Image Shown: Shares of Apple have climbed significantly higher during the past year as of this writing, and we see room for additional capital appreciation upside and tremendous dividend growth potential.
By Callum Turcan
One of our favorite companies is Apple Inc (AAPL) as the firm offers investors a wonderful combination of capital appreciation and dividend growth upside. Apple has three of the core considerations we look for when seeking to identify high-quality companies and long-term investment ideas: 1) a pristine balance sheet (Apple has an enormous net cash position–a key cash-based source of intrinsic value), 2) a stellar free cash flow profile (relative to its revenue, Apple’s capital-expenditure requirements are modest, facilitating robust free cash flow generation), and 3) its growth outlook is both bright–the firm just recently launched its first-ever 5G-capable smartphone, the iPhone 12–and is underpinned by secular growth and sustainable tailwinds (the global shift toward digitally-provided services). In this article, we will cover Apple’s impressive growth outlook, stellar financial position, and why we are big fans of the stock.
Reviewing Apple’s Recent Strong Performance
Apple has two core business reporting segments, ‘Products’ (includes sales of its hardware such as the iPhone, Mac, and iPad along with its Wearables offerings) and ‘Services’ (includes sales of digitally-provided services such as Apple TV+, Apple Music, and Apple Arcade, along with its AppleCare unit which includes its repair and replacement operations). The iPhone accounted for ~50% of revenue during fiscal 2020 (ending September 26, 2020), though depending on the timing of new iterations of the iPhone, the device could account for as much as 60% or more of total revenue, as it did during fiscal 2018 (as shown in the image below). Its Wearables and ‘Services’ categories have been growing rapidly in recent years, somewhat reducing its dependence on future iterations of the iPhone, but the device will remain Apple’s key revenue source for years to come.
Image Source: Apple’s recently-filed Form 10-K (October 30, 2020).
When it comes to its bread-and-butter iPhone, according to data cited by Morgan Stanley (MS), it appears the various versions of the new iPhone 12 are selling quite well, which speaks very favorably to Apple’s near-term revenue outlook (as well as its ability to drive recurring, repeat sales from loyal customers in the longer run through product cycle after product cycle). Though Apple’s digital services sales–such as revenue generated by its Apple TV+, Apple Arcade, and Apple Music subscriptions along with sales generated through its App Store–have grown at a brisk pace of late, its hardware sales (namely its iPhone) will remain the firm’s bread-and-butter for some time yet. We won’t know for sure how well the iPhone 12 series is selling until Apple reports its next earnings report, but early signs are very encouraging.
In the recent past, demand for Apple’s Mac and iPad offerings have been quite strong, too, due to the shift toward working-from-home and home schooling activities, which was brought on by the ongoing coronavirus (‘COVID-19’) pandemic. Net sales from both of these categories advanced 11% in fiscal 2020, and there are hints that sales are accelerating in these areas. During the fourth quarter of fiscal 2020 (period ended September 26, 2020), for example, Apple’s Mac and iPad sales, combined, advanced 36% from year-ago levels. Its iPhone sales were a bit of a laggard last fiscal quarter as consumers were delaying their smartphone purchases until the iPhone 12 was available, which is understandable, but interestingly, the timing may be setting the firm up for a potential upside surprise next quarter.
For starters, if Apple’s new iPhone 12 offerings continue to experience strong demand at the same time that its Macs and iPads are selling well, which appears to be the case based on recent data cited by Morgan Stanley, that should lead to a meaningful uplift in Apple’s financial performance going forward (and a potentially strong revenue and earnings beat) and even stronger-than-expected free cash flow generation, both of which would further support the high end of our fair value estimate range (which we’ll explain later) and its long-term dividend growth prospects, which are phenomenal, in our view. Strong iPhone sales also help drive demand for Apple’s other offerings (the “halo effect”), whether that be for its “premium” AirPods headphones, its various digital services, or its other offerings.
Due to the decline in Apple’s iPhone revenue last fiscal quarter (as a result of a timing issue as consumers waited for the launch of the new iPhone 12), its ‘Products’ revenues fell 3% year-over-year. However, we think a strong rebound is currently underway on this front. As it concerns Apple’s ‘Services’ revenues, that category increased 16% year-over-year last fiscal quarter (a pace that was in line with full fiscal year 2020 performance) thanks in part to the company’s ongoing launch of new digital services. Looking forward, we see room for substantial upside in this area as its digital services subscriber base continues to grow. We expect fiscal 2021 to be one of Apple’s best years yet (even better than what some optimists are anticipating), and we’re forecasting material revenue and earnings growth for the fiscal year, despite economic challenges brought about by COVID-19.
Apple TV+ Has A Long Growth Runway
In line with recent yearly trends, we expect Apple’s digital services business to continue to become a bigger part of company-wide financials (net revenue and earnings) going forward for a few reasons. Its Apple TV+ video streaming service is still in its early days as that offering just launched in November 2019. The company will need to invest significantly more toward growing its original content library to build up a more competitive offering, and one that can keep households entertained for a long period of time, but Apple has the financial capacity to make those investments.
Disney’s (DIS) recent “blockbuster” success in streaming is evidence that there’s room for new entrants with established brand names like Apple to captivate audiences, and so far, Apple TV+ is off to a good start, having launched several popular programs including The Morning Show, Ted Lasso, Greyhound, and For All Mankind. Additionally, Apple could also acquire the rights to third-party content to bulk up the content library of Apple TV+. Management has not recently released subscriber numbers for the service, though during Apple’s latest earnings call, CFO Luca Maestri noted Apple TV+ was experiencing decent growth.
Reportedly, privately-held and privately-traded MGM Holdings Inc (OTC:MGMB), which is home to a large slate of movie titles including Rocky and The Hobbit along with various TV shows including The Handmaid’s Tale and Vikings, is considering selling itself. MGM Holdings produces and distributes TV shows and movies, is the co-owner of the James Bond franchise and owns Epix, a “premium” cable channel and video streaming service. Should Apple want to, the tech giant could make a bid for MGM Holdings to bulk up the content library for its Apple TV+ service. The WSJ reported that Apple was in talks with MGM Holdings about acquiring the firm back in 2018, though talks fell through.
Things might be different now, and Apple could change its mind given the likelihood of success in this area based on the evidence of others. Netflix (NFLX), for one, has defied all odds with its transition from mailing DVDs to becoming an online streaming powerhouse, and as noted before, Disney’s massive success in streaming out of the gates adds further credence to this viable long-term opportunity for Apple. In April 2019, for example, Disney had expected that Disney Plus would hit 60-90 million subscribers by 2024. Just a little over a year later, Disney has now tripled that forecast to 230-260 million. Apple doesn’t have to achieve similar success as Disney for this initiative to be a needle-mover for the stock, but we’re not ruling out massive success in this area for Apple given its huge and loyal customer base.
Pushing Deeper Into The Casual Gaming Space A Smart Move By Apple
In September 2019, Apple launched Apple Arcade, which allows the firm to capitalize on the secular growth tailwinds supporting mobile video gaming as casual gaming has become significantly more popular in recent years. Apple Arcade allows subscribers to play from a vast library of mobile games for a modest monthly fee.
SLA Digital, which provides carrier billing solutions, estimates global mobile game revenue will come in at $76.7 billion in 2020 and will represent ~60% of the total gaming market by 2021. The group estimates 45% of the US population could be categorized as casual (2–5 hours per week) or occasional (up to 2 hours per week) video gamers, with “hardcore” gamers representing approximately 20% of the US gamer base.
We think Apple’s push into the casual gaming space is a wise decision given the massive potential user base for its Apple Arcade offering. Many casual gamers are active on mobile platforms, while hardcore gamers are usually playing on desktops, laptops, and consoles. During Apple’s latest earnings call, management noted that Apple Arcade was also experiencing decent growth, though subscriber numbers for the service were not made public. The outbreak of COVID-19 has introduced many new people to mobile video gaming as they search for things to do during stay-at-home and lockdown orders in certain states, jurisdictions, and counties.
But that’s not the only driver. Casual gaming is also supported by strong long-term secular tailwinds, as evidenced by the long-term performance and recent strength from Activision (ATVI) and Take-Two Interactive (TTWO), both of which are experiencing very strong top-line growth. COVID-19 may be the shot-in-the-arm for casual gaming adoption for newbies that are now at home for many more hours during the day than before, but the rise of the global middle class (and additional households in emerging economies gaining access to the Internet) are other key catalysts for Apple’s mobile video gaming initiatives in the longer run.
Apple’s Digital Services Upside Is Enormous
Apple has only just begun to scratch the surface of the lucrative opportunity a growing digital services segment provides. Apple TV+ and Apple Arcade are still in their early innings and have room to run. Furthermore, its Apple Music offering is well-positioned to capitalize on the ongoing secular trend towards music streaming services, though we do acknowledge that Apple will face significant competition on all these fronts. The company recently launched a bundle of its digital services, Apple One, which should help drive subscriber growth across all of its digital services offerings.
During Apple’s latest earnings call, management noted the company’s ‘Services’ segment was on track to grow its paid subscriber base to 600 million by the end of calendar year 2020. In the fourth quarter of fiscal 2020, Apple added 35 million paid subscribers to its operations on a sequential basis and as of October 2020, the firm’s total paid subscriber base stood at over 585 million according to recent management commentary. The company’s growth runway remains enormous on this front, and driving higher revenue per subscriber is yet another lever for more revenue growth potential.
Image Source: Apple’s recently-filed Form 10-K (October 30, 2020).
As noted, Apple’s ‘Services’ segment has been quite profitable and has steadily become a larger part of Apple’s company-wide operations. From fiscal 2018 to fiscal 2020, its ‘Services’ segment grew its revenues 35% and represented ~20% of Apple’s net sales in fiscal 2020 (up from ~15% in fiscal 2018). More importantly, Apple reported that its ‘Services’ segment saw its gross margins grow by ~520 basis points during this period, hitting 66.0% in fiscal 2020 (see image immediately above). For reference, the gross margin at Apple’s ‘Products’ segment shifted lower during this period and stood at 31.5% in fiscal 2020. Apple’s ‘Services’ segment generated ~34% of the firm’s total gross margin in fiscal 2020, up from ~24% in fiscal 2018.
We expect Apple’s new higher-priced (i.e. potentially higher margin) iPhone 12 offerings will help improve the profitability of its ‘Products’ segment going forward while also providing a major source of revenue growth. This tailwind combined with ongoing strength at its ‘Services’ segment should translate into strong revenue and earnings growth over the coming fiscal years as one can see in the upcoming graphics down below, which are sourced from our 16-page stock reports generated by our discounted cash-flow model (enterprise valuation, the free cash flow to the firm process). The free cash flow to the firm process is the industry standard approach to calculating an intrinsic value estimate of a company.
Over the next five years, we project Apple’s revenue to advance at a 9.9% compound annual growth rate. Our revenue growth estimates for fiscal 2021 and fiscal 2022 are $314.9 billion and $352.7 billion, respectively. Our fiscal 2021 estimate does not differ too much from consensus, but we are slightly above consensus forecasts for fiscal 2022, though we are below the high estimate on the Street. Our revenue growth forecasts are supported by continued strength in its iPhone line-up and continued expansion across its portfolio of products and services thanks in part to the “halo effect” and an incredibly loyal customer base.
Image Shown: We forecast that Apple will post solid revenue growth over the next several fiscal years. The grey line represents our “base” case scenario while the green dots represent our “bear” case scenario, and the blue dots represent our “bull” case scenario. Image Source: Valuentum.
Over the next five years, we project earnings per share will advance at a 15%+ compound annual growth rate, augmented in part by share buybacks. Our average operating margin assumption is ~26% over this time period, as we expect the higher percentage of higher-gross-margin ‘Services’ revenue in its business mix to drive higher levels of profitability in the coming years. For reference, Apple’s operating margin in fiscal 2020 was 24.1%, so we’re not being too aggressive with our profitability forecasts, and we view them as achievable. Our EPS forecasts for fiscal 2021 and fiscal 2022 are $3.99 per share and $4.36 per share, respectively, roughly in-line with consensus.
Image Shown: We forecast that strong revenue growth, particularly from Apple’s more lucrative offerings, will drive the firm’s net income higher over the coming fiscal years. The grey line represents our “base” case scenario while the green dots represent our “bear” case scenario, and the blue dots represent our “bull” case scenario. Image Source: Valuentum.
Image Source: Valuentum’s Pro Forma Income Statement of Apple, as found in its 16-page stock report.
Apple Pushing Into the Self-Driving Car Market Could Generate Additional Upside
Reportedly, Apple is also considering entering the self-driving car market which could lead to additional upside over the long term. Note that we have not factored this development within our valuation model, meaning that success in this area would make the high end of our fair value estimate range of $168 per share even more achievable.
Apple is targeting a 2024 launch date and aims to use its own battery technology, keeping in mind Apple has already invested considerable sums towards these endeavors through its Project Titan (which has undergone several major strategic pivots over the years). While there are numerous headwinds, especially as it relates to state regulatory hurdles (self-driving automobiles could get banned in certain states) and insurance considerations (namely, who is liable if a self-driving car gets into an accident), this development is very intriguing.
The massive success of Tesla (TSLA) is undeniable, and Apple has considerable resources to allocate to the growing electric-vehicle market. Mobile connectivity is a key advantage in this area, and Apple already has a massive installed base with its existing product line-up. We would expect Apple to use the same playbook as it has with Wearables and digital services to leverage the existing excitement of its loyal customer base to create what could be one of the greatest innovations of this decade, a self-driving car solution that dominates the competition (even Tesla). M&A on this front can’t be ruled out either, and even a purchase of one of the Big 3 Detroit automakers wouldn’t be a terrible idea given their depressed prices of late.
For example, Tesla boasts a market capitalization over $600 billion, while Ford’s (F) is ~$35 billion, General Motors’ (GM) is ~$60 billion and Fiat Chrysler’s (FCAU) is ~$35 billion. At the end of September 2020, Apple had total cash and marketable securities of $191.8 billion. It could buy Ford, for example, with just 18% of its total cash and marketable securities balance, and it would be able to replace that purchase price with about half a years’ worth of free cash flow generation (it pulled in $73.4 billion in free cash flow during fiscal 2020). Turning Ford’s market capitalization, for example, into just half of Tesla’s existing market capitalization implies material value creation in the hundreds of billions. We think Apple could do this in 5-10 years.
Potential Downside Risks
While we are optimistic on Apple’s outlook, there are some downside considerations to be aware of here, of course. The state of US-China trade relations can have a powerful impact on Apple’s supply chain and ultimately its financial performance, with an eye toward US tariffs on Chinese imports. With Trump leaving office soon, the new U.S. administration’s stance on China could pose both challenges and opportunities for Apple.
Another important consideration is the ability for Apple to meet demand for its new iPhone offerings while facing headwinds from the ongoing COVID-19 pandemic. Recently, Apple temporarily closed some of its stores in California and the UK as the pandemic flared up in these regions. However, we maintain the view that COVID-19 is a transient event and that it will eventually become part of history, much like the Spanish Flu one hundred years ago. Stocks are priced on normalized expectations, not those during a once-in-a-century pandemic.
Whenever we talk of the iPhone, we also can’t forget flash-in-the-pan gadgets, the MotoRazr and Blackberry’s (BB) device, but Apple is in a much different position than these two prior fan-favorites, in our view, especially given its “halo effect,” large and very satisfied installed base, and digital bundling opportunities. During the past three fiscal years, Apple has spent $18.8 billion (2020), $16.2 billion (2019), and $14.2 billion (2018) in R&D, respectively, or about 5%-7% of sales, so it is certainly not resting on its laurels either.
There are anti-trust concerns, which may only grow as the company continues its track record of dominance in many areas. Security and privacy is a big issue these days with customer information, so Apple is a big target for hackers, so any breaches on this front may hurt its relationship with its valued customer base. All things considered, however, we view Apple as well-positioned to navigate the COVID-19 storm and truly any reasonable and known obstacle given its rock-solid financial position.
Impressive Free Cash Flow and Dividend Growth Outlook
In fiscal 2020, Apple generated $73.4 billion in free cash flow and spent $14.1 billion covering its dividend obligations along with another $72.4 billion that went towards buying back its stock during this period. As an aside, given that shares of Apple traded well below their fair value estimate during this period, we view its historical share repurchases as a good use of capital. At Apple’s current share price, share buybacks continue to be a good use of capital given they continue to trade below their intrinsic value, in our view.
Generally speaking, buybacks completed below a fair value estimate of a company generate value for continuing shareholders, as the number of shares are reduced at a price that is less than what the company is worth, further increasing the value of the enterprise. Think of a company’s buyback program in a similar light as that of the investor. Certainly, one wouldn’t want to overpay for stock, and neither should investors want companies to overpay for their own stock. We can point to the recent missteps at the airlines and Boeing (BA) as value-destructive buyback programs. Apple’s, on the other hand, has been value-creating for many years.
The strength of Apple’s dividend coverage on both a historical and forward-looking basis (supported by expectations that its free cash flow will grow meaningfully going forward) is simply stellar (phenomenal, in fact). Apple exited fiscal 2020 with $79.4 billion in net cash (inclusive of short-term debt and long-term marketable securities), which provides a cushion should the firm’s annual free cash flows, which already handily cover annual cash dividend obligations by about 5 times, face headwinds of any kind. Having a net cash position is an immense source of strength and intrinsic value during these turbulent times (unlike a large net debt position, for example).
As it concerns Apple’s long-term dividend growth potential, the firm’s stellar free cash flow generating abilities combined with its pristine balance sheet should enable the company to push through tremendous payout growth going forward. Payments for dividends and dividend equivalents have hovered at ~$14 billion in each of the past two fiscal years (2019 and 2020), a number that is dwarfed by just one year’s worth of free cash flow generation ($73.4 billion in 2020, for example). Said another way, hypothetically, if Apple, retains most of its free cash flow in just one year (no buybacks or acquisitions), it’d accumulate enough extra cash in just one year to pay its dividend at current rates for another 5+ years! Shares of Apple yield a modest ~0.6% of as this writing, and they have the potential for unbelievable growth in coming years.
Image Shown: Apple’s future expected free cash flow and net cash position, exclusive of short-term debt, dwarf expected cash dividends (and growth in them) over the next five years, suggesting that the company has considerable room for even higher future dividend increases that we expect (~12%-15% growth per annum).
In the upcoming graphic down below, we highlight our free cash flow forecasts for Apple over the coming fiscal years, with growth being driven by the recent launch of its iPhone 12 offerings and expectations that its lucrative digital services revenues will continue to grow, helping net income expansion. Our explicit forecasts for cash flow from operations for fiscal 2021 and fiscal 2022 are $96.1 billion and $104.8 billion, respectively. Our capital spending projections average ~$10.5 billion over the next two fiscal years, roughly in line with fiscal 2019 levels, but materially above fiscal 2020 levels, which came in at ~$7.3 billion.
Image Shown: We forecast that Apple’s free cash flows will grow significantly going forward. The grey line represents our “base” case scenario while the green dots represent our “bear” case scenario, and the blue dots represent our “bull” case scenario. Under any of these three scenarios, our model indicates Apple’s free cash flows will likely climb higher over the medium- and long-term. Image Source: Valuentum.
Image Source: Valuentum’s Pro Forma Cash Flow Statement of Apple, as found in its 16-page stock report.
Through our discounted free cash flow (enterprise valuation) analysis process, we have derived a fair value estimate of $140 per share of Apple under our “base” case scenario. The key valuation assumptions used in our cash flow models are laid out in the upcoming graphic down below (and partially summarized in previous commentary of this article). Please note that should Apple significantly exceed these assumptions (which we view as an increasingly likely proposition given recent initiatives and trends), the high end of our fair value estimate range sits at $168 per share. We see Apple housing ample capital appreciation upside in light of this analysis.
We use a three-stage discounted cash flow model. The graphical stair-step bridge image below shows the duration of value composition and coincidentally helps explain why near-term assumptions, as that impacted by COVID-19, aren’t nearly as important as mid-cycle and longer-run assumptions, which derive most of the value of Apple (and any other company). Enterprise free cash flow, or free cash flow to the firm, growth of ~11.6% is forecasted over the next five years, normalized to the 2-3% over the duration of the model through perpetuity. Apple’s net cash position of $79.4 billion is a key contributor to its intrinsic value, but it is dwarfed by the value of its future expected free cash flow stream, which is incredibly robust.
Image Shown: Under our “base” case scenario, Apple has a fair value estimate of $140 per share with room for upside should it outperform these assumptions. Image Source: Valuentum.
Image Shown: We believe that in light of recent developments, the high end of our fair value estimate range for Apple is becoming increasingly more probable as its “true” intrinsic value. Image Source: Valuentum
Apple is a great company that offers investors tremendous capital appreciation and dividend growth potential, in our view. Management is committed to rewarding shareholders, as evidenced by Apple’s large share buyback program and the steady growth seen at its dividend payout (which we expect will continue going forward). We are excited to see how well Apple’s initial iPhone 12 sales are holding up when the firm reports its next earnings report, though we will also be keeping a close eye on any commentary regarding the firm’s digital services growth story. Apple’s outlook is bright, with its self-driving car initiative yet another opportunity to drive the value of shares ever higher. We would not be surprised to see the shares hit the high end of our fair value estimate range of $168 per share under bullish market conditions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Callum Turcan does not own shares in any of the securities mentioned above. Apple Inc (AAPL) is included in Valuentum’s simulated Best Ideas Newsletter portfolio and simulated Dividend Growth Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.