Apple Inc. (AAPL, Financial) is the largest public equity holding of investing guru Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A) (BRK.B). Apple currently accounts for roughly 50% of the conglmerate's public equity portfolio. Comparably, its second-largest holding, Bank of America Corp. (BAC), accounts for just 10% of its portfolio.
Buffett has called Apple the best business that Berkshire owns:
“Apple is different than any other business we own. It just happens to be a better business.”
However, despite this positive endorsement, the Oracle of Omaha has recently reduced the Apple position by roughly 13%. While this is certainly a newsworthy development, I do not believe it is cause for concern.
Potential reasons why Buffett curbed his position
It is difficult to know exactly why Buffett decided to sell Apple shares, but one potential reason is diversification. Simply put, the stock has grown to dominate Berkshire's public investment portfolio, and smart risk management argues for somewhat broader diversification.
Another thesis that has been put forward is Berkshire trimmed its stake as it had sold other losers such as HP (HPQ, Financial) and Paramount (PARA, Financial), which generated losses to offset the realized capital gains related to the Apple sales.
However, during Berkshire's recent annual shareholder meeting, Buffett commented on the Apple sale and tax rates:
“It doesn't bother me in the least to write that check and I would really hope with all that America's done for all of you, it shouldn't bother you that we do it…And if I'm doing it at 21% this year and we're doing it a little higher percentage later on, I don't think you'll actually mind the fact that we sold a little Apple this year.”
He continued:
“Almost everybody I know pays a lot more attention to not paying taxes than I think they should. We don't mind paying taxes at Berkshire, and we are paying a 21% federal rate on the gains we're taking in Apple and that rate was 35% not too long ago, and it's been 52% in the past when I've been operating”
Based on these comments, it appears a major factor behind Buffett's decision to sell is the potential to lock in the 21% capital gains rate as opposed to locking in gains at a higher tax rate in the future.
It must also be noted that the guru could be selling due to a potential change in his outlook for the stock. Given Berkshire's large position, it would take time for him to liquidate the entire position and thus, he would not want to let other market participants know that he intends on reducing his stake further. However, I believe this is unlikely as Buffett said he expects Apple will continue to be Berkshire's largest public equity holding at the end of the year. Moreover, he also expressed confidence in Apple CEO Tim Cook.
Significant earnings growth potential
While Buffett's move to sell Apple shares has generated a lot of headlines, ultimately the most important factor when considering an investment is the growth potential.
Despite Apple's status as one of the largest companies in the world, it continues to have solid long-term growth prospects. Perhaps the biggest potential growth area is in emerging markets. While the company has a strong presence in key markets such as China and India, its market share remains fairly low. In India, the company currently has roughly 6% market share, which is expected to grow to 8% in 2024 by some analysts. In 2023, Apple surpassed Samsung (XKRX:005930, Financial) to become the leading smartphone seller worldwide with an estimated 20.10% global market share, having grown market share by 3.70% on a year-over-year basis. Thus, Apple has significant market share gain opportunities going forward to drive increased earnings growth.
Another key potential growth opportunity for Apple is its Mac business. In 2023, the tech giant generated nearly $30 billion of revenue from its Mac business. In the U.S., Apple is estimated to have just 16% of the PC market, up from closer to 12% in 2013. Thus, while Apple's Mac business has been gaining share, the company has substantial growth opportunities from continued market share gains.
In addition to revenue growth opportunities, Apple is also poised to benefit from margin expansion as increasing revenue allows shared costs such as research and development to be spread across a larger revenue base. Additionally, the company's service business, which is higher margin than other segments, is likely to account for an increasing percentage of total revenue overtime, resulting in margin expansion for the company. Over the past five years, Apple has grown earnings per share at a compound annual rate of roughly 16%. Net income, which excludes the impact on earnings per share due to share repurchases, has grown by nearly 12% over the same period. However, the company has grown revenue at a compound annual growth rate of roughly 8% during this period.
A key driver of the difference between net income and revenue growth rates has been margin expansion. Apple recently reported second-quarter 2024 results that included a gross margin of roughly 46.60% and a net margin of roughly 26%. Comparably, during the same period five years ago, Apple reported gross and net margins of roughly 37.60% and 20% respectively. I believe Apple is poised to experience continued margin expansion over the new few years, which is likely to drive higher earnings.
Currently, consensus estimates call for Apple to report earnings per share growth of 7.30%, 9.40% and 10.80% for fiscal 2024, 2025 and 2026.
Reasonable valuation and aggressive buybacks
Apple currently trades at roughly 28 times forward earnings per share. Comparably, the S&P 500 trades at roughly 21 times forward earnings.
While the company's near-term growth prospects are in line to slightly below the broader market, its medium to longer-term growth prospects are much better given the potential growth opportunity in emerging markets, new product cycles and margin expansion. Over the past 10 years, Apple has grown earnings per share at a compound annual rate of roughly 16%. While it might be difficult for Apple to repeat this level of growth over the next 10 years, I believe the company can grow earnings at double-digit annual rates over the next 10 years. Comparably, the S&P 500 has historically grown earnings at a high single-digit rate, which I expect to continue going forward.
In addition to trading at an attractive valuation relative to the broader market, Apple is also trading at a reasonable valuation relative to its own historical norms. Over the past five years, Apple has traded at an average price-earnings ratio of roughly 27, which is roughly in line with current valuation levels.
As part of its second-quarter earnings release, Apple announced a new repurchase program of $110 billion, which is in addition to the $30.10 billion remaining under the prior buyback authorization as of March 30. The significant increase in the repurchase program suggests management views shares as reasonably attractive at current levels.
Conclusion and key risks
Buffett has reduced Berkshire's Apple stake over the past two quarters. However, the company remains by far its largest public equity holding. His public comments suggest that tax planning played a key role in the decision.
Despite being a mature company, Apple has considerable earnings growth opportunities due to its relatively low market share in emerging market countries such as India, new product cycles and margin expansion opportunities.
Apple shares are reasonably valued versus their own historical norms and the recent buyback announcement suggests management views the stock as reasonably attractive at current levels.
While I believe the Apple bull case remains intact and Buffett's decision to sell is not cause for concern, investors should continue to actively monitor regulatory developments as the company is currently facing a lawsuit accusing it of using anticompetitive behavior to maintain a monopoly in the smartphone market. The company has managed through other lawsuits historically and I expect this time around to be no different.
Another key risk to monitor is that Apple is falling behind in the artificial intelligence race. Recently, Microsoft (MSFT, Financial), Meta Platforms (META) and Alphabet (GOOG, Financial) (GOOGL, Financial) all have launched their own AI-specific products. Apple has yet to launch a flagship AI product of its own, but is said to be in talks with Alphabet to have Gemini power new iPhone AI features. While Apple has been late to the game with AI, I believe there is plenty of time for the company to catch up. The company is expected to unveil its AI strategy at its worldwide developers conference in June.
