As many of us know, Apple’s (AAPL) hardware business has stagnated massively over the last five years. The company has since very successfully pivoted to other growth channels, namely wearables and services, and these segments are set to drive free cash flow per share higher throughout the 2020s, and thereby drive the price of the stock higher as well. Coupled with the enormous capital return program, Apple’s share price is set to rise, and in this article, we will determine whether this rise is capable of outstripping the SPY.
To Recap A Bit
1. Over the last five years, Apple’s total revenues have grown at 7% CAGR, with iPhone growth at 7% CAGR, Mac at 1% CAGR, and iPad de-growth at -7% CAGR. In the last two years, even iPhone revenues are in decline.
2. Services have grown at 21% CAGR over the last five years, and now contribute ~20% of Apple’s total revenues. They are expected to grow in the mid-high teens for the next few years.
3. Wearables, home, and accessories are growing at 24% CAGR and contribute ~10% of total revenue.
4. iPhone SE will allow further distribution of phones, which will fuel services and ecosystem growth (i.e., wearables and other accessories).
5. The company’s goal of achieving a net cash neutral position through a leveraged recapitalization should continue to drive free cash flow per share higher, thereby enhancing shareholder return.
Since 2013, Apple has returned $450B+ to its shareholders in the form of dividends and buybacks. The net cash at Apple still stands at $83+ Billion, and Apple currently makes over $65 Billion in annual free cash flow. Thus, massive buybacks and dividends are set to continue for at least another 4-5 years.
Apple has shown that it is an opportunistic buyer of its own stock, carrying out accelerated buybacks when the stock is down. Thus, an investor can be virtually assured that Apple’s share price has something of an imaginary floor at all times (as a result of management’s willingness to do massive buybacks to support share price… though that isn’t their objective. It’s just a nice byproduct.)
Through new growth channels and buybacks, Apple has enhanced shareholder value, driving free cash flow per share ever higher. I expect this trend to continue and Apple to grow its FCF to equity by 7-10% over the coming decade.
Wearables And Services Save The Day
I mentioned the stagnation in Apple’s hardware business, which has led to slow revenue growth at the company.
The effects of this stagnation have been ameliorated by Tim Cook’s and Apple’s decision to aggressively pivot to Wearables and Services. The following graph tells us the whole story:
Source: Created By Author In Excel
Segments like iPad and Mac are in decline, while the iPhone is stagnant. On the flip side, Wearables & Services are thriving with each of them growing at above +20% in the last few years. These two segments more or less compensated for the losses in iPhone, Mac, and iPad sales; enabling Apple to still grow sales at a healthy clip of ~7%.
Here’s a nice video encapsulation of Apple’s products (for those that aren’t within the ecosystem currently):
Apple’s services like Apple Music (60+ million subscribers), Apple TV+ (35+ million subscribers), Apple News (125 million monthly active users), and many others have been immensely successful with its consumer base. Wearables, home & accessories round out a fantastic ecosystem that Apple has built over the last several years. As further evidence, Apple Watch makes up ~55% of the global smartwatch market.
Here’s a quick video highlighting the extent to which Services continue to power Apple’s revenue growth:
As Apple moves from one-time hardware sales to a recurring subscription-based services business, the company is bringing the iPhone SE – an affordable smartphone that will help Apple add consumers to its ecosystem of wearables, accessories, and services.
Let’s investigate this further.
Apple iPhone SE
Apple’s primary revenue source, the iPhone, has been losing steam in the last couple of years, limiting overall revenue growth. The alarming drop in iPhone sales was caused by several factors like the US-China trade war, consumers delaying purchases in anticipation for 5G devices, etc.
But to remedy this issue, Apple has come out with the iPhone SE – an affordable iPhone starting at just $400. It is the cheapest iPhone ever in Apple’s history.
Apple’s iPhone SE move should enable the company to increase its target customers (addressable market) significantly. The hype surrounding the iPhone SE is exciting, and management believes the iPhone SE will be a very successful product. Many people who couldn’t afford an iPhone before, can do so now. Thus, a lot of new consumers will be added to the Apple ecosystem, and the services and wearables cash register will keep ringing at Apple for several years to come. In fact, I believe that the new iPhone SE may even reverse the trend of revenue decline, as many who’ve been historically priced out of the iPhone market begin to enter.
Apple Is Apple’s Biggest Fan
I already mentioned that Apple had returned over $450 Billion to its shareholders since the inception of its capital return program. The company is trying to achieve a “net-cash neutral” position. Let’s take a look at the capital return history:
The total capital Apple returned to its shareholders since 2012 stands at $454.2 Billion ($344.7 Billion in share repurchase and the rest in dividends). Interestingly, the size of buybacks has increased from $29 Billion in 2016 to $66 Billion in 2019. Apple is returning more cash than its free cash flow via a process us finance folks call a leveraged capitalization, which thereby reduces its net cash position and alters its capital structure. After returning $450B, Apple’s net cash has decreased from $140 Billion to $80 Billion, which indicates more than anything the extent to which Apple generates consistent and robust free cash flow.
And in recent news…
During Apple’s latest earnings call, Apple announced that its board had approved an additional $50B to its share repurchase program, which already had $40B outstanding. That’s now $90B allocated capital for the share repurchase program.
Apple has shown in the past that it is an opportunistic buyer, repurchasing shares worth $10B during the sell-off in Q1 2020.
Apple’s dividend yield of ~1% is not significant, but the company has grown its dividends too over time. Just last quarter, dividends were raised by 6%. We will explore the effects of Apple’s capital return program on its financial statements in the next section.
In this section, we will try to decipher the underlying strength of Apple’s business through the analysis of its financial statements. We will see how Apple has been able to pay for such large buyback programs, and why it will be able to continue down this road for many more years. Let us start with the income statement.
Income Statement Analysis
Apple’s revenues grew at 3.5% CAGR over the last five years, with gross margins remaining stable around 38%. The operating margins have reduced from 30% to 24.5% in the same time frame. The drop in operating margin is attributable to higher SG&A and R&D expenses.
Now, let’s turn our attention to Apple’s revenue diversification.
Revenue Diversification – Subscription Strategy Success
Source: Excel Graph Created By Author
Apple has been diversifying its revenues from products to services. During the recent quarter, Services revenue reached a record of $13.3 billion, growing 17% (YoY). This is further evidence that the revenue mix is changing rapidly at Apple.
As Apple’s services revenue continues growing in high double digits, Apple’s overall revenues should keep rising for the foreseeable future. Margins in services are around 65%, i.e., higher than product margins. Thus, a margin improvement can be expected, coupled with revenue growth going forward.
Balance Sheet Analysis
As of March 2020, Apple had cash and short-term investments worth $94.05B along with long-term investments of $98.79B and total debt of $109.51B. In the last two years, debt has stabilized, and long-term investments have decreased ~50% from a peak above $200B. Where is the money going? You guessed it right, “Share repurchase.”
Cash Flow Analysis
As you can see in the chart above, Apple increased its buyback program from $35B to over $72B in 2018. It also paid $14B in dividends. Free cash flow to equity stood at ~$65B, but Apple returned $81.6B to its shareholders in 2019.
Let’s see how the capital return program has helped Apple to enhance shareholder value. As can be seen below, free cash flow to equity per share has grown at +6% CAGR. Dividends are increasing steady at about the same pace. The cash dividend payout ratio is modest at 21%.
The majority of the funds allocated to the capital return program at Apple are utilized to carry out stock buybacks. As the size of buybacks has increased, the number of outstanding shares has decreased significantly. In five years, Apple has managed to reduce its outstanding shares by ~5% every year (from 5.75 billion to 4.40 billion). We already know Apple has $90 billion allocated to perform more repurchase transactions; therefore, you can expect the number of shares outstanding to keep going lower in the years to come.
Impact of Apple’s Capital Return Program
Even with moderate revenue growth and flat FCF, Apple’s stock has outperformed the S&P 500 by a mile. If an investor put $10,000 in Apple and the SPY ETF Trust (SPY), they would have made a lot more money in Apple stock, which is evident from the chart above. You can attribute this outperformance directly to Apple’s capital return program. An investor can draw confidence from Apple management’s commitment towards returning capital to shareholders, as opposed to squandering it on empire-building or projects with little chance of success.
Hmmm… What To Pay, What To Pay
Here, we will employ our proprietary valuation model. Here’s what it entails:
- Traditional discounted cash flow Model using free cash flow to equity discounted by our (as shareholders) cost of capital.
- Discounted cash flow model including the effects of buybacks.
- Normalizing valuation for future growth prospects at the end of the 10 years. (3a.) Then, using today’s share price and the projected share price at the end of 10 years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.
Now, let’s check out the results!
L.A. Stevens Valuation Model
Free cash flow per share
Free cash flow per share growth rate
Terminal growth rate
Years of elevated growth
Total years to stimulate
Discount Rate (Our “Next Best Alternative”)
Using the L.A. Stevens Valuation Model, I determined that Apple’s fair value is $292.28, i.e., the stock is currently “Overvalued” by 2.64%.
Source: L.A. Stevens Valuation Model
The expected CAGR on investment in Apple for 10 years at the current price of $300 is 9.93%, which is just higher than our hurdle rate (9.8%, i.e., 90-year annualized return on S&P 500).
Source: L.A. Stevens Valuation Model
Therefore, if one were to buy at today’s price of $300, they should expect an annualized return, conservatively speaking, of about 9.93%, which is just over our “hurdle rate,” i.e., the 90-year annualized performance of SPY (9.8%).
Therefore, I would say that you’d beat the SPY, but not by much of a significant margin…
Here’s a look at the performance of the stock when accounting for dividends and the growth thereof:
|Total Return Without Reinvestment|
|Total Return With Reinvestment|
Apple And The “Digitalization of Reality”
After the world defeats COVID-19, a new normal will be established, as evidenced by Twitter’s new “lifetime work from home” policy. During the crisis, many people experienced work-from-home for the very first time in their lives. If companies determine that productivity does not suffer from the majority of their employees working from home, they might make this shift permanent; reducing office leasing costs significantly. And this shift to home offices will create a demand uptick for Apple’s products and services like Macbooks, iPhones, and cloud storage. Thus, Apple fits in well with the “Digitalization of Reality” investment megatrend, which has enabled us to pick market-beating stocks.
Apple’s strong financial position will enable it to continue with its humungous capital return program. Some revenue growth shall return, too, with Apple’s services gaining traction among consumers, and more home offices creating a demand uptick for Apple’s products. Apple’s newest iPhone, the affordable iPhone SE, widens Apple’s addressable market and provides fertile ground from which revenue growth might emerge.
For those looking for a very conservative, steady investment (with a low beta), picking Apple might just be up your alley.
However, don’t expect Apple to decimate the market as it has over the last year or so!
Key Takeaway: Buy Apple at $300 and below.
Please provide your feedback in the comments below.
As always, thanks for reading; remember to follow, and happy investing!
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Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.