53641497 - montreal, canada - february, 2016 - aapl - apple inc stock ticker with charts under magnifying glass.
Apple Inc. (NASDAQ:AAPL) is struggling with weak top line growth. Sales are stagnant in every major product category, and fierce competition in the smartphone market has led to margin erosion on the iPhone and other products. But Apple still has growth baked into its stock price. And investors expect the multinational tech giant to continue growing its profits and paying out a hefty dividend.
In the future, Apple’s investors can expect expansion into AI technology and self-driving automotive systems to be the next leg up for Apple’s massive revenue stream. But in the near-term, the company will have to increase the profit margins on existing sales by cutting costs and streamlining its supply chain. Thankfully, Apple seems to have a plan for this – and it will come at the expense of Qualcomm (NASDAQ:QCOM), one of its iPhone chipset suppliers.
As competition in the smartphone market heated up, Apple’s once mighty margins nosedived. In fact, Apple’s margins peaked all the way back in 2012. Back then, falling margins weren’t such a big deal because sales on the iPhone were still in super growth. However, margins continued to drop throughout 2016.
Improving margins will be an effective way for Apple to prevent top line weakness from filtering down to the bottom line and hurting its EPS, EBITDA, and net income. In terms of EPS – the bottom line metric most relevant for dividend sustainability – Apple is using a two-pronged approach to keep its investors happy: Improving margins and reducing shares outstanding through buybacks.
This is a powerful combination, and if Apple pulls it off, the company can sail through this rough patch and keep its stock price up while it invests in new growth drivers. The fewer shares exist, the easier it is to grow EPS even when revenue is declining.
Supporting Margins at Qualcomm’s Expense
Apple has a mountain of cash so buying back shares is easy. But improving margins is much harder because Apple’s supply chain is already a miracle of efficiency. Further, Apple’s brand cachet depends on the quality and durability of its products. Apple can’t, for example, support its margins by outsourcing production or improving manufacturing systems because these techniques have already been exhausted.
Apple’s best alternative is to squeeze suppliers for costs that aren’t directly related to the quality of the end product. Technology licensing fees are a good example of these types of costs. To this end, Apple has accused Qualcomm of charging too much in royalty fees for some of the technology licensed to create the iPhone. Recently, Apple took things a step further and decided to withhold $1 billion in royalty payments until the legal dispute is settled.
This is a power move by Apple. The Cupertino-based tech giant knows that with both revenue and margins falling, it needs to protect its bottom line to keep investors happy.
$1 billion is just a drop in the bucket for Apple. But for Qualcomm, it’s a big deal. Apple’s move has ruined Qualcomm’s first quarter guidance and caused a 4% drop in its stock price. I expect Qualcomm to acquiesce to Apple’s demands, and reduce its licensing fees.
A combination of share buybacks and margin stabilization should help keep Apple’s bottom line performance strong despite weakness in its top line growth.
Disclaimer: The author has no position or business relationship in any stock or company mentioned in this article, and he has no plans to initiate a position at any time. The author is not receiving compensation for this article expect from Smarter Analyst.