The Apple Services Machine

Apple's services business is remarkably strong yet surprisingly mysterious. A closer look at Apple Services reveals an apparatus, which can easily qualify as a Fortune 100 company, that isn't what it seems from the outside. Apple isn't becoming a services company focused on coming up with a myriad of ways to milk existing users. Instead, Apple's services strategy primarily reflects the company's long-held ambition of becoming a leading content distribution platform. 

Momentum

Services represent Apple's second-largest revenue source behind iPhone. In 2017, Apple reported $31 billion of Services revenue, which represented 13% of overall revenue. As seen in Exhibit 1, Apple Services revenue has experienced steady growth for years.

Exhibit 1: Apple Services Revenue (TTM)

Screen Shot 2018-05-15 at 3.05.48 PM.png

In recent quarters, Apple's services business has seen renewed momentum. As shown in Exhibit 2, Services revenue growth began accelerating in late 2015 and is now at multi-year highs. The growth likely coincided with very strong new user trends for the iPhone business. An acceleration in growth despite Apple's already large Services revenue base is that much more impressive. 

Exhibit 2: Apple Services Revenue (TTM) Growth

Screen Shot 2018-05-15 at 4.17.11 PM.png

The Services Machine

Services is a financial catch basin for Apple's non-hardware revenue. As disclosed in Apple's financial filings, Services consists of five categories: digital content, iCloud, AppleCare, Apple Pay, and licensing. 

Exhibit 3: The Apple Services Machine

 
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Digital content. This includes revenue from Apple's various content stores, including the App Store and iTunes. Apple Music is also included in this category. While Apple doesn't disclose the total amount of revenue associated with selling digital content, the company has provided the amount paid to app developers on an annual basis. This data point makes it possible to derive the total amount of App Store revenue. In addition, Apple regularly discloses the number of paid Apple Music subscribers, which can be used to derive Apple Music revenue.  

iCloud. Apple offers three tiers of additional iCloud storage (50GB, 200GB, and 2TB). Prices vary depending on the geography. The 200GB and 2TB storage tiers are eligible for family sharing. While Apple has not disclosed the number of users on a paid iCloud storage plan, management recently disclosed that iCloud revenue was up over 50% year-over-year to a record high, which implies good new user growth. 

AppleCare. Apple sells a number of service and support options for its products. 

Apple Pay. Apple earns a small percentage of every amount transacted through Apple Pay. Initial reports pegged this percentage at 0.15% for U.S. transactions. For every $100 of Apple Pay purchases in the U.S., Apple earns 15 cents. However, in the UK, Apple reportedly receives a smaller fee. Given Apple Pay's prominence outside the U.S., a safe assumption is that Apple earns on average less than 0.15% of every Apple Pay transaction.

Licensing and other services. Apple earns revenue from third parties for offering their services as default options on Apple devices. One of the more well-known examples is Apple's contract to have Google be the default search provider for Safari on Mac and iOS. Apple recently expanded its Google relationship to include Google for web searches via Siri and YouTube for video searches. Microsoft Bing remains the option for Siri image searches.

Estimating Services Revenue

Apple doesn't disclose the amount of revenue generated by each Services category. However, after sifting through years of earnings call transcripts as well as recent news releases involving the App Store and Apple Music, it is possible to put together a few pieces of the Apple Services puzzle. 

According to my estimates, Apple earns a majority of its Services revenue from delivering content to nearly a billion people using more than 1.3 billion Apple devices. In 2017, Apple earned an estimated $21 billion from selling digital content ranging from apps (especially games) to music and movies. 

Back in January, Apple disclosed that it paid $26.5 billion to app developers in 2017. Apple keeps either 15% or 30% of app revenue, depending on the app and whether it is a subscription. This suggests that overall App Store revenue was approximately $37 billion. Since Apple reports App Store revenue on a net basis, recognizing only the commission it retains, the full $37 billion of App Store revenue is not reflected under Services. Instead, Apple reports just its $11 billion share of the revenue.

The remaining portion of Apple's digital content revenue came from iTunes and Apple Music. Apple reports Apple Music revenue and some digital content sold through iTunes on a gross basis. This results in iTunes and Apple Music representing a large portion of Services revenue despite bringing in significantly less revenue than the App Store. In fact, iTunes and Apple Music likely contribute close to the same amount of Services revenue as the App Store. 

Exhibit 4: Apple Services Revenue Mix (2017)

 
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To put the preceding revenue totals in context, Apple Watch generated $6.5B of revenue in 2017. 

The primary reason Apple has experienced accelerating Services revenue growth since late 2015 is that the company has seen a dramatic increase in the number of people accessing its various content stores. The iPhone installed base grew by more than 100 million people each year from 2013 through 2017. These new users are spending an increasing amount of money buying various forms of content through Apple's stores. 

One of the more interesting revelations from my estimated Apple Services revenue mix is the degree to which licensing is a key revenue driver. My estimate has Apple earning $4 billion per year from licensing. While Apple doesn't discuss its licensing business, recent reports of Google paying much higher TAC (traffic acquisition costs) suggests Apple has seen strong growth in its licensing revenue. The growth is a result of iOS gaining power at the premium end of the smartphone market. Companies like Google increasingly need access to iPhone users in order to feed their free data capturing services. According to my estimates, the $4 billion of revenue associated with licensing is roughly the same amount of revenue generated by AppleCare.

While Apple has built new services revenue streams in the form of iCloud and Apple Pay, neither come close to matching the revenue associated with content distribution. Given the economics surrounding Apple Pay, it's not likely the service will be a significant revenue driver for Apple in the near term. For every $1 trillion transacted through Apple Pay, Apple would generate just $1.5 billion. As for iCloud, while management boasts about record revenue, the total likely pales in comparison to content distribution. 

Estimating Services Gross Margin

In addition to not breaking out Services revenue by category, Apple management has kept Services margins under wraps. We know from management commentary that Services end up boosting Apple's overall gross margins. This is a major clue suggesting Services gross margin exceeds 40%. One way of reaching a more specific Services margin estimate is to look at each revenue driver.

Exhibit 5: Apple Services Gross Margin Mix (2017)

 
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As shown in Exhibit 5, each Services category has a different gross margin. Licensing is likely the most profitable for Apple, followed by Apple Pay and iCloud. Extended warranties, such as AppleCare, are also highly profitable. The fact that Apple reports some iTunes revenue and Apple Music revenue on a gross basis weighs on digital content gross margins. Overall, my estimate is that Apple's services business has a 55% gross margin. 

The Services Strategy

Apple's services strategy is misunderstood. Many have looked at Apple's services momentum and concluded that Apple is turning into a services company. In addition, a growing number of people are positioning services as Apple's future. Neither viewpoint is true.

Apple has been pursuing two goals with services:

  1. Deliver Content. Apple has a long-standing ambition of leveraging its platforms in order to become a leading content distributor for apps, music, books, podcasts, and video. To claim that Apple has only recently begun to focus on earning revenue from delivering content is incorrect.  
  2. Increase Hardware Value and Functionality. Management looks at services as a key differentiator that increases the value found in using Apple hardware and software. Services like AppleCare, iCloud storage, and Apple Pay are designed to improve the experience found in using Apple hardware and software.

A recurring theme found with Apple Services is hardware dependency. Apple's ambition to be a content distributor is intertwined with its hardware capabilities. Without more than 1.3 billion devices in the wild, Apple's digital content revenue would be a fraction of its current size.

In addition, AppleCare, Apple Pay, iCloud, and licensing are also heavily dependent on the number of Apple devices in the wild. It is this hardware dependency that makes it impossible to look at Apple Services as a stand-alone business. The relationship between services and hardware is one reason why an Apple Services narrative on Wall Street hasn't been able to stick. The Services narrative isn't compelling if it excludes Apple hardware from the equation.

Apple's future isn't about selling services.  Rather, it's about developing tools for people. These tools will consist of a combination of hardware, software, and services. 

Looking Ahead

Apple management recently reiterated its goal of reaching approximately $50 billion of Services revenue by 2020. The most likely way Apple will reach this goal is by growing the amount of revenue associated with digital content distribution. App Store revenue has been growing by approximately 30% per year. Assuming Apple Music revenue growth more than offsets a decline in paid music downloads, Apple stands to grow its digital content revenue by at least $15 billion over the next two years. This will push Apple very close to its $50 billion Services revenue goal by 2020. These calculations don't take into consideration any new content subscription offerings from Apple.

Apple currently has more than 270 million paid subscriptions across its services, up over 100 million year-over-year. My suspicion is that a good portion of those subscriptions are content subscriptions. Apple is currently developing two new paid services for delivering content: Apple Video and a paid tier to Apple News. Each service will likely be given a long-term target of having at least 100 million paying users. In addition, Apple is in a good position to benefit from growing momentum for video streaming services including Netflix, HBO, and Hulu. It is not a stretch to claim that Apple will one day have 500 million paid subscriptions across its services. 

Apple isn't becoming a services company. Instead, Apple is building a leading paid content distribution platform. 

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Apple 2Q18 Earnings Expectations

Wall Street has major jitters when it comes to Apple's upcoming earnings release. Sentiment has decidedly swung toward the negative as questions swirl around iPhone X demand. Despite the dramatic downturn in expectations, Apple's stock price has held up remarkably well. While many eyes will be on iPhone sales tomorrow, my suspicion is that the data point won't have as much influence as consensus assumes. Instead, Apple's capital return update has the potential to be the major takeaway from 2Q18 earnings.  

The following table contains my Apple 2Q18 estimates. The ingredients are in place for Apple to report a slight EPS beat to consensus although 3Q18 revenue guidance will likely come in below consensus. 

My full perspective and commentary behind these estimates are available to Above Avalon subscribers. (Become a subscriber to access my full 5,000-word Apple 2Q18 earnings preview available here. To sign up, visit the subscription page.)

Items Worth Watching

Here are the five variables worth watching when Apple releases earnings on Tuesday: 

iPhone Channel Inventory. Given prior management commentary, iPhone unit sell-through growth and iPhone average selling price don't represent the major wildcards for 2Q18 earnings. Instead, the big unknown is found with iPhone channel inventory. A significant channel inventory drawdown will result in Apple reporting iPhone unit sales closer to 50M units. Vice versa, a relatively minor decline in iPhone channel inventory may lead to Apple reporting iPhone sales slightly ahead of my 52M unit expectation. 

iPad ASP. The days of dramatic iPad unit sales declines are over. Accordingly, instead of unit sales, average selling price (ASP) stands to provide much more information regarding the latest iPad trends. A weaker-than-expected iPad ASP may support the view that the 9.7-inch iPad at the low end of the line is likely gaining momentum at the expense of the higher-end iPad Pro options.

Other Products. Apple's "Other Products" category has the sales momentum. The line item includes various products such as Apple Watch, AirPods, HomePod, Beats headphones, iPod touch, and Apple-branded and third-party accessories. 

3Q18 Guidance. Apple's 3Q18 revenue guidance will likely provide a few clues as to how iPhone demand has been trending. One complicating factor when it comes to revenue guidance is that Apple's non-iPhone part of the business is seeing major momentum. iPhone weakness will be partially offset by strength in Other Products and Services. 

Capital Return. Apple will announce changes to its capital return program. My expectations are for a $100 billion increase to share buyback authorization and a 20% increase to the quarterly cash dividend. Management commentary regarding timing associated with share repurchases will be closely monitored. 

2Q18 Expectation Meters

Each quarter, I publish expectation meters ahead of Apple's earnings release. Expectation meters turn single-point financial estimates into more useful ranges that aid in judging Apple's quarterly performance.

In each expectation meter, the grey shaded area is my expectation range. A result that falls within this range signifies that the product or variable being measured is performing as expected. A result in the green shaded area denotes strong performance and likely leads me to raise my assumptions and estimates going forward. Vice-versa, a result in the red shaded area has the opposite effect and leads me to reduce my assumptions. 

I am publishing three expectations meters this quarter: iPhone unit sales, Other Products, and 3Q18 guidance. 

My iPhone unit sales expectation range stretches from 50M to 54M iPhones. iPhone unit sales within this range would be labeled as expected. If Apple reports iPhone sales greater than 54M units, results would best be described as strong. A sub-50M iPhone result would lead me to reassess my sales expectations going forward. 

For "Other Products," revenue that exceeds $4 billion would support the view that Apple Watch and AirPods were strong sellers during the quarter. HomePod sales will also likely contribute to the year-over-year growth in revenue.  

Screen Shot 2018-04-30 at 2.33.20 PM.png

Revenue guidance that exceeds $50 billion would likely be viewed positively while revenue closer to $45B would be viewed negatively. It is likely that Apple's 3Q18 revenue guidance will reflect a year-over-year revenue increase. The increase is due to momentum in Services and Other Products.

Above Avalon subscribers have access to my full 5,000-word Apple 2Q18 earnings preview (four parts):

  1. Setting the Stage
  2. iPhone Estimates
  3. iPad, Apple Watch, Mac, Services Estimates
  4. Revenue, EPS, Capital Return, 3Q18 Guidance

Subscribers will also receive my exclusive earnings reaction emails containing all of my thoughts and observations on Apple's 2Q18 earnings report and conference call. To read my Apple earnings preview and receive my earnings reaction notes, sign up at the subscription page

Making the Case for Doubling Apple's Share Buyback Pace

Next week, Apple will provide an update to its capital return program. In what has become an annual tradition, the announcement will include a sizable increase to Apple's share repurchase authorization and a hike in the quarterly cash dividend. Given recent management commentary, Apple's overall thought process regarding capital allocation is already known. The only way Apple will be able to accomplish its capital return goals is by doubling the pace of share buyback from current levels. 

Capital Return Update

For the past five years, Apple has used FY2Q earnings to announce updates to its capital return program. Here are the changes Apple announced to its share buyback authorization over the years:

  • 2012: $10 billion buyback authorization 
  • 2013: $60 billion (increase of $50 billion)
  • 2014: $90 billion (increase of $30 billion)
  • 2015: $140 billion (increase of $50 billion) 
  • 2016: $175 billion (increase of $35 billion)
  • 2017: $210 billion (increase of $35 billion)

In terms of the quarterly cash dividend, Apple has announced five increases over the years:

  • 2012: $0.38 per share
  • 2013: $0.44 (15% increase)
  • 2014: $0.47 (8% increase)
  • 2015: $0.52 (11% increase)
  • 2016: $0.57 (10% increase)
  • 2017: $0.63 (11% increase)

Excess Cash

In order to assess the most likely changes Apple will announce next week to its share buyback authorization and quarterly cash dividend strategy, we turn to recent comments from Apple CFO Luca Maestri: 

"Tax reform will allow us to pursue a more optimal capital structure for our company. Our current net cash position is $163 billion. And given the increased financial and operational flexibility from the access to our foreign cash, we are targeting to become approximately net cash neutral over time."

Maestri's comments tell us three things:

  1. Apple considers its current excess cash position to be $163 billion. After taking into account repatriation taxes, Apple's excess cash totals approximately $125 billion. 
  2. Apple wants to remove the vast majority of this excess cash from the balance sheet in order to reach "a more optimal capital structure." This isn't a management team that will sit on the excess cash indefinitely. 
  3. Apple's "net cash neutral" target implies management is okay with holding debt on the balance sheet. It's not likely that Apple will use excess cash to reduce its debt obligations significantly. 

In addition to holding $125 billion of excess cash (after taxes), Apple is also kicking off significant amounts of cash. A successful capital return strategy needs to account for this ongoing cash flow generation. The company is currently generating approximately $50 billion of free cash flow per year. This total reflects approximately $60 billion of operating cash flow per year and between $10 billion and $15 billion spent on property, plant, & equipment. Over the next five years, it is conceivable that Apple will generate more than $200 billion of free cash flow. Management has been funneling nearly all of its free cash flow into capital return initiatives. 

Combining Apple's $125 billion of excess cash currently on the balance sheet with its $200 billion of free cash flow generation, Apple is on track to have $325 billion of excess cash over the next five years. Without record-breaking increases to share buyback authorization and quarterly cash dividends, Apple will have trouble spending this excess cash prudently in a timely manner. Since 2012, Apple has spent just shy of $250 billion on capital return initiatives. Assuming Apple maintains its current share buyback pace and cash dividend payouts, it would take Apple close to ten years to spend $325 billion of excess cash. Big changes are needed in order for Apple to reach an optimal capital strategy in a reasonable amount of time. 

Changes

Apple has a number of options at its disposal when it comes to spending $325 billion of excess cash over the next five years. The company can utilize mechanisms like a Dutch auction tender offer to repurchase a significant number of shares in a very short amount of time. There are also various cash dividend strategies that management can follow involving special dividends. However, the odds of Apple utilizing such strategies are not high. Instead, Apple will likely follow its existing capital return strategy but at much higher levels. Such a strategy is realistic, achievable, and financially prudent for shareholders. 

One possible path Apple can follow includes announcing the following changes next week: 

  • Increase share buyback authorization by $100 billion (would represent a record increase).
  • Increase the quarterly cash dividend by 20% to $0.75 per share (would represent a record increase).

Buyback Changes

Apple is currently buying back approximately $30 billion of shares per year. While this is a significant amount for any company to spend on share repurchases, Apple will have to materially increase this buyback pace to spend its excess cash in a timely manner. At the same time, there are limits as to the number of shares Apple can realistically buy back before distorting the market.  (My Apple stock buyback program primer is available for Above Avalon subscribers here.)

Increasing share buyback authorization by $100 billion would give Apple the best of both worlds: the ability to buy back substantially more shares over the next two years while avoiding much market dislocation. In fact, a $100 billion authorization would allow Apple to double its buyback pace to $60 billion per year. Given Apple's daily trading volume, a $60 billion annual share buyback pace amounts to about 10 days of AAPL buying pressure. In subsequent years, Apple could announce smaller increases to buyback authorization in the range of $50 billion to $75 billion. This would be done to maintain the $60 billion per year buyback pace. 

As shown in Exhibit 1, Apple can continue to utilize both open market transactions and accelerated share repurchase arrangements (ASRs) to buy back shares. The ramp in buyback from 2017 to 2020 reflects the amount of time Apple will utilize to bring back foreign cash to U.S. subsidiaries. 

Exhibit 1: Apple Share Buyback

In the above scenario, Apple will have spent $275 billion on share buyback over the next five years. While Apple could certainly announce a larger increase to share buyback authorization next week such as $125 billion or even $150 billion, it's not likely that such authorization would result in a significantly higher buyback pace as Apple must still back its foreign cash to U.S. subsidiaries. In addition, a significant higher pace of share buyback would begin to raise questions about market dislocation.   

Dividend Changes

A scenario that includes doubling its share buyback pace will have a major impact on Apple's dividend strategy. The company has been following a dividend strategy of conservative year-over-year increases in dividend expense. Due to the share buyback program, Apple has been able to grow dividends per share by larger margins each year given the reduction in the number of shares outstanding. Whereas Apple's dividend expense has increased by 21% since 2013, Apple's quarterly cash dividend has increased 66% during the same time period. 

By ramping share buyback to $60 billion per year and increasing dividend expense gradually to $16 billion per year in 2021 (from the current $13 billion a year), as shown in Exhibit 2, it is possible for Apple to increase its quarterly cash dividend per share by as much as 80% over the next five years. In this scenario, Apple's dividend expense would increase by only 25% during the same time period.

Exhibit 2: Apple Dividend Expense

In the above scenario, Apple will have spent close to $75 billion on dividend expense over the next five years. The exact magnitude of Apple's dividend increase will be dependent on the price at which the company buys back its shares in the coming years. However, there is no question that Apple's quarterly cash dividend stands to benefit from a large increase in share buyback pace. An 80% increase over five years would bring Apple's quarterly cash dividend to $1.10 per share by the end of 2022. 

Summary

Apple's balance sheet objective is to reach an optimal capital structure by giving excess cash back to shareholders. This goal will be achieved via the continued use of share repurchases and quarterly cash dividends. Following U.S. corporate tax reform, and assuming continued robust free cash flow generation, Apple will possess as much as $325 billion of excess cash over the next five years.

As shown in Exhibit 3, a realistic and prudent way for Apple to remove this excess cash from the balance sheet is to double the pace of share buyback (from $30 billion to $60 billion) while gradually increasing the amount spent on dividend expense over time. 

Exhibit 3: Apple's Capital Return Program

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By spending $75 billion per year on capital return initiatives, up from the current $45 billion per year pace, Apple will be on track to spend more than $325 billion of excess cash in order to reach an optimal capital structure. 

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Apple Found a Wall Street Narrative

After months of iPhone sales estimates being slashed by analysts, expectations have been reset. The iPhone mega upgrade cycle of 2018 that so many were calling for is not going to happen. One assumes such a reset would have been accompanied by a significant decline in Apple's stock price. Instead, Apple shares have outperformed the market and continue to trade near all-time highs. The resiliency in Apple's stock price reflects the company finally finding a narrative on Wall Street, and it's not centered on the iPhone. Apple has become a capital allocation story. 

Narratives

Narratives matter on Wall Street. A compelling and easy to understand narrative allows companies to navigate rough waters such as a disappointing earnings report. Amazon and Netflix currently possess some of the strongest narratives on Wall Street. Amazon is all about coming up with the best retail experience for customers. Wall Street is OK with Amazon funneling a good portion of its operating cash flow back into the business with the intention of becoming a better retailer. Netflix is focused on delivering a superb entertainment experience in which subscriber dollars are used to fund additional video content. Profits are not as important as subscriber growth

Apple has long struggled with Wall Street narratives. A good argument can be made that Apple has never had a true Wall Street narrative. Instead, the company was judged merely by unit sales growth of whatever its best-selling product was at the time. This posed a challenge as unit sales growth will inevitably slow. In addition, a narrative revolving around unit sales growth ignores attributes that make Apple's business model unique. Apple is viewed merely as a hardware company. 

In early 2016, Apple management began disclosing new data points in an attempt to find a Wall Street narrative and in the process, get investors to think about the company differently.

  • Installed base related purchases. Instead of relying on the Services line item to denote the amount of revenue driven by Apple's installed base, management disclosed the amount of installed base related purchases. The much-higher total included revenue retained by third-party app developers and digital content owners.  
  • Number of paid subscriptions. In an effort to demonstrate Apple's ability to monetize the iOS base beyond hardware sales, management began disclosing the number of paid subscriptions across Apple's various services. The data point also reinforced the idea of Apple possessing a stream of consistent revenue. 
  • Number of devices in use. Apple disclosed the total number of devices in use to highlight the strength of its ecosystem.

While a narrative revolving around services or ecosystem strength seems attractive for Apple, the stories contain major holes. A significant portion of Apple's Services revenue is tied to growth in the iPhone installed base. According to my estimates, Apple has grown the iPhone installed base by more than 100 million users per year since 2013. Once this new user growth slows, which has already begun to occur, Apple's Services revenue growth will likely face a headwind. 

A narrative involving the Apple ecosystem and the number of devices in use addresses some of the downsides found with a services narrative. Even in an environment of slowing product sales, the number of active devices in use could still increase. However, an ecosystem narrative lends itself to Apple being judged by growth rates in terms of the number of devices in the wild. Both narratives lack sustainability. In addition, neither is able to capture the attributes that make Apple unique. 

Stock Price Outperformance

Evidence is building that Wall Street has begun looking at Apple differently. As shown in Exhibit 1, Apple's stock price began to outperform the market in 2017. Apple shares were up 48% in 2017, more than double that of the S&P 500. Apple has continued to outperform the broader market in 2018 despite a sharp increase in market volatility.

Exhibit 1: AAPL vs. S&P 500

Screen Shot 2018-04-18 at 1.54.24 PM.png

Many look at Apple's recent stock price outperformance as a sign that Apple management's efforts to weave a new narrative are working. Wall Street must be paying more attention to Apple Services or the broader Apple ecosystem. In addition, lofty iPhone sales expectations leading up to the iPhone X launch were repeatedly cited in the press as driving Apple's stock price increase in 2017. None of these explanations for Apple's stock outperformance sit well with me. Instead, there's likely something else at play. 

A New Narrative

In July 2017, two months before the iPhone 8, 8 Plus, and X were announced, I published "Wall Street Has Begun to Think About Apple In a New Way" with the following thesis: 

"The iPhone no longer has the same kind of influence over Apple shares as it once did. Instead, Apple has turned into a balance sheet optimization story on Wall Street. Apple's growing net cash balance (now standing at an all-time high of $158 billion) has taken the place of iPhone unit sales growth as the most influential variable impacting Apple shares."

With no new evidence disproving my theory, it is time to expand on my thinking. Apple has found a narrative revolving around capital allocation. Instead of iPhone sales or Apple Services revenue gaining importance, Apple's balance sheet strategy is driving the company's new Wall Street narrative. 

There are three core tenets to Apple's capital allocation narrative:

  1. Superb cash flow generation. Apple's business model predisposes the company to superior cash flow generation. Apple is able to monetize premium experiences more effectively and efficiently than anyone else. Instead of chasing scale, Apple sells tools that management think people will want and are willing to pay for. Scale ends up being merely a byproduct of a successful strategy. Apple is generating more than $60 billion of operating cash flow per year. 
  2. Capital efficiency. Apple's business model is remarkably efficient in terms of the amount of capital required to generate these cash flows. Instead of owning a complex web of factories, Apple has built a network of third-party suppliers and assemblers that are second to none. In addition, the company remains focused when it comes to funding capital expenditures for organic growth. As a result of these actions, Apple reports more free cash flow than Alphabet, Facebook, and Amazon combined
  3. Returning excess capital to shareholders. Given such strong free cash flow generation, Apple is kicking off more cash than management needs to fund growth opportunities. Instead of sitting on the excess cash or spending the cash on unattractive projects, management has shown the willingness to return excess cash to shareholders via share repurchases and quarterly cash dividends. 

Apple is a capital utilization machine spitting out more than $50 billion of free cash flow every year, nearly all of which will be used to fund the company's capital return program. This capital allocation narrative is not driven by any one product. Weaker iPhone sales won't derail the narrative. In addition, new revenue streams such as Apple Watch, AirPods, or growth in Apple Services don't represent holes in the narrative. Apple's new narrative is all about management's unique philosophy regarding how shareholder capital is used to generate future cash flows. Stronger product sales will lead to additional cash flows and consequently more cash for buyback and cash dividends. The opposite will be true as well with weaker product sales leading to a reduction in cash flow and less cash for share repurchases and cash dividends.

At its core, Apple's capital allocation narrative describes the company as a design-led organization tasked with developing tools for people. Apple doesn't develop products to drive revenue. Instead, many ideas are passed over to focus on a few really great ideas. Maintaining a focused product line and working closely with contract manufacturers on new processes to build products are key attributes of Apple's design culture. A narrative involving Apple's capital strategy rather than any story based on one particular product like iPhone or iPad ends up doing a better job of describing the company's design story.

Implications

There are a number of implications found with Apple possessing a capital allocation narrative on Wall Street. 

  1. Quarterly iPhone sales won't matter as much. While there will continue to be value in monitoring iPhone sales trends, Wall Street will increasingly not care about the quarterly gyrations in iPhone unit sales growth. This is my theory for why negative iPhone reports have simply been tossed aside by the market. 
  2. The level of free cash flow will gain influence. The emphasis won't be on any one particular product but rather on the collective result of new products such as Apple Watch, AirPods, HomePod, and new services contributing to Apple's overall cash flow picture. It is certainly possible that wearables and Services revenue growth will offset any weakness in the iPhone business. 
  3. Apple's capital return program will continue to matter. New disclosures related to Apple's share buyback and cash dividends have the potential to move the share price higher or lower depending on how new revelations compare to expectations. 
  4. New initiatives may be judged more strictly. Traditionally, Wall Street hasn't cared much about new Apple products and initiatives since they were financial rounding errors next to iPhone. However, with a capital allocation narrative, increased attention may be given to new strategies that have the potential to change Apple's thought process regarding capital and the balance sheet. 

Apple's capital allocation narrative has also led to changes in the way the market is valuing Apple shares. As shown in Exhibit 2, Apple's stock price is up more than the percentage increase in market cap. This is likely due to two factors: The market is valuing Apple's future cash flows at a higher multiple, and Apple's cash on the balance sheet is being priced differently since the share buyback program was launched. Both developments are likely a result of Apple's capital allocation strategy taking hold. 

Exhibit 2: AAPL vs. Apple Market Cap vs. Apple Enterprise Value

Screen Shot 2018-04-18 at 1.34.54 PM.png

Nearly all of the increase in Apple's enterprise value over the past five years has come from the market attaching a higher valuation to Apple's future cash flows (i.e. a higher market capitalization). Apple shares are currently trading at a 13.5x forward price to earnings multiple. Two years ago, this multiple was closer to 10.5x. Apple has experienced a nearly 30% increase in valuation multiple.

As shown in Exhibit 3, Apple's market capitalization and enterprise value are up by approximately $330 billion since the beginning of 2016. These are significant moves that are indicative of a major shakeup in Apple's shareholder base and the market's view of the company. Investors are focused on Apple's ability to generate significant free cash flows and then return excess cash to shareholders via share repurchases and cash dividends.

Exhibit 3: Apple Market Cap vs. Apple Enterprise Value

Screen Shot 2018-04-18 at 1.51.07 PM.png

Offsetting Pessimism

Despite the sharp increase in share price and valuation, Apple shares are still trading at a 20% discount to the S&P 500 when comparing forward price-to-earnings multiples. Some of this valuation discount may be due to Apple's capital allocation narrative not being as simple as other stories on Wall Street. However, the more likely reason is that the narrative is polarizing. Not every investor or market participant is behind Apple's story. Some investors may not have confidence in Apple's ability to continue generating robust levels of free cash flow. Various theories involving greater competition or Apple's inability to innovate can lead to more pessimistic cash flow projections. This is where the impact from Apple's share repurchase program enters the discussion. 

Apple has likely seen massive turnover in its investor base since launching its share buyback program. Over the past four years, Apple has used share repurchases to reduce the number of shares outstanding by 23%. Stories are everything on Wall Street, and Apple is using its share repurchase program to buy back shares from existing shareholders not buying into Apple's capital allocation story. Apple has been the largest buyer of Apple stock in recent years thanks to the share buyback. There is no question that this dynamic has likely played some role in Apple's stock price outperformance. 

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An Apple R&D Bonanza

After a brief lull, Apple's R&D expenditures are once again exploding higher. Apple's 2Q18 financial guidance implies the company will soon report the largest year-over-year increase in quarterly R&D expense in its history. Management is on track to spend $14 billion on R&D in FY2018, nearly double the amount spent on R&D just four years ago. The dramatic rise in Apple R&D expenditures raises questions regarding the company's product pipeline and whether management's overall approach to R&D is changing.

The Numbers

Apple's pace of R&D expenditures is nothing like the company has ever seen. The $14 billion of R&D expense that Apple will spend in FY2018 will be more than the amount Apple spent on R&D from 1998 to 2011. The CAGR for Apple's R&D expenditures has been a remarkable 32% since 1998. As seen in Exhibit 1, the ramp in Apple R&D expense spanning more than two decades has been breathtaking. 

Exhibit 1: Apple R&D Expense (Annual)

Another way to demonstrate the dramatic rise in Apple R&D is to look at the year-over-year increase in expenditures on a quarterly basis. As seen in Exhibit 2, beginning in FY2Q17, Apple R&D expense growth has been on an uptrend. The expected $725 million increase year-over-year in Apple R&D expenditures in FY2Q18 will be nearly 25% higher than the previous R&D expense growth record. This $725 million figure is obtained by using Apple's guidance for operating expenses and backing into estimates for SG&A and R&D expenses. The recent ramp in R&D expenditures suggests Apple is definitely up to something.  

Exhibit 2:  Year-Over-Year Increase in Apple R&D Expense (Quarterly)

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R&D Growth Drivers

It's easy to assume that the increase in Apple R&D expenditures over the years simply reflects Apple's expanding product line. However, there is more behind Apple's R&D expenditures. Three items are responsible for the growth in Apple R&D expenditures:

  1. Existing products. Apple is doing more these days given a broader product portfolio.  
  2. In-house tech development. Apple has positioned controlling the core technologies powering its devices as a main goal. 
  3. New products. Apple is developing products for which it has no guarantee of future commercial viability. 

Once a project's commercial viability has been established, it becomes that much more difficult for Apple to classify subsequent manufacturing or evolutionary product updates as R&D. This means that cash spent on developing new versions of existing products may not necessarily qualify as R&D. Instead, such expenses may have to be marked as a capital expenditure and amortized or depreciated over the life of the asset. 

Another item that isn't contributing to Apple R&D expense is Apple Park construction. Real estate construction costs related to general corporate usage, or even design labs where some R&D may take place, cannot be categorized as R&D expense. Instead, for real estate to be classified as R&D, there has to be uncertainty regarding future commercial viability. As an example, the numerous buildings Apple bought, or began leasing, in the mid-2010s specifically for Project Titan likely boosted R&D at the time. (A map of Project Titan buildings is available to Above Avalon subscribers.)

New Products

Whereas Project Titan was a leading R&D driver a few years ago, there are likely two new items now driving the recent surge in R&D expenditures: 

  1. Smart glasses. We know Apple is working on smart glasses given the company's M&A track record (Vrvana, SensoMotoric Instruments, patents, and subtle clues found in Apple management commentary. The team dedicated to the effort is likely massive.
  2. Content distribution efforts. Apple appears to have settled on a broader strategy for content, and it involves doubling down as a content distributor. Apple is investing big when it comes to delivering music, video, apps, news, and written content to more than 850 million users (of which 500 million visit the App Store on a weekly basis). Apple's effort to launch a video streaming service from scratch is likely being classified as R&D. For example, Apple has no guarantee that money spent on script development will lead to a commercially viable video streaming product. We also know Apple is reportedly spending $1 billion on original video content. 

Apple is also continuing to work on doubling down on hardware to control the brains powering its products. As long as the byproduct of such efforts leads to products that are significantly different from existing products, Apple is likely able to qualify such efforts as R&D. Ongoing costs associated with Project Titan are also likely substantial, especially relative to smaller product-specific projects found throughout Apple. 

Changes

Although Apple remains an incredibly focused company when it comes to products, the amount of money spent on R&D would seem to suggest that management may be relaxing its focus mantra a bit when it comes to researching new ideas. As seen in Exhibit 3, Apple R&D expenditures as a percent of revenue now stand at a 14-year high. This tells us that Apple is spending more on R&D for every dollar of sales earned despite the dramatic rise in sales over the years. For some companies this may not mean much, but for Apple it can't be ignored. 

Exhibit 3: Apple R&D Expense as a Percent of Revenue

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There are a few possible explanations for the growth in Apple R&D expenditures in recent years:

  1. Greater ambition. Apple finds itself in a position of being able to do a whole lot more. It is estimated that Apple spent $150 million to build the first iPhone in the mid-2000s. At the time, it was a significant amount of cash for Apple. Nearly ten years later, Apple finds itself spending that much money developing one show for its upcoming video streaming service. To a certain degree, Apple management may feel it has an obligation of having to do more given its size. As Tim Cook recently put it, "We can do more things than we used to do because we’re a bit bigger." 
  2. Competition. One factor driving Apple's ambition to do more is competition. It is no longer enough just to control hardware and software. Apple now finds itself needing to control the technologies powering its devices. Bringing development of fundamental technologies in-house doesn't come cheap. Apple has opened a series of R&D centers around the world (China, Japan, India, Indonesia, New Zealand, Canada, France, Italy, Israel, Sweden, and the U.K.), many of which are tasked with developing hardware. Some of these R&D outposts are a result of Apple acquiring teams of talent. 
  3. More experimentation. Apple is likely experimenting much more when it comes to new ideas and processes. While there is no evidence of Apple allowing more of these ideas to actually proceed to market, it sure looks like Apple management wants to be in a position where it can afford to say "no" to more ideas than in the past. 

The third point involving additional experimentation ends up being the most interesting. For a company that positions its ability to focus on a few things at any one time as a core competency, increased experimentation seems to be at odds with this value.

Apple R&D Theory

My theory on the dramatic rise in Apple R&D expenditures is that management is becoming more ambitious. Apple's future is found in new industries. Just as Apple moved from desktops/laptops to personal music players, smartphones, and watches, the company will need to enter new industries to remain relevant. This is not a company that is holding onto the iPhone as tight as possible for fear of change. Apple management is investigating new ideas and processes in order to support future moves into new industries.

This explains Apple's ongoing interest in transportation and Project Titan, an area that Apple has pretty much no expertise in. We have Apple building an entertainment arm from scratch despite having no experience developing scripted content. In each case, Apple has had to rely on outside hires and significant cash outlays to build core competencies. 

It's not that Apple has thrown its focus mantra out the window. Apple remains very selective in terms of both its M&A activity and deciding which products make it to market. Instead of funding significant R&D endeavors with no intention of them one day leading to a product, Apple's R&D remains focused on ideas that at least have the potential to see the light of day. The years of development behind making Face ID a reality would be a recent example. 

Much of this focus mantra is driven by the fact that Jony Ive and his Industrial Design group oversee Apple's product vision and the user experience found with Apple products. With only 20 or so members, Jony and team can only do so much at any given moment. In a way, Apple's organizational and leadership structure serve as safeguards preventing Apple from spreading itself too thin and doing too much. Instead of trying to expand the design team in order to work on more products, Apple's strategy appears to be to do the opposite and place bigger bets on a few products.

These bigger bets come in the form of owning the core technologies powering Apple devices. Apple wants to reduce dependency on others. We are quickly moving to the point at which every Apple product will be powered by core technologies developed in-house. Such a reality would have been a pipe dream just a few years ago. Apple believes this strategy will give them an advantage in the marketplace. It's a new twist to the Alan Kay line about "people who are really serious about software should make their own hardware." We are moving to the point at which companies serious about software should design their own silicon. Having $285 billion of cash on the balance sheet gives Apple the freedom to pursue this ambitious goal. It is this motivation to control more of the user experience while pursuing new industries to enter that is driving the remarkable increase in Apple R&D expenditures. 

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