Above Avalon Podcast Episode 137: A Cheaper Buyback

Given the magnitude of its buyback program, excess cash position, and free cash flow generation, no other public company is in as good of a position as Apple to benefit from stock market turmoil. Episode 137 is focused on how Apple can leverage its buyback program to take advantage of stock market dislocations. The discussion begins with my thoughts on the recent weakness in AAPL shares. We then look back at previous AAPL stock downturns to find a few similarities and takeaways. The discussion turns to Apple’s share buyback and the impact a change in stock price has on Apple’s buyback activity. Additional topics include Apple buyback scenarios, valuation, and the irrationality found in comparing a company’s stock price to its underlying health.

To listen to episode 137, go here

The complete Above Avalon podcast episode archive is available here

Leveraging Apple's Share Buyback

AAPL has had a rough two months. The shares are down nearly 20% from all-time highs, shedding $275 billion of market cap in eight weeks. Unprecedented does a good job of describing the fall’s magnitude and speed.

Apple’s dramatic stock price drop is now leading to a surge in pessimism towards the company. An increasing number of Apple management’s actions are being questioned while criticism is being thrown at various Apple products. In reality, most of this criticism is nothing more than a byproduct of a declining stock price. This has happened before, and a closer examination of previous stock price drops suggest Apple management will use the lower AAPL share price to its advantage by leveraging its share buyback program.

Why Is AAPL Down?

Surfing through Twitter over the long Thanksgiving weekend led to some Apple-related observations. There was no shortage of reasons being passed around for why the company’s stock price was in free fall:

  • Apparently, no one is buying the newest iPhones because they are too expensive.

  • Management must want to hide something really bad by no longer disclosing unit sales data.

  • Apple’s fortunes in China continue to sour.

In essence, there was a surge in fear, doubt, uncertainty, and overreaction.

People love to come up with reasons for why a particular stock or market index is up or down on any given day. Much of this is due to the human desire to add clarity to what is an inherently unknown process. Unfortunately, the only way to figure out why Apple’s stock price dropped more than 20% would be to poll every market participant as to why he or she sold or bought shares. Obviously, this isn’t feasible.

We know a few developments took place in recent weeks:

  1. Apple provided slightly weaker-than-expected 1Q19 revenue guidance and cautious commentary. Management cited uncertainty around supply for some of the new products, slowing demand in emerging markets (India, Turkey, Brazil, and Russia), and foreign currency headwinds.

  2. Apple announced it would no longer provide unit sales data, which came as a shock to Wall Street, who as a collective body relied on unit sales as a financial crutch. While consensus has been negative on the move, management’s decision makes sense given how unit sales have been telling us less about business fundamentals over time.

  3. Apple EPS estimates are being revised lower. While every analyst is guided by different motivations, many have cited Apple’s 1Q19 guidance and weaker demand for flagship iPhones as driving their lower estimates. Over the past month, FY2019 EPS estimates have been cut by 2% although many analysts have yet to update numbers. My FY2019 EPS estimate was cut by 7% due to a higher tax rate going forward and lower revenue attributed to a number of product categories. Above Avalon members have access to my current earnings model here.

  4. The broader stock market has been in disarray. The four largest companies saw nearly $800 billion of market cap wiped away in less than two months. On a combined basis, Apple and Amazon saw more than $500 billion in market cap evaporate.

While some market participants may have been swayed by one or more of the preceding developments, others may have been guided by unrelated matters. Accordingly, the most accurate explanation for why Apple shares lost $275 billion in market cap is because Apple shares were down. Selling pressure begets more selling pressure.

We’ve Heard This Song Before

Apple’s stock price has never been immune from rough patches. Prior to 2018, the most recent downturn occurred in 2015 and 2016. Over the course of a year, the stock traded down 30% from an adjusted $124 to $87. There was even a two-month span from November 2015 to January 2016 in which shares fell nearly 20%, reminiscent of AAPL’s recent downturn.

The 2015 and 2016 stock price decline was set within an environment of slowing iPhone sales. In November 2015, Apple provided weak 1Q16 revenue guidance. The implication was that iPhone unit sales growth would soon evaporate despite Apple having just reported 37% unit sales growth in FY2015. Wall Street quickly turned its attention to 2Q16 guidance to determine if iPhone sales weakness would be temporary or a longer-term trend.

Three months later, Apple’s 2Q16 guidance not only implied even weaker iPhone sales, but also an overall year-over-year decline in revenue. Many market observers became concerned about the long-term health of the iPhone business. Analysts fumbled over each other in a rush to cut estimates. AAPL shares ended up bottoming three months later and then went on to see two years of gains totaling 150%. Apple added $600 billion of market cap during this time period as its forward P/E multiple increased from less than 10x to 15x.

Apple went through an even steeper stock price decline in 2012 and 2013 when shares fell 37% from an adjusted $69 to $44. However, the circumstances around that decline were quite a bit different. Apple’s gross margins were evaporating due to the iPad mini launch. Apple’s revenue growth then began to slow as iPad sales imploded. There were also genuine fears in the marketplace that the iPhone would lose at the hands of Android smartphone manufacturers. In summary, the worry was that Apple’s long-term gross margin picture would deteriorate, resulting in less profits and cash flow.

Looking back at previous AAPL downturns, a few takeaways become apparent:

  1. Expectations reset. AAPL shares faced an earnings expectations reset. Either gross margin projections were dialed back or the company’s revenue growth projections were cut. Both changes had a negative impact on earnings expectations.

  2. Negative sentiment. The broader narrative around Apple had turned remarkably negative. In 2012 and 2013 it was about competition driving lower margins while in 2015 and 2016, it was based more on a slowing iPhone upgrade cycle.

  3. Bottoming process. AAPL shares put in a trough once market commenters and analysts stopped trying to call a bottom and instead assumed the stock would keep falling. In essence, once people stopping paying attention to AAPL and expectations had been reset, the shares were in a better position to begin outperforming.

It shouldn’t come as a surprise that the most recent AAPL stock price move is taking place during an earnings expectation reset. Analysts are cutting estimates due Apple’s 1Q19 revenue guidance and fears of slowing iPhone sales although it is debatable if overall iPhone demand is actually that much different from that of previous quarters. In my view, fears of an iPhone demand implosion are off-the-mark.

Similar to previous stock price downturns, AAPL stock weakness is also leading to a rise in criticism facing the company. Some people are convinced that Apple is getting greedy by charging higher prices for iPhones, iPads, and Apple Watches. Gross margin data, which Apple will break out between Services and hardware for the first time, will shine much light on the issue. My expectation is that margin data would show higher product prices are primarily to reflect the additional technology included in the latest flagships. Add in worries about slowing emerging markets growth and the U.S. / China trade tension boogeyman, and the result is a toxic brew of Apple revenue growth concerns.

The Buyback Wild Factor

Instead of going on the PR offense to calm fears about business and product demand, Apple management is in a prime position to stay quiet and take advantage of AAPL share weakness. Given the lower stock price, Apple can leverage its share buyback program to repurchase additional shares for the same amount of cash.

Apple began buying back shares at the end of 2012. Over the span of six years, Apple has spent $239 billion buying back 2.1 billion shares at an average price of $115 per share. As seen in Exhibit 1, Apple’s total number of shares outstanding has been on a steady decline and is now 25% below peak levels. This is another way of saying Apple has repurchased 25% of itself over the past six years.

Exhibit 1: Apple Shares Outstanding

Breaking out Apple’s buyback by quarter, it’s easy to see management’s decision to ramp its buyback pace following U.S. tax reform. Apple no longer has an excess cash dilemma with cash “stuck” in foreign subsidiaries.

Exhibit 2: Apple Share Buyback ($)

As Apple’s stock price increased, it took much more cash to repurchase the same number of shares. In essence, the share buyback became more expensive. For example, Apple repurchased 92 million shares via open market transactions last quarter to the tune of $19 billion. This total ended up being a little more than double the number of shares repurchased in 2Q16 (41M) via open market transactions, for which Apple spent just $4 billion on open market repurchases. Apple paid an average of $210 per share with its repurchase activity last quarter versus $98 in 2Q16.

Apple is currently spending $20B on buyback per quarter. As shown in Exhibit 3, assuming AAPL shares remain near $180, Apple will be able to buy back 330M additional shares over the next two years versus if Apple shares were trading at $230+. An additional 330M shares amounts to buying back seven percent of the company in just two years. This exercise assumes Apple spends the same $20B per quarter.

Exhibit 3: A Cheaper Apple Stock Buyback

If Apple shares trade down to $160, management would be in a position to buy back nine percent of the company in two years. This amounts to 30% more than what can be repurchased at $180, assuming the same $20B is spent on buyback every quarter.

For every $10 price drop in AAPL shares, management can repurchase an additional one percent of the company over two years, assuming Apple spends the same $20B per quarter on buyback. This produces an interesting dynamic as it is in Apple management’s best interest, from the perspective of the share buyback, for AAPL shares to decline in price.

Valuing Apple

Share buyback is not created equal. For some companies, buying back shares is a mistake and nothing more than a ploy to distract shareholders from mismanagement. For other companies, share buyback is a very attractive way to return excess cash to shareholders.

From Apple management’s perspective, as long as AAPL shares trade at an appropriate valuation, the buyback is an attractive way to return excess cash to shareholders. Apple is generating more than $50 billion of free cash flow per year, all of which can be returned to shareholders. Free cash flow is the cash left over after investing in the business and organic growth opportunities. Given Apple’s balance sheet, the company has about $125 billion of excess cash that can be returned to shareholders. Combining the excess cash with free cash flow generation, Apple is in a position to continue the current $20B of buyback per quarter for the foreseeable future.

The key ingredient required for Apple to properly leverage its share buyback is maintaining the buyback pace even in the face of market volatility and dislocation. This is where Apple management has a significant advantage over the market.

Tim Cook and Jony Ive are overseeing a design company tasked with coming up with tools for people. Given how Apple is a toolmaker, the market has had a very difficult time valuing the company’s future cash flows. Revenue and profits are the result of a successful product strategy built on intense collaboration and focus. Once a product ships, the Apple machine keeps churning, pushing out iteration after iteration in a process that is hard for competitors to match.

A consequence of this product strategy is that at any given moment, by just looking at the products Apple is currently selling, one is seeing only a snapshot of the Apple machine. Most of Apple’s long-term value is found with the process used to come up with future products. The market is not in a good position to value this process.

During periods of severe market dislocation, Apple’s market value can swing by hundreds of billions of dollars. For example, Apple’s enterprise value is currently $750 billion, down from $975 billion at the beginning of October. Apple management has an advantage when it comes to determining whether Apple shares are under or overvalued given the unannounced product pipeline. In addition, management is in a good position to judge how effective the Apple machine is in coming up with new ideas for future growth.

By capitalizing on the market’s worry, anxiety, and unease, Apple management can leverage the share buyback program to buy additional shares when Apple shares come under pressure. Given the magnitude of the buyback program and Apple’s free cash flow generation, no other public company is in as good of a position as Apple to benefit from stock market turmoil.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 136: The Unit Sales Crutch

The most surprising part of Apple’s 4Q18 results wasn’t found with the numbers or even guidance. Instead, by announcing unit sales data would no longer be provided starting in 1Q19, management dropped a bomb on Wall Street. Episode 136 is focused on discussing Apple’s decision to move beyond unit sales. We go over how unit sales became a crutch for financial analysts. The discussion then turns to management’s new blueprint for how it wants Wall Street to judge Apple. Additional topics include Apple revenue and gross margin trends, Wall Street narratives, and Apple as a toolmaker.

To listen to episode 136, go here

The complete Above Avalon podcast episode archive is available here

Apple Outgrew Unit Sales

In 2014, Apple management surprised many by announcing they were not going to disclose Apple Watch unit sales once the product went on sale the following year. The decision was interpreted by many outsiders as Apple not thinking too highly of Watch’s prospects. As it turned out, nothing could have been further from the truth. Apple’s Watch disclosure decision ended up foreshadowing management’s recent announcement that it will no longer disclose iPhone, iPad, or Mac unit sales. While a number of factors are behind Apple’s decision, the simplest explanation for the disclosure change is that Apple outgrew unit sales.

Disclosure Changes

Apple announced four financial disclosure changes for the new fiscal year (2019):

  1. Unit sales data for iPhone, iPad, and Mac will no longer be provided.

  2. Gross margin data will begin to be broken out by services and products (i.e. hardware).

  3. Revenue corresponding to the amortization of the deferred value of bundle services (Maps, Siri, and free iCloud) will shift from products to services. The same reclassification will apply to costs associated with delivering the bundled services. The impact from these changes will amount to less than 1% of Apple’s overall revenue.

  4. The “Other Products” category will be renamed “Wearables, home, and accessories” to reflect the category’s primary revenue drivers (Apple Watch, AirPods, Apple TV, and HomePod).

Not surprisingly, most of the attention flowed to the first item. The thought of Apple no longer disclosing unit sales surprised most people and some went so far as to say Apple wants to hide something really bad in the coming quarters. Others acknowledged Apple made the right decision to move beyond unit sales, although it wasn’t a great development in terms of public company disclosure.

The Unit Sales Problem

Apple management’s decision to no longer disclose unit sales makes plenty of sense. In recent years, it was becoming increasingly clear that unit sales weren’t as useful of a metric for analyzing Apple’s business now as it had been in the past. The primary problem found with unit sales was how the data provided a limited look inside the Apple machine.

Consider the following items:

Unit sales became a crutch for financial analysts. The quarterly numbers were telling us less about Apple’s business and were instead providing a false sense of security to outsiders. As it turned out, unit sales were painting a less attractive picture of Apple’s business fundamentals.

The primary reason unit sales data lost much of its value is Apple’s significant growth over the years. With an iPhone installed base of more than 750M people, quarterly iPhone unit sales were providing less information about the iPhone business. Unit sales went from a measure of the market’s reception to iPhone to a financial data point more likely to be misinterpreted than anything else. The same can be said about the iPad and its installed base of 240M people. Years of unit sales declines gave many the impression that iPad was a dead-end. In reality, iPad fundamentals have been improving for years. Unit sales data was masking the improvement.

The one item that for which unit sales continued to prove valuable was deriving average selling prices. However, given the growing impact the gray market is having on Apple’s various product categories, and wider product price ranges, even ASP data has started to lose value in analyzing business fundamentals.

Revenue and Gross Margin

Analysts are making a big mistake in claiming Apple’s decision to move away from unit sales means management wants to be more like a services company. Claiming Apple is a services company in 2018 is no different than claiming Apple was a hardware company ten years ago. Both are incorrect.

Apple is a design company focused on developing tools for people. These tools allow people to get more out of technology without having technology take over their lives. This mission leads to a simple, but important, realization: Apple has to continuously develop new tools that people want. A question raised by such a mission is how best to measure Apple success and failure.

Management is painting a new long-term blueprint for how it wants Wall Street to judge Apple: revenue and margins. By having attention flow not just to revenue but also to gross margins, Apple ends up adding an interesting twist to the financial disclosure debate.

Revenue has been one of the most consistent metrics for determining how Apple is doing in the marketplace. Exhibit 1 depicts Apple revenue over the past eight years. Despite years of unit sales volatility, Apple’s revenue trends have been much smoother. The only hiccup in Apple revenue followed a surge in iPhone revenue in 2014 associated with the iPhone launching at China Mobile.

Exhibit 1: Apple Revenue (TTM)

Management will continue to disclose iPhone, iPad, and Mac revenue going forward. It’s difficult to see Apple not eventually disclosing Apple Watch revenue, or at least wearables revenue, as sales continue to grow.

However, revenue data by itself is unable to tell the full story. Management could juice near-term revenue by running with lower prices and margins in an attempt to grab market share. Such a move may boost near-term revenue at the expense of problems down the road. Vice-versa, Apple could be generating additional revenue by milking existing customers with excessively high prices and margins. The strategy contains various long-term risks when thinking about the health of the Apple ecosystem.

This is where gross margins enter the picture.

Gross margin data allows outsiders to dive deeper into Apple revenue. Strong revenue growth combined with steady margins tell us that Apple isn’t chasing market share with unsustainable pricing. Steady gross margins, despite higher-priced products, tell us that Apple isn’t milking existing users of profit, but is instead running with higher prices to reflect additional technology. Gross margins add much-needed context to Apple revenue.

Historically, Apple has disclosed one overall gross margin figure for the entire business. Given the lack of disclosure detail, we were only able to reach a few general takeaways about Apple’s gross margins.

  1. Given how Apple’s overall gross margins trend between 37% and 39% and iPhone represents such a large portion of the revenue, it’s fair to assume iPhone margins are somewhere around 40%.

  2. Based on management commentary, Apple’s Services business has gross margins that exceed the company’s overall margins. This tells us that Services gross margin exceeds 40%. My estimate pegs Services gross margin in the mid-50s.

  3. Based on management commentary, Apple Watch gross margins were lower than the company’s overall margins. This tells us Watch margins are somewhere around 25% to 35%. It is a fair assumption that iPad and Mac have a similar margin profile.

As shown in Exhibit 2, for the past four years, gross margins have trended within a narrow 200 basis point range. This hasn’t exactly told us a whole lot about the different variables driving gross margins. Based on Apple’s new margin disclosure, management will break out gross margins by hardware and services. Accordingly, we will be able to see whether or not Apple has been running with higher product margins to boost profits or merely to reflect higher component costs. (My suspicion is it’s the latter.) We will also get our first look at Apple’s Services margins which will help decode the various Services revenue growth drivers. In summary, providing more granular gross margin data is a big step forward from a financial disclosure perspective. While it may seem like an exaggeration, trading unit sales data for more granular gross margin data could prove to be more beneficial for analyzing Apple’s business fundamentals.

Exhibit 2: Apple Gross Margin (TTM)

What About User Growth?

One school of thought regarding Apple’s unit sales disclosure change is that management is gradually moving towards providing completely new metrics such as the number of users in the Apple ecosystem. Apple’s success would then be measured by tracking the total number of users and management’s ability to monetize those users. One way of doing this would be to take Apple revenue and divide the total by the number of users.

Presumably, rising revenue per user would be viewed as a good thing, while a declining revenue per user metric would be viewed negatively. However, there are a few issues to consider.

  1. It’s not sustainable. Unless Apple changes its pricing philosophy, the company will eventually begin to hit a ceiling when it comes to new user growth. Accordingly, why would Apple management elevate an unsustainable metric, especially since the company is moving away from unit sales given its unsustainable nature.

  2. Questions around usefulness. It’s not entirely clear how useful revenue per user actually would prove to be for analyzing Apple. Unless Apple breaks down revenue per user by hardware and services, the overall average won’t tell us much about the various moving parts.

  3. Bias towards services over hardware. By focusing on revenue per user, there is an inherent bias to elevate Services revenue given its more predictable and steady nature.

It’s All About Narratives

The decision to elevate revenue and margins while moving past unit sales is Apple management’s latest attempt to cement a new long-term narrative for the company on Wall Street.

People love great stories, and Wall Street is all about narratives. A strong narrative allows a management team to navigate rough waters while a weak narrative may result in depressed valuation multiples. Accordingly, Apple’s inability to find a sustainable narrative has been a thorn in management’s side for years.

Apple’s narrative problem was relatively straightforward: The key variables management focused on in earnings releases and conference calls weren’t sustainable. By placing an emphasis on unit sales, the inevitable slowdown in unit sales growth for its largest product categories posed a problem for Apple.

Forcing Wall Street to move beyond unit sales and focus on revenue and gross margins isn’t about driving home a Services narrative for AAPL shares. Instead, it’s a big step in elevating a capital allocation narrative. Compelling tools will lead to strong revenue trends and margins, which support attractive free cash flow and consequently more cash for buyback and cash dividends. The opposite is true as well with weaker product sales leading to a reduction in cash flow and less cash for share repurchases and cash dividends.

At the heart of this narrative is management's unique philosophy regarding how shareholder capital is used to generate future cash flows. Apple doesn't develop products to drive revenue. Instead, many ideas are passed over to focus on a few really great ideas. A narrative involving Apple's capital strategy rather than any one story based on a particular product like iPhone or Apple Watch will end up doing a better job of describing the company's design story. More importantly, a capital allocation narrative will be able to grow with Apple as the company evolves over time.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Apple 4Q18 Earnings Expectation Meters

Apple will report another good earnings report on Thursday. Revenue guidance for 1Q19 will be one for the record books as Apple will guide to its best quarter ever. However, when diving down deeper into Apple’s 4Q18 results, things may look a bit messier. The fourth quarter was one of transition for Apple as the company launched new iPhones and Apple Watches. It would not be surprising if demand for a number of product categories waned heading into September. However, stronger iPhone and Apple Watch ASP trends will more than offset unit sales weakness.

Estimates

The following table contains my Apple 4Q18 estimates.

The methodology and data behind my estimates are found in my full 3,600-word Apple 4Q18 earnings preview available here exclusively for Above Avalon members. (To become a member and access my full earnings preview, visit the membership page.)

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 white shaded area reflects my single-point estimate. The gray shaded area represents my broader expectation range. A result that falls within this gray range signifies that the product or variable being measured is pretty much performing as expected. A result that falls in the green shaded area denotes strong performance and the possibility of me needing to increase my estimates going forward. Vice versa, a result falling in the red shaded area has the opposite effect, potentially leading me to reduce my assumptions going forward. 

As with last quarter, I am publishing three expectations meters for Apple's 4Q18:

  1. iPhone unit sales

  2. "Other Products" revenue

  3. 1Q19 revenue guidance

iPhone

My expectation is for Apple to report iPhone unit sales between 44M and 48M units. A result north of 48M units would be considered strong while a sub-44M result would be considered weak.

Other Products

Apple's "Other Products" category is a catch basin for the following products: Apple Watch, AirPods, HomePod, Apple TV, Beats headphones, iPod touch, and Apple-branded and third-party accessories. The closer 4Q18 "Other Products" revenue is to $5B, the more likely it is that Apple Watch and AirPods results were strong. A result closer to $4 billion of revenue would reflect some Watch demand being pushed into 1Q19 due to customers waiting for Apple Watch Series 4.

Guidance

Apple’s 1Q19 revenue guidance has a good shot at exceeding Wall Street’s expectations. My $98B to $100B revenue guidance estimate is $5B to $7B higher than consensus. The discrepancy is likely explained by different estimates regarding iPhone unit sales mix and its impact on iPhone ASP.

My full 4Q18 earnings preview contains three parts:

  1. Setting the Stage

  2. iPhone, iPad, Mac, Apple Watch, and Services Estimates

  3. 1Q19 Guidance, Updated Apple Earnings Model, Final Thoughts

To read my full preview and receive my Apple earnings review later this week, sign up at the membership page