Image Shown: Shares of Apple continue to surge higher and were supported by positive US-China trade talk news on Friday October 11.
By Callum Turcan
One of our favorite companies, Apple (AAPL), has been off to the races with shares pushing up into the mid-$230s as of this writing. Apple is a top holding in both our Best Ideas Newsletter and Dividend Growth Newsletter portfolios. We value Apple at up to $266 per share at the top end of our fair value estimate range, and shares of AAPL yield 1.3% as of this writing. Please note Apple’s fiscal year ends in late September. Let’s start out by covering an area Apple has had some trouble with over the past few fiscal years, and where the company can generate upside going forward.
A Problem and an Opportunity
Apple’s GAAP gross margins came under pressure from FY2016 to FY2018, with management citing higher product cost structures and the negative impact of a strong US dollar relative to other currencies. Ongoing strength in the US dollar continued to play a role in pressuring Apple’s margins in fiscal 2019, as did lower iPhone unit sales. Additionally, Apple is exposed to the escalating US-China trade war to some degree, but there has been positive movement on that front very recently (particularly during trade talks and various meetings held October 10-11).
Image Shown: Apple’s GAAP gross margins have come under pressure over the past few fiscal years in part due to the negative impact of a stronger US dollar. Image Source: Apple – FY2018 Annual Report, third quarter FY2019 10-Q filing, table created by the author
During the first three quarters of fiscal 2019, Apple’s ‘Product’ segment reported a gross margin of 32.4%, down 220 basis points from the same period in the prior year (management cited lower unit iPhone sales as one of the culprits). However, the company’s ‘Services’ segment reported a 300 basis point increase in its gross margin during this period, hitting 63.6%. Scale is key here as Apple’s ‘Services’ business continues to grow. The segment’s net sales were up 13% year-over-year in the third quarter and 16% during the first three quarters of fiscal 2019, while Apple’s total revenue was down 2% and 3%, respectively, during these periods. Here we must stress that we view Apple’s growing ‘Services’ revenue as underpinning our forecast that calls for the company’s EBIT margin to expand modestly over the coming fiscal years (particularly compared to FY2017-FY2018 levels).
During the first three quarters of FY2019, ‘Services’ represented ~17% of Apple’s net sales. That was up from ~14% during the same period the prior fiscal year, and we expect this upward trend to continue going forward with Apple getting ready to launch its own streaming service Apple TV+ at the beginning of November. Apple just recently launched its own gaming subscription service Apple Arcade back in September, highlighting the many avenues Apple can pursue when seeking ‘Services’ sales growth. Here’s what Apple’s CFO, Luca Maestri, had to say during the firm’s third quarter FY2019 quarterly conference call with investors (emphasis added):
“Turning to ‘Services’, we reached an all-time revenue record in spite of foreign exchange headwinds with double-digit growth from the App Store, Apple Music, cloud services, and AppleCare, and triple digit growth from Apple Pay and our App Store search ad business. All geographic segments had double-digit growth in services revenue and set new June quarter records with all-time records in the Americas and Rest of Asia Pacific. In total, services accounted for 21% of Apple revenue and 36% of gross margin dollars.
Customer engagement in our ecosystem continues to grow. The number of transacting accounts on our digital content stores reached a new all-time high in the June quarter and the number of paid accounts grew strong double digits compared to last year. We now have over 420 million paid subscriptions across the services on our platforms and we are well on our way to our goal of surpassing the 500 million mark during 2020.”
How well Apple TV+ performs in terms of subscription growth will be driven in part by the low starting price the company has opted for. Apple plans to charge just $4.99 per month for Apple TV+, below the starting price offered by Netflix (NFLX), by Hulu (majority owned by Disney (DIS) with Comcast (CMCSA) owning the rest), and lower than the monthly non-promotional price offered by the upcoming Disney+ streaming service that’s also going live this November. That should give Apple an edge in the roaring streaming wars, an edge made possible by its impressive financial position (enormous free cash flows and large net cash load). Analysts are likely to pay very close attention to the subscription numbers of Apple TV+ given the sheer size of the total addressable market (“TAM”) this offering is catering towards, and the hefty costs associated with creating a sizable amount of original content.
Apple Arcade starts at $4.99 per month and is competing with Alphabet’s (GOOG) (GOOGL) Google Play Pass which costs about the same amount per month. Subscription based sales may cannibalize some of Apple’s App Store sales, but in the long run this offering could build up the kind of sticky recurring revenue streams that investors often appreciate. These are the kind of revenue streams that are well suited to supporting quality free cash flow profiles (consistent revenue, high margins, plenty of visibility as it relates to future financial performance, relatively low capital expenditure requirements to support these types of operations on an ongoing basis after an initial build out of infrastructure, i.e. data centers).
Concluding Thoughts
We continue to like Apple and think shares will continue advancing toward the upper end of our fair value estimate range ($260+). Recent technical strength at Apple is possibly a sign that investors are beginning to price in the very positive tailwind the tech giant’s ‘Services’ segment represents in terms of both sales and margin upside (and the positive effect that has on Apple’s expected future free cash flows).
Computer Hardware Industry – AAPL BB CRAY HPQ IBM TDC
Media Entertainment Industry – CNK DIS IMAX ISCA LYV MSG NFLX NWSA SIRI
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Callum Turcan owns shares of Apple Inc (AAPL). Alphabet Inc (GOOG) (GOOGL) Class C shares are included in Valuentum’s simulated Best Ideas Newsletter portfolio. Apple Inc (AAPL) is included in Valuentum’s simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.