I Know First Research Team

-Read this article and you will understand why there is no need to be concerned about Q1 2019 iPhone sales being lower than Q1 2018, and a possible continuation of this with today’s Q2 results

-There is a great buying opportunity for AAPL shares as the market is too focused on iPhone sales unit numbers, and APPL is trading at a cheaper P/E than the average on the S&P 500

-Besides dividend growth, EPS growth will come from the higher margin services business

-EPS growth will also come from the continuing monster-buyback-program

-I Know First Algorithm APPL Stock Forecast is currently bullish on AAPL

Apple’s stock did not hit a low on 24^th Dec 2018 as did many other stocks in the S&P 500 universe. In fact it bottomed on 3^rd January 2019 at $142 when the company warned the market that revenue in fiscal Q1 would be 10% lower than original forecasts, meaning a decline of 5% of overall revenue from a year ago. Apple blamed lower than anticipated iPhone revenue, primarily in greater China. Since then the stock has staged a recovery up to $208, around 10% short of the all-time high of $232 the stock hit on 3 October 2018.

Services

The services side of Apple, as distinct from hardware sales that include Iphone and Ipad, refers to AppStore sales, ApplePay, AppleCare, AppleMusic, iCloud, AppleTv and the recently announced Apple Arcade. 

Over the past seven years hardware sales are up approx. 50%, but services sales up 100%.  Still this is off a low base as hardware sales still represent almost four times as much as software sales. In Q4 2018 services made up 16% of revenue compared to 10% in Q4 2015.  Growth is still very strong with services revenue in Q1 2019 28% higher than a year prior, and on track to double the 2016 figure by 2020. This is great news as the services (essentially software) business has naturally better economics for shareholders than the devices (hardware) business – costs are more fixed in nature as revenue increases with more paying subscribers .

Already benefiting from music streaming’s growth with AppleMusic, further growth can be expected from AppleTV and Apple Arcade.  Apple’s installed user base of almost 1.4 billion devices has allowed it to attract top talent for collaboration to produce AppleTV’s own content, including Steven Spielberg, Oprah Winfrey, M. Night Shyamalan, and many others. As a comparison, leading streaming service Netflix’s user count was last reported at 137m. Collaboration with this calibre of creative talent will hopefully improve prospects for AppleTV to convince users to subscribe to its service – in addition to, or in place of their existing subscriptions with incumbent streaming content providers, such as Netflix.

Apple’s services business growth is not constrained by the size of its installed hardware user base.  For example, AppleTV is unlocked from Apple devices, so if someone has for example a Samsung TV, they can still pay for and watch AppleTV. AppleTV content will be available in 100 countries from May this year compared to 10 countries for the current app. Streaming services already exceed cable in the US and if Netflix’s growth is anything to go by, AppleTV’s own-content streaming service that launches later this year could be a boon for services revenues.

As per the below chart, the gaming market is well-entrenched, but globally it is still growing at more than 10% annually with over 2.3bn games worldwide [source: newzoo] and mobile gaming comprises around 50% of the market.  Apple is looking to tap into this growth of mobile games with the recently announced Apple Arcade.

Aside from adding new service lines, with so many users within the Apple ecosystem, the company now has the opportunity to further monetize and improve more existing services. For example the Apple Search Ad business that sells ads that appear in the Appstore is on track to quadruple revenue to $2bn by next year, compared to $500m in 2018.  Another example is the recent introduction of the Apple Card in partnership with Goldman Sachs and Mastercard, which allows Apple to further increase its revenue take from Apple-pay transactions.  Mobile payments has a lot of runway ahead, particularly in North America, Europe and the Middle East & Africa, where it is under-penetrated at under a third of internet users using mobile payment in the fourth quarter of 2018 – compared to almost 50% in Asia Pacific.

Concerns here and there have been voiced in relation to the resilience of some of the services revenue. In the gaming space, Apple is proposing a subscription model rather than the well-established and successful free-to-play-with-in-game-transactions model. In the Appstore , some leading Apps such as Netflix have elected to bypass the Appstore entirely and save the commission that Apple takes for in-store purchases. But overall the services business is well-diversified and broad enough so that Apple can weather these concerns.

The diversification in the services businesses is still underpinned by the size of the user base in the Apple eco-system.  Despite the China woes, Apple is retaining customers and expanding its user base. 16% of new iPhone units went to Android switchers in November 2018, which is up from the 11% mark in November 2017. [source: Consumer Intelligence Research Partners (CIRP)]. The price-it-higher strategy that Apple has been implementing for the latest iPhones, combined with the arguably less dramatic improvements in technology as each handset is released (this applies to Apple’s handset competitors as well) also means that the replacement cycle is lengthening and switching out of the iOS is less likely. These forces are good for the user base to retain size ahead of the 2020s when the next replacement cycle is likely for widespread adoption of 5G devices.

Buybacks

Overall forecast 2019 revenue growth is 4%, in line with the S&P 500 for 2019. This seems like a safe assumption given the services revenue growth opportunities emanating from the user base of almost 1.4 billion devices. Services made up only 16% of revenue in Q4 2018 so Apple’s raising of prices on its latest Iphones will also assist in offsetting slowing iPhone unit volume sales, particularly in China. Continued growth in Mac unit sales also assists. Apple’s strategy of pricing the newest phones higher and targeting a less price-sensitive consumer means that all things being equal, any tariffs imposed on the phone should have less impact at the margin. 

The growth in services revenue, and consequent higher margins than hardware due to a more fixed cost base, will mean 4% revenue growth should translate to 6-7% earnings growth from operations. This seems conservative given that earnings growth from operations has averaged around 10% over the last ten years when lower margin hardware made up a greater proportion of total revenues.  An additional approximately 6% of earnings growth has been realised each year since 2012 due to buybacks, and it is reasonable to expect buybacks to continue with Apple’s recurring and resilient cash flows, and management’s stated intention to maximise capital efficiency and reduce net cash to zero.   

AAPL completed its multi-year $210bn share buy-back program earlier than scheduled in June 2018, which reduced the share count by over 25%. Since then it is on track to repurchase an additional $100bn which represents more than 10% of the shares outstanding. In addition AAPL is continuing its policy of paying out 25% of after-tax earnings in dividends which amounts to just under US$15bn per year. Aside from the extra yield for existing shareholders, this expands the potential buyers universe to dividend seekers as well.

In FY2019 Apple generated US$62bn of free cash flow on twelve-month revenue of $265bn in 2018, and boasts approximately USD$245bn in cash and cash equivalents. Some buybacks and dividends are being financed by bond sales. Since the buyback program commenced in 2012, debt has increased from zero to around USD$140bn today. This is a sensible move for a company like Apple, just about the largest in the world with just about the most valuable brand in the world – debt can be financed cheaply at a 2% post-tax cost. A pittance compared to Apple’s return on equity and assets thanks to its fantastic operating and net margins – and the icing on the cake is that this is predominantly still a hardware business that has yet to transition to be more reliant on higher margin services/software.

As evidenced by its balance sheet, Apple is a well-oiled cash-machine generating a free cash flow yield of over 23%. Its forward P/E of 17.86 is modest compared to the S&P 500’s current 22. Buybacks are a problem if one overpays to reduce the share count, but throughout the buyback program – since 2012 –  Apple has never purchased its shares when the P/E has exceeded 18.1. Apple is not only cheap on a comparable P/E basis – a DFC valuation today values the shares at around $320 on an earnings basis, and $360 on a FCF basis.

Final thoughts

Apple will no longer report unit sales for iPhones, iPads, and Macs in future reports as Apple contends that device sales are “not representative of the underlying strength of our business.” [source: Apple CFO Luca Maestri at Q4 2018 Results Announcement]

Indeed the business is successfully slowly but steadily transitioning to higher margin services, thanks to its already-installed user base of over 1.4bn. Combined with continued buybacks financed by the company’s ongoing massive free cash flow generation and existing balance sheet, whilst Apple is no longer disrupting and spawning entire new industries with totally new product releases like the iPod, iPhone, and iPad, it is still a cash-generating machine with market-beating earnings-per-share prospects and therefore a current valuation that is relatively modest. 

My bullish endorsement for Apple is backed by the positive algorithmic forecasts from I Know First. The 1 month, 3-month and 12-month algorithmic forecasts for AAPL are all positive. The underlying future trend is that this stock is likely to go up in price.

Past I Know First success with AAPL

I Know First has been bullish on Apple’s shares in past forecasts. Around the time Warren Buffett initiated his position in Apple that would become his largest security holding, on May 22, 2016, the I Know First algorithm issued a bullish 1 year forecast for AAPL with a signal of 204.78 and a predictability of 0.72. The algorithm successfully forecast the movement of the AAPL share.  Over the next twelve months, AAPL shares rose by 58.73% in line with the I Know First algorithm’s forecast.