Valuentum Exclusive Analysis for the Discerning Investor

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Image Shown: Shares of Apple Inc have staged an impressive rally since bouncing off their March 2020 lows, with AAPL up ~46% year-to-date as of this writing on August 3. We added shares of Apple back to the Best Ideas Newsletter and Dividend Growth Newsletter portfolios on June 12, 2020. Later on this August, Apple intends on completing a four-for-one stock split.

By Callum Turcan

We added Apple Inc (AAPL) back to both the Best Ideas Newsletter and Dividend Growth Newsletter portfolios on June 12, 2020 (link here). Companies that are supported by secular growth tailwinds and pristine balance sheets, such as Apple, are well-positioned to deal with the ongoing coronavirus (‘COVID-19’) pandemic. Shares of AAPL have surged significantly higher since mid-June and are now trading well above the top end of our fair value range as of this writing, but we want to stress here that we like to let our winners run. It is not until after a firm’s technicals turn against it that we would consider removing shares of that firm from our newsletter portfolios. Given its stellar third quarter fiscal 2020 earnings report (period ended June 27, 2020) published on July 27, shares of Apple may have room to run further still.

Quarterly Overview

In the fiscal third quarter, Apple reported $59.7 billion in GAAP net sales, which was up 11% year-over-year. Strength at both its ‘Products’ and ‘Services’ divisions propelled Apple higher. As we have noted often in the past, we continue to be intrigued with the long-term trajectory of Apple’s Services division sales given the high margin nature of those revenue streams. Here is what management had to say on that issue during the firm’s latest earnings call (lightly edited, emphasis added):

“…We had strong performance in our digital services with all-time revenue records in the App Store, Apple Music, video and cloud services as well as elevated engagement on iMessage, Siri and FaceTime. Customers are loving new offerings across Apple services like Apple News today, our new daily audio briefing and Greyhound, our new summer blockbuster starring Tom Hanks.

In fact, Apple TV+ just hit a history making 95 awards nominations and 25 wins and accolades. Based on these results and our performance over the last four quarters, we are proud to announce that we have achieved our goal of doubling our fiscal 2016 services revenue six months ahead of schedule.”

Management noted that sales growth at Apple’s well established “App Store, Apple Music, video and cloud services” led the charge at its Services division last fiscal quarter, supported by the company’s newer “Apple TV+, Apple Arcade, Apple News+ and Apple Card” services. Paid subscriptions rose by 35 million last fiscal quarter and now stand at approximately 550 million. Apple mentioned that the firm remains on-track to reach 600 million paid subscribers by the end of calendar year 2020. On the downside, Apple noted that advertising and AppleCare sales were negative impacted by the pandemic last fiscal quarter, which appears to have been completely offset by strength elsewhere.

Pivoting to Apple’s Products division, net sales of iPhones, Macs, iPads, and ‘Wearables, Home and Accessories’ were all up year-over-year last fiscal quarter. The work-from-home trend encouraged the purchase of laptops, desktops, and tablets. Going forward, management is optimistic that the back-to-school shopping season will support Apple’s non-iPhone Products revenues this fiscal quarter given the potential for many students to continue to get schooled at home (which in particular is expected to support Mac and iPad sales). Apple’s Products division sales were further supported last fiscal quarter by the launch of the second-generation iPhone SE in April 2020, a more affordable iPhone offering.

For reference, Apple generated over $8.8 billion in gross profit (up 20% year-over-year) at its Services division on $13.2 billion in net sales (up 15% year-over-year) last fiscal quarter, good for a division-level gross margin of 67.2% (up ~310 basis points year-over-year). We strongly appreciate Apple’s ability to grow its division-level Services margin as that highlights the scalability of this business. Apple’s Products division generated $13.8 billion in gross profit (up 7% year-over-year) on $46.5 billion in net sales (up 10% year-over-year) last fiscal quarter, good for a division-level gross margin of 29.7% (down marginally year-over-year). We appreciate the resilience of Apple’s supply chain as that enabled the firm to meet brisk demand for its various products last fiscal quarter.

Please note that pent up demand, due to the negative impact COVID-19 had on key markets during Apple’s second quarter of fiscal 2020 (period ended March 28, 2020), is not primarily responsible for Apple’s strong performance in the fiscal third quarter. Apple posted modest year-over-year GAAP net sales growth in the fiscal second quarter, and that momentum continued into the fiscal third quarter.  

Financial Strength Retained

Apple exited June 27 with $193.6 billion in cash, cash equivalents, short-term marketable securities, and long-term marketable securities on hand combined. Stacked up against $112.7 billion in commercial paper and repurchase agreements, short-term term debt, and long-term term debt combined, Apple continued to carry a massive net cash position of $80.9 billion at the end of its fiscal third quarter. That net cash position provides the firm with ample financial firepower to ride out the storm.

During the first three quarters of fiscal 2020, Apple generated $54.6 billion in free cash flow ($60.1 billion in net operating cash flow less $5.5 billion in capital expenditures). The firm spent $10.6 billion covering its dividend obligations and $55.2 billion repurchasing its common stock during this period. Some of its share repurchases were funded by the balance sheet and given how shares off AAPL were trading well below their fair value estimate during most of this period, that appears to have been an effective use of capital. Apple reduced its outstanding diluted share count by over 5% year-over-year in the fiscal third quarter.

Promising Dividend Growth Trajectory and an Upcoming Stock Split

Shares of AAPL yield ~0.8% as of this writing. We see room for Apple to continue pushing through meaningful dividend increases, even during harrowing times such as these, given its high quality cash flow profile and pristine balance sheet. From August 2014 to August 2020, Apple grew its quarterly per share payout by over 74%. Apple’s forward-looking dividend strength is simply stellar given its Dividend Cushion ratio of 5.7, earning Apple an “EXCELLENT” Dividend Safety rating. That factors in strong double-digit annual per share dividend growth over the coming fiscal years, and we give Apple an “EXCELLENT” Dividend Growth rating.

Apple intends on pursuing a four-for-one stock split that is expected to be completed later this month. The goal of this maneuver is “to make our stock more accessible to a broader base of investors” according to management. While this will have no fundamental impact on Apple’s operations or financials on a company-wide basis, given the rise of day trading (otherwise known as gambling) during the pandemic from investors new to equity markets, it is possible shares of AAPL will become more appealing to certain retail investors at a lower per share price point. 

Key Events

Reportedly, Apple intends to improve its mobile payment capabilities (likely for its iPhone) by acquiring Montreal-based Mobeewave for ~$0.1 billion. Mobeewave offers technology that allows users to tap their credit card or smartphone on another smartphone using Near Field Communications (‘NFC’) technology to process a payment. In an increasingly “cashless” world, the payment processing and payment solutions industry is supported by very powerful secular growth tailwinds and there is plenty of room for multiple winners in this space.

Probably the biggest near-term catalyst investors tend to pay close attention to is Apple’s iPhone launch cycle. Apple mentioned that the launch of its next-generation iPhone, which could be 5G-capable, is getting delayed by a few weeks due to the pandemic. Here is what management had to say during Apple’s latest earnings call (emphasis added):

“Similar to last quarter, given the uncertainty around the world in the near-term, we will not be issuing revenue and margin guidance for the coming quarter. However, we will provide some additional insight on our expectations for the September quarter for our product categories.

On iPhone, we expect to see recent performance continue for our current product lineup, including the strong customer response for iPhone SE. In addition, as you know, last year we started selling new iPhones in late September. This year we project supply to be available a few weeks later. We expect the rest of our product categories to have strong year-over-year performance.

For services, we expect the September quarter to have the same trends that we have observed during the June quarter except for AppleCare where during the September quarter a year ago we expanded our distribution significantly. As a consequence, we expect a difficult comp for AppleCare also considering the COVID related point of sale closures this year.”

The announcement of a modest delay in the next iteration of the iPhone did not seem to worry investors as share of Apple soared after its latest earnings were published. Additionally, we appreciate that management expects Apple’s momentum at its Services division will continue going forward, keeping the headwinds facing AppleCare and the firm’s advertising segment in mind.

Concluding Thoughts

We continue to like Apple as a holding in both our Best Ideas Newsletter and Dividend Growth Newsletter portfolios. Please note we significantly raised our fair value estimate for shares of AAPL back on June 12 (not taking the four-for-one stock split into account), as we view Apple as one of the best prepared companies to ride out the COVID-19 pandemic. To read more of our tech coverage, please check out our thoughts on Microsoft Corporation’s (MSFT) latest earnings report (link here), which was also added back to the Best Ideas Newsletter and Dividend Growth Newsletter portfolios on June 12.

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Computer Hardware Industry – AAPL BB HPQ IBM TDC

Software Industry – ADBE ADSK EBIX INTU MSFT ORCL CRM

Internet Content & Services Industry – GOOG GOOGL BIDU FB JD TCEHY TWTR

Internet Content and Catalog Retail Industry – BABA AMZN BKNG EBAY EXPE GRPN IAC OSTK QRTEA STMP

Related: AMZN, SPY, QQQ, XLK

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Callum Turcan does not own shares in any of the securities mentioned above. Apple Inc (AAPL), Microsoft Corporation (MSFT), and Oracle Corporation (ORCL) are all included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Alphabet Inc (GOOG) Class C shares, Apple Inc, Facebook Inc (FB), and Microsoft Corporation are all included in Valuentum’s simulated Best Ideas Newsletter portfolio. Both the simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios include a SPDR S&P 500 ETF Trust (SPY) put option holding with a $295 per share strike price that expire on August 21, 2020. 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.