Image Source: William Hook
Apple delivered fiscal first quarter results after the close January 29 that were largely in-line with recently adjusted expectations. China has been and will likely continue to be a soft spot, but the company’s Services revenue continues to impress. Strong free cash flow generation and balance sheet health are synonymous with the company.
By Kris Rosemann
Apple (AAPL) reported fiscal 2019 first quarter reports after the close January 29, but the market already had a good idea of what to expect due to a January 2 update from CEO Tim Cook that included a stark warning on the current demand environment in China (FXI, MCHI). Here’s some of what Valuentum’s President of Investment Research Brian Nelson had to say in his write up of that update, “Here It Comes… Apple’s Shot Across the Bow:”
Apple mentioned four anticipated factors that impacted performance during its fiscal first quarter of 2019 (and one new one). The only one of the four that didn’t play out “broadly in line with (its) expectations” was “economic weakness in some emerging markets.” In CEO Tim Cook’s words, “this turned out to have a significantly greater impact than (it) had projected.” In no uncertain terms, this was China (FXI, MCHI). According to Apple, “most of its revenue shortfall to (its) guidance, and over 100% of (its) year-over-year worldwide revenue decline, occurred in Greater China across iPhone, Mac, and iPad.” The company also noted there were fewer upgrades within its iPhone product line than expected (the new factor), but the news with China is a big one.
Without a doubt, it looks like US-China trade tensions are having a big impact, and while the market was already getting jittery in December, it appears these jitters haven’t fully played out yet. Apple noted that Chinese economic growth is beginning to slow and that the country’s GDP growth for the calendar third quarter was the second-lowest in a quarter century. Apple also noted that traffic to its retail stores and channel partners in China also declined as the quarter progressed. What this means is that fiscal second-quarter performance may be even worse. This may be the biggest negative. Again, we’re taking all of this in stride.
We continue to highlight shares of Apple in both simulated newsletter portfolios, and we’re sticking with our current fair value estimate of $217 per share for the time being. The company’s Dividend Cushion ratio is among the strongest across our coverage universe at 5.8, but we cast a cautious eye over management’s plan to take its fortress-like balance sheet to a net cash neutral position over time. Shares yield ~1.9% as of this writing, and with that, let’s dig in to fiscal 2019 first quarter results.
Shares of Apple rallied after hours January 29 as results came in largely in-line with Cook’s preliminary announcement earlier in the month, despite second quarter guidance coming up a bit short of consensus expectations. Revenue in the quarter fell 5% on a year-over-year basis as a 15% decline in iPhone revenue (accounted for ~62% of total revenue in the quarter, down from ~69% in the comparable period of fiscal 2018) was too much for 19% growth in all other revenue to offset. The Greater China region (accounted for ~16% of total revenue in the quarter, down from ~20% in the comparable period of fiscal 2018) was the key source of weakness, and net sales fell nearly 27% in the region from the year-ago period.
Services revenue, which remained on track of its goal to be doubled over the period from fiscal 2016-2020 and accounted for ~13% of total revenue in the period, was a bright spot in Apple’s fiscal first quarter as it grew 19% on a year-over-year basis to a quarterly record of $10.9 billion. Growth in this area was helped along by the company’s active installed base of devices hitting an all-time high of 1.4 billion in the quarter. We continue to highlight Apple’s incredible ecosystem and ability to make its products and applications an integrated part of the everyday lives of consumers. This may ultimately be the greatest strength it has, and it becomes even more bonding with consumers when taken with the status symbol that is its brand.
Mac revenue (~9% of total revenue in the period) advanced 9% from the year-ago period in the quarter, Wearables, Home, and Accessories revenue (~9% of total revenue in the period) leapt 33%, and iPad revenue (~8% of total revenue in the period) climbed 17%. The attractiveness of the Apple brand is not restricted to the iPhone, which is a notion supported by the impressive installed base of active devices.
Apple’s GAAP gross margin came in at 38% in its fiscal first quarter, in-line with Cook’s updated projections and down roughly 40 basis points from the year-ago period. GAAP operating margin was also in-line with recently set expectations but faced more material pressure in the period, as it contracted more than 2 percentage points to ~27.7%. Nevertheless, a significantly lower tax bill and lower share count helped grow diluted earnings per share by ~7.5% on a year-over-year basis to $4.18.
Operating cash flow followed Apple’s operating income lower in the quarter, falling by nearly 6% from the year-ago period to $26.7 billion, and capital spending growth only further pressured free cash flow generation, which dropped more than 8% on a year-over-year basis to ~$23.3 billion. This is still a tremendous level of free cash flow generation, and it had no trouble in covering cash dividends paid in the period of ~$3.6 billion; share repurchases came in at ~$8.8 billion in the quarter. Management continues to reiterate its commitment to taking its balance sheet to a net cash neutral position over time, but its net cash position rose to $130.3 billion at the end of the quarter from $122.6 billion at the start of the period as it continues to throw off gobs of excess cash.
Apple is expecting its revenue decline to accelerate in its fiscal second quarter, as measured by the midpoint of its $55-$59 billion revenue guidance range for the period. Ongoing gross margin pressure is expected in the period (down to 37%-38% from ~38.4%), and operating expenses are expected to grow materially over the comparable period of fiscal 2018. This should not come as a surprise to Valuentum members, as Brian Nelson had already put the potential for similar expectations on members’ radars.
Despite the less-than-rosy near-term outlook, we continue to like shares of Apple, which are trading below the lower bound of our fair value estimate as of this writing. The company has unparalleled balance sheet strength, though it may eventually wane as a result of its own strategy, and tremendous free cash flow generation; its dividend is among the healthiest we’ve seen. We’re not panicking over short-term weakness in the Chinese market, and the firm’s seemingly ever-growing ecosystem of devices and applications appears poised to find itself more and more integrated into the lives of consumers.
We’re not letting one bad apple ruin a great bushel, and we expect to continue highlighting shares of Apple in both newsletter portfolios for the foreseeable future in the face of what may very well be transient weakness in an important market.
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.