Let’s start our analysis of how a deal might impact Apple Inc. (NASDAQ:AAPL)’s earnings with some quick numbers from the company’s most recent 10-Q. In its last quarter, Apple’s Greater China segment- which also includes Hong Kong and Taiwan- was responsible for $1.4 billion in operating income for the company out of $11.8 billion in total segment operating income. This was based on a 31% operating margin and $4.6 billion in Chinese sales. The iPhone was responsible for roughly half of Apple’s worldwide sales, but given the lack of full access to China Mobile Ltd. (ADR) (NYSE:CHL)’s network we’d guess that fraction is somewhat lower in Greater China- say, half that amount- but that over time it would in fact rise to half of Chinese revenue in the event of a deal. If we also account for cross-selling to customers who become accustomed to Apple products and therefore choose to buy iPads and other devices, it’s possible that the company will double its revenue from Greater China, an $18 billion increase on an annual basis.
Of course, this assumes that pricing and margin are equivalent to what Apple Inc. (NASDAQ:AAPL) has already been doing in China. In that scenario, $18 billion in additional annual sales converts to about $5.6 billion in additional annual operating income at current margins. After taxes- Apple’s primary nonoperating expense- that is about $4.1 billion at current effective tax rates. Trailing net income is currently $38 billion. If we assume that China Mobile Ltd. (ADR) (NYSE:CHL) negotiates availability of lower-priced and lower-margin products then of course this figure would be lower. For example, $12 billion in additional annual sales at a 25% operating margin results in closer to $2.2 billion in after-tax earnings on an annual basis.
Apple Inc. (NASDAQ:AAPL) bulls would be quite excited about a 10% or even a 5% rise in profits from these improvements. Why? Because Apple is not priced for growth as many other emerging tech companies are. In fact, at a trailing earnings multiple of only 12- and with nearly a third of the company’s market capitalization in the form of cash and marketable securities rather than enterprise assets- the market is already pricing in a modest decline in Apple’s net income. Quarterly earnings continue to track over $1 billion lower than a year ago. Any way for Apple to conserve earnings per share, including adding profits in China to offset continually weaker margins in other markets such as the United States, is therefore positive for the company. This could of course come alongside other initiatives to create shareholder value including a larger buyback program as billionaire activist Carl Icahn has pushed for.
We’d note that hedge funds have generally been backing out of Apple, according to our database of 13F filings. We track quarterly 13F filings from hundreds of hedge funds and other notable investors as part of our work developing investment strategies; for example, we have found that the most popular small cap stocks among hedge funds earn an average excess return of 18 percentage points per year (learn more about our small cap strategy) and our own portfolio following this strategy has easily beaten the market over the last year. Our database also allows us to identify the most popular stocks among hedge funds, and Apple Inc. (NASDAQ:AAPL) slipped to third on this list last quarter (check out the full top ten list).
