Apple reported a good holiday quarter relative to muted expectations. The company got back on a growth track, albeit modest, after three straight quarters of declining revenue and iPhone shipments. With revenues up 3%, EPS up 2%, and iPhone shipments up 5%, Apple is no longer the growth stock we once knew. But it does not have to be with reasonable valuation of 12x estimated 2018 EPS that ignores $30 per share in net cash. With repatriation a real possibility, crediting Apple’s valuation for some of the cash held abroad seems warranted. Northlake remains long Apple, seeing upside to $150-180 over the next year depending on the strength of iPhone 8 cycle.
Apple shares responded well to the earnings report, especially getting a boost from guidance for the March quarter. Guidance was slightly below Wall Street expectations but above what many investors had feared. Under Tim Cook, Apple has mostly reported in close approximation to its guidance, so putting the holiday season and March quarter to bed is leading investors to look ahead to what sets up as a very strong iPhone upgrade cycle. The upcoming iPhone 8 is presumed to be the first major upgrade in form factor in three cycles and upgrade rates have slowed considerably over the last few years. As a result, the installed base of potential upgrades is massive and Apple may give buyers a reason to upgrade with new features. This is the main leg of the bull case for Apple over the next year.
Northlake’s current view is that the iPhone 8 cycle may represent the last big up move for Apple shares unless new higher growth, high margin opportunities develop on a large scale. Perhaps the best opportunity is the services business, which received a great deal of attention on the company’s quarterly conference call. Now at a run rate of $7 billion quarterly at high margin, services such as the App Store, ApplePay, iCloud, and Apple Music have the potential to be a differentiator for Apple investors. For perspective, iPads produced $5.5 billion in revenue in the just completed seasonally strong holiday quarter. iPhones are still Apple’s dominant source of revenue with sales of $54.4 billion. Services grew 20% last quarter adjusted for one-time items. Management seems very confident that this level of growth can continue for several years as it reiterated its forecast for a doubling of services revenue in four years. If this occurs, services will be big enough to matter and will also bring a higher multiple business into the Apple valuation story.
Beyond services and the usual dissection of revenues, margins, and inventories, the two most interesting discussion points on the conference call were China and India. China improved in the December quarter but still saw declining revenue for the fourth straight quarter. Management noted that adjusting for currency weakness and poor results in Hong Kong, mainland China actually grew. They also pointed to positive data on switchers and new to Apple users as a sign of brand strength. China historically has done well when major upgrades came to the iPhone, potentially setting up a big return to growth against much easier comparisons that begin in the current quarter.
Comments on India were brief but management is confident that Apple is finally breaking through there with a full strategy including manufacturing and retail stores. India is starting from almost nothing and if it could grow to just ¼ the size of China could add materially to Apple’s earnings potential.
The bottom line is that the pressure is off Apple until iPhone 8 cycle is imminent. Low valuation and the prospect for positive financial momentum and repatriation should allow the shares to continue to work higher. We expect weak June quarter guidance given the immensity of the iPhone 8 publicity but April is when Apple updates its capital allocation policy and a big dividend increase and another massive share buyback should be well received by investors.
AAPL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. AAPL is a net long position in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.