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