Published on May 6th, 2019 by Jonathan Weber
Apple Inc. (AAPL) is one of the largest companies in the world in terms of market capitalization. The consumer electronics focused company has produced outsized returns for investors in the past, through a combination of strong earnings growth rates and huge cash returns.
Due to its large size, Apple’s growth has slowed down over the last couple of years. Still, Apple is the largest publicly-traded company in the world by market cap, and is the largest component of the Dow Jones Industrial Average. You can see the entire list of Dow 30 stocks here.
Apple could still produce solid total returns going forward, as the company still has some avenues for growth, with its services business being the most important one. Shareholder returns, which are heavily weighted towards share repurchases, will also play a major role.
However, due to the fact that Apple’s shares trade significantly above our fair value estimate right now, we nevertheless do not rate the stock a buy right now.
Overview & Recent Events
Apple is a consumer electronics focused technology company that started out by developing and selling the world’s first personal computers. Apple has expanded its product portfolio immensely over the last decade. The company currently offers smartphones, tablets, personal computers, wearable tech, and more.
On top of that, Apple has built out a large services franchise, which includes the App Store, iTunes, Apple Music, Apple Pay, and many more. Apple also owns and operates a global network of retail stores where it sells its products directly, on top of offering them online and through a vast amount of retailers.
With a market capitalization of $991 billion, Apple is currently the largest publicly traded company in the world, just ahead of Microsoft (MSFT). Apple was first to break the $1 trillion market capitalization level.
During the last couple of weeks, there were 2 significant events for Apple. The first one was the announcement of a settlement with Qualcomm (QCOM), regarding the legal dispute that the two companies had been fighting for roughly two years.
This legal dispute started when Apple accused Qualcomm of demanding excessively high license fees, while Qualcomm accused Apple of infringing on its patents. There had not been a lot of movement regarding this dispute over the last two years, but in mid-April, the two companies announced that they had agreed on a settlement.
Source: Qualcomm presentation
Apple and Qualcomm agreed to a 6-year license deal with a 2-year option on top of that. According to the settlement, Apple will pay royalties to Qualcomm, and Apple will also make a one-time payment to Qualcomm to balance out the fact that it had not been paying the royalties that Qualcomm had demanded over the last two years.
The most important fact is that all litigation between the two companies will be dropped, which means that both companies will save a lot of money on legal expenses, while this also does take out some uncertainties for both stocks.
The other major news item was Apple’s second-quarter earnings report, which featured a double-beat on the top and the bottom line. Apple generated revenue of $58 billion during the quarter, a decrease of 5% from the same quarter a year ago, but still ahead of the analyst consensus. Apple generated earnings-per-share of $2.46 during the quarter, beating the consensus estimate by $0.10. Apple’s earnings-per-share were down 10% from the previous year’s quarter.
Apple’s second fiscal quarter was not as strong as the year-ago quarter, but Apple still performed substantially better than what the analyst community and the market had feared. Among Apple’s various business segments, iPhone revenues, iPad revenues, Services revenues, and Wearables revenues all beat estimates, with Apple’s Mac business being the only unit that performed worse than expected. Apple achieved a 16% revenue growth rate in its Services segment, which allowed for a new all-time revenue record for this unit.
During the second quarter earnings release, Apple also announced that it would raise its dividend by $0.04, or 5.5%, to $0.77 per share per quarter.
The combination of the consensus beat, the strong Services performance, and the dividend increase made the market react very positively to Apple’s results, which has resulted in a 5% share price gain on the day following the release.
Growth Outlook
Over the last decade, Apple achieved an outstanding earnings-per-share growth rate of 33% per year on average. This high of a growth rate is not likely to be replicated going forward, as the factors that led to Apple’s outsized growth in that time frame have subsided. During this decade, many consumers bought their first ever smartphone and their first ever tablet, which means that Apple has been selling to a fast-growing market, which allowed for such high earnings growth rates.
Right now most consumers already have smartphones, which means that the market is not growing (at least in richer countries). Apple still can sell a large number of smartphones, but mostly as a replacement for older smartphones, meaning the number of iPhones sold will not grow at a high rate.
Apple’s major smartphone competitor Samsung (SSNLF) forecasts that the total amount of smartphone sales will rise by 19% between 2018 and 2022. A large amount of these additional smartphone sales will come from emerging markets, which could pose a challenge to Apple, as it only holds a very small market share in markets such as India. Apple’s high-priced phones are too expensive for many consumers in these countries.
Apple nevertheless should be able to benefit from rising smartphone demand to some degree, which is why we believe that the hardware business can continue to grow, although the long-term revenue growth rate will likely only be in the low single digits.
Apple’s Services segment has more room for growth, as Apple can easily monetize its large installed base (1.4 billion active devices) by rolling out new features regularly. This has happened with the introduction of Apple Pay and Apple Music a couple of years ago, and at the same time services that have existed for a longer period of time continue to grow as well due to the rising amount of consumers that use Apple’s products.
Services revenues have not only been growing at a strong pace (mid-teens or higher for several years), they are also high-margin revenues, as there are no production costs or similar expenses. With its App Store, for example, Apple just takes a cut from every sale that any app developer makes, without having to spend significantly for these revenues.
Overall, even when we factor in the above-average growth rates from Apple’s Services segment, the company will likely still not be able to repeat its growth rate of previous decades. Earnings growth is likely to be more modest going forward, due to the fact that maintaining high growth rates once a certain size has been reached becomes increasingly difficult.
Impressive Cash Returns
Apple could see a growth slowdown moving forward, particularly if an economic downturn occurs. The company could nevertheless achieve a compelling earnings-per-share growth rate, though, as long as it keeps lowering its share count through share buybacks.
Over the last five years, Apple bought back roughly one-fourth of its stock, which equates to an annual repurchase pace of 5.2% of its share count. This led to an annual increase of 5.5% to Apple’s earnings-per-share growth rate, and was thus a major component for Apple’s earnings growth during that time frame.
Apple can afford to repurchase such a large amount of its stock, because the company is highly profitable and generates massive free cash flow. Apple generated free cash flow of $62 billion over the last year, which equates to a free cash flow yield of slightly more than 6%. This is a strong shareholder yield, which allows for a high level of buybacks and/or dividends.
Since Apple’s dividend yields 1.5% right now, Apple could thus reliably buy back 4%-5% of its shares annually, at its present rate of free cash flow. With share repurchases providing a mid-single-digit tailwind to Apple’s earnings-per-share growth, not a lot of underlying business growth is necessary for Apple to achieve a high-single-digits earnings-per-share growth rate. Therefore, we believe that a long-term earnings-per-share growth rate of 8% is very achievable, with buybacks likely being responsible for a large amount of that growth.
As mentioned above, Apple’s dividend yields roughly 1.5%. This is not overly attractive relative to the broad market’s yield (1.9%), nor versus the dividend yields that some other tech stocks. Apple’s dividend growth rate slowed to 5.5% in 2019, a slowdown from previous year’s dividend increases. Combined with its low current yield, this is why Apple is not a very attractive stock for income investors right now.
Valuation & Expected Returns
Even though Apple is not highly appealing for high-yield income investors, due to its low current dividend yield, the stock could still produce positive total returns going forward. Share price gains are dependent on two factors: earnings-per-share growth, and changes in the stock valuation.
Apple could reasonably grow its earnings-per-share at a relatively attractive pace of ~8% a year going forward, but valuation changes will, in all likelihood, not be a tailwind going forward.
With Apple’s shares trading at $211 right now, the company is valued at 17.7x our estimate for this year’s earnings-per-share ($11.95). This is not an extremely high valuation in absolute terms, but it still represents a large premium relative to how Apple’s shares were valued in the past.
Apple stock has held an earnings multiple of 12 to 19 throughout the last decade, and we believe that shares would be fairly valued at a 15x earnings multiple, which is roughly in line with the long-term median price to earnings ratio. If Apple’s valuation would decline to a P/E ratio of 15 over the next five years, this would result in an annual headwind of ~3% to the company’s share price gains, and thus also to Apple’s total returns.
As a result, Apple would produce annual total returns of roughly 6.5% over the coming five years, consisting of an 8% earnings-per-share growth rate, a dividend that yields 1.5%, and a negative impact of 3% annually from multiple contraction. While a 6%-7% annual total return is not a bad result at all, we believe that this is not an outlook that is strong enough to justify a buy recommendation at this time.
Using a 15x target price to earnings multiple, Apple’s stock would be fairly valued at $180. From that level, Apple’s shares would produce total returns of close to 10% a year, consisting of an 8% earnings-per-share growth rate and a higher initial dividend yield of 1.7%. We would deem such a total return outlook attractive, which is why we believe that Apple’s shares are a buy at $180 and below.
You can see a video further detailing our expected returns for Apple stock below:
Final Thoughts
Apple is a fundamentally strong company that has an excellent balance sheet and a management team that has been very adept at innovating new products to keep the company growing.
On top of that, Apple has one of the most attractive shareholder return programs of any company. The company recently announced a dividend increase, and simultaneously expanded its share repurchase authorization by another $75 billion.
Apple should be able to grow its earnings-per-share at a high-single-digit rate going forward, but that alone is not a reason to buy the company’s stock. We believe that shares are trading above fair value right here, which is why we only rate the stock a hold for now. We would rate Apple a buy on a valuation basis at a fair value price of $180 or below.
