Written 1 day ahead of the JAN2017 quarterly earnings. by Jeremy T.
Using the key statistics Apple shows strong fundamental signs. For background, Since
the company’s highs in June 2015, apple maintained $33B in cash domestically with approximately 150B cash overseas. The collapse of the Chinese market threatened
Apples largest international market and forecasted reduced growth in that segment. A year and a half later, apple has DOUBLED its domestic cash as well as increased its foreign holdings to over $200B. It is important to note that its domestic debt has raised proportionally as apple borrows against its foreign cash to conduct aggressive stock buybacks, CAPEX on their new campus, supply chain investments, and acquisitions. To its detriment, Apple has faced international headwinds from international market health, a strengthening dollar, and foreign competition from cheaper alternatives resulting in contracting operating margin by 2%.
From a value standpoint, Apple is better positioned that it was 2 years ago with strengthened Price to earnings, sales, and book rations. A more significant discussion is the company’s P/E relative to its competitors and industry. The P/E ratio is reflective of a retail company, specifically a consumer electronics. Apples fastest growing segment is their ‘services’ segment, which grew at 22% last quarter. The iPhone segment still is the flagship item for Apple accounting for 63% of the the company’s top line. The services segment will likely surpass both the iPad and MacBook sectors in this next quarter. As this becomes a leading segment, apple could reasonably be valued as a software or subscription based company rather than simply a retail company. Based off of current EPS and the peak P/E valuation from 2015 of 16.11 Apple indicates $133.87 as a sale price ceiling. IF Apple develops its services sector, then it can be valued as a service provider vs an electronic retail company. Telecommunications service provider AT&T has a P/E of 20. (AAPL $166). An example is Google- with a P/E of 31.8 (JUN2015) and 29.54 (JAN2017). (APPL $249.3)
- iPhone. As discussed previously this is the primary segment of Apple’s business. Two major factors drive the sales of the iPhone- A) the penetration into new international markets as the BRICS develop 4G telecom infrastructure and B) the upgrade of users to newer versions of the iPhone.
- iPhones penetration into foreign markets is restraining by foreign trade deals and the availability of 4G infrastructure. China Mobile’s development of 4G network and subsequently carrying the iPhone allowed for one of the strongest international growth bursts following the reveal of the iPhone 6. Apple is currently trying break into India as their international 2017 play. Significantly, the fall of Apple’s share price was led by the crash of China’s market and subsequently the strengthening of the USD in foreign markets. This cut into the iPhone Gross margin by as much as 4-5%. It appears that currency headwinds and trade deals will likely continue to cut into iPhone’s margins and forecasted revenue from abroad.
- The iPhone used to be relatively predictable. The customer base predictably upgraded every two years, encouraged by phone carrier marketing plans. The surge of iPhone 6 sales in 2014 was driven by a massive upgrade cycle coupled with international expansion. The significant hardware upgrades from the 5/5S to the 6, specifically a larger screen iPhone, helped encourage the upgrade cycle. The 2 year free upgrade marketing trend has started to alter. Telecom, Apple Services, and other marketing methods now encourage monthly subscription style plans, while offering free upgrades 1-2 years into the plan. Apple offers every year for a slightly higher premium than VZ, which just reduced its cycle to 1 year. This new marketing method will likely work better in foreign markets since foreign telecom rarely offer subsidization for the iPhone and the USD price is significantly higher ($1400 in Canada). For last quarter and 2017, the 2015 product cycle was an interim cycle with the introduction of the 6S model. In 2015, Apple also introduced the 6S+, a supersize model of the phone, which offered nothing but a larger screen. However, last quarter this changed. The iPhone 7 made a few hardware changes, with a processor x2 fast as the 6, no headphone jack, stereo speakers, and an updated camera. However, the 7+ model added even more features. Specifically the dual camera feature of the iPhone 7+ allows for crisper pictures and long range camera zooms. I believe this feature leads to an increase in the amount of the iPhone 7+ phones sold relative to the 7. With the additional $150 premium, the sale of the 7+ model will drive a higher ASP. So while the upgrade cycle may be affected by increasing slimming improvements between annual phones, the margins may improve with upgrades from the 6/6S to the 7+ model. The number of iPhones sold and the amount of new Apple customers may also receive a nice bump from the Galaxy 7 and Note 7 malfunctions, though customers may have switched to cheaper alternatives.
- iPad. I cannot make to much of an assessment on the iPad, but it accounts for ~10% of Apple’s quarterly revenue. The upgrade cycle of the iPad is much longer and the use for retail customers seems limited to media. However, with the introduction of the iPad Pro, the product line is trying to penetrate into the enterprise market. The iPad will likely face significant competition from cheaper android tablet alternatives until Apple can make the product a necessary part of the Apple ecosystem.
- MacBook. In the last quarter, Apple introduced a new MacBook with a touch bar to another segment that accounts for ~10% of Apple’s top line. The product appears to have mixed support among customers. The MacBook comes with a healthy premium compared to others in the PC Market, which may continue to provide cheaper alternatives. Additionally, the PC market as a whole is on the decline. For these reasons both MacBook and iPad segments will likely decrease or be flat year over year. Without a major upgrade and innovation with these products, they will likely have increasingly less of an impact on Apples growth.
- Services. As mentioned previously this segment offers a growth story narrative. This segment is the apple subscriptions for phone renewal, Apple Care, iTunes, Apple Music, cloud storage, and Apple Pay. Additionally, this segment includes non-flagship items such as the TV and Watch. This has been and will continue to be Apples fastest growing segment as the company begins to capitalize on monetizing their installed user base.
- Apple Watch. While version 1 of Apple Watch underwhelmed many users, the series 2 has been met with more excitement. The improved speed, battery life, waterproofing, and GPS capabilities that the watch offers have contributed to the overall acceptance of the product and months of sold out supply. This product is still relatively new in its life and as it becomes more accepted you will see accelerated growth in the services segment until Apple breaks it out into its own segment.
- iPhone subscription. The membership in the iPhone subscription service is a significant accounting point. The subscription will help flatten revenue throughout each quarter, but will reduce the surge that surrounds the new product introduction quarters. As this becomes an attractive option, users may choose this option to get a free upgrade every year rather than open purchase every year. Subscriptions, in general, are much easier ways to predict revenue streams annually.
- iTunes, Apple Music, Apple Pay etc. As mentioned before as this segment increases it stands to become its own company with accelerating growth, strong margins (85-90%), and capitalizes on the over 1B iPhones sold and the installed user base. This has significant ramifications as apple diversification play and with regards to valuation metrics.
5) The New Thing. As always, many people are awaiting the introduction of a new revolutionary product to include the Apple Car, the Apple Home (Apples answer to the Amazon Echo, in addition to the TV products), Augmented Reality, Health Care development, or other consumer electronic new product. Branching into a new market or creating a new market as significant upside potential for the stock.
Apple has been on a strong upswing since the fall and rallying 33% from its 52 week lows. In the weeks leading up to the earnings release the stock has been essentially flat. Additionally, the public sentiment is progressively negative with concerns about unimpressive iPhone sales, border taxes, Trump-e-nomics, the strengthening dollar, and generally Apple’s inability to innovate. Therefore, ANY surprise to the upside will likely cause a strong bounce upwards.
I have strong buy opinion for Apple. On a value side, their P/E ratio is below the S&P. If investors view Apple as something other than consumer electronics (i.e. like Google) the valuation alone could drive the price upwards. As a growth story, their immense warchest allows rapid acquisition into new markets. The accelerating growth of their services sector is already an indication of diversification into new markets. As a status quo, the Chinese new year should boost the future sales expectation as the rumor mill of the new iPhone 8/10/X should help keep the stock floating on any strong news. Headwinds with the strong dollar, China competition, regulation in India markets will subside. Other economic and trade policies will likely benefit the company to include a repatriation of cash special tax, reduced regulation, and reduced corporate taxes. Apple will face negatives pressures to include fines to encourage moving jobs and supply line home, increasing cheaper competitors in other countries, aggressive international trade agreements that may increase foreign regulation and further strengthen the USD, as well as the slowing of the main sectors of Apple’s line. Each of these put some strong bearish narratives for the short term, but overall the company is healthy over the long term.