APPLE (AAPL): Still the Epicenter of the Connected Society?
The odds are pretty high that your home or office has at least one Apple device if not more. A new report from the digital media analytics company comScore suggests that Apple’s iPhone has continued to grow its lead in the U.S. smartphone market, with just over 44 percent share of all American smartphone users in July 2015, an increase from the 43.1 percent share it held in April of this year.
We’ve long seen Apple sitting in the pole position of our ever increasing Connected Society, with its iPhone, iPad, Mac, Apple TV, Apple Watch, iTunes and App Store platforms, as well as iOS and HealthKit, CarPlay and HomeKit solutions. As we see it, Apple has strong assets across the smartphone and computing spaces, but a position that is far less commanding in the living room compared to Microsoft’s ([stock_quote symbol=”MSFT”]) or Sony’s ([stock_quote symbol=”SNE”]) PlayStation, and a presence that is just burgeoning in the Connected Car and Connected Home markets. Don’t get us wrong, we’ve loved our Apple TV as a video portal for iTunes videos and other streaming apps like Netflix, Hulu, Vimeo and others. But to be fair, it contributed to the console clutter sitting next to the cable set top box, DVD player, and gaming system.
That was until this past week when Apple took the wraps off several new products at what’s become its annual showcase for announcing what will be hitting the shelves in the coming weeks, in preparation for the upcoming holiday shopping season (yes folks, the holidays are not too far away). This week, there were new iPhone 6S and 6S Plus models, a new enterprise and small to medium size geared iPad Pro complete with the new Apple Pencil and detachable smart keyboard; some new features for the Apple Watch along with some new watch bands and colors; and an upgraded Apple TV complete with voice interface, an improved OS (dubbed tvOS), and it’s own Apple TV App Store. Let’s dig into the details:
Apple Watch. Things started off with the Apple Watch, and we have to be honest: we still want-to-want one, but don’t feel compelled to buy one, simply because we’re not sure we need one. In talking with folks who have taken the plunge, they praise the ability to pay with their wrist and see messages; however more than a few quickly shoehorned into the conversation that “well, it was a gift.”
Apple did announce more fashion-related items, bands and colors, but in our view that doesn’t really move the needle like the way the new iPad Pro did. The bottom line on the watch is, at least from our perspective, there is much more to go, and companies like FitBit (FIT) and others are way ahead of them, much the way Amazon’s ([stock_quote symbol=”AMZN”]) Kindle hardware continues to have a place in the e-reader space.
Apple TV. Long positioned within Apple as a “hobby”, Apple TV gets a much-needed upgrade. Much the way the original App Store transformed the iPhone into a digital Swiss Army knife — allowing you to play games, shop, check your finances, post to Facebook or tweet on Twitter and over the ensuing years do almost anything — we see the new Apple TV app store having a similarly transformative effect on how people use their TV. Pulling up sports stats as you watch a game, shop online via Gilt or other apps that will soon be available, downloading games to play such as “Galaxy on Fire” and Walt Disney Co.’s new Star Wars game, “Disney Infinity,” would come to Apple TV. Popular real estate sites like AirBnB and Zillow also are developing apps that would allow big-screen house hunting.
Of all the improved features, it’s the gaming potential that could be the most disruptive long-term. Over the last few years Apple’s iPods, iPhones and iPads have demolished the handheld gaming market, much the way iTunes and iPod completely eviscerated the rest of the MP3 player market. In the console gaming market, Apple is going head to head with Amazon and Sony. But with a $149 price point, the Apple TV is well below the $250 or so sticker price of Microsoft’s current Xbox. Granted, the initial slug of games will be found wanting relative to Xbox and even Sony’s ([stock_quote symbol=”SNE”]) PlayStation, but we know Apple will continue to pack more memory and improve the chip speed in the device over time. Let’s not forget the content leverage Apple has with the developer community — a quiet competitive advantage it has enjoyed with its tablets and smartphones and is now extending into Apple TV. We anticipate now that Apple has “figured out” Apple TV, the product will be on the annual model upgrade path that we’ve seen with iPhone and iPad. More processing power, more storage, better graphics…. Apple TV.
As part of the Apple TV unveiling, Apple CEO Tim Cook made what we found to be an interesting comment:
“We believe the future of TV is apps.”
He probably saw the same report we did from research company Millward Brown Digital that showed 22 percent of cable subscribers also subscribe to an over-the top service, such as Netflix, Hulu and others. As consumers of content through Netflix, HBO Go, Amazon Prime and other apps, we are believers in the time shifted approach (yes you can call it binging if you want) or the app-ification of TV. Combined with its expanding global footprint (more on that on page 14), this was one of the core reasons why we used the recent market pullback to add Netflix ([stock_quote symbol=”NFLX”]) shares to our Tematica Select List.
iPad Goes Pro. Over the last few quarters, the iPad has been one of the sore spots in Apple’s quarterly reports. Even so, Apple CEO Tim Cook has remained upbeat about the tablet category. Apple recently announced a new partnership with Cisco Systems ([stock_quote symbol=”CSCO”]) that builds on the enterprise-focused relationship with IBM (IBM). We suspect that Apple has used these and other partnerships to determine the needs and wants of the enterprise market to develop the much talked about iPad Pro.
We’ve tried several times to use the iPad in place of our MacBook products and found it to be relegated to the realm of pinch-hitting when it comes to getting any substantive work done. Editing documents and toggling back and forth between apps for example was more than cumbersome…it was downright painful compared to the notebook or desktop experience.
With the debut of the iPad Pro it looks like we now have a serious productivity tool in tablet form. Hand in hand is iOS 9, which brings split screen, drag and drop, and other multitasking productivity features to Apple’s iPad — no more toggling with the home button. You can tell we’re excited about this. With Apple Pencil, Apple’s also addressed some of the annoyances with editing and marking up documents, but we’ll need to see what bells and whistles the developer community brings forth with this accessory to make its $99 price point palatable.
In our view, the new iPad Pro targets the enterprise customer segment from a tablet and app perspective rather than a stripped own notebook computer, which is pretty much what we think of the Microsoft Surface. Before we get all “boo-hoo” for Microsoft, let’s remember that outside the Xbox, hardware is a relatively small contributor to Microsoft, which has increasingly become an enterprise software play.
One announcement that Apple slipped in during all of this comes as mobile operators like Verizon ([stock_quote symbol=”VZ”]) and AT&T ([stock_quote symbol=”T”]) are moving away from the long-standing practice of signing customers up for long-term service contracts and offering subsidies to blunt the high cost of smartphones. Seeing the potential dilemma for its smartphone business, Apple introduced its own installment and leasing programs.
By buying directly from Apple, a consumer can pay $27 to $31 a month for 24 months for the iPhone 6S and 6S Plus. At the end of those two years, the consumer would own the phone outright. Cell phone service fees, of course, come on top of that.
Apple also introduced, and is displaying prominently on the Apple.com store, a new iPhone Upgrade program. You can purchase the iPhone 6S on a monthly payment plan starting at $32.41 for the 16GB model or $36.58 for the 16GB 6S Plus (going up by a little over $4 a month if you want more storage). The pricier plan includes the ability to upgrade to a new iPhone after 12 months. You would continue to pay the installments on the new phone and would just be “restarting the clock,” having to pay the monthly fee for another two years before you would own the newer phone. In this way, the customer is essentially leasing the phone from Apple.
Taking a step back and viewing Apple’s upgrade program alongside its recently introduced Apple Music, we see Apple is quietly shifting its business towards a subscription-based revenue stream. From a business perspective, subscription-based business models have great visibility, planning and consistent cash-flow attributes. From an investor perspective, those recurring payments and cash flow offer predictability and reliability, which tends to be rewarded when valuing the shares, assuming the subscriber-rate continues on an upward trajectory. Past examples include the subscription businesses of AOL dial-up service, Weight Watchers ([stock_quote symbol=”WTW”]), NutriSystem ([stock_quote symbol=”NTRI”]) and Netflix ([stock_quote symbol=”NFLX”]). We’ll need to see evidence of consumers getting onboard with this subscription approach from Apple — remember, Apple Music is still in it’s three month free trial mode, with the first automatic payments kicking in over the next month for those that were first to sign-up with the offering was released. If consumers do go for it, this could all turn Apples’ valuation on its head, and we mean that in a good way.
Does all of this make Apple shares attractive at current levels?
With the launch of its iPhone 4s model in 2011, Apple shifted to a fall release for its smartphone business. With each new release, Apple shares have tended to march significantly higher over the following six month period, reflecting the staged nature of launches around the globe and this impact on Apple’s earnings.
What’s different this year is, with the exception of its Mac line of products and to some extent Apple Watch, Apple is launching several new products ahead of the all important year-end holiday gift giving season and Chinese New Year, one of the biggest gift giving holidays.
Current expectations have Apple growing its earnings to $9.75 per share over the coming twelve months, up from $9.13 per share the company is expected to deliver for the twelve months ending September 2015. Given the timing of these new product announcements, expectations for revenue, profits and earnings in the coming quarters have yet to be revised.
We suspect Wall Street will wait until these new products hit the shelves so they can gauge the initial reception before adjusting their models and forecasts. With a strongly invigorated Apple TV and iPad Pro as well as the inherent iPhone upgrade cycle for those still using an iPhone 5s or earlier model we find the odds of Apple euphoria returning to be rather high.
From a stock valuation perspective, over the last few years Apple shares have peaked at an average multiple just shy of 16x earnings. Even in 2013, a year in which Apple’s earnings fell 11 percent, the shares still peaked at 14.2x earnings. Applying those two figures to the consensus expectation of $9.75 per share in earnings over the coming year derives a price target of $140-$150, or an upside of 29 percent at the midpoint.
Let’s remember, Apple is on a path to return cash to shareholders, in part with its quarterly $0.52 per share dividend payment as well as share repurchase program. While the current dividend yield is just below 2 percent, added to the $145 price target, the shares offer 30 percent upside from current levels.
On the downside, Apple shares have bottomed at 10.5x forward earnings on average over the last four-year, period which implies potential downside to $103 (which is close to where shares bounced on August 24) or roughly 8 percent from current levels. In more absolute terms, Apple shares bottomed at less than 10x earnings in 2012 and 2013, but counter balancing that today is Apple’s massive share repurchase plan. Apple has committed to returning $200 billion of cash through dividends and share repurchases over the August 2012- March 2017. As of its June 2015 quarter, the company had more than $100 billion remaining under its current authorization. That’s a lot of dry powder to back stop the shares, and we’d note that since Apple embarked on its capital return program its share have bottomed closer to 11x earnings on average.
The Bottom Line on Apple
From several perspectives, the risk-to-reward ratio in Apple shares is compelling at a time when the company has one of its most pronounced new product cycles hitting, which will likely result in ratings upgrades and boosted earnings expectations. Ahead of that —and because of its now at the epicenter in our Connected Society thematic, we are adding Apple shares to our Tematica Select List.
Playing Apple through an ETF
With our recent PayPal ([stock_quote symbol=”PYPL”]) recommendation, we included an ETF alternative for those that would prefer a more diversified approach. With Apple and it’s halo effect that touches many companies, including the Tematica Select List Skyworks Solutions ([stock_quote symbol=”SWKS”]), there are many ETFs involved. As we see it however, an ETF play would need to have meaningful exposure to Apple as well as several of its key suppliers in order to pack a meaningful punch.
Two such ETFs are the Technology Select Sector SPDR ETF ([stock_quote symbol=”XLK”]), which hold roughly 16 percent of its assets in Apple shares, and the other is iShares U.S. Technology ETF ([stock_quote symbol=”IYW”]) that holds more than 19% of its assets in Apple shares. Between the two we would favor XLK shares given the larger market capitalization as well as far greater average daily trading volume and higher dividend yield.
