- Apple reported better-than-expected Q2 FY2022 results, with net sales growth of 9% to $7.7 billion.
- The Board authorized an additional $90 billion for share repurchases.
- Its strong cash generation, low requirement of maintenance CAPEX, and large share repurchases form an overpowering combination.
- Such large share repurchases at its current valuation are very accreditive and are projected to propel its share price to $200 by 2025.
- A key risk is the business’ large exposure to China. The ongoing COVID shutdowns there could negatively impact iPhone deliveries and sales in the near term.
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Apple (NASDAQ:AAPL) reported its Q2 FY2022 last Thursday. It is another record-setting quarter, and AAPL delivered results better than Wall Street expectations. Net sales growth of 9% to $7.7 billion during the second quarter of 2022 compared to the same quarter in 2021, driven primarily by strong iPhone sales, Mac Sales, and also growth in Services.
Looking forward, I am optimistic about AAPL's strong performance to continue and maintain our bullish thesis for a few key considerations.
First, the company is maintaining a healthy balance of mature products (such as its iPhone, iPad, and Mac, which are widely successful) and an exciting pipeline of new products. The company also released a few key products during the quarter including iPhone SE with 5G technology, iPad Air powered by the Apple M1 chip, and the all-new Mac Studio also powered by Apple's own M1 Max and M1 Ultra chip.
Secondly, the company is maintaining sustainable and effective R&D efforts. In Q2, it has increased its research expenditures to 7% of total sales from 6% in the past year. Don't overlook the 1% increase given Apple's magnitude. Such sustainable investment allows AAPL to actively pursue futuristic products such as augmented reality headsets, wearable electronics, and the rumored Apple car.
Third, share repurchases are highly accreditive under current conditions and can boost shareholder returns effectively. Its strong cash generation and low maintenance CAPEX requirements are such a potent combination for share repurchases. The Board authorized an additional $90 billion for share repurchases and plans to maintain a cash neutral position going forward. At the current rate and valuation, the share repurchases could propel its share price to $200 by 2025
With this, we will elaborate on the highlights from the earnings and analyze some of the key risks as we see.
AAPL keeps enjoying enviable capital allocation flexibility. Let's start with the R&D expenses as shown below. It is a typical accounting exercise to list R&D expenses as operating expenses. However, for a high-tech business such as Apple, it is more insightful to view it as a capital expenditure. The new products being developed in the R&D process are the lifeblood of sustainable profitability. As seen, the company has been maintaining steadily growing R&D efforts. In Q2, it has increased its research expenditures to 7% of total sales from 6% in the past year. The growth in R&D expenses during the second quarter and first six months of 2022 compared to the same periods in 2021 was driven primarily by increases in headcount-related expenses, engineering program costs, and professional services. At Apple's scale, such a level of R&D is a mindboggling amount (exceeding $20 billion in 2021) and it allows it to prepare for technologies far into the future such as AI and autonomous vehicles.
In terms of CAPEX expense, the business model is so good that it does not need that many CAPEX expenditures to grow. As a matter of fact, as analyzed in my earlier article, if you just glance over its financial statements, you would see that its CAPEX has been lower than its total depreciation for years. And the current quarter is no exception. Its total CAPEX expenditure is about $5.3B in the quarter as shown, and its total depreciation and amortization are a bit higher at $5.4B. Of course, this does mean that the company does not believe in capital investments or has learned the dark magic of growing without CAPEX. As detailed in my earlier article, it is just that AAPL's business model is so profitable that A) it needs little maintenance CAPEX, and B) most of its CAPEX is growth CAPEX as a result.
Its strong cash generation and low maintenance CAPEX requirements are such a potent combination. As a result, AAPL could pursue high-risk and high-return futuristic products (such as AI and autonomous cars) AND at the same time generously reward its shareholders by share buyback program and dividends, as detailed next.
Share repurchase and dividends
Apple has been aggressively buying its own shares in recent years as you can see from the following chart. Cumulatively, it has spent a total of more than $467 billion in the past 10 years on share repurchases. As a result, its net outstanding shares have shrunk from 26 billion 10 years ago to roughly 16 billion currently. In Q2 2022, the Company continued its large buybacks. It repurchased $22.9 billion of its common stock. In comparison, its dividends are a relatively minor part of shareholder return. Its dividends and dividend equivalents totaled $3.6 billion during the second quarter of 2022). And the Board authorized an additional $90 billion for share repurchase.
To me, such large share repurchases programs are a no-brainer and highly accreditive to shareholders, for two key reasons. First, AAPL's return on capital is so much higher than its cost of capital. As detailed in our other articles, its ROCE (return on capital employed) and ROE (return on equity) are both above 100%. And its cost of capital should be no more than 10%. Second, its current valuation is very reasonable. As a result, large repurchases at these larges will be effective to boost returns.
The following chart shows a simple projection to illustrate the potency of such share repurchase programs. The chart is made under the following assumptions:
- Firstly, it assumes that Apple spends a fixed percentage of its operating cash flow on share repurchases. The percentage is taken to be 78%, consistent with the average in recent years, and also consistent with the board's plan to maintain a cash neutral position.
- Secondly, it assumes that Apple's profits grow at an 8% CAGR according to consensus estimates.
- And finally, it assumes that Apple's valuation is maintained at 22.5x of its operating cash, which is slightly lower than its current valuation to be on the conservative side. Also, 22.5x operating cash is also its average valuation in the past five years. And 22.5x operating cash is actually at a relative discount to the overall market (either represented by S&P 500 or especially by the NASDAQ 100).
Based on these assumptions, you can see that Apple will be able to reduce its total share count by another 16% in the next five years. And also its share price is projected to reach about $210 per share by 2025, and about $262 by 2027.
Risks - China's larger role and uncertainty
In terms of risks, a key risk is the business' large exposure to China. The 9% growth was unevenly distributed geographically though. North America grew about 19%, while Europe and greater China's growth are more muted. And at the same time, the greater China market is the third-largest market for Apple, a close third after the Europe market. Its total sales in the past six months are $44 billion, not too far behind the Europe market, which raked in $53 billion in the past 6 months. Looking forward, the ongoing COVID shutdowns in China, especially in a key port city like Shanghai, could negatively impact iPhone deliveries and sales in the near term. As commented by CEO Tim Cook:
I also want to speak to the unpredictable nature of the pandemic. We are excited to be welcoming employees back to the offices in the US and Europe. At the same time, we are monitoring COVID-related disruptions in China.
Summary and other risks
In summary, Apple reported another strong quarter. Net sales growth of 9% to $7.7 billion thanks to strong iPhone sales, Mac Sales, and also growth in Services. Looking forward, I am optimistic about AAPL's strong performance to continue and maintain our bullish thesis. The company is maintaining a healthy balance of widely successful products and an exciting pipeline of new products. It has increased its research expenditures to 7% of total sales to pursue futuristic products. Its strong cash generation, low requirement of maintenance CAPEX, and large share repurchases form an overpowering combination. At the current pace, its share repurchase program will propel its share price to about $210 per share by 2025 and about $262 by 2027.
In terms of risks, its large exposure to China represents a key risk given the COVID situation there. Also, the recent large fluctuations of foreign exchange can cause some headwinds too. Management expects exchange rates to be a nearly 300 basis point headwind to our year-over-year growth rate.
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This article was written by
Sensor Unlimited is an economist by training with a PhD, with a focus on financial economics. She is a quantitative modeler and for the past decade she has been covering the mortgage market, commercial market, and the banking industry. She writes about asset allocation and ETFs, particularly those related to the overall market, bonds, banking and financial sectors, and housing markets.Sensor Unlimited contributes to the investing group Learn more.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAPL either through stock ownership, options, or other derivatives. 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.
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