Apple (AAPL) showed in the recent quarter how its strategy of margin expansion can help to more than compensate for the effect of slowing iPhone unit sales. Shares however have fallen significantly as investors appear to be questioning the long term thesis - it is nonetheless hard to blame them as AAPL after all did briefly cross $1 trillion in market cap. While the short term buyback thesis is very well known, the services thesis however is in my opinion overlooking the surprising potential lasting impacts that it can have on making revenues more recurring. Furthermore, there’s a potential supercycle just around the corner, leading me to rate shares a buy.
AAPL reported decent 4th quarter numbers: revenues grew 20% to $62.9 billion and EPS grew 41% to $2.91. AAPL saw iPhones revenues grow 29% despite having no growth in units sold. It appears that AAPL has found that price hikes can more than make up for declining unit sales growth:
Yet AAPL has performed poorly since their report - this is likely due to management’s commentary on the conference call.
Management indicated that they will no longer be breaking out the unit sales for each of their product lines. While some viewed this as consistent given AAPL’s desire to move away from being a “smartphone company,” others viewed this as an unfortunate step backwards in disclosure. I personally lean more towards the latter.
Furthermore, their guidance for the holiday quarter for $89 billion to $93 billion in sales was on the lighter side.
Suddenly, people stopped talking about AAPL being a brilliant Warren Buffett pick and instead seem to have started worrying about iPhone sales peaking soon. Should we be worried?
Core Thesis Intact
The buyback thesis is still alive and well. As of the latest quarter, AAPL had $237.1 billion in cash & marketable securities, versus $114.5 billion in debt for a net cash position of $122.6 billion. Management reiterated their intention to reach a net cash neutral position over time - heavily implying that the $122.6 billion will be used on share repurchases. Of course we can not base an entire buy thesis on buybacks alone, but AAPL represents a rare situation where cash is such a huge percentage of their market cap. Whereas many typical companies in the S&P 500 are taking on significant leverage, even up to two times EBITDA, AAPL has this significant net cash position. AAPL generated about $83.8 billion in EBITDA the last year, meaning that assuming they could take on 1 times EBITDA in debt, they would have over $200 billion in additional share-reducing firepower at their disposal. I believe that management is intentionally raising debt instead of using cash for their current share repurchases because this makes it much easier for them to reach such a leverage ratio - we must consider that even if 1 times EBITDA can be considered “normal,” $80 billion of debt is anything but.
When AAPL is viewed as a quasi-consumer staples/ technology company, its earnings multiple of around 15 looks reasonable as AAPL pays a steadily growing dividend, has the rather significant share repurchase catalyst listed above, and may even have more upside due to margin expansion. On these notes, it does not appear that the core thesis has been harmed - but now I want to explain why “peak iPhone” is not something I’m worried about here.
Service Revenues Are Not What You Think
AAPL reported seeing 27% revenue growth in the latest quarter in their services division, which includes digital content, iCloud, AppleCare, and Apple Pay. Over the past three years, AAPL has steadily increased service revenues to almost 15% of total revenues:
They noted that the increase in 2018 was primarily due to an increase in App Store and AppleCare revenues. The appeal for service revenues is easy to understand: in comparison with their iPhone and hardware products which are arguably quite cyclical, service revenues should theoretically be more recurring and thus more “SAASy.”
I however view the rise of the services a bit differently. While high margin revenues are of course nice, I think that misses the potentially bigger picture. The iPhone makes up 63% of total sales which after subtracting services is an increasingly large number as revenues from iPads and Mac computers both dropped by 100 basis points YOY. What we are seeing right now is a very self-fulfilling beneficial circle between iPhone sales and services.
How iPhone sales help service revenues is obvious - more Apple users must lead to more service revenues. It's the other direction of the equation that however is more fascinating. While AAPL has seen strong earnings growth almost annually, “peak earnings” has been a constant worry throughout their lifetime. In short, investors are worried that at some point they won’t sell enough due to either a lack of new buyers or consumer churn to Android products. Services, however, such as things like iCloud, are in my opinion instrumental in increasing the “stickiness” of the Apple ecosystem. Data storage, while modest at first, is something that should only keep going up during a consumer’s lifespan. By hosting all of the data on their iCloud, this would dramatically increase switching costs and thus make it more unlikely that consumers would want to switch over to Android devices. The more data is involved, the greater the stickiness and greater the recurring revenues. Thus whereas service revenues are hailed for being recurring themselves, the biggest impact in my opinion is the impact it has on core iPhone revenues in making those revenues more recurring as well. On a side note, I suspect that the biggest impact that the Apple Watch will have in the future is also the impact to stickiness (if you have the watch then you will probably get another iPhone because it’d be useless otherwise).
While it absolutely is possible that we may see another 2016-like sales slowdown, I am actually anticipating for iPhone sales to exhibit greater recurring nature in the future as AAPL can keep improving the benefits of staying in their ecosystem. If AAPL can prove greater recurrence in iPhone sales, then it would be much easier to justify a premium valuation.
The 5G Catalyst
We have just discussed the anti-thesis to the peak iPhone worries, but now I want to bring the reader's attention to the possibility of a new supercycle potentially coming soon. Everyone must have heard about 5G at some point - this is the fifth generation of mobile cellular communications which is projected to have speeds 20 times faster than 4G LTE and even has been so hyped as being the missing link in self-driving cars.
It seems reasonable to assume that when 5G is built out, most everyone may want to take part in the data revolution. How does this relate to AAPL? It’s this simple truth: current smartphones are not compatible with 5G. I can buy the argument that AAPL has somewhat struggled in convincing iPhone users to upgrade as often as before - this can be argued to be due to lack of necessity and lack of differentiating appeal in newer models. I however believe that insanely faster internet, on the other hand, offers up a more convincing proposition. It does not appear that AAPL will release a 5G phone in 2019 but instead may wait until 2020 for the release. Telecom operators aim to enable 5G in select areas in 2019, but 2020 is when experts agree that it will really take off. Regardless of when they finally release a 5G phone, I believe that we may see a surge of buying for the foreseeable future following such a release as the current set of smartphone users set out to get their hands on a 5G compatible device.
Valuation and Price Target
Over the past 12 months, AAPL has earned $11.91 per share. At recent prices, AAPL trades just around 15 times earnings. If we adjust for net cash, then AAPL trades for just under 13 times earnings, and adjusting for potential debt (1 times EBITDA), shares trade for 11.5 times earnings. The valuation looks reasonable, but not necessarily super cheap. One must have confidence that their increasing services presence can help stabilize unit sales moving forward - if this can happen then shares would warrant an earnings multiple of at least 16 times as a high quality dividend play. That would suggest about 23% upside (when compared to their cash adjusted earnings multiple). If my 5G thesis comes true then there would be an earnings boom which would potentially bring even more upside.
While shares are not necessarily “pounding the table” cheap, I view shares as being reasonably priced with room for upside from continued margin expansion, the aforementioned ancillary benefits from services, and the 5G catalyst.
While the 5G thesis may lead to a dramatic rise in iPhone sales, it may also have unintended results should AAPL somehow fail to produce a 5G phone competitive with peers. Such a scenario would potentially lead to iPhones seeing declining demand on a long term basis as more and more leave the ecosystem. I however view this to be very unlikely as AAPL management has shown dedication in maintaining their high R&D spending.
5G will not be rolled out instantly and will require great capital spending by the telecom providers to enact. There may be inevitable delays and it might even prove to be just hype. In such a scenario investors may have to wait a long time or forever for the supposed catalyst to materialize.
AAPL’s share buyback should not be the main reason to buy the stock. If management executes the buyback at high prices, then the buyback may have shareholder-destroying effects. I instead advise readers to focus on the cash-adjusted earnings multiple and simply decide from there if shares are cheap. Investors tend to have bias when there is “upside” annually (in this case from continued share buybacks). Looking at the cash-adjusted earnings multiple would filter out this bias because all of the “upside” would already be incorporated and quantified.
AAPL indeed saw unit sales growth decline but the combination of margin expansion, ancillary benefits from services, and the potential 5G catalyst make shares look like a solid long term buy at 15 times earnings. I wouldn’t pound the table here but I rate shares a buy.
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(Tipranks: AAPL: Buy)
Disclosure: I am/we are long AAPL. 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.