Apple’s Transformation Is Underway

Investment Thesis

Since trading at a 20-month low of $142 to start the year, Apple (AAPL) has gained 18% back to their early December 2018 levels. We picked up some stock around the $154 levels, but still feel the stock is trading at an attractive level. The days of strong iPhone growth are behind us, but service revenue, wearables, and OTT services, among others, may have something to say going forward. Investors need to shift their view of the company away from a predominately hardware company and more towards a software technology company, similar to the way investors did for Cisco (CSCO) over the years. It took investors years to change their thought process, but those that did early on are being vastly rewarded.

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Apple Watch Growth Is Just Beginning

Of late, the hottest item among the Apple portfolio has been the Apple Watch. The company does not break out unit sales, but CEO Tim Cook alluded to the fact that the wearables segment grew more than 50% during the two most recent quarters, Q1 2019 and Q4 2018. The quarter before that, Q3 2018, saw wearables grow 60%, so to say the segment is growing at a strong clip would be an understatement.

The wearable market as a whole has been a strong growth driver for the company, as well as competitors like Garmin and Fitbit (FIT). Here is a look at the wearable markets top players:

The Apple Watch 4 is a new generation watch that cannot only attract the typical “Apple Fans”, but more importantly transform the healthcare industry as it is the first Apple Watch approved for medical use. In January 2019, Johnson & Johnson (JNJ) announced they would be partnering with Apple to conduct a study to help improve AFib outcomes, including stroke prevention. Apple Watch will soon be able to have ECG capabilities along with glucose monitoring.

Not too soon after the Apple Watch 4 was released, I read a news article on how the Apple Watch 4 saved a man’s life. The man was active three to four days a week, and in what he thought was good physical condition, when his Apple Watch started sounding AFib alerts every time he had worn the device. Long story short, after shutting the watch down a couple of times, just to get the same alert upon restarting, the man went to the urgent care where it he was detected to have an irregular heartbeat.

This is just the beginning in terms of the impact the watch can have on healthcare. I expect many other companies like JNJ to begin performing studies alongside Apple to look for ways to prevent life-threatening heart conditions earlier. It has been said that up to 30% of AFib cases go undiagnosed until life-threatening complications occur.

The revenue potential is BIG moving forward when it comes to Apple Watch. Right now, you can connect Apple Watch to the iPhone because every Apple Watch user needs an iPhone. SO even if they buy the cheaper version of the iPhone, they are still paying half the price of an iPhone for the watch. Ways this could blow up even further is if Apple ever decided to de-link the watch from the iPhone and allow any user to use the device. This could in turn bring in millions more, but we are not there yet. These are all things to think about when it comes to the transformation. If you are like me, a long-term investor, buying Apple at 14x earnings with the potential they have to transform the healthcare industry with the Apple Watch and become more of a software play (which we will discuss more about shortly), you are getting a big-time bargain.

Apple: The Software Technology Company

As I mentioned in my opening paragraph, I like to think that investors are not pricing in the vast changes that are taking place within the company. The change that is and has been taking place is the shift from a pure hardware consumer products company to more of a software technology company. A similar transformation took place with Cisco (CSCO) in which many investors have missed out on their continued surge. Now that investors have figured out their game plan, CSCO stock has jumped nearly 50% in the last two years.

Around 2016/2017 is when CSCO set out to change from a hardware company to more of a software company, which contains more stabilized and recurring revenue streams. Through 2017, the stock traded at an average Price-to-Earnings ratio of 12.5x, which is about in line with their historic multiple. Fast forward to today and the stock is trading at a Price-to-Earnings multiple of 17.6x, and has traded at an average P/E of 17.4x since the beginning of 2018.

A similar transformation is happening right before our eyes with Apple. So many analysts are fixated on the decline in iPhone sales that they are missing other facets of the business that are thriving. Other facets such as service revenue, which has grown 22+% each of the last three years. Service revenue grew 19% in the most recent quarter. Service revenue includes the likes of Apple Music, the App Store, Apple Pay, and iCloud. Apple subscriptions reached another new high in Q1 with over 360 million paid subscriptions across the services platform, a 50% increase from prior year.

Services revenue accounted for 8% of total sales in 2012, fast forward to 2018 where service revenue accounted for 14%. Here is a look at the service segment revenue since 2012:

Chart created by author

As you can see, service revenue has grown nearly 200% since 2012, which is sizable growth that cannot go unnoticed. As more and more consumers turn digital, we continue to foresee strong growth ahead for this segment, which will help alleviate some fears of a saturated smartphone market.

Another area of the business we find interesting is the company’s strategy around over the top services or OTT, which feeds into the services segment. As it currently stands, consumers sign-up for separate OTT services (Netflix (NFLX), HBO, NBA League Pass, etc.) separately, but Apple is now looking to have consumers sign-up through one Apple TV interface, allowing them to be the so-called “middle-man” generating upwards of $50 billion per year in revenue by 2021, according to Bloomberg.

Just last month, Apple announced a partnership with smart-tv manufacturers Samsung and Sony to bring their iTunes app on their TVs. It will allow Apple users to play content they own or rented through their TV devices.

Looking forward, the transformation to more of a software technology company will not only provide a more stable stream of re-curing revenues, through subscriptions, but also increase operating margins. Software is a much higher margin business than hardware, which will bode well for Apple investors moving forward.

Milking The Cash Cow

It has been well documented the piles of cash Apple has at its discretion. As of the most recent quarterly earnings report, the company has $245 billion in cash on hand, which is up from the $237.1 billion they reported at the end of their fiscal 2018 period. The piles of cash allow management numerous options, such as continued increase in dividends, buybacks (which the company has not been great at), R&D spending, or acquisitions.

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In 2018, the company increased the dividend 16% and investors should be expecting the next hike to come after the release of the Q2 earnings results. Over the course of the last five years, the company has increased their dividend an average of 10.6% each year. The payout ratio is only 24%, which means the company has plenty of run to continue raising the dividend at a healthy clip going forward.

Something that makes Apple so great is the fact that they are not only a solid growth play for investors, but also a sound dividend play as well. Since reinstating its dividend in 2012, the company has grown their dividend by nearly 80%. As mentioned earlier, the company recently increased the dividend 16%, which was the single largest dividend raise to date.

During the company’s most recent fiscal year, 2018, the company reported free cash flow of $64.1 billion, a 24% increase from prior year. This was the second largest free cash flow earned by the company, behind only 2015 in which the company reported FCF of $70.0 billion. Growth in the service industry should not only lead to stronger margins, but higher FCF as well going forward, which again bodes well for future dividend increases.

Investor Takeaway

Based on the main points we touched on above, we are big proponents of the stock and where we project it to be in the future. The stock had a strong pullback during the market-wide selloff late in 2018, but we still believe today’s valuation is enticing. Trading at a P/E of just 14x, which is under their 5-year average of 15.9x, could be a compelling entry point for those on the side line. I added at $154 in late January, but still may look to add more under $170.

iPhone sales are beginning to plateau, but that has garnered too much attention as this has been a well-known topic for some time now. What investors seem to be missing is the transformation taking place to more of a software technology company. Service revenue continues to be a strong growth driver and now accounts for 14% of the business. In terms of hardware, iPhone revenues will still hold up for the near future as average selling prices help make up for some of the decline in unit sales. However, the new gem within hardware is the wearables segment, which has seen record growth quarter after quarter with the ever-popular Apple Watch leading the charge.

As there are with every company, risks do lurk for the company. One area for concern for the company and investors alike, has been the performance of China and the looming trade war. Reports have been more positive of late, but the company saw revenue decrease 27% during the quarter, which has become a major concern. Another area of concern as an investor has been the companies use of capital when it comes to buybacks. In the past, the company has made ill-timed investments to buyback shares. One last risk to mention is that of the strong dollar. The US dollar has been on a tear for some time now and that has put added pressure on companies with international exposure, so this is something to keep an eye on before investing.

The company is loaded with cash to make a strategic acquisition, increase the dividend, which should be coming next quarter, or continue to fund further research and development. Apple’s long-term approach is what makes this stock a great buy for any portfolio. Getting in early, could prove to be a home run for investors.

We hope you all enjoyed the article and found it informative. As always, we look forward to reading and responding to your comments below and feel free to leave any feedback. Happy investing!

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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.

Additional disclosure: This article is intended to provide information to interested parties. We have no knowledge of your individual goals as an investor, and we ask that you complete your own due diligence before purchasing any stocks mentioned or recommended.

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