AAPL is a services juggernaut- Q2 earnings report
Portfolio: How I interpreted their numbers and my plan going forward
I have held AAPL in my portfolio for many years and it is one of my favorite stocks. Their business performance and earnings reports are widely followed and written about. So I will not regurgitate what you can find elsewhere. I will try to offer my perspective on why the company is on track to become a services monster based on the flywheel effect that is fed by the growing use of its hardware products around the world (see more in the Market share section below).
Last week, Apple delighted markets with a less-concerning-than-expected Q2 earnings report. (By AAPL’s books, it was the Q3 report, however for consistency, I will refer to it as the Q2 report because it contained business results ending June 30th 2022). They set new revenue records, for all their segments during their historically weak Q2 quarter, in the US, Europe and the rest of the world. This was impressive in spite of macro headwinds, currency exchange impacts and the Ukraine-Russia war.
Here is what stood out to me in AAPL's Q2 earnings report: (refer to the AAPL financials map below)
Revenue - Q2 revenue came in at $83B (2% YoY & -15% QoQ). Excluding foreign exchange impacts, the growth was 5% YoY. They do not provide forward looking guidance, however these revenues were ahead of analyst expectations. Apple mentioned that the negative impacts of supply chain constraints were not as bad as they expected i.e. below the $4-8B revenue impact they had earlier predicted. Deferred revenues stayed flat at $7,728M (1% YoY & -2% QoQ).
Looking forward, CEO, Tim Cook, said that they expect to accelerate revenues in Q3 (inspite of foreign exchange headwinds due to the strong US $), while services revenues could experience a dip due to declining consumer sentiment.
Profitability - Gross margins overall are steady in the mid 40s. Products gross margin was 34.5%, down 1.9% QoQ and Services gross margin was 71.5%, down 1.1% QoQ. Both these drops were mainly due to seasonality and currency effects.
Operating margin overall dipped slightly to 28%. EBITDA margin stayed consistent in the 30s while net P/L dipped slightly to 23%. Even though they are trending lower, these margin numbers are healthy, especially in the light of…here it is again…macro headwinds, currency effects and seasonality.
Cashflow - Apple was able to maintain operating cash flow at 28% ($22,892M) and free cash flow at 25% ($20,790M). Both these cash flow metrics are on track to hit the $100B per year mark for the second year running. Just take a moment to appreciate that…a company that is generating $100B in free cash flow for two years now!
Market share - While the products segment declined by about -1% YoY, the services segment grew by 12% YoY.
Now here is where we need to truly understand where this company is heading and the immense market share it can still capture. This is important, so pay attention, please.
About 1B iPhones in use versus 3B Android phones.
About 500M iPads in use versus 1.3B tablets total.
More than 1.8B Apple devices in use
In the US:
About 115M iPhones in use, which represents only 47% of the US market.
53% of US adults (about 260M) use a tablet and only 44% of those own an iPad.
Apple has more than 860M paid subscriptions across their business lines, which is up from 160M from a year ago. That is 5x growth in 12 months.
The iPhone celebrated its 15th birthday this quarter and the iPhone13 is in year 2 of a typical 3-year upgrade cycle. In addition to the immense market opportunity as represented by the numbers above, we know that 5G penetration in several global markets (such as Latin America, Southeast Asia and Africa) is still low.
The M chip series has introduced blazing speed and power efficiency to the entire range of Apple products, especially Mac laptops and desktops. The new M2 chip in the latest Macs puts it in strong contention for wider enterprise usage, a huge target market for the company. This quarter, nearly half of Mac buyers were new to the product…aka…converts from the Windows family. This interesting statistic applies to new iPad buyers in Q2 as well and over 2/3rd of Apple Watch buyers who were new to the product.
Car Play is being used in 98% of cars in the US and more than 75% of car buyers are looking for autos that support Car Play. This Apple service will soon be able to customize the entire intra-car experience, with deeper integration into vehicle hardware, allowing drivers to control their music, change the temperature and monitor their fuel levels, all from a single integrated platform.
Apple TV+ has more than 25M paid subscribers and twice as many user accounts (includes free promotional users) that are ripe for upselling. Their content development is more focused (than Netflix) and seems to have a higher ROI. The latest partnerships with major league sports will continue to draw more eyeballs and subscribers.
Last but not the least, Apple customers have a 98% satisfaction rating with the company's products and services.
As I step back and digest these numbers above, it is clear to me that while the company is nowhere close to topping out on product sales in any market, it is now leveraging this growing user base to bring in more services revenue such as video and music streaming, auto services, payment services, app store services, commissions etc.
Services bring in about $80B per year at a 71.5% gross margin. In comparison, NFLX generates about $30B in annual subscription revenues at a 42% gross margin. COST generates about $4B in annual memberships and AMZN Prime brings in about $8B per year.
Debt and cash - Cash on hand, including marketable securities, is about $179B and debt totalled up to about $120B. Their debt to cash ratio is a healthy 0.67.
Institutional ownership - is staying flat in the 57-58% range over the past four quarters. For the last 14 quarters, Apple has been steadily decreasing the no. of diluted shares via its aggressive share buyback program. They have returned about $28B back to shareholders in Q2 via share buybacks and dividends.
So here is my plan regarding AAPL:
My conviction level in AAPL remains high. Repeating myself a bit here, it is clear that while the company is nowhere close to topping out on product sales in any market, it is now leveraging the growing user base to bring in more profitable services revenue. And it has a foothold in several secular tailwinds such as mobile, cloud, streaming, CTV, next gen automobiles and integrated payment systems.
AAPL scored a paltry 10 points in my scoring algorithm. This is not surprising because my method punishes slower growing stocks and Apple is no exception here.
Elevator pitch - Apple is the most admired brand in the world and their products are widely sought, inspite of higher prices. Phones, desktops, ipads, airpods, streaming TV, automobile software, app store etc....the list keeps growing. Each of these segments are large enough to compete as separate companies in their own right.
While the company has significant TAM that it can capture in mature product segments like phones, tablets and desktops, I am most excited about its services business lines like Car Play, Apple TV and payment systems which are steadily on a path to SaaS-like high margin, high cashflow run-rates.
Beachman’s plan - I currently have an 8.6% position in AAPL and I plan to keep it as is. If the stock prices comes down to anywhere in the $130s and below, I will likely buy more.
Morningstar rates the stock at a fair market value of $130. From a gross margin and profits standpoint, AAPL seems to be undervalued. However taking the forward growth rate into consideration, this stock remains "expensive".
AAPL does not give us many opportunities to buy in at a lower valuation. One has to be ready to just bite the bullet and buy when needed.