Wedgewood Partners recently published its Q4 investor letter to discuss its performance during the quarter – you can download a copy here. In the letter, the investor discussed why it still loves Apple (NASDAQ: AAPL) despite the stock was Wedgewood’s leading detractor to performance during the fourth quarter. Wedgewood believes that Apple has “a solid strategy for growth over the next several years.” Here are the firm’s thoughts about the iPhone maker:
Apple was a leading detractor during the fourth quarter. On the fundamental front, in their most recent earnings report, the Company’s reported +20% sales growth, driven by a +30% increase in iPhone revenue and a +20% increase in software and services revenue. Despite this torrid growth, the stock declined precipitously and is currently trading around 12X 2019 earnings expectations of $12.00 per share – well below the market – as guidance for their holiday quarter implied a low-single digit growth in sales. Subsequent to the year-end quarter, management unexpectedly further guided next quarter revenues to be lower, year-over-year, due to a sudden slowdown in demand for the iPhone, iPad, and Mac in the Greater China region, plus a -200 bps international headwind due to the stubbornly high U.S. dollar. That bad news aside, the Company’s results in China did include a new record for Services revenue, plus their installed base of devices in Greater China posted positive growth over the last year. Despite this near-term headwind, we continue to think Apple has a solid strategy for growth over the next several years.
First, Apple continues to grow its user base (selling 300 million hardware devices in 2018) and increase the wallet share of its overall product and services ecosystem, beyond just the iPhone. For example, the Company has over 330 million paid subscriptions running through their platforms, up a sterling +50% year-over-year – estimated to generate about $30 per annum, per device. In comparison, market darling Netflix has less than half the number of paid memberships and is growing about half as fast, while burning prodigious amounts of free cash flow. In addition, Apple’s installed base of active devices hit a new all-time high – growing by more than 100 million units over the past 12 months to a best-in-class 1.4 billion global device ecosystem.
Second, we earnestly believe the past few years and the next few years of faster growth in higher margin software services will lead to stickier gross margins at the Company. Apple’s financial model contrasts with high-fixed cost hardware technology companies more deserving of lowly 10X-12X earnings multiples. For example, despite the recent iPhone revenue and implied unit shortfall, the Company guided gross margins to roughly 38%, about in-line with gross margins we’ve seen over the past few years. Of course, Apple’s strategy of capturing value beyond just hardware is not new, but we continue to be dismayed that too many investors continue to underappreciate how sustainable this will make Apple’s longterm cash flow growth. Again, using Netflix as comparison – which sports a roughly $150 billion enterprise value – if Apple’s subscription services are twice as large, growing twice as fast, while being highly free cash flow accretive, relative to Netflix, then we do not think it is too speculative to assume Apple’s subscription businesses are worth twice as much as Netflix and, alone, would make up more than half of Apple’s current enterprise value.
Relatedly, the Company tacked sharply in a new and significant direction to open up their iTunes platform to non-Apple hardware vendors. We saw such a move back in July 2002 when Apple opened up their pre-iTunes (Musicmatch) software to sync with Microsoft Windows. Apple just announced at CES that the Company is making its iTunes available on Samsung TV sets. This is quite a big deal as heretofore Apple has incentivized customers to buy AppleTVs, so it didn’t make iTunes or other Apple software features available on smart TVs. The Company has finally recognized the limitations of the walled AppleTV ecosystem. It now recognizes the notable success of Roku, Amazon, and Google – which dominate the category with their cheaper devices and their respective smart TVs’ growing market. Ultimately Apple is building a streaming service with original content to challenge companies like Netflix and Hulu. For that it needs wider distribution. So, beginning with Samsung (other TV manufacturers will surely follow), iTunes Movies and TV Shows app will debut only on Samsung Smart TVs in more than 100 countries in the Spring of 2019. In addition, AirPlay 2 support will be available on Samsung Smart TVs in 190 countries worldwide. Sony, Vizio and LG have teamed up with Apple as well.
Within the Company’s recently updated earnings guidance, please note that during the December quarter, Services revenue grew +27% – the second fastest quarterly growth rate and an acceleration from the +17% rate posted during the September quarter. Wearables revenues (Watch, AirPods) grew a sharp +50% during the December quarter.
Last, we think it is rare for a Company with Apple’s market cap to generate such large absolute and proportionate levels of free cash flow, and that this extraordinary financial strength which has been deployed in share buybacks adds significant and accretive value for shareholders. We think Apple management’s track record of share repurchases has been underappreciated – retiring about 25% of the outstanding shares since the initiation of shareholder capital returns back in just 2013. Despite this, we expect them to be aggressive with buybacks at these valuation levels, retiring at least 5% or more of shares outstanding, this year, if the earnings multiple stays depressed. In sum, over the past several years, we think Apple’s methodical, predictable pattern of software and hardware upgrades, along with a focused but prudently expanding price umbrella, has created new avenues for profitable growth that should serve shareholders well for years to come. Backing out a peer-relative valuation multiple for the Company’s software services business (against the overall multiple of 10X-12X) renders the Company’s hardware line (iPhone, iMac, Mac and Watch) a run-off-mode steel mill-like multiple of just 8X-9X. We continue to hold shares at a relative overweight, given Apple’s attractive valuation.
Let’s take a look at what hedge funds – covered by us at Insider Monkey – think about Apple. Our database shows that 22 hedge funds added Apple to their portfolios during the third quarter of 2018. As of the end of the third quarter, 112 funds held APPL in their portfolios, versus 90 funds at the end of the second quarter of 2018, according to the Insider Monkey database. Meanwhile, APPL is one of 30 stocks that billionaires love.
Apple shares didn’t perform well in 2018, falling 8.43% during the year. Over the past six months, the share price has dropped 19.99%. While the value of the iPhone maker’s stock has fallen 31.17% over the past three months.