Image Source: Eric Wüstenhagen
On April 27, Apple (AAPL) reported record numbers for its second quarter of fiscal year 2015. Record second-quarter sales of the iPhone and Mac, and best-ever performance from the App Store drove revenue growth of 27% on a year-over-year basis, resulting in $58 billion in revenue. In addition to the significant top-line growth, EPS increased to $2.33 per diluted share, an increase of 40% over the year-ago quarter. Gross margin was higher than expected, at 40.8%, and cash flow from operations also reached a second-quarter high at $19.1 billion. Apple noted that 69% of the quarterly revenue was provided by international sales.
Management announced a plan to increase its capital-return program by more than 50% by the end of March 2017. The $70 billion increase includes an additional $50 billion in share repurchases, and management on its earnings call pointed to the incredible value it sees in its own shares as the reasoning for the increase. Apple also increased its dividend, the third time in less than three years, by 11% to $0.52 per share quarterly dividend. Some investors may have expected a larger jump, but we think Apple is building to become a long-term dividend growth gem, something we like a lot!
The company plans to fund the capital-return program using its incredibly strong net cash position, its robust free cash flow generation, as well as by raising domestic and international debt. At the end of the quarter, Apple’s net cash plus marketable securities was $193.5 billion, an increase of $15.6 billion from the previous quarter. The strength of Apple’s balance sheet is extraordinary, a dynamic that we are particularly fond of. We think free cash flow generation and balance sheet strength are indicative of not only future economic returns but also stock-market returns.
It comes as no surprise that the iPhone played a major role in Apple’s terrific performance in the most recent quarter. Management named several reasons as to why its crown jewel had such success. Since the release of the iPhone 6 and 6 Plus, there has been a higher rate of non-iPhone users switching to the iPhone than in previous cycles. In addition, only ~20% of Apple’s active installed base has switched to the iPhone 6 or 6 Plus. This leaves great opportunity for continued growth within Apple’s pre-existing customers. Total iPhone sales for the quarter were 61.2 million units, a 40% increase year-over-year. Overall, iPhone revenue grew 55% over the year-ago period, while iPhone unit sales in emerging markets advanced 63%.
Another one of the firm’s strengths had one of its best second quarters in history. The App Store reported a record number of customers making purchases in the quarter and a 29% increase in revenue on a year-over-year basis. According to App Annie, cited by management in its earnings call, the App Store generated 70% more global revenue than Google Play, up 10 percentage points from the same comparison last fall–furthering the notion of Apple’s diverse ecosystem domination. The company’s retail and online stores also increased the number of quarterly customer visits by 22%, and Apple set yet another quarterly record, reporting a record $5 billion in services revenue, a 9% increase.
Apple continues to defy the trend of weakening global PC demand; 10% growth in unit sales of Macs is a terrific figure, particularly when comparing that to the global market for PCs, which is contracting by ~7%, according to International Data Corporation. The bucking of this trend may very well continue for Apple, as its newest MacBook has been well received since it began shipping a few weeks ago. Management believes its product is the future of the notebook, and we’re hard-pressed to disagree.
Management provided color on research and development trends. The firm’s R&D costs have been ahead of revenue growth for a number of quarters now. Of course, the development of two iPhones and the Apple Watch have played a large part in the increased R&D spending, but the firm is also developing more core fundamental technologies in house than ever before. Closely related to this, operating expenses have been growing at a slower rate than revenue expansion, showcasing Apple’s ability to manage the expense line to achieve earnings growth. In addition to strategic investments in R&D, Apple has made 27 acquisitions during the past 6 quarters. Excess cash generation should continue to allow Apple to innovate and grow its core.
The firm is excited about recent additions to its portfolio line-up and the momentum that each will carry into the future. As previously mentioned, the new MacBook has received excellent reviews in the first few weeks on the market, and HBO Now, which allows users to stream HBO content on any Apple device, has been one of the most downloaded apps in the US since its debut last month. The most anticipated new Apple product, however, is the Apple Watch.
Though the availability of the Apple Watch is currently limited–it’s only available through Apple’s online stores–the wearable technology has been well-received. For one, there are already 3,500+ apps available for the Apple Watch. For comparison, when the iPhone was launched, there were only 500 apps available; the iPad only had 1,000 available when it was released. This is clearly a positive sign for the usability of the wearable technology, and at the moment, demand for the watch is far greater than supply. Apple plans to start selling its latest product in additional countries by the end of June.
Apple’s other strengths are experiencing momentum as well. One of its many bright spots, the Apple ecosystem, continues to expand, particularly when considering the momentum of Apple Pay. As of last month, the number of locations accepting Apple Pay has tripled. Beginning in the fall, Discover (DFS) users will be able to make contactless payments in participating stores with Apple Pay. Long-time partner Best Buy (BBY) has announced that it is offering Apple Pay for use and plans to offer Apple Pay in all of its US stores later this year. A leading healthcare payment network recently announced the acceptance of Apple Pay for its clients. Now over 50 major hospitals across the country will accept Apple Pay for copays and bill payments at registration and check-in.
Momentum in other health-related solutions also continues to grow. Since the release of the HealthKit along with iOS 8 last September, over 1,000 health-related apps have been created to transform how people track and manage their health. These are all now available on the App Store and are likely contributors to the terrific performance of the App Store. The release last month of ResearchKit, which helps doctors and researchers gather data from research participants, should help continue the momentum of health-related apps. The firm also hopes to integrate this technology into the available apps for the Apple Watch. Over 60,000 iPhone users have begun using the various research apps that have been created in just a few short weeks since the release, and over 1,000 researchers have expressed interest in using the products as well.
Management highlighted the growth of its business in China. The company reported record quarterly revenue of $16.8 billion from the country, an incredible increase of 71% over the year-ago quarter, and record net income of $13.6 billion. Gross margin came in above expectations for the geography. Performance in China is largely tied to the booming population of the country’s middle class, which is where the firm believes the bulk of its sales are coming from. Record iPad sales in China must be taken with a grain of salt though, as the quarter marked the major holiday quarter in China in relation to the Chinese New Year. Continued investment in the country should drive growth into the future. Apple plans to have 40 stores in China by mid-2016 and appears to be well on its way to achieving that goal.
From a sustainability point of view, Apple continues to improve. The company remains keen on its efforts to protect the environment, continuing to invest in renewable energy. A planned 40 Megawatt solar farm in the Szechuan Province, China will produce more power than all of Apple’s China operations combined will use. This is in addition to an investment of $2 billion to build two data centers in Denmark and Ireland that will run on 100% renewable energy from the start of operation. These will be Apple’s two largest data centers worldwide. Apple is doing a lot of things right.
Looking ahead to the current period, Apple is not forecasting record quarterly performance, but the company is expecting continued year-over-year growth. On a sequential basis, a number of performance metrics are expected to decline, including revenue and gross margin. The sequential pressure will lead to some deleveraging in terms of gross margin, which management states is typical of the firm’s seasonality. Currency headwinds will continue to negatively affect results; an impact of about 40 basis points is expected for the current quarter.
The slowing of the surge in iPhone 6 and 6 Plus orders will also pull gross margins down. Despite the expected slight downturn in sales for the current quarter, we are not overly concerned with competition from the new Samsung (SSNLF) Galaxy S6, which seems far too similar in terms of styling to the iPhone 6 to win transfer customers from Apple. The Apple Watch will also negatively affect margins, as Apple is still in the learning stages of how to handle not only the new product but also the wide range of new features and technologies. The company’s near-term margin on the Apple Watch is expected to be below that of the average Apple product.
Considering all of the recently-released information, Apple is as strong as ever. Its fortress-like balance sheet should shield it from any kind of obstacles it may face, though admittedly we’re not anticipating any troubles that will significantly hurt the tech giant. It is one of the most recognized brands in history and boasts a line-up with enough firepower to make the 1992 Dream Team jealous. We expect continued increases in the dividend, and buybacks continue to be value-creating at current levels. Apple’s momentum and growth strategies are sound, in our view, and the firm continues to do what it does best–generate value for shareholders.
Apple remains a core position in both newsletter portfolios: the Best Ideas portfolio, in which it is the highest weighting, and the Dividend Growth portfolio. From both a fundamental and financial standpoint, there is very little that we don’t like about the company; its fundamentals only seem to improve with time. Though we’re not raising our point fair value estimate of ~$140 at this time, we think the high end of our fair value range ($160+) is certainly achievable for shares.