Valuentum Exclusive Analysis for the Discerning Investor

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Image Shown: Shares of Apple Inc have sharply rebounded since falling precipitously from the start of 2020 through March, keeping in mind we removed shares of AAPL from our newsletter portfolios back on January 13, 2020 (link here), when shares of Apple were trading well over $300 per share. We announced on March 17, 2020, that we like Apple as a way to ride out the ongoing coronavirus (‘COVID-19’) pandemic.

By Callum Turcan

Apple Inc (AAPL) reported earnings for its second quarter of fiscal 2020 (period ended March 28, 2020) that beat both consensus top- and bottom-line estimates. The company also pushed through a 6% sequential increase in its quarterly payout, bringing it up to $0.82 per share or $3.28 per share on an annualized basis. At the new payout rate, shares of AAPL yield ~1.1% on a forward-looking basis as of this writing. We highlighted Apple as a COVID-19 idea back on March 17 (article here) considering its enormous net cash balance and strong cash flow profile provides the firm with the strength to emerge on the other side of the pandemic with its financials intact. Given its large net cash position, Apple increased its share buyback authority by $50.0 billion in conjunction with its latest earnings report.

Earnings Overview and Operational Commentary

Services continues to be a bright spot for Apple, with revenue from that segment growing by 17% year-over-year in its second fiscal quarter. The cost of sales of its services segment rose by just 11% year-over-year, allowing for segment level gross margin expansion which was in part due to a favorable service mix shift (growing sales of higher margin offerings within this segment). Product sales were down by 3% year-over-year last fiscal quarter while the cost of sales of its product segment dropped by just 2%, highlighting that Apple faced modest margin pressure on that front. The slowdown in its Greater China business played a role, as did an unfavorable product mix shift. In total, Apple’s GAAP revenues climbed up almost 1% year-over-year last fiscal quarter. Here’s what Apple’s CFO, Luca Maestri, had to say regarding Apple’s services segment during the firm’s latest quarterly conference call (emphasis added):

“On Services, we are seeing two distinct trends. First, customers are actively engaging with our ecosystem and digital services, and we believe the very strong recent performance in the App Store, Video, Music, and cloud services will continue throughout the June quarter. Second, due to the overall reduced level of economic activity, due to the lockdowns around the world, services like AppleCare and advertising are being impacted.

AppleCare is comprised of our product repair business and the warranty agreements with our customers, both of which have been obviously affected by store closures and reduced level of customer traffic. Advertising, which is comprised of third-party agreements, our App Store search ads, and Apple News ads has been impacted by overall economic weakness and uncertainty on when businesses will reopen.”

Most of Apple’s services business is doing well, save for its digital advertising business (which we think will rebound strongly once the global economy starts to reopen) and its product repair business. Apple’s cloud business and Apple Music both set revenue records last fiscal quarter with management noting that the sales were up by double-digits (presumably on a year-over-year basis). Its paid subscriber base (across all of Apple’s services) climbed by 125 million users year-over-year, reaching 515 million, which was up over 35 million sequentially (indicating this strong growth rate continued last fiscal quarter), according to management commentary.

When it comes to Apple’s supply chain, management noted that while there were temporary problems that started in February, the company’s supply chain is now fully functioning for the most part. That means when the global economy begins to restart, Apple will be able to meet pent up demand for its products.

Rock-solid Financials

Apple exited the fiscal second quarter of 2020 with $40.2 billion in cash and cash equivalents, $53.9 billion in short-term marketable securities, and $98.8 billion in long-term marketable securities on hand versus $10.0 billion in commercial paper and repurchase agreements, $10.4 billion in term debt maturing within a year, and $89.1 billon in term debt with maturities greater than one year. In all, Apple exited last fiscal quarter with a net cash position of $83.3 billion after spending $39.3 billion repurchasing its common stock during the first half of fiscal 2020. Apple generated $39.9 billion in free cash flow during the first half of fiscal 2020, paid $6.9 billion to cover its dividend obligations, and utilized a combination of its free cash flows and balance sheet strength to fund $39.3 billion in share buybacks.

In the fiscal second quarter of 2020, Apple’s outstanding diluted share count fell by 6% year-over-year, which helped the firm grow its GAAP diluted EPS by 4% even though its GAAP net income declined by 3% on a year-over-year basis. Here’s what Apple’s CFO had to say regarding Apple’s capital allocation priorities during the firm’s latest quarterly conference call (emphasis added):

“With regard to capital allocation, our approach remains unchanged. We continue to invest confidently in our future while also returning value to our shareholders. We are in the midst of developing our most exciting pipeline of products and services ever while contributing over $350 billion to the U.S. economy and expanding our footprint in many cities around the country over a five-year period.

We also continue to believe that there is great value in our stock, and we are maintaining our target of reaching a net cash neutral position over time. As a testament to the confidence we have in our business today and into the future, our Board has authorized $50 billion for share repurchases in addition to the over $40 billion authorization remaining under the current share repurchase plan.”

Our fair value estimate for shares of AAPL sits at $255 per share under our base case scenario, which rises to $306 per share under our bull case scenario. Should Apple outperform our base case scenario, then its major share buyback program would represent a good use of shareholder capital.

Concluding Thoughts

Apple intends on repurchasing an enormous amount of its stock over the coming years, taking advantage of its large net cash pile and sizable free cash flows. The launch of a 5G-capable iPhone and continued growth at its services segment supports its growth outlook in the medium- and long-term, however, the firm will need to contend with material exogenous headwinds in the short-term. That being said, Apple is very well positioned to ride out the storm.

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Related: SPY, QQQ

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Callum Turcan 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.