Apple Is Proving The Naysayers Wrong

Apple (AAPL) shares have been on an absolute roller coaster over the last year or so. This time last year, AAPL shares were trading for $155 or so. Then, they skyrocketed up to all-time highs, breaking through the $1 trillion market cap threshold, topping out at $233/share late last year. This is great, right? Who would have ever thought that a company with such a large market cap would post such rapid growth? Well, the jubilee was short-lived. An Apple sell-off began last October and lasted for months, with AAPL hitting lows of nearly $140/share in early January. But, more recently, shares have bounced, soaring up nearly 25%, to the $175 level. In this piece, I wanted to talk about why the recent recovery happened, why I think it’s justified, and what I think the market is missing when it comes to AAPL shares.

I think that a lot of the 2018 run-up had to do with Apple’s capital return story. I know the focus in the media and amongst the analyst community is oftentimes centered around the iPhone franchise, but to me, much of the underlying bullish sentiment was probably fueled by Apple’s massive buyback. It’s much easier to rally when there is a bit of a floor underneath the stock on down days. Apple bought back nearly $73b worth of shares during its most recent fiscal year. This allowed the company to reduce its float by ~6.6% in 2018. I know that some view big buybacks like this as financial engineering which can result in « artificial » growth, yet I was very impressed by the company’s astute use of cash and I look forward to the EPS growth moving forward as AAPL management continues to dedicate billions of its cash hoard/cash flows to buybacks which should further reduce the outstanding share count.

I like owning companies that see value in their own shares. I like owning companies that are willing to bet on themselves. I like knowing that management believes their current shares are a better buy than any other share out there in the market. In short, I like owning shares on companies that feel confident enough to invest in themselves.

An alternative to a large share buyback is M&A moves. However, oftentimes M&A comes along with high valuation premiums (which oftentimes reek of desperation). I’m pleased to see AAPL being disciplined with its capital allocation, buying back its own shares on the cheap. The way I see it, AAPL shares have been chronically undervalued for years (with the exception for a short period of time late last year when I think it was fair to say that had reached fair value and possibly risen higher, above that threshold). I’m a value investor myself who’s been more than happy to buy Apple trading at sub-market multiples, so why wouldn’t I like to see their management team doing the same?

Another benefit of such a strong buyback like this is it makes long-term dividend growth prospects more sustainable. Apple doesn’t have to pay a dividend on the retired shares anymore. A lower outstanding share count reduces the burden of the dividend on the balance sheet and this reduced burden compounds over time when you’re talking about a company that regularly increases the dividend. As a dividend growth investor hoping to see double-digit annual dividend growth from Apple over the medium to long term, I’m always pleased when they reduce the share count in a significant manner.

I also think that the Buffett effect sort of took hold of Apple shares during the recent run-up. For the first time in years, the valuation that the market was willing to place on Apple shares rose to levels on par with the broader market. I can only assume that the fact that one of the greatest investors of all-time was so bullish on the stock (having invested billions into AAPL shares since he began building his position in early 2016) increased the market’s appetite for Apple. The fear of missing out is the real deal in the stock market. This is especially true in the tech space. And when someone like Warren Buffett is trumpeting the bullish story of a stock, it has to have some sway on market sentiment.

Yet, while many of Buffett’s largest individual positions happen to be dividend growth companies, he’s never really come out and embraced the income-oriented strategy. Actually, on the contrary, he’s spent a lot of time talking about the inefficient nature of dividends and why he prefers buybacks. So, while I suppose that Apple’s large buyback was part of the selling point that inspired Buffett to buy so many shares (Berkshire (NYSE:BRK.A) (NYSE:BRK.B) owned over 252m shares when the company’s last 13-F was released), I have to imagine that it’s actually the underlying cash flows that support the buyback that Buffett is really interested in. Buffett likes to talk/write about the benefits of a buyback, but what really butters his biscuits is well run, highly profitable business and Apple certainly fits that bill.

So, I suppose you could say that it’s not a shareholder return story, but instead, a cash flow story. Either way, the focus should never have been on the iPhones, on the super cycle, or the refresh cycle, or whatever else is the bearish key phrase of the week. To me, it’s never really been the iPhone sales number that has been important, but instead, the global active user base and the cash that it generates. iPhones sales definitely represent a solid business for Apple, but reoccurring, high margin revenues are what the market really likes these days… and who can blame it?

For years, we’ve talked about the Apple ecosystem. Back when I first started investing in Apple, this was referring to things like iTunes or the messaging system, but flash forward 5 years or so and we’re looking at a massive suite of services that Apple offers its device holders. I suspect that the capabilities of Apple’s hardware will allow for this number to continue to increase moving forward. And, as we found out in the quarterly recent earnings call, the margin of these services at large is huge (at 62.8%). In terms of generating cash flows, these high margin businesses are really where the focus should lie.

But, I’ve gotten a bit sidetracked (give me the opportunity to talk about my favorite company and my favorite investor and I can get a bit carried away). While it’s fun to look back at recent history and try and dissect it, what probably matters more to people’s portfolio is what is going on in the immediate past/future.

To me, the biggest news coming out of the recently announced quarter was the fact that revenues from the Services segment combined with the Wearables, Home, and Accessories segment totaled $18.2b during the quarter. Services revenues increased 19% y/y and Wearables, Home, and Accessories sales were up 33.3% y/y. This means that Apple’s two highest growth segments now represent 21.5% of total sales.

It’s no wonder the company doesn’t want analysts to focus so much on iPhone sales figures. It’s segments like these that will fuel the company’s future growth. When analysts and investors look at a company like Microsoft (NASDAQ:MSFT), they don’t focus on the legacy cash flows. No, instead they focus on cloud growth. I think Apple is starting a similar shift away from legacy (hardware) sales dominating their results and it’s time the market took notice. It wasn’t all that long ago that MSFT traded with a sub-market multiple and today shares are being valued at 25x. If Apple traded for a 20x+ multiple, we’d be talking about share prices above $250.

When you think about the sales numbers, the sales growth, the sales growth potential, and the margins on these sales, there is little doubt that these two segments of Apple business deserve a high multiple. As their share of the revenue pie increases in size, I suspect that the market will begin to reward the overall stock with a higher multiple to reflect this.

That huge growth number in the Wearables, Home, and Accessories segment is what caused the stock to bounce from recent lows, in my opinion. For years, the negative narrative surrounding Apple and its CEO Tim Cook has been focused on the company’s lack of innovation. I’ve never bought into that theory, citing the watch, amongst other things, as truly impressive innovation. Apple just spent $3.9b on R&D during its recent quarter and this isn’t an anomaly. This company continues to dedicate massive resources to future growth and I think it’s only a matter of time before this work starts to pay dividends (literally).

Thus far, the Apple Watch has been overshadowed by the massive iPhone sales, and rightfully so. However, that could all be changing. Jim Cramer has been harping on Apple’s potential in the healthcare space lately. In a world where heart disease is a huge issue, having more real-time data here can save lives (and money, if you’re an insurance company). I know that some like to discount Cramer’s opinions as sensational, but he’s not alone here.

In December, Cook posted this Tweet about the watch, saying « We believe that our work to help people better manage their health will be among Apple’s greatest contributions. »

A few days later in a CNBC interview, former Apple CEO, John Sculley, said that the healthcare potential for the watch could be a game changer for Apple, allowing it (and other devices like it) to potentially revolutionize healthcare like the iPhone revolutionize the mobile business. Sculley went on to say that he thinks the watch could become more than useful, but « indispensable » for consumers concerned about their health.

These are a couple of very notable names singing the same tune as Cramer. I think we’re just seeing the tip of the iceberg as far as the capabilities of wearable technology to monitor health and use data to prevent issues before they occur. If I’m correct, the Wearables, Home, and Accessories segment has a long way to run and will work wonders to reduce the company’s reliance on iPhone sales.

Furthermore, as we enter into a 5G enabled world and the internet of things becomes reality, I have a hard time believing that Apple won’t be a major player here. My focus thus far on the Wearables, Home, and Accessories segment has been on the watch, yet I think there is going to be plenty of room to grow and market share to take in the smart home segment as 5G infrastructure increases the capabilities of technology in this regard. There are rumors that Apple is working on software for the car and I suspect that the same is true of the home. If 5G is as revolutionary as many say it will be, Apple has the talent and cash flows to become a major player in the IoT world. This should only add to its active device count, increasing the reach of its ecosystem, and giving legs to the growth of its service segment.

Now that we’ve had the first quarter where Apple moved away from reporting iPhone sales figures and began to focus more on its other segments, I think it’s only a matter of time before the new narrative sticks. Yes, the iPhone sales were down 15% y/y; however, total sales were only down ~7.2%, meaning that the rest of the business is picking up the slack. Making matters even better, net income was basically flat y/y during Q1 (this is impressive considering the significant decline in sales). And, even better yet, EPS was up 7.65%, showing management’s astute ability to generate bottom line growth during a tough sales growth environment.

With regard to the negative sales during Q1, I think it’s important to note that sales in the Americas were up nearly 5% and European sales were down just 3.2%. The major issues came from Greater China and Japan, where Apple’s sales were down 26.7% and 4.5%, respectively. Sales in the rest of the Asia Pacific region were basically flat (up ~1%).

Basically, if you take out the negative Chinese performance, Apple’s most recent quarter would have looked a lot better. With trade talks still ongoing, your guess is as good as mine with regard to the outlook here. The Chinese market makes up ~20% of Apple’s business, so any improvement in the relationship between the U.S. and China is bullish for Apple. Furthermore, with a near single digit forward multiple of shares, I think the current weakness (and the potential for more) was already priced into shares. Some of the recent Apple bounce was probably inspired by rumors that negotiations are going well and we could see a deal in the near future (both Xi and Trump could use one, that’s for sure).

Only time will tell in that regard. Instead of focusing on trade deals and forex issues, I prefer to focus on the numbers and as this article makes clear, whether the naysayers will admit it or not, Apple has several strong growth drivers which can fuel its ascent back towards prior highs. I think management is doing a good job of changing the narrative, focusing on growth segments and positives like digital security (I loved the « What happens on your iPhone, stays on your iPhone » mega-billboard that Apple hung in Vegas at CES recently), rather than solely on device sales (no one’s ever going to get too excited about a hardware company).

I think the sell-off in response to the reporting changes and slowing iPhone sales will ultimately be short lived. I was happy to have recently added to my Apple position at $142.10. Honestly, I wouldn’t be surprised if the stock never sees that price point again (barring a stock split). If it does, I’ll be happy to add to my position near the lows, but in the meantime, I’m more than happy to sit back and watch as this company continues to revolutionize the world that we live in (oh, and collect its growing stream of dividends along the way).

If you enjoyed this piece, please stay tuned for the upcoming Seeking Alpha market place service that I’m currently working on The Dividend Growth Investor Club. I’m hoping that this will be a place where income-oriented individuals can come together and discuss their ideas as we all pursue financial freedom. I’ll be posting a variety of exclusive content, including single stock research, sector DGI watch lists chock-full of relevant fundamental data and sample portfolios with different target dividend yield and growth thresholds for Club members. The service should be launching in the coming weeks.

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.


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