Sunday, July 17, 2016

Apple: Three Items To Watch

I’ve been tracking the performance of Apple for nearly twenty five years and chronicling the twists, turns, successes and changes at the company for most of that time. Over the past several months I’ve taken time to look at the company in several different ways and today I will mention three items I consider important for long-term shareholders of the company. These items are the share repurchase program, Apple’s rising R&D expenses and the growth in the company’s Services revenue segment. 

I consider these three items important as Apple faces yet another period of change and eventual transformation. The pace of iPhone units sales growth has slowed and the company faces challenges in all three of its major device lines. Yet for long-term shareholders there’s more to Apple than this fiscal year’s performance. I will explain more in this article.

Today’s coverage of Apple in the financial and popular press frequently mentions speculation about the upcoming iPhone refresh, rumors about changes in the iPhone’s form expected in the fall of 2017 and the decline in iPhone unit sales compared to last fiscal year’s nearly 37% unit sales growth rate. But there’s much more to Apple than the iPhone franchise and while unit sales will always be in flux, the three items I’m mentioning today demonstrate a trend that may lead to higher shareholder value over the next several years. 

Apple’s Share Repurchase Program
The graph below illustrates the impact of Apple’s massive share repurchase program on the fully diluted share count as reported each quarter. Since reaching a peak of 6.637 billion shares on a split-adjust basis in the September quarter of FY2012, management has reduced the fully diluted share count as of the end of the March quarter to about 5.541 billion shares or by about 16.50% in under four years. 

As of the end of the March quarter Apple had exhausted $117 billion of the $175 billion in authorized share repurchases. The remaining $58 billion in authorized repurchases are scheduled to be completed by the end of March 2018. Notwithstanding the debt acquired to fund the massive share repurchase program, Apple’s cash position remains the envy of much of corporate America. Net of debt the company’s cash and equivalents position stood at nearly $164 billion at the end of the March quarter. 

For long-term shareholders the reduction in the fully diluted share count boosts the company's reported earnings per share due to the fact there are fewer shares by which reported net income is divided to determine the eps results. It’s my view net income growth is the primary driver of Apple’s share price appreciation. In periods of rising net income, the share repurchase program will amplify the impact of rising net income on the earnings per share results. In addition to a beneficial impact on earnings per share results, the fewer number of shares may mean a larger dividend per share in the years ahead.
Apple’s R&D Expenses
The graph below illustrates Apple’s rising R&D expenses and those expenses as a percentage of reported net sales. Not only has the rate of increase in R&D expenses been fairly consistent over the past several quarters, the percentage of net sales dedicated to R&D expenses has gradually been on the rise. For example, in the recent March quarter R&D expenses rose to about 5% of reported net sales.
There’s rampant speculation Apple is working on a car project of some kind and the company’s recent investment of $1 billion in Didi Chuxing, a Chinese ride-hailing service, has only heightened the level of speculation. Nonetheless, the company continues to invest heavily in the ongoing development of its major product lines and services. Rising R&D expenses portend the release of upgrades to the company’s current product lines as well as continued development of new and existing services.

Apple’s Rising Services Revenue
The graph below illustrates the rise in revenue of Apple’s Services revenue segment. In this graph I have also included the revenue performance of the company’s Other Products revenue segment.
Although in the fiscal year ending in September Apple will report year-over-year declines in unit sales in all three of the company’s major device lines, the Services revenue segment is currently delivering double-digit revenue growth year-over-year. This double-digit revenue growth rate over the past few quarters has occurred in part from the release of the Apple Music subscription service. In the December quarter Services revenue surpassed $6 billion and came very close to that threshold of revenue activity in the recent March quarter. I view Apple’s Services revenue segment as a proxy of sorts for the growth in consumer participation in the company’s expansive eco-system of devices, apps, content and services.

The graph also highlights the changes in Apple’s Other Products revenue segment as the revenue from iPod sales has greatly diminished and new products such as the Apple Watch and products acquired in the Beats acquisition generate revenue. A new version of the company’s Apple TV product has also been released to the marketplace. 

Reflecting on Apple’s Challenges
In the fiscal year ending in late September, Apple will report negative iPhone unit sales growth for the first time in the product line’s history. The Mac line may experience negative unit sales growth in all four quarters of the fiscal year and the iPad line continues to see a diminishment in revenue performance for the third consecutive fiscal year. 

Apple products are built to last and generate high levels of customer satisfaction. In my view, consumers choose Apple products particularly when the products are perceived to deliver innovative uses for the consumer and provide conspicuous enhancements to the user’s digital lifestyle. The larger-screen iPhones that debuted last fiscal year generated high consumer interest and the company was rewarded with fast unit sales growth in its most popular product line. This fiscal year unit sales have fallen on a year-over-year basis. But unit sales in this year of the iPhone 6s are on track to surpass unit sales in the year of the iPhone 5s by more than 20%.

Apple’s unit sales for the iPhone are highly cyclical and unit sales are best compared over two-year periods not necessarily year-over-year. Without new geographies to enter and with most of the world’s major cellular services providers already working with Apple, a slowdown in the pace of iPhone unit sales is to be expected. I will cover this topic in more detail in a future article. 

Moving Forward…
In my view, the primary driver of Apple’s share price appreciation is and will remain the pace of net income growth. In the absence of net income growth this fiscal year I believe it’s important to take a long-term view of the company’s prospects and consider factors that are currently in play that support the interests of long-term shareholders and will add value as net income growth returns next fiscal year. These include the ongoing share repurchase program, rising levels of R&D and the emergence of Services revenue as an important component of the company’s future growth story.

Robert Paul Leitao
Disclosure: The author is long Apple shares