I get asked the question all the time, “why are you writing this article?” The short answer is there are several companies that I follow and write articles about on a regular basis. I’ve been accused of being an Apple (NASDAQ:AAPL) fanboy, yet in other articles, I’ve been asked if I was shorting the stock. To be clear, I own Apple shares, and I’ve never shorted a stock. I own Apple products as well. However, shareholders, who aren’t willing to believe that Apple has challenges, are investing with their eyes closed. The stock has been on a tear this year despite declining revenue. The company’s last earnings report made clear three significant challenges facing Apple. In short, it may be time to take some profits, as the market digests the company’s new reality.
Watching for growth
For years, Apple has grouped multiple products into one revenue line item. While iPhone, iPad, Mac, and Services get broken out separately, Apple Watch hasn’t earned this distinction yet. In fact, Apple Watch doesn’t even get its name mentioned. Instead, it’s part of “Wearables, Home and Accessories.” Investors have been calling for a breakdown of Apple Watch sales for a while, and given the current Watch is technically the 5th version, this revenue detail seems long overdue.
(Source: Apple Watch)
According to Counterpoint Technology Market Research, Apple holds nearly 36% of the global smartwatch market. The company said the ECG feature on the Series 4 is driving demand. Tim Cook said that Wearables growth was near 50%. In addition, Luca Maestri CFO said that, “three quarters of purchases going to customers who have never owned an Apple Watch before.” On the surface, it seems Watch is a huge opportunity for the company, and investors should be excited.
(Source: Counterpoint Technology Market Research)
However, if we dig a little deeper into the numbers, there are threats on the horizon. This brings us to the first significant challenge facing Apple. Apple Watch’s growth will likely slow down beginning this year. First, the Series 4 was introduced in September 2018, and the ECG feature was a unique reason to buy for the first time or as an upgrade option. However, as we get closer to the anniversary of this model, Apple will have to come up with a leap forward for the Series 5 if customers are going to continue buying and upgrading at the same rate.
Second, though smartwatch sales have grown significantly, research suggests a slowdown is coming. According to Allied Market Research, the smartwatch market is expected to grow at a compound annual growth rate (CAGR) or just over 16% through 2025. Another study suggests a CAGR of 16.4% and yet another suggests a rate of as much as 18.4%. It seems the biggest growth in the smartwatch market has already occurred.
Third, as Apple has seen with other devices, the company’s market lead may not stay safe forever. In the above chart, two of the significant market share gains were from companies that Apple is all too familiar with. Samsung (OTC:SSNLF) moved up from 7.2% to 11.1% of the global market. Fitbit’s (NYSE:FIT) focus on smartwatches moved the company’s market share from 3.7% to 5.5%. While Apple managed to maintain its market share despite gains from other companies, at some point, it’s logical to expect Apple’s market share may suffer. With potential market share challenges and much slower growth coming in the next few years, Apple Watch may not be the massive growth business some investors expect.
If we look at Apple’s quarterly revenue, including Apple Watch, it increased from $3.2 billion in Q4 2017 to $4.2b in Q4 2018. By Q4 2018, following this same pattern would suggest revenue of about $5.5 billion. If we annualize current quarter results, this suggests “Wearables, Home and Accessories” will generate about $20 billion in revenue for 2019. Based on analyst estimates, this amount would equate to about 7.8% of the company’s total revenue for the year. By 2020, with the market expected to grow at about 16%, Apple’s other businesses would generate about $23.2 billion, or 8.6% of overall expected annual revenue. The bottom line is Apple Watch and these other devices may be great businesses, but the days of 50% growth may end this year.
How long can Apple aggressively buy back shares?
One of the ways Apple has been rewarding shareholders over the last few years has been through share repurchases. This is the second big challenge; aggressive share repurchases aren’t guaranteed forever. It’s no secret that Apple seems to have hit a wall when it comes to iPhone growth. However, there are two charts that really drive home what a significant challenge Apple has run into in the last two quarters.
(Source: Q1 2018 – Q2 2018 – Q3 2018 – Q4 2018 – Q1 2019 – Q2 2019)
As we can see, through last year, Apple increased its core free cash flow (FCF) on a sequential basis. In Q1, this trend ended quickly, as free cash flow was essentially flat year over year. By Q2, free cash flow declined annually by just under 1%. For investors to believe that Apple will keep buying back shares, any chance of declining free cash flow directly challenges this assumption.
In addition, Apple’s net cash position gets a lot of press, but what investors may be missing is just how fast the company’s cash pile is declining. Over the last year and a half, Apple went from growing its net cash balance to draining its cash at an increasing rate.
(Source: Q1 2018 – Q2 2018 – Q3 2018 – Q4 2018 – Q1 2019 – Q2 2019)
As recently as Q1 of 2018, Apple’s cash pile was growing year over year even while doling out billions in dividends and share repurchases. By Q2 2018, Apple began spending more cash on dividends and repurchases than it generated in core free cash flow. In the last four quarters, the company’s net cash balance has declined by between 14% and nearly 21% annually. What is doubly worrisome is Apple’s net cash declined by the most in Q2, while the company’s annual core free cash flow declined.
Apple is sitting on over $124 billion in net cash as of the last quarter. Part of the investment thesis for Apple is its cash pile could allow it to do a transformative acquisition. If Apple’s free cash flow doesn’t grow, and net cash declines by 20% per year, by 2022, Apple’s cash pile will have been cut by more than half to about $55 billion. This is still a huge amount of money, but just proves that Apple’s aggressive share repurchases cannot go on forever.
A nice story with several holes
Some analysts would suggest that the future of Apple lies with its Services business. In the last year, this division’s revenue growth has been impressive. In the most recent quarter, Services revenue of over $11 billion, represented just under 20% of the company’s overall revenue. With that in mind, Services revenue growth increased by just over 16% annually in the last quarter, unfortunately, this was the slowest growth rate of the last year.
(Source: Apple TV+)
While the amount of Services revenue gets the headlines, what is being played down is this rate of growth was almost half of a year ago. In addition, Apple’s own projections suggest Services won’t grow fast enough to offset potential weakness in the iPhone business. In the current quarter, Products revenue declined by more than 9%, while Services increased. By 2020, Apple expects quarterly Services revenue of $14 billion. If we combine Apple’s projections for Services with analysts’ projections for overall revenue, we get a sense of the challenges facing the company over the next two years.
By 2020, analysts are calling for Apple’s revenue to reach almost $270 billion. If Services equals $14 billion per quarter, this works out to $56 billion per year. Using these numbers, this would suggest that products would generate $214 billion, or an average of $53.5 billion per quarter. To put a percentage of growth to these figures, Products revenue would increase by 14.6%, whereas Services would grow by 22.3%.
There are two significant challenges imposed by these assumptions. First, Services revenue grew by 16% last quarter. It’s possible that new Services like Apple Arcade, Apple News+, Apple Card, and more, may help this line item to grow. However, moving from a 16% annual growth rate up to more than 22% next year is a big challenge. Seemingly a more significant challenge is the company’s product turnaround that these numbers imply.
Apple says that its price cuts, trade-ins, and financing options, are helping the company’s iPhone business to begin to recover. However, investors need to look at the product breakdown. In the last quarter, iPhone sales of $31 billion were down by 17% annually. Excluding Services, Apple’s other products generated $15.5 billion in sales, which were up by just over 13%. Achieving growth of more than 14% in products by 2020 means not only a massive turnaround in the iPhone business but also a better growth rate in other products as well. This doesn’t sound like a challenge; it sounds like an impossibility.
The bottom line
Apple’s relative value seems to have declined while the stock has increased. In the last 90 days, analysts’ estimates for Apple’s 2019 and 2020 earnings have declined by 4% annually for each year. Some analysts believe the Apple Watch will be a big revenue driver for the company. However, research from multiple firms suggests smartwatch sales will grow over the next few years, but at a less torrid pace. In addition, there are companies like Samsung and Fitbit looking to make further inroads.
Apple has a ton of cash and it could do a transformative deal. The problem is it seems the company is comfortable buying tiny companies and plowing its cash into share repurchases. Unfortunately, Apple’s core free cash flow growth turned negative last quarter for the first time in a while. In addition, the company’s cash pile is dwindling at its fastest rate in over a year.
Last, Services growth seems to have matured, and the days of 30% growth are likely over. The bottom line is Apple’s stock seems to have gotten ahead of reality. Challenges abound, estimates have been cut, but the stock marches higher. Long-term investors would do well to wait for what seems like an inevitable correction in the stock.
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.