Apple Does An About-Face

Summary

• This cash-generating machine is about to increase its return to shareholders.
• Apple Services delivers yet another strong performance.
• Still too cheap to be ignored.

Investment Thesis

Apple (NASDAQ:AAPL) has been for a long time one of my favorite mega-cap investments. Thus, the results that Apple delivered Tuesday really made for satisfying reading. Moreover, to my delight, Apple announced a change to its capital allocation strategy. Apple makes for a phenomenal investment.

Shareholder Return

I wrote an article about Apple a few weeks ago, where I referenced Apple's Q1 2018 earnings call and said,

[CFO] Maestri made it clear that the excess cash that Apple had, was going to be deployed slowly over time. That the cash belongs to Apple's patient and long-term investors, that Apple would not be returning the cash over a few swift years, with a special dividend or any such program.

That comment was made in reference to the Q&A section of the earnings call, where Maestri had said,

We’re going to be very thoughtful and deliberate about [redeploying the cash]. Obviously, we want to make the right decisions in the best interest of our long-term shareholders.

Therefore, when Apple released its Q2 2018 press statement - which revealed a brand new $100 billion share repurchase plan and a 16% dividend increase - analysts who were long the stock felt delighted.

Results In More Detail

There was really no aspect to fault Apple on this quarter. For a company of its size, to deliver top-line growth of 16% is practically unheard of – a truly remarkable performance. If you have read any of my previous articles on Apple you will know that I have been for a long time highly bullish of Apple's opportunity to expand on its margins through its increased exposure to its Services. Thus, Apple's increased revenue from Services together with continued cost improvements allowed Apple to deliver a solid gross margin of 38.3%, in spite of having to deal with increased cost in memory prices. Altogether, this allowed Apple to have a 30% YoY increase in EPS.

Apple's Transformation

I know that many readers of this article are huge fans of Apple's gadgets, and often, but not always, they confuse liking a product with thinking that its stock makes for a good investment. I, on the other hand, absolutely abhor Apple's products (blasphemy!) but love this investment. Apple's newest ambition to grow its Service segment offers Apple a phenomenal runway. When Steve Jobs stepped down, so many felt that Tim Cook would be no match for Jobs. However, Cook's vision to transform Apple from a pure-play, capital-intensive, hardware company to a more diversified asset-light enterprise, speaks volumes of Cook’s own drive and ambition.

Moreover, Apple's Services were up 31% YoY and brought in a remarkable $9.2 billion. In part, this was driven by the sheer number of subscribers to Apple Music, which reached 40 million. In fact, in my humble opinion, Apple's medium-term opportunity lies in its ability to continue to increase the number of paying subscribers to its Apple Music platform. Incidentally, as of Q2 2018, Apple's total paid subscriptions crossed 270 million.

Valuation

For now it appears that the investment community continues to be unwilling to assign Apple a strong multiple, as it does some of its peers, namely Alphabet (GOOG)(GOOGL).

Here are a couple of interesting facts to compare Alphabet and Apple. Alphabet's 5-year average EPS CAGR stands at 2.2%, whereas Apple's 5-year EPS CAGR stands at 7.9%. Fascinating, right? And which stock does the market reward with a higher multiple? As you can see in the above table, investors are willing to pay 6.1X for Alphabet's revenue and only 3.5X for Apple. And just to complicate matters, both Alphabet and Apple have, for all intents and purposes, roughly the same 26% operating profit margin - yet investors still prefer to pay relatively more for Alphabet than Apple.

From time to time, the market becomes uninterested with Apple and unwilling to reward this quality company with the multiples that Apple’s deserves. However, we know that in time Apple fever will return, and those investors who were price sensitive and contrarian today will be rewarded nicely by Apple over time.

Takeaway

We are entering the last leg of this prolonged bull market, where investors are throwing caution to the wind and choosing hypergrowth stocks over solid cash-generating machines such as Apple. Against this backdrop I know that sticking with Apple will be the wisest choice from a capital preservation perspective. Not only that but, as discussed above, Apple still has plenty of weapons in its arsenal to deliver growth as well as a strong return of capital to shareholders. Not many companies in the market today are able to boast these two key attributes while at the same time carry that all-important margin of safety in its share price.

Disclaimer: Please do your own due diligence to reach your own conclusions.

Note: The only favor I ask is that you click the "Follow" button, so I can grow my Seeking Alpha friendships and our Deep Value network. Please excuse any grammatical errors.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.