Media Talk

No Apple Super Cycle But Super Financial Strength

Apple (AAPL) reported strong growth but mixed results relative to expectations for its 1Q18 ending December 31st.  iPhone unit sales fell short of still high expectations but higher than expected average selling prices allowed revenue growth to match or exceed Wall Street estimates.  Specifically, iPhone unit sales fell a little short of the 80 million estimate but ASP of $796 easily beat the consensus of $755 as the mix of iPhone X in the quarter was stronger than expected.  Receiving less attention but of growing importance to the long-term attractiveness of AAPL shares was another quarter of very strong growth for the company’s services and other products business segments.  App Store revenue, Apple Music, Apple Watch, and AirPods all are growing rapidly giving these combined segments another quarter of greater than 20% revenue growth at extremely high and accretive margins.

Over the past month, there has been a steady of drumbeat of signals that the iPhone super cycle was not living up to expectations.  Dramatic production cuts for March quarter iPhone units seemed clear from leaks in the supply chain.  Expectations of Apple’s iPhone, revenue, and EPS had all fallen significantly heading into the quarterly report.  Guidance for the March quarter ultimately came in at the low end of recent estimates, driving Apple shares lower on Friday in an awful market environment.

The debate on iPhone now shifts to whether this will be an elongated cycle driven by more gradual replacement of the massive installed base with FaceID based phones or whether smartphones have peaked and offer little or no growth with the risk of price cutting to drive units that undermines margins.  In other words, will smartphones face the same down cycle seen after PCs peaked?

We side with the elongated cycle and are comfortable that if we are wrong that the installed base can drives services and other product revenues and sustain organic growth in Apple revenue and EPS. Furthermore, the company’s massive financial strength is supportive of at least the current stock price and likely can drive the shares higher even if organic growth flattens (which we are not predicting).

Besides discussion of operating trends, the other highlight of the conference was the company stating that it intended to operate with zero net debt.  This means that the new tax law rules on repatriation will free up about $169 billion for the company to use for share buybacks, dividend increases, and acquisitions.  Given the largest acquisition Apple has ever made cost $3 billion, massive share repurchase is coming.

We are comfortable with consensus EPS estimates of $11.45 and $12.95 for this year and next year.  We also believe Apple can achieve those numbers before the benefit of incremental share buybacks.  The shares are not expensive relative to the market at less than 15 times 2018 earnings and the balance sheet provides strong downside support.  Thus, we feel we can remain patient with Apple even though we see less upside in the next few quarters.  Many Northlake clients have overweighted positions in Apple so if you see some partial sales, it is position management rather than a shift in our still modestly bullish view.

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.

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