Apple: Blowout Quarter, Still Overvalued (NASDAQ:AAPL)
Blowout Quarter
Apple’s (NASDAQ:AAPL) F3Q earnings report was one of the strongest reports I have seen from Apple ever, period. Admittedly, it’s hard to still be fundamentally bearish on the stock after this blowout. Let’s just quickly go over the numbers before we look at the announcements in the quarter.
- Revenue: $59.69 billion vs. $52.56 billion expected (13% BEAT)
- EPS: $2.58 vs. $2.07 expected (25% BEAT)
- iPhone Revenue: $26.42 billion vs. $22 billion expected (20% BEAT)
- iPad Revenue: $6.6 billion vs. $4.8 billion expected (37% BEAT)
- Mac Revenue: $7.1 billion vs. $6.03 billion expected (18% BEAT)
- Wearables & Other Revenue: $6.5 billion vs. $5.99 billion expected (8% BEAT)
- Services Revenue: $13.2 billion vs. $13.13 billion expected (0.5% BEAT)
Apple delivered an across-the-board beat. While they didn’t provide guidance for F4Q (Calendar 3Q), this quarter alone was enough of a blowout to drive the stock despite the lack of guidance.
The most interesting facet of this print was the iPhone. They delivered a staggering 20% beat relative to expectations. As management noted, the primary driver for this strength was strength in iPhone SE sales as well as a strong iPhone 11 backdrop. Apple has done what I thought would be almost impossible, selling a more mainstream smartphone at the same margin profile, with lower pricing to drive revenue. The growth of the iPhone SE in the lockdown era has been extremely surprising (at least to me) in terms of Apple’s brand power. I knew that Apple’s brand was resilient and strong. I was not expecting people to spend $399 on a new iPhone in the midst of a global recession. Honestly, the success of the iPhone in the quarter is merely a testament to Apple’s brand.
iPad and Mac likely benefitted from the work-from-home economy. Increasing corporate IT budgets relating to buying WFH supplies (i.e. computers and tablets) led to strength in the overall market for tablets and computers. A rising tide lifts all boats, including Apple’s evidently, even though their products are higher priced and operate in the Mac OS environment while enterprises are generally Windows-reliant. With all this being said, Mac and iPad were extremely strong this quarter.
Wearables was interesting. Going into the COVID-19 pandemic, I predicted demand surrounding AirPods would fall, while demand around Apple Watch would increase, offsetting the weakness in AirPods resulting in a net positive for the segment. This seems to have played out, as health-conscious consumers likely purchased the Apple Watch (which has many great health tracking features) as fear surrounding the coronavirus spread. This demand trend was likely reflected in the results.
The most bland part of the quarter, ironically enough, was the services segment. Despite consumers spending more time at home, and more time on their Apple devices, it didn’t seem to translate to as much of a beat as the other segments. This was interesting, as normally, Apple’s hardware business lags, while software outperforms. This isn’t to say however that services were weak in the quarter. Quite the contrary actually. The only point I have is that Services didn’t drive the beat.
And finally, how did all of this strength in revenue from these segments translate to the bottom line? Evidently quite well. Apple’s growth in iPhone, driven by lower-price iPhone SE units didn’t have much of a negative impact at all on the overall margin profile. While total revenues beat by 13%, notice that EPS beat by 25%. So, there was some upside relative to expectations on the margins side of things.
All in all, if I had to grade this quarter, considering the well-rounded strength from all of Apple’s business segments, I would call this an A+ quarter.
Qualitative News
On the qualitative front, Apple had some interesting commentary. We know that the iPhone SE drove Apple’s iPhone revenue beat, and likely drove the overall quarter. The real question is, looking forward, what should we expect to see out of Apple’s much-hyped 5G iPhone. Fortunately, CFO Luca Maestri was fairly direct in telling us that the 5G iPhone will be delayed a few weeks. I’m assuming he is referring to iPhone sales, not production. Even so, that could lead (in my view) to a muted holiday quarter for demand if sales aren’t able to begin on time. It really depends on how many weeks “a few” weeks are. If it’s two or three weeks, then I wouldn’t anticipate too much of a headwind. If it’s five or six, demand may not be as strong as investors anticipate. That being said, the coronavirus’s impact on global supply chains remains fluid, so it is likely difficult for management to give us much more commentary.
Valuation, Rating, And Price Target
Anybody who has followed me on Seeking Alpha knows that for quite a while, I was bullish/neutral on Apple before more recently turning into an outright bear on the stock. My rating is based on the story of the company (i.e. the narrative) and the upside/downside in relation to my price target. I like Apple’s narrative. The company is fundamentally solid, with a strong hardware-centric backdrop and a compelling software-centric growth narrative. The problem I have had with Apple has been the valuation. The way I value the stock involves breaking up the hardware and software businesses up, and valuing each of them individually. So, let’s look at my revised expectations for Apple’s hardware business first.
| FQ1’20 (Actual) | FQ2’20 (Actual) | FQ3’20 (Estimate) | FQ4’20 (Estimate) | FY’20 (Estimate) | |
| iPhone Shipments (in millions) | 72.3 | 40.0 | 40.0 | 43.9 | 196.2 |
In 2019, Apple’s iPhone ASP was ~$727.95/device. I estimate a ~7% ASP decline in fiscal 2020 because an increased portion of the iPhone sales mix is the lower-priced iPhone SE. Thus, in 2020, I project a full year ASP attach rate of ~$676.95/device. So, I am anticipating iPhone revenues of $132.818 billion.
The second part of my valuation model is the iPad and Mac. As we saw with this print, the Mac and iPad have been incredibly strong lately, fueled by an increased consumer electronics appetite in the work-from-home economy. Factoring in the recent strength from the iPad and Mac lineup, here are my estimates for the segments.
| Revenue (in billions of $) | 2019A | 2020E | Y/Y Growth |
| Mac | $25.74 | $29.601 | 15% |
| iPad | $21.28 | $23.408 | 10% |
| Total | $47.02 | $53.009 | 12.7% |
Apple’s usage of ARM “Apple Silicon” for processors in laptops instead of x86 silicon will enable greater cost efficiency, allowing them to either (a.) lower pricing on laptops or (b.) keep internal cost savings and let them drop to the gross margin. Either way, Mac will likely see strong growth this year from both WFH and a move to ARM solutions instead of x86.
The final part of the hardware analysis is Apple’s “wearables, home, and other” segment. This segment includes hardware like the Apple Watch and AirPods, as well as Apple’s smart speaker, the HomePod. COVID-19 has likely led to an increase in demand for the Apple Watch, but reduced demand for AirPods. In FQ3, Apple saw wearables revenue growth of 16.7%, in a quarter depressed by the coronavirus. As time goes on, I can see reaccelerating growth for the AirPods in particular. I’m modeling 20% Y/Y growth in wearables right now for the full year to $29.378 billion in revenue.
Here are my full expectations for Apple’s FY’20 hardware expectations.
| Hardware Revenue (in billions of $) | Hardware GM% | |
| 2020E | $215.205 | 32.0% |
| 2019A | $213.883 | 32.2% |
An interesting thing that not many people have noted about Apple was the contraction in Y/Y in gross margins on the product business. This is interesting, but not necessarily surprising considering the fact that Apple moved downstream in the smartphone market.
Finally, we have the software services business. Apple grew this segment at 15% in the quarter. I anticipate Apple will grow its services segment at this rate for the full year.
| Software Revenue (in billions of $) | Software GM% | |
| 2020E | $53.235 | 65.5% |
| 2019A | $46.291 | 63.7% |
Final Valuation
Under this model, Apple sees a gross profit of $103.734 billion, two-thirds of which come from the hardware segment. My full year expectation for OpEx remains $35.028 billion. This means Apple sees $68.706 billion in operating income for the full year. Now back out 16.5% of this for taxes, and you get to net income of $57.37 billion. Two thirds of this comes from hardware, so on a per-share basis (assuming 4.33 billion shares), Apple’s hardware business makes $8.74/share in profit. The other third of this net profit comes from software, equaling out to $4.50/share in profit.
Let’s value the hardware segment. Cyclical tech hardware normally trades between 10-15x earnings. Considering Apple is unique in its brand, shorter upgrade cycle, and growth opportunities (5G iPhone, Apple Watch and AirPods growth), the stock warrants a higher multiple. I’m going with 22x in my valuation, which puts the hardware business’s valuation at $192.28/share.
The software segment is more recurring revenue, higher margin, and has a stronger long-term growth trajectory. For those reasons, I am more comfortable giving software a higher multiple against its earnings. I’m using a multiple of 30x earnings, as it is somewhat comparable to other mega-cap software stocks. On 30x earnings, Apple’s software business is worth $135.00/share.
Putting these two valuations together, I get to a sum-of-the-parts valuation of $327.28/share. This reflects a downside of ~20% compared to the after-market price. As good as Apple has been as an investment lately, it is still not a buy, and remains overvalued. Admittedly, this quarter was a stellar quarter, the best quarter I have ever seen from Apple. But that does not make it a buy at this price.
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Additional disclosure: I am not a financial advisor. This is not financial advice. Please do not interpret anything I say here as financial advice. Do your own due diligence before initiating a position in any of the securities mentioned.
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