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Why Apple Is Still A Growth Company

About: Apple Inc. (AAPL), Includes: GOOG, GOOGL, MSFT
by: Mark Hibben
Mark Hibben
Long only, tech, chipmakers, software

Bearish misconceptions.

iPhone 11, earnings report bode well for 2020.

Long-term growth expectations.

Investor takeaways.

Following Apple's (AAPL) fiscal Q4 earnings report, the stock has risen by about 6.6%, prompting many in the tech business media to ask whether the rise is justified. Some have even offered bearish assessments that Apple has ceased to be a growth company. My view is the diametrical opposite. Not only is Apple still a growth company, but it remains significantly undervalued.

CEO Tim Cook introduces iPhone 11 and 11 Pro. Source: Apple.

Bearish misconceptions

One of the best articulated bearish views I've read was recently offered by SA contributor Beth Kindig, and she makes some legitimate points. Apple is very susceptible to downturns in consumer spending, especially in China, as we have seen in fiscal 2019. She also criticizes Apple's share buybacks as a means to prop up its EPS. She asserts that Apple should be spending more on innovation.

The criticism that Apple isn't spending enough on R&D is near and dear to my heart, since I've made it often enough. Despite the 2% y/y revenue decline for fiscal 2019, R&D spending grew by 14%. Given the intense competition for engineering and scientific talent that exists in Silicon Valley as well as globally, I doubt that Apple can go much faster. Apple could simply throw a lot more money at the problem, but then the efficacy of Apple's R&D would likely suffer.

I also question whether Apple's capital returns program is the best use of Apple's cash pile, but it's popular with Apple investors, so I can't complain too much. Apple bears frequently complain that it's artificially inflating the stock, but it's only the bears that complain.

For my part, I would rather see Apple accept lower margins on its products, such that the cash pile ($98 billion net, as of the Q4 report) is gradually whittled down. I think of this as “returning cash to customers” rather than shareholders. This notion has never been particularly well received.

In fact, Apple's gross margin has declined over the years, from the low 40% range in fiscal 2011 to about 38% for fiscal 2019. But this itself has become a point of bearish criticism. Whether Apple can benefit from accepting lower margins is something I'll turn to in the next section.

Despite some common ground, I disagree with Kindig's fundamental premise that Apple has ceased to be a growth company. The primary factual support for it is that Apple suffered a revenue decline in fiscal 2019. The misconception here is the implication that a near-term effect must be permanent.

Apple suffered a similar decline (7.7% y/y) in fiscal 2016, but there was nothing permanent about it. Apple recovered to y/y growth in fiscal 2017 and achieved an all-time high in revenue in fiscal 2018.

A favorite pastime of Apple bears has been to cite such setbacks as proof of permanent decline. This has been going on almost since the founding of the company. One wonders why the bears still regard such arguments as persuasive.

Another misconception I frequently encounter among the bears is that “Apple is just a consumer goods company.” I don't think that Kindig shares this view, but I bring it up since I frequently encounter it in articles and comments. It appeared once again in a comment on Kindig's article. I'll be blunt. Consumer goods are things like toothpaste and dish washing liquid. To call Apple a consumer goods company is to completely ignore the fact that Apple is one of the most successful fabless semiconductor companies on the planet.

The broader context here that bears tend to either ignore or discount is the significance of Apple's business model. I've called this the “new semiconductor paradigm” and have written about it at length. Briefly, Apple became a fabless semiconductor company with the A4 system on chip (SOC) that powered the first iPad and iPhone 4.

Apple's vertical integration of semiconductor engineering, device design, and operating system design has fueled the growth of iPhone and other iOS derived products such as iPad, Apple Watch and AirPods. It's not an exaggeration to say that the products simply wouldn't be possible at their current level of performance and functionality without Apple's semiconductor prowess.

And if there's still doubt about the significance of Apple's business model, one only has to look at the way Apple's key competitors try so hard to emulate it. Following Apple's September iPhone event, both Microsoft (MSFT) and Google (GOOG) (NASDAQ:GOOGL) held events to feature their own self-designed hardware.

Microsoft, at its Oct. 2 event, even went so far as to brand the processor in its Surface Pro X as the Microsoft SQ1. It's well known that the SQ1 must be some variant of the Qualcomm 8cx processor that Qualcomm has been trying to get Microsoft to adopt for an “always on” mobile PC.

Google's “Made by Google” event on Oct. 15 also seems similarly pretentious. Even Apple doesn't claim that its products are “Made by Apple,” but rather “Designed by Apple.” But this is more than just wanting to seem like Apple. Google's acquisition of Fitbit demonstrates that Google has realized it needs to be more like Apple in order to compete effectively.

Strategy Analytics' recent survey indicates that Apple's global smartwatch market share actually grew y/y in calendar Q3 2019 to 47.9%. The situation with Google's Android Wear (now changed to WearOS) has become dire. As Ron Amadeo of Ars Technica observed in a September 2018 review:

Whether this new Wear OS update is good or not is kind of irrelevant, since there isn't any good Wear OS hardware to run it on. It's not that OEMs aren't trying — there are more than 50 different Wear OS models out there. The problem is that they all use the same underlying components to make these watches, and the component vendors (namely Qualcomm) are not creating quality components that make it possible to build competitive Wear OS hardware.

Apple's revenue growth in Wearables has been made possible, once again, by its semiconductor expertise, since Apple designs the processors that run its wearable devices. Apple Watch is growing share and is the primary driver of Apple's 54% y/y growth in the Wearables category in fiscal Q4. This performance should not be discounted as part of a bear case.

iPhone 11, earnings report bode well for 2020

Prior to the release of the iPhone 11 series, I had been a little pessimistic about prospects for fiscal 2020. Following the fiscal Q2 earnings report, I reduced my projected revenue for fiscal 2019 to $254.4 billion and for 2020 to $251.3 billion.

The iPhone 11 series launch started to turn around my expectations, as I described on Oct. 3 in an all-access article. In the article I pointed to Apple's willingness to decrease the price on iPhone 11 and hold the line on the 11 Pros, while simultaneously offering more value (an extra camera, faster A13 processor, and a free year of TV+).

Apple enhanced the value proposition of its new iPhones, and probably lowered its gross margin on the devices more than usual for a launch. I speculated that Apple might exceed its guidance and provide an upside surprise for fiscal Q4.

In my final pre-earnings guidance to subscribers, I moderated this view somewhat. I concluded that Apple would be supply constrained for iPhone 11 Pro and that this would limit it to achieving the high end of its guidance range of $64 billion. This was still better than analyst consensus, however.

That turned out to be exactly what happened, and iPhone 11 Pro didn't reach supply/demand balance in North America until the end of October, judging by shipping times on the Apple web site. iPhone 11 series sales couldn't completely reverse the revenue decline in fiscal Q4 due to supply constraints, but they did serve to reduce the decline compared to previous quarters to 9% y/y.

I believe iPhone 11 is an example of a case where cutting the cost of the product can benefit revenue by boosting unit volume. What the price elasticity is for iPhone is difficult to determine, and here I think Apple decided to experiment, to positive effect.

The greater than 54% y/y growth in Wearables and 18% y/y growth in Services offset the iPhone decline for a 1.8% yy gain in revenue in fiscal Q4. More important than the Q4 results was the guidance for fiscal Q1. Apple guided to a revenue range of $85.5-89.5 billion. At the midpoint this represents 3.8% y/y growth. If Apple hits the top end of its guidance range, it will achieve all-time record revenue for the quarter.

That's really very strong guidance, given that iPhone might still be in decline. During the conference call, Morgan Stanley's Katy Huberty asked the natural question of when iPhone might return to growth. Cook replied:

We are very thrilled with what we're seeing in early going on iPhone 11 and iPhone 11 Pro and Pro Max. It's early but the trends look very good. So I don't want to make a long-range forecast here. We've put our current thinking in the guidance and you can tell from the guidance we are bullish.

Naturally, he wouldn't commit to a return to iPhone growth in the quarter, and we may not get that even if Apple makes the high end of the guidance range. I think this is not really important this year. I'll be satisfied with approximately flat y/y revenue performance for iPhone, combined with the Services and Wearables growth that we're seeing.

Long-term growth expectations

I came out of the Q4 earnings report convinced that Apple already was pulling out of the latest downturn. I capture long-term financial expectations for companies in the Rethink Technology Portfolio via Discounted Cash Flow models. Following the Q4 report, I took the opportunity to update the Apple DCF model for the new fiscal year and to reflect my more bullish outlook.

I now expect modest y/y growth in iPhone revenue, combined with continued growth in Wearables and Services, for an all-time record revenue in fiscal 2020 of $273 billion. I expect Apple to release 5G capable iPhones in its September 2020 launch.

For fiscal 2021, I see iPhone returning to stronger growth on the basis of a 5G upgrade cycle, then essentially leveling out in subsequent years.

I expect Wearables and Services to be the key growth drivers beyond 2021. I expect Apple Watch to continue to drive growth in Wearables. The net effect is expected to be a revenue CAGR of about 6% over the model period. Shown below are the revenue and EBITDA profiles assumed in the model:

Under the above assumptions, the DCF calculated fair value is $291, indicating that Apple is still undervalued, as perhaps it always will be.

Investor takeaways

One of the reasons that I think analysts tend to ignore the importance of Apple's business model is that it's difficult to quantify. It's an intangible the effect of which will always be open to dispute.

This will always be a problem for Apple investors. How does one prove that Apple will continue to innovate, to introduce new products that generate revenue growth? It can't be proven, but then, nothing about the future of any company can be.

The best that one can do is to verify that the essential ingredients for product innovation exist. These include adequate R&D spending, intelligent allocation of R&D resources, and a track record of successful innovation.

Adequate R&D spending? Could be better, but it's certainly adequate at $16.2 billion in fiscal 2019. This can be expected to rise in fiscal 2020.

Intelligent allocation of R&D resources? Difficult to tell, given Apple's secrecy. As far as I can tell, Apple is spending in the right areas. These include OS, software and services development, including AI. On the hardware side, Apple's biggest development expense appears to be semiconductor design and engineering, followed by product design. There also are longer-term research projects under way for smart glasses, new display technologies, and Apple car. Smart glasses look to be closest to commercial release, sometime in 2020-2021.

Track record of successful innovation? I don't think there can be much dispute on this one. Bears may argue that Apple isn't innovative, because it often isn't first to market with a new technology. I would argue that what sets Apple apart is its ability to succeed when it enters a new market or product category. Apple wasn't the first to market with an MP3 player, but iPod was enormously successful.

My opinion is that Apple is best situated to continue to innovate in products and services compared to peers such as Google and Microsoft. Apple has mastered a level of hardware/software integration that its competitors can only aspire to. I'm confident that Apple will continue to innovate new products and services that will drive continued growth for many years. I remain long and rate Apple a 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.