Apple: The Bad Year Ends

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Execution is the Killer App

People talk about it, but generally don’t understand it, or acknowledge it once it’s happened. You can have the best plan in the world, but if you can’t execute it, what does it matter? The past four quarters have shown Tim Cook and the Apple (AAPL) team executing like never before. Leadership earns their absurd remuneration for how they handle bad times, not good times. Let me tell you a story of bad times.

Once upon a time, there was a kingdom in Cupertino with a cash cannon named iPhone. But several years ago, trouble for the cash cannon loomed. Carrier “subsidies” (actually a 2-year loan at a low rate) were disappearing and upgrade cycles were lengthening. On top of that, much of iPhone’s near-term future growth was predicated on the growing Chinese consumer market, and that came to a halt with the trade war.

The long-term plan was to leverage Apple’s high customer satisfaction, iPhone’s popularity, and its legendary installed base to feed new revenue streams from services and new wearables products. But that is a long-term plan, and the cannon was running low on powder.

In FY 2018 Apple saved their financials with a one time lever-pull with the price increase on the iPhone X. Units were down, but who cares when EPS is up 30% YoY?

Coming into FY 2019 last October, Apple was facing tough comps from that blowout 2018, but still facing declining units and no price increase to save them. With the trade war killing their China numbers on top of it and Europe and Japan flagging as well, Apple had their first guidance miss in years in the past December quarter. Only by Apple standards is this true, but iPhones XS/R were flops.

So Apple had to start pulling levers.

  • Leverage iPhone’s high resale value, and try and get people back on to a 2-year upgrade cycle with a trade-in program and monthly payments with no interest.
  • Invest heavily in services, leaning into their billion user installed base.
  • Keep growing the base by having a low price point on each product line.
  • Accelerate buybacks to mask some of the YoY negative growth in EPS.
  • Keep everyone focused on services with the March services event, long before the services launched.

This is what that story looks like on a chart:

Two things to note here. First, once the lever pulling began, they were able to get those negative columns to start shrinking. The other is this, Apple stock since they announced they would not be hitting their December guidance:

Chart

Data by YCharts

That’s execution. So the bad year has ended with an upside earnings surprise. Net income was down only 3.1% YoY on a very tough comp, and EPS up 3.7% on a less tough comp because of all the buybacks that happened in the intervening 12 months. I thought they had a good shot at $2.99, but they blew past that for $3.03

But the best part is they were able to do that with iPhone not having a terribly good quarter:

iPad has been really accelerating since the introduction of iPad Pro and Pencil. That giant wearables number is Airpods and Watch. And of course, services continues to pop like a weed. Together, wearables and services, two businesses that barely existed for Apple just a few years ago, were almost 30% of net sales in the quarter.

Breathe that in for a second. iPhone revenue was down 9.2% YoY, but total revenue was up 1.8% in the quarter. Last quarter, iPhone was down 11.8% YoY, but total revenue was up 1.0%. This is not just the iPhone company anymore.

Lever: Pricing

Apple has leveraged this in two ways. In the first place, since iPhones became unlocked at the end of carrier contracts, it also unlocked the very high resale they have. Since then, smart consumers have been putting their 2-year old iPhones on eBay to fund their upgrade. Apple has always had a trade-in program, but they always paid far less than the eBay price, and they never emphasized it in either the online or retail Apple Stores.

But that changed last Christmas season when iPhone XS/R numbers were coming in slow internally. They bumped up the trade-in values, more so on older phones, and promoted it more in the stores. With the 2019 iPhones, they took that up a notch by adding two years of 0% interest and putting it all front-and-center. This is now what greets you when you go to buy an iPhone 11 at the Apple Store:

The first number you see is $16.62. That doesn’t sound like much, does it? But that’s for a trade-in of a two-year old iPhone X. A more relevant trade in would be the two-year old iPhone 8. With that, the monthly payment is $19.95/month. (Not) coincidentally, the carriers charged you $20/month in the old “subsidy” days. Apple is trying to get everyone back to thinking that way. Many are even speculating that the phone will move to a subscription.

Apple reported that they have quintupled their trade-in volume YoY (I think on a unit basis), so it seems to all be working the way they’d like.

The second way Apple is leveraging pricing is by having an entry level model for each major product line. Mac has long had the $799 Mac Mini. iPad has the $329 base model. If the normally reliable Ming Chi Kuo is correct, there will be a $399 iPhone SE2 in the spring. These lines will likely get less frequent updates than their more expensive siblings, but they establish a low price point to enter the Apple walled garden.

Lever: Services

My sister, the bank strategist: What sort of multiple do you think services get?

Me: They have 64% gross margins. What multiple does that get?

There are two aspects of this, one real and one perception. The real part is that Apple services have been showing double-digit YoY growth for some time now, and they have giant margins. The perception part is that people have not failed to notice, and Apple is happy to keep reminding them. This is how they headlined their Q4 press release:

Services gets top billing over record EPS.

Moreover, the March services event was a bit of a strange beast. It is very unusual for Apple to announce anything that early before launch, but they did it because they needed to distract people from the ugly on some of those charts above. Remember, it came a little over a month before they reported the March quarter, their worst in some time. The event revealed a future where services revenue could keep growing at double digits every year, and Apple wanted to make sure everyone saw that before they saw the March quarter numbers.

In any event, they have been investing heavily here, at about a billion dollars a quarter at its peak, which has thinned margins of course. Apple traditionally has had a surprisingly low R&D line item in their reports, but that has changed in the last couple of years:

March 2017 quarter = 100

Over 9 quarters, R&D expenses were up over 50%, though you can see that’s tailing off now that much of the infrastructure is in place.

In any event, at a very high cost, they are executing here nicely and continue to gain momentum.

Lever: The Cash. My God, the Cash

For many years as Apple’s cash pile grew, people asked what it was for. People and companies save cash for a rainy day, and since last fall it’s been raining as hard in Cupertino as it has for some time. Apple is using their cash strategically to distract from some of those ugly YoY numbers we saw above.

Back in May, Horace Dediu of Asymco updated his Most Helpful Apple Chart Ever. It’s a little stale now 5 months later, but it’s a great framing of our discussion.

Asymco

It’s an incredibly information-rich chart, so spend a little time with it if you like that sort of thing. But I’d like you to focus on that red line, cash net debt. The cash return program began in 2012 where you see the red line begin to diverge from the blue line, generated cash. Previous to that, Apple had zero debt.

Because most of the cash was technically in Apple’s Irish subsidiary, the cheapest way for Apple to return cash was to take out debt, at rates just above the US Treasury, to return to shareholders while the cash pile in Ireland continued to grow. As you can see, that red line went pretty straight for several years.

In 2018, they shifted the cash to the US with the tax bill, and began to return it much more aggressively, as you see that red line dip down. There are two more reported quarters after that chart, and that red line is now down to under $98 billion, the first time the red line has dipped below $100 billion since 2011.

So Apple has been using its cash tactically, and the biggest way is that big light gray blob at the top of the chart – buybacks. You can see how it’s accelerated, and the net effect is to make the YoY EPS numbers better than the YoY net income numbers.

Guidance

Apple had an unusual miss on their guidance last December, but I would not count on it happening again. Let’s look at that ugly chart from above, but add in their high and low guidance:

Lo scenario assumes net 50M share reduction of weighted average share count. Hi assumes net 70M.

The December quarter is the fattest in terms of the iPhone and overall revenue. Cook was talking pretty optimistically regarding the Phase One trade deal and reduced tensions, but he did point out that the optimistic Hi scenario was predicated on that. In any event, if they hit that, it will be EPS of $4.70 vs. $4.18 last year.

The Big Risk: China and the Trade War

No one has more exposure to trade war risk than Apple, who sees risk on both the supply and demand side with China. Of course almost all their products are made there, and the December tranche of tariffs would hit them hard if implemented.

But a large part of their near-term growth scenario had been predicated on the Chinese consumer, and they are taking the hardest hit in all this. Maybe Apple’s strongest execution was in China this year, fighting big headwinds, but turning a -16% YoY growth rate to a -2% growth rate this quarter.

But still, this has the potential to turn ugly for Apple. It could put both their supply chain at risk, and also lose a huge source of future growth. Cook has been ingratiating himself with Chinese leadership for a decade now, and with Trump since he came into office. So far, they have been able to escape the worst, but that may not last.

Miscellany

  • Apple performed 3 billion Apple Pay transactions in the quarter, more transactions than PayPal (PYPL).
  • Wearables now generates more annual revenue than two-thirds of the Fortune 500.
  • They are getting close to half a billion paid subscriptions. That was 330 million just a year ago.
  • Apple returned $21 billion to shareholders at a net cost of $4.3 billion to net cash. They borrowed $7 billion for the first time since 2017.
  • Apple had $1.1 billion in foreign currency headwinds this quarter. Without it: China was slightly up; revenue up 3.6% vs. 1.8%; gross profit up 5.5% vs. 1%; EBT up 4.9%, vs. down 1.8%; net income up 4.7% vs. down 3.1% and EPS of $3.27 instead of $3.03.

Conclusions: The New Apple is the Same Apple

FY 2020 has begun, and the 2019 iPhones seem to be a little more popular than their predecessors, but not especially so if you look at the guidance. The 2020 iPhone will be the first 5G iPhone, and most analysts are looking for this model to be a big iPhone comeback. I am less convinced that 5G will be a must-have feature in a year, but I seem to be in the minority on that one.

In any event, regardless of the 2019 and 2020 iPhones, wearables and services seem to be poised to continue their rocket rise. We haven’t yet gotten to the point where their growth is replacing iPhone’s, but when iPhone is off nearly 10% YoY, and Apple can still show revenue growth, we are looking at a new Apple.

But it is still the same Apple. Apple makes one product: customer satisfaction, which, as always remains well into 90+% for all their product lines. Increasingly, there are more ways to buy it, and some more attractive ways to pay, but they all amount to the same thing, and it is the same thing they were selling when they only had the Apple ][.

I remain a huge Apple bull long term, though I think you will likely be able to pick it up cheaper than it is now. Always buy on the dip; there is always one coming. If you go back and read my WWDC coverage, what you see revealed is a company that has a complete tech stack – hardware, software, services – that their customers love, and their competitors cannot match. No one is better prepared for the future, whatever it brings.

Someday, something will replace the touchscreen smartphone as people’s main device. Apple will likely not have the first, but they will have the one that everyone else winds up copying.

Disclosure: I am/we are long AAPL. 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.

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