Apple Inc. (AAPL) reported first quarter results for fiscal 2019 after the close on Tuesday.
For the quarter, revenues declined 5% to $84.3 billion (on a constant currency basis, revenues were down 3%). The weak results were in line with the updated guidance management provided in early January. The revenue decline was primarily attributable to Greater China (down 27% year-over-year to $13.2 billion) and the iPhone business (down 15% year-over-year to $52.0 billion).
Outside of the iPhone, the company reported solid results, with revenues for Mac, iPad, Services and Other (Wearables, Home and Accessories) up 9%, 17%, 19% and 33%, respectively.
Despite the difficult quarter (and forward guidance that calls for a comparable mid-single digit decline in revenues in the second quarter), the company continues to attract new users. At the end of the quarter, the active installed base for Apple exceeded 1.4 billion devices, a mid-single digit increase from a year ago. In addition, the iPhone active installed base increased 9% to more than 900 million devices.
As we all know, a big question as it relates to an investment in Apple is how the company will spend its prodigious free cash flow (it generated $64 billion in free cash flow in fiscal 2018), as well as its plan for the $130 billion in net cash currently sitting on the balance sheet.
The impact of large share repurchases in recent periods was evident in the first quarter results, with the diluted share count declining by 7.5% year-over-year. However, the pace of repurchases was materially slowed in the first quarter, with total spend of $8.8 billion compared to $19.1 billion last quarter. To put that number in context, repurchases accounted for less than 40% of free cash flow in the first quarter, with total capital returns (repurchases and dividends) barely crossing 50% of free cash flow. Said differently, the pace of spend in the quarter wasn’t nearly fast enough to consume the cash generated in the last three months – let alone to start chipping away at the $130 billion in net cash.
In addition, based on commentary from CFO Luca Maestri, it’s clear that almost all the buying was completed in the first month of the quarter (October), with little to no activity in November or December. Amazingly, in a period where the stock price was around $190 per share, the average price per share for the company’s repurchase activity was around $216 per share. Clearly this is not the outcome shareholders are hoping for. Analysts inquired about the future plan for repurchases on the conference call, but management did not say anything meaningful.
The most plausible explanation for this result is that management had a sense that the quarter was going to be a tough and didn’t want to spend significant amounts of money just prior to a material decline in the stock price. In addition, given the timing of the guidance revision (after quarter end), their hands were somewhat tied.
Now, with that said, my theory assumes that management will step up and engage in significant repurchases in the coming quarter (assuming the stock does not run higher). And to be clear, I mean something north of what they spent in the fourth quarter of fiscal 2018 ($19.1 billion), not a slight increase from the $8.8 billion spent over the past 90 days. If this doesn’t happen, shareholders need to start wondering if management is truly committed to bringing the balance sheet to a “net cash neutral position over time” (at least a reasonable period of time). Given what we saw this quarter, shareholders also need to start wondering if those repurchases will be completed at prices that add value. This is far from a trivial concern for Apple investors.
Here’s some math to help quantify the importance of share repurchases. Assuming the company gets to net zero cash over five years and generates around $60 billion a year in free cash flow (compared to the $64 billion generated in fiscal 2018), there is $430 billion available for capital returns. Dividends over that period (assuming the payout ratio climbs to 40%) will be roughly $90 billion.
That leaves $340 billion, or nearly $70 billion a year, for share repurchases. To put that in context, the market cap with the stock at $162 per share is $770 billion. The annual repurchase spend over five years would be equal to about 9% of the market cap every year – and even in that scenario, I would argue that the company will be left with an insanely conservative balance sheet.
That’s a long way of saying that there is a strong case for the stock at these levels if you believe that current results are sustainable and if you believe management will not continue to hoard huge piles of cash on the balance sheet for no reason (given the company’s history and the public comments of management, it seems unlikely that it will engage in a huge acquisition).
There is one other important element, which relates to this quote from CEO Tim Cook:
“We are as confident as ever in the fundamental strength of our business and we have a very strong pipeline of products and services with some exciting announcements coming later this year. Apple innovates like no other company on earth and we are not taking our foot off the gas. We'll continue to invest through near-term headwinds just as we always have and we'll emerge stronger as a result.”
Apple is definitely investing in the future. Consider the company’s $3.9 billion in research and development expense in the first quarter, which was up 15% year-over-year. That was equal to 4.6% of revenues, or roughly 200 basis points higher than the company’s R&D spend as a percentage of sales five years ago (fiscal 2013). If the first quarter growth rate holds for the remainder of the year, it will spend $16.3 billion on R&D in fiscal 2019, compared to $6.0 billion five years ago (fiscal 2014).
Now, I admit that it’s hard for me to get a sense of how effectively these funds are being spent, so I don’t know how much credit to give the company for the future value of these investments. With that said, I think it is safe to assume that a material percentage of this spend is equivalent to “growth” R&D as opposed to maintenance spend. It’s just one example of how GAAP accounting may not be appropriately capturing the long-term economic reality of the business (again, we will have to wait and see the fruits of this spend).
Conclusion
It is impossibly of course to know what will happen in any given quarter or year, but one can make a fairly compelling case for Apple shares at current levels. That is even more accurate if we see management step up and complete meaningful share repurchases in the second quarter. The company’s large and growing user base points to the strength of its ecosystem.
In addition, Apple is finding additional ways to monetize user activity (as noted on the call, the company now has 360 million paid subscribers across the services portfolio – a 50% year-over-year increase). I don’t own the stock at this time, but I can definitely see the merits for doing so. For the first time, I am seriously considering an investment in Apple.
Disclosure: None.
