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The Science of Hitting
The Science of Hitting
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Apple: Improving Results, but at a Higher Price

A look at the company's fiscal 2019 financial results.

November 01, 2019 | About:

Apple Inc. (NASDAQ:AAPL) recently reported financial results for the fourth quarter of fiscal 2019.

Revenues for the quarter were up 2%, with diluted earnings per share up 4%. For the year, revenues declined 2% to $260 billion, with operating income and net income down 10% and 7%, respectively.

Notably, the company continued to see a material improvement in its Greater China business, with revenues down 2% in the fourth quarter (and up slightly on a constant currency basis) compared to a more than 20% decline in the first half of the year. Around the rest of the world, sales growth ranged from a low single-digit decline (Europe and Japan) to a low single-digit increase (rest of Asia Pacific and the Americas). For some perspective, it helps to look at the long-term results in these regions, which provides some context on the short-term changes in trajectory that we see at times.

Trends improved throughout the year for the company’s most important product as well: iPhone revenues were down only 9% in the fourth quarter compared to a 16% decline in the first half of the year (collectively down 14% in 2019). Again, I think it helps to zoom out and look at how the business has performed over the past few years (with a trailing five-year revenue compounded annual growth rate of 7% as well).

The iPhone was Apple’s only product category that shrunk in 2019, offset by growth in iPad (up 8%), Mac (up 10%) and Services / Other (up 24%), which includes wearables like the Apple Watch, AirPods and Beats products. Collectively, the non-iPhone portion of Apple’s business increased by 17% for the year to $118 billion. Over the past five years, the company's non-iPhone revenues have increased at a high single-digit compounded annual growth rate.

As CEO Tim Cook noted on the conference call, Services continues to be a bright spot:

"Services revenue in the quarter was $12.5 billion, up 18% over last year… This isn't a local phenomenon. We saw double-digit services revenue growth and all-time records in all five of our geographic segments. And it wasn't a narrow success either. We established new all-time highs for multiple services categories including the App Store, AppleCare, Music, cloud services and our App Store search ad business. We are well on our way to accomplishing our goal of doubling our fiscal 2016 Services revenue [$24.4 billion] during 2020."

The active installed base of Apple devices reached another new all-time high in the quarter, with year-over-year gains in each region and product category. The company now has more than 450 million paid subscriptions, an increase of roughly 15% over the past six months.

Despite higher revenues, outsized growth in expenses and mix shift away from high margin iPhone and Greater China sales led to a 10% decline in operating income for the year. As shown below, while Apple’s revenues have increased by 500% over the past decade, the company’s annual research and development expense has climbed 10-fold over the same period (resulting in research and development as a percentage of sales doubling to more than 6%).

In 2019, cash flows from operations was $69.4 billion (down 10%), with free cash flow of $58.9 billion (down 8%). During the year, Apple spent $66.9 billion on share repurchases and $14.1 billion on dividends. The per share results benefited from repurchases (share count down 7% to 4,649 million shares), with diluted earnings roughly flat for the year at $11.9 per share. As shown below, the company’s share count has now fallen by nearly 25% over the past five years.

Apple currently has $98 billion in net cash, or $21 per share. As Chief Financial Officer Luca Maestri noted on the conference call, the company is still on track to reach net cash neutral “over time.” Considering that the net cash balance declined by roughly $25 billion over the course of the year, it looks like the company is well on its way to reaching that target in the next few years.

Conclusion

As I’ve noted in the past, a material component of the Apple investment thesis relies on the effectiveness of capital returns. It will likely spend something like $300 billion on repurchases over the next few years. The problem, in my eyes, is that the efficacy of those repurchases will depend on what the stock price does over that period. Personally, I felt a lot more confident saying this was the right move six to 12 months ago when the stock was at $150 to $175 per share than I am today after a run in the stock price of roughly 50%.

At this point, the stock is a bit rich for my blood. While I appreciate the company's strategic shift to non-iPhone areas like Services (lifetime value as opposed to single a device purchase) and Wearables, I still question what impact this will all have on profitability. 2019 is a good example why I have some doubts: while there were a lot of positives during the year, including growth in the installed base and mid-teens revenue growth in services, operating income still declined 10%. I can live with those concerns at the right price. But when I try to conservatively model results for the next few years, I struggle to get to $250 per share.

And the fact remains that the recent run-up in the stock price is actually a negative for long-term shareholders. They should hope to see the shares trade down again. It will be much better for the long-term, per-share earnings power of the business if Apple trades at $150 to $200 per share over the next few years as opposed to $250 to $300 per share (this assumes that Apple continues to commit a significant percentage of its free cash flow to share repurchases). The dollars currently being allocated in that manner are not going to go nearly as far for the long-term owners of this business as they did just a few quarters ago.

Disclosure: None.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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