Apple Inc. (AAPL, Financial) reported financial results for the second quarter of fiscal 2019 earlier this week. For the period, revenue declined 5% to $58 billion (-3% on a constant currency basis).
The company had another difficult quarter in China, where revenue declined 22% (following a 27% decline in the first quarter). Interestingly, management noted the iPad returned to growth in the region, which suggests the decline in iPhone sales was likely north of 25%. While the region accounts for less than 20% of Apple’s sales, it has flipped from a major contributor to growth over the past several years into a headwind for the company. For what it’s worth, CEO Tim Cook said on the call that the company feels “a lot better [on China] than [it] did 90 days ago.”
Globally, iPhone sales have declined by a mid-teen’s percentage in the quarter and year to date (despite the drop-off, the iPhone still accounted for roughly 60% of Apple’s sales in the first half of 2019). Based on management’s commentary on the call, it sounds like they’ve needed to pull back on prices in China to try and stoke demand (and it sounds like they’re going to start taking similar actions in India). That speaks to a competitive environment in these regions that seems much different than what Apple faces domestically (sales in the Americas increased by low single digits).
Weak product revenues were offset by continued services growth (up 16% in the quarter to $11.5 billion). The company now has 390 million paid subscriptions, an increase of 44% since last year (that compares to an active installed base of more than 1.4 billion devices). As noted on the call, management expects to reach half a billion paid subscriptions by next year.
In the first six months of 2019, operating income (EBIT) declined 13% to $36.8 billion, with net income down by a mid-single-digit percentage due to a lower tax rate. The share count declined by more than 7% (to 4,737 million shares), resulting in flat earnings per share year to date.
As I noted following the first-quarter results, there was a big question mark on capital allocation:
“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 quarter, with total capital returns (repurchases and dividends) barely crossing 50% of free cash flow… Based on commentary from Chief Financial Officer 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. 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)… This is far from a trivial concern for Apple investors.”
Well, the company didn’t disappoint: Apple stepped up to the plate and repurchased $23.7 billion worth of stock in the second quarter. Prior to this point, I think the company only paid lip service on getting to the net cash neutral position over time. After what we saw over the past 90 days, I think you can say it is ready to get moving.
But even then, it’s hard for the company to spend fast enough (a good problem to have). Year to date, cash from operations was $38 billion, with free cash flow of $32 billion. By comparison, the company spent just under $40 billion on repurchases and dividends. For the first six months of the year, it worked through less than $10 billion of net cash. To put that number in context, Apple still had roughly $113 billion in net cash. Even at the pace exhibited in the first half of 2019, getting to net cash neutral (“a more optimal capital structure”) will take a long time.
Conclusion
A significant part of the Apple investment thesis rides on capital returns. I think the company is likely to return more than $300 billion to shareholders through repurchases over the next five years. The problem is the effectiveness (and intelligence) of those repurchases declines as the stock price rises; $300 billion of repurchases at $150 per share would have a lot more impact on per-share results than a comparable amount of repurchases at $250 per share.
By my math, assuming share repurchases are completed over the coming years at a comparable multiple to where the stock currently trades, I think Apple can earn somewhere around $17 per share in five years. I’ll leave it to you to decide whether or not that’s compelling relative to the current stock price of $210 per share. I have no position in the stock, so that should give you a pretty clear sense of how I feel about the risk-reward at these levels.
Disclosure: None.
Read more here:
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
