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Apple: ex-growth consumer electronics business or undervalued ecosystem?

Is it a seller of commoditised electronic devices that is over the hill, or an undervalued ecosystem that still makes the shares a good long-term bet?
Apple: ex-growth consumer electronics business or undervalued ecosystem?

Apple (US:AAPL) is a company that divides investor opinion. To some it is an ex-growth consumer electronics hardware company that is far too reliant on the iPhone. To others it is a valuable ecosystem which can grow by selling more accessories and services to its users. I take a closer look at this consumer electronics giant to see which side of the argument I come down on.

 

The business

Apple is a business that many investors will understand well because they use many of its products and services. The company splits its business into two separate parts: products and services.

Its key product is the iPhone smartphone which runs Apple’s IOS operating system. It also makes personal computers (Macs) and tablet computers (iPads), which also use Apple’s own operating systems.

Other key products are wearables such as the Apple Watch and wireless headphones called Airpods. It also makes smart speakers (Homepod), the Apple TV streaming device, Beats headphones and the iPod Touch music player.

These products are sold directly to consumers over the internet, through a network of Apple stores around the world, mobile telecom providers and electrical and general retailers.

The services side of the business is split up into various bits. The first bit involves the sale of music, books, tv series, films, video games and podcasts through the iTunes store. Apple users can also buy apps for their devices through various App stores. Apple makes money on sales by charging commissions to sellers.

The next part of the services business involves selling subscriptions to users. These include Apple Music, Apple News, Apple Arcade (video games) and the recently launched Apple TV+ video streaming service.

The final part of the services business involves the sale of AppleCare extended warranties for products and iCloud cloud storage services. Apple has also started rolling out an Apple credit card, which gives benefits such as cashback and money off Apple products.

 

Apple’s revenues are still dominated by the iPhone, which accounted for just under 54 per cent of total revenues in the year to March 2020. This has come down from 66 per cent in 2015, but still shows how Apple is very reliant on iPhone sales for its prosperity. iPad sales have also declined significantly as a percentage of overall revenues since 2014.

Services and wearables are the key areas of revenue growth for the company at the moment. The Apple Watch and Airpods are proving a hit with consumers and are helping to offset the decline in iPhone sales. However, Apple’s overall revenues have stagnated for the past 18 months.

Apple’s revenues and profits do have some seasonality to them. The first quarter of its financial year is its most important. It lasts from the beginning of October until the end of December, which takes in the key gift buying occasions of Thanksgiving in the US and Christmas. In 2019, the first quarter accounted for 32 per cent of annual revenues and just over 36 per cent of annual operating profits.

It is therefore not surprising that Apple tends to launch its new products in September so that it can maximise its sales during its peak selling period.

In terms of geography, the Americas and Europe are by far Apple’s most important markets. China, Japan and the rest of the Asia-Pacific area are also key areas for the business.

 

Business strategy and competitive position

Apple faces lots of competition. It aims to compete by selling a complete integrated hardware, software and services ecosystem of products and services to its user base at a premium price. It tries to differentiate itself from its competitors in areas such as performance, security, product quality and the ability to connect and synchronise across multiple devices.

As a fully paid-up participant in this ecosystem and the user of Apple products and services my view is that Apple does a pretty good job. I find its operating systems much easier to use, more reliable and more secure than Windows and like the fact that all my devices and data are synchronised through iCloud. This does come at a cost, but one I and others – particularly in America and Europe – are happy to pay, for now. 

There is also a strong fashion element to Apple’s products. The company has been extremely successful at creating a cult following amongst some – but not all – of its customers, who feel the need to own the latest Apple gadget. This puts a lot of pressure on Apple to keep innovating and creating new must-have products, which is becoming increasingly difficult to do. It is not uncommon to hear grumblings that Apple’s latest products are not offering the same features as some of its rivals – such as Samsung – were offering a year before or that the latest product isn’t much different from the previous version.

The key competitive threat to Apple is that there are cheaper ways for consumers to do the same or similar things that Apple products and services do. In emerging markets such as India, China and perhaps even in an increasingly cash-strapped western world, the willingness or ability to pay high prices for devices that do similar things is not as strong.

Apart from more affluent and brand-conscious consumers, Apple has struggled to gain traction in the Chinese smartphone market. Local manufacturers such as Huawei, Xiaomi, Oppo, Lenovo and ZTE are dominating this market with much cheaper phones and in Huawei’s case high-end alternatives that are very good. Huawei is also rumoured to be launching a new operating system called Harmony, which is new competition to both Apple’s IOS and Google’s Android.

Apple’s key response to these developments has been to stress the security and privacy of its operating system. It does not sell user data to advertisers and its apps are arguably more secure. That said, Apple’s security is not bulletproof as a recent issue with its email software has highlighted.

Apple knows that the smartphone market is now pretty mature in many parts of the world and is going to be hard to generate revenue and profit growth from. It is having to adapt its business model accordingly. 

The push into wearables is going well. The Apple Watch has been a bright spot in the company’s recent innovation, with features such as health monitoring that seem to be well supported by ageing populations.

Its Airpods wireless headphones have been a huge hit and do have scope to increase sales further, but also face competition from cheaper alternatives.

Looking at Apple’s services and subscription proposition it does face very stiff competition. There are plenty of alternative options to buy videos and stream music. Savvy and cash-strapped young people will use the free versions of Spotify and watch videos on YouTube for nothing. Most apps are available on Google’s Android platform.

Elsewhere, Apple News and Apple Arcade have received a lukewarm response from consumers, whereas Apple TV+ can best be described as underwhelming and of no real threat to what’s on offer from Netflix (US:NFLX), Amazon (US:AMZON) or Disney (US:DIS). The credit card is not being rolled out very quickly and while it looks like an interesting way for Apple to retain people in its ecosystem – as the cashback and card fees will not eat into profit margins much – whether banks will be willing to partner up and offer credit in the current economic climate remains to be seen.

AppleCare looks like a very lucrative product unless people smash their smartphone and computer screens too often. That said, when people are already being asked to pay premium prices for products in the first place, to be asked to stump up another chunk of money for extra peace of mind perhaps has limits even though it has been a staple – and key profit generator – of the consumer electronics industry for decades.

Yet there is no doubt that Apple has many competitive strengths as evidenced by a large active installed base of more than 1.5bn products across the world.

 

Business performance

The company ticks a lot of boxes in terms of the desirable financial performance characteristics that many investors look for. It has high profit margins, very good returns on capital and generates lots of free cash flow as it has fairly low capital investment requirements.

 

Apple: Key performance measures

Apple ($bn)

2014

2015

2016

2017

2018

2019

TTM

Revenue

182.795

233.715

215.639

229.234

265.595

260.174

267.981

Gross profit

70.5

93.6

84.3

88.2

101.8

98.4

102.1

Op Profit

52.503

71.23

60.024

61.344

70.898

63.93

65.591

Profit after tax

39.51

53.394

45.687

48.351

59.531

55.256

57.485

Capital Employed

174.7

212.2

246.2

281

258.6

243.1

234.7

Capex

9.571

11.2

12.7

12.5

13.3

10.5

8.7

Free cash Flow

50.1

71

53.1

51.8

64.1

58.9

66.6

Total Debt

35.3

55.8

78.9

103.7

102.5

102.1

99.5

Cash

155.2

205.7

237.6

268.9

237.1

205.9

192.8

Dividend paid

11.1

11.6

12.2

12.8

13.7

14.1

14

Share buybacks

45

35.3

29.7

32.9

72.7

66.9

73.2

        

Gross margin

38.6%

40.0%

39.1%

38.5%

38.3%

37.8%

38.1%

Op margin

28.7%

30.5%

27.8%

26.8%

26.7%

24.6%

24.5%

ROCE

30.1%

33.6%

24.4%

21.8%

27.4%

26.3%

27.9%

FCF margin

27.4%

30.4%

24.6%

22.6%

24.1%

22.6%

24.9%

FCF conv

126.8%

133.0%

116.2%

107.1%

107.7%

106.6%

115.9%

Debt to FCF

0.7

0.8

1.5

2.0

1.6

1.7

1.5

Div & BB as % of FCF

112.0%

66.1%

78.9%

88.2%

134.8%

137.5%

130.9%

Capex to Sales

5.24%

4.79%

5.89%

5.45%

5.01%

4.04%

3.25%

Source: Annual Reports/Investors Chronicle

 

However, there are signs that its profitability is under pressure. While its gross profit margins have stayed fairly stable, its operating margins have fallen from a peak of 30.5 per cent in 2015 to 24.5 per cent for the year to March 2020. Its total operating profit has also stopped growing and is below its 2015 peak.

Since then, its gross margins have fallen by 190 basis points and its research and development costs as a percentage of revenues has increased by 300 basis points.

 

Apple has gone from spending $6bn on R&D in 2014 to over $17bn in the year to March 2020. The spending has helped to produce new products such as the Apple Watch and Airpods, but has yet to take the company’s profits to a fresh peak.

However, the company has kept its closely followed earnings per share (EPS) number moving up by spending a whopping $321bn (most of its free cash flow) on repurchasing more than 2.2bn shares since 2014.

If we look at the difference between its net income and net income per diluted share (or EPS), we can see that net income for the year to March 2020 is only 7.1 per cent higher than it was in the year to September 2015, yet EPS is 38.7 per cent higher.

 

Apple: Net income growth vs EPS growth

Year

Net income $bn

WADS million

EPS $

Change in net income

Change in EPS

2014

39.5

6,122,663

6.45

  

2015

53.4

5,793,069

9.22

35%

43%

2016

45.7

5,500,281

8.31

-14%

-10%

2017

48.4

5,251,692

9.21

6%

11%

2018

59.5

5,000,109

11.91

23%

29%

2019

55.3

4,648,913

11.89

-7%

0%

TTM

57.2

4,473,417

12.79

4%

8%

Source: Annual Reports/Investors Chronicle  WADS = weighted average diluted shares

 

Some might say that this shows the power of share buybacks. Others might say that it is a great example of financial engineering used to mask the lack of real growth in its core business.

Can Apple deliver meaningful real profit growth? Not in the short term, as the impact of the coronavirus has proved to be very disruptive to the business and to consumer spending. 

Over the longer term it is by no means certain that Apple will be making a lot more money in five or 10 years’ time than it is now in my view.

The bull case is that the growth and profit opportunity in services is better than products. The chart showing their respective gross margins shows that a dollar in revenue from services makes a much bigger contribution than a dollar from products.

 

The gross profit margin from products is on a downwards trend as Apple keeps trying to defy the law of price deflation in consumer electronics, whereas services’ gross margins at 64.5 per cent are twice as big and are on an upwards trend.

That said, the absolute gross profit from products still dominates the business and accounted for 68 per cent of gross profits in the year to March 2020. The outlook for this business is hard to be bullish about, with a couple of exceptions.

I buy into the optimism that growth from wearables – especially the potential the Apple Watch may have as a medical device – has some way to go, but that Mac computers and iPads look like mature and limited growth businesses. 

Which brings us back to the continued reliance on the iPhone. There’s almost constant chatter about what new mind-blowing feature the iPhone 12 will bring when it is released later this year, but the fact is that most of Apple’s recent iPhones have been evolutionary rather than revolutionary. Things like the camera, display and battery life have got better, but they have not been must-haves.

There’s a lot of talk that the new phone will have 5G capability that will lead people to upgrade, but the roll-out of 5G networks has been so slow – and 4G is arguably good enough for most people – that you don’t really need it right now.

People are keeping their smartphones for longer as they are good enough for what they need and have been moving away from mobile phone contracts to buying them outright, which has reduced the number of typical two-year upgrades. That said, there are probably plenty of iPhone 7 and 8 users who are thinking about a new phone right now.

But they might buy the recently launched iPhone SE – which starts selling at $399 (£419 in the UK) – instead of an iPhone 12 as it’s a pretty good upgrade.

It’s true that the iPhone SE is a cheaper and very good phone that could bring more people into Apple’s ecosystem, but it could cannibalise Apple’s smartphone business and lead to lower profits.

Having said this, I think the iPhone 12 will do quite well as there’s enough Apple fans, combined with a helpful point in the upgrade cycle, to make it so.

It’s therefore not unreasonable to think that the iPhone’s days as a major contributor to sustainable profits growth has gone and perhaps for good. The current spat between the US and China could see Apple moving its manufacturing out of China and incur higher costs and lower margins. The big unknown is how much a drag the iPhone will be on the growth from wearables and services. At the moment it is quite a big one.

The bull case is that Apple’s services business continues to grow rapidly as more people buy its subscription services. Apple Music is growing nicely and sales through the App store continue to grow. AppleCare is still making a healthy contribution to profits. I can see these trends continuing, but I think Apple TV+ is a dud and that News and Arcade will not be meaningful to growth.

It is disappointing that Apple missed the boat on developing a commercial cloud computing business as this could have been a significant source of incremental value as Amazon, Microsoft (US:MSFT) and lately Alphabet (US:GOOGL) have proved.

Services’ revenue is currently at an annual run rate of $50bn – doubling since 2016 – and could be a $60bn business in a couple of years’ time. With higher profitability there are reasonable grounds for arguing that the quality of profits is improving and is therefore more valuable. 

Apple’s installed user base of more than 1.5bn devices is a massive asset that is very loyal and can be milked for more income from services in the years ahead, but I’m not sure that this trend is going to have a big impact on Apple’s bottom line for a while. That said, I cannot see profits collapsing either.

No doubt the company will try to keep its EPS rising through more buybacks, but this is not high-quality growth that investors should pay up for in my opinion.

Apple is a superb business, but there remains a big cloud over its long-term growth prospects in my view. These concerns are not new and have not stopped its shares becoming more highly valued in recent years and delivering an 8 per cent return so far in 2020.

But I don’t think Apple shares are good value now. I think the company is stuck in a rut that will be hard to get out of.

At $315, the shares trade on 24.6 times its last 12 months’ EPS and offer a trailing 12-month free cash flow yield of 4.7 per cent. This makes it look cheap relative to its FAANG peers who have more secure growth stories and that feels about right to me.