smartphone other than the iPhone. Ultimately, we believe that existing iPhone users are relatively locked in to the iOS ecosystem and interface.

Major competitors include Samsung (Galaxy) which, coupled with Google (Android OS), dominates market share in smartphones. But neither offer an integrated suite of products that can compete with Apple.

Segments

Apple sales are dominated by iPhone but there is little year-on-year growth.

Segments

Growth is concentrated in the Services and Wearables segments.

Segments

Geographically, sales in the US are growing fastest, while China declined in FY19.

Segments

Apple is losing market share in China as local smartphone technology improves. From The Wall Street Journal:

Apple’s share of the Chinese smartphone market has been shrinking, crowded out by tech giants such as China’s Huawei Technologies Co. that market increasingly sophisticated phones at a lower price tag.

Apple’s share of the Chinese smartphone market contracted to 7.8% in the first three quarters of 2018 from a peak in 2015 of 12.5%, according to Canalys, a market research firm.

Performance

Revenue growth and operating cash flows have been disappointing in FY19 and FY20 so far. We expect a 15% fall in the next 12 months due to the impact of the coronavirus outbreak and declining sales in China.

Revenue & OCF

Thereafter we expect annual growth to recover to 7% in the long-term.

Declining operating margins reflect an increasingly competitive environment.

Operating Margin

Capital expenditure declined as a percentage of sales, suggesting limited growth opportunities.

Capex % of Sales

Capital Structure

Stock buybacks reduced shares outstanding by 32% since FY12.

Shares in Issue

A further $50 billion has been authorized for the year ahead.

Buybacks & Dividends

Buybacks from FY13 to FY17 were largely funded by debt.

Net Debt Issued

Debt at $99.5 billion (Q2 FY20), or 2.1 times projected free cash flow, however, remains comfortable when compared to cash & marketable investments of $156.8 billion.

Outlook

Apple did not issue guidance for the quarter ending in June, as it usually does, due to uncertainty from the coronavirus outbreak.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above company.

Moderna Inc (MRNA)

Stock: Moderna Inc
Exchange: Nasdaq Symbol: MRNA
Date: 25-Mar-20 Latest price: $27.13
Market Cap: $8.98 bn Fair Value: Uncertain
Forward P/E:       – Payback Period Uncertain
Financial Y/E: 31-Dec-20 Rating: BUY (above 30)
Sector: Healthcare Industry: Biotechnology
Investment Theme: LT Growth Structural Trends: Medical Technology

Moderna is at the forefront in developing a vaccine for the coronavirus COVID-19. Development work done on SARS and MERS vaccines has given the company a lead on competitors, with government approval to fast-track trial of the vaccine on humans.

Summary

It is difficult to determine a fair value for Moderna — vaccines the company is working on are still in the development phase — but there is massive upside if development is successful. We rate MRNA as a BUY if it closes above 30.00.

We suggest a weighting of 1% of portfolio value because of the uncertainty.

Technical Analysis

Moderna (MRNA) was listed late 2018 and is testing resistance at its previous high of 30.00. Momentum is rising but declining Trend Index warns of strong resistance. A close above 30.00, or Trend Index recovering above zero, would be a buy signal.

Twiggs Trend Index & Twiggs Momentum (13-week)

Company Profile

Moderna is a clinical stage biotechnology company, based in Cambridge, Massachusetts, focused on the discovery and development of messenger RNA (mRNA) therapeutics and vaccines.

Messenger RNA plays a fundamental role in human biology, transferring the instructions stored in DNA to make the proteins required in every living cell. Moderna’s approach is to use mRNA medicines to instruct a patient’s own cells to produce proteins that could prevent, treat, or cure disease.

The firm uses mRNA to develop therapeutics and vaccines for infectious diseases, immuno-oncology, rare diseases, autoimmune and cardiovascular diseases.

Coronavirus COVID-19

Moderna is at the forefront in developing a vaccine for the coronavirus COVID-19. Michael Diamond, a viral immunologist at the Washington University School of Medicine in St. Louis, Missouri, and on Moderna’s scientific advisory board, says the company has obtained FDA permission to commence phase 1 trials on human volunteers:

A vaccine represents the best long-term defense against the virus, known as SARS-Cov-2, and could help thwart future outbreaks. But even if one is found to be safe and successful at preventing infection, public health experts say it will take at least a year to become widely available. While that seems like a long time, it’s actually extremely fast for vaccine development.

Just weeks after China shared the genetic sequence of the coronavirus in January, Moderna announced that it would ship its experimental vaccine to the U.S. government for testing. Last week, a handful of volunteers in Seattle became the first to receive that vaccine……

A total of 45 healthy adults ages 18 to 55 years are expected to receive the investigational vaccine over the next six weeks. Known as a Phase I trial, this initial human study will test the safety of the vaccine as well as its ability to produce an immune response at three different doses. An effective vaccine must be able to create an immune response in the body that imitates an infection but doesn’t make a person sick.

Moderna manufactured the vaccine quickly, skipping lab experiments to determine how well it prevents infection in animals. Typically, scientists must test vaccines on animals before moving to human subjects, but the U.S. Food and Drug Administration has given Moderna permission to instead conduct animal tests in parallel with the human safety trial.

Dr. Nathan Erdmann, an infectious disease physician at the University of Alabama at Birmingham, says the decision is warranted amid a public health crisis. “Fortunately, we had a head start on this…..Because of our experience with SARS and MERS, there’s been work toward developing ways of having an immune response to a coronavirus vaccine for some time.”

….The viruses that cause SARS, or severe acute respiratory syndrome, and MERS, or Middle East respiratory syndrome, are also coronaviruses. Previous outbreaks of these diseases provided scientists with a starting point for making a coronavirus vaccine so quickly. Moderna was already working with researchers at the National Institute of Allergy and Infectious Diseases on an experimental MERS vaccine.

Coronaviruses are sphere-shaped, with protein spikes protruding from their surface. These spikes lock onto human cells, allowing the virus to get inside and infect them. The vaccine that Moderna is developing consists of a short segment of genetic material, called messenger RNA, that provides instructions for a human cell to make a harmless version of the spike protein. The RNA is packaged into nanoparticles to be delivered as a vaccine. (Unlike some other vaccines, this one does not contain part of the actual pathogen.)

Once in the body, the vaccine is meant to spur cells into producing some of the harmless spike proteins. If it succeeds, the immune system will recognize the spikes as foreign and unleash antibodies to attack them. These antibodies will continue to live in the body and would prevent infection if a person is exposed to the virus in the future.

…..There is no vaccine on the market today that uses this approach. So far, this type of vaccine — known as an RNA vaccine — has only been tested on people in small safety trials. Scientists don’t actually know how effective it is in people. In previous experiments on animals, RNA vaccines produced antibody levels “in the same ballpark” as other types of vaccines, says Diamond.

RNA vaccines have some advantages compared to current vaccines. “They can be developed and deployed very rapidly,” says Diamond, [who] worked with the company on an RNA vaccine for Zika virus. The process is much faster than other methods of making vaccines. Moderna was able to manufacture and ship the vaccine to the NIH for testing in a matter of weeks.

“Even generating the flu vaccine takes months and months, and we know exactly what we’re working with year to year,” says Erdmann.

This type of vaccine could also be fairly inexpensive to manufacture because RNA is cheap to produce in the lab. Plus, some scientists think the risk for serious side effects is low because the body makes the protein itself. But because these vaccines haven’t been tested widely in people, their side effects aren’t well understood.

Even if Moderna does not win the race to produce a COVID-19 vaccine, the appeal of vaccines that do not contain part of the actual pathogen could go a long way towards overcoming anti-vaxxer safety concerns surrounding vaccines.

Financial Position

Moderna spends close to $500 million a year on research and development and has accumulated losses of $1.5 billion against contributed share capital of $2.7 billion.

With cash balances of $1.1 billion and trade liabilities of $140 million, the company has roughly a two-year window to start generating revenue or else raise further capital.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above company.

Apple Inc. (AAPL) – window dressing with buybacks

Apple (AAPL) is a notable omission in my international model portfolio. Here is one of the reasons.

Michael Santoli at CNBC reports that Apple’s sales and earnings over the past 4 years are essentially flat. The only metric that has improved is earnings per share (EPS) because of stock buybacks. Shares in issue have shrunk by 20.7%, from 5.8 to 4.6 billion.

Apple (AAPL) Metrics

Let’s break this down.

Earnings per share grew by an average 5.7% over the past 4 years, of which 0.2% was from actual growth and 5.5% from buybacks. Apple spent $170 billion on stock buybacks in the 4 years to September 2018 at an average of $150.85 per share.

Apple Stock Buybacks

In FY18 buybacks totaled $72.7 billion, or 7.5% of current market cap ($965.4 bn), well above its earnings of $59.5 bn. Apple is distributing capital to stockholders by way of buybacks.

FY19 estimated earnings yield is 5.4% and dividend yield is 1.4%, leaving retained earnings are 4.0%. Far less than the buyback yield. The company has heaps of cash and can basically keep doing this for a long, long time. But it erodes shareholder value.

Total return investors can expect, if they buy at the current price of $213.04,  is 5.6% (5.4% earnings yield and 0.2% actual growth). That is all that Apple will earn on the money invested into buybacks. An admission that the company is standing still, powerless to inject new growth.

A PE ratio of 17.9 appears modest but it isn’t if you only have 0.2% growth. That amounts to a PEG ratio of a staggering 90 times growth!

Bottom Line

Apple is no longer a growth company. Earnings are shrinking in real terms and the only way the company can maintain the illusion of growth is by buying back stock at exorbitant prices.

Apple Inc. (AAPL)

Apple (AAPL) is a notable omission in my international model portfolio. There are several reasons.

First, sales growth has been declining for several years.

Apple Revenue Growth (AAPL)

Second, Apple is vulnerable if there is a US-China trade war. Greater China represents almost 25% of projected sales and imposition of tariffs or other trade barriers could hurt Apple. But, even without trade barriers, sales in China are already slowing.

“While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China. In fact, most of our revenue shortfall to our guidance, and over 100 percent of our year-over-year worldwide revenue decline, occurred in Greater China across iPhone, Mac and iPad…” (Tim Cook, January 2 letter to shareholders)

Third, Apple is losing market share in China as local smartphone technology improves. From The Wall Street Journal:

Apple’s share of the Chinese smartphone market has been shrinking, crowded out by tech giants such as China’s Huawei Technologies Co. that market increasingly sophisticated phones at a lower price tag.

 

Apple’s share of the Chinese smartphone market contracted to 7.8% in the first three quarters of 2018 from a peak in 2015 of 12.5%, according to Canalys, a market research firm.

Fourth, Apple is testing primary support at $150 on the long-term chart. Bearish divergence on Twiggs Money Flow warns of selling pressure; a peak at zero would strengthen the signal. Respect of resistance at $180 would also be bearish, while breach of support at $150 would confirm a primary down-trend.

Apple (AAPL)

Last, Apple is trading at a Consensus Forward P/E of 14.8 (Morningstar, February 12, 2019) which equates to an estimated LT growth rate of 10% at 12.5% p.a. rate of return. Given the current sales outlook, that seems optimistic.