Apple: To The Stars?

Summary

  • The launch of a range of new digital services is indicative of Apples short to midterm strategy.
  • Apple TV remains the biggest risk (and possible cash sink) in the face of stiff competition.
  • Over the next 10 years Apple is projected to deliver reasonable returns and remains worthy of further consideration and exploration.

 

Introduction

Apple continues to broaden its appeal via a strong services based lineup through 2019. This is on the back of a strong balance sheet and favorable growth prospects over the next decade delivering meaningful value to shareholders. While the previous entry point in the $150s range would have been preferable, buyers today can generally expect acceptable returns over the decade ahead.

Background

Founded in 1976 by Steve Jobs and Steve Wozniak, Apple has seen world wide success due to its continual innovation, notably in its iPod and now iPhone ranges. This was created in a large part due to the control over both hardware and software that Apple took, the polar opposite of that of Microsoft. Since then Apple has gone on to employ around 130 thousand people across the globe and remains one of the worlds most valuable companies as measured by market cap.

Pillars of Growth

Services

Apple News+

In the March Apple event, the first major service announced is the revamped News App.

This is in-tune with the current privacy concerns and level of trust in online content, which a company such as Apple is able to effectively solve. It does this by way of curated news by experts, using AI only for personalization aspects of an individual’s news feed. As each piece of content is sourced exclusively from reputable sources, the level of trust in this service provides an attractive proposition to users of competing service Google News, which is often littered with low quality stories from actors with questionable motives.

Monetization by way of advertising is likely to be the long term business model for this service, while publishers face headwinds in terms of opting in for inclusion to this service (and thus being part of the Apple ecosystem) or continuing to rely on fully owned means of distribution. Interestingly, Apple could perceivably charge publishers to be included in the app, and this raises a source of concern for current publications.

Magazines form the second point of order at the event, a move following that of Amazon which currently maintains an impressive magazine segment included as part of its Prime service.

This move is unlikely to be of material consequence moving forward, but it does help flesh out the core services offerings and builds towards a stronger Apple ecosystem. The more diversity in terms of appeal across various services the better, as Apple takes the view that providing something for everyone is ultimately how it will entice a broad range of users to sign up to its paid services.

Apple Pay

This is a bet on technology replacing the wallet, and for demographics such as millennials it is reasonable to assume uptake will continue to grow very quickly. Its primary value is convenience, and Apple is projecting 10bn transactions across 2019 (Apple, 2019).

Key to this is accessibility, with merchants across the US standing at 70% acceptance and notably 85% in the UK and 99% in Australia. This trend is only going to move upwards through 2019, and so the problem of acceptance is largely irrelevant and has already been solved (Apple, 2019).

Apple Card

Expansion into the credit card market provides a particularly interesting opportunity in enhancing the Apple Pay service. Successfully taking on the likes of Visa and Mastercard would open up a lucrative new revenue stream, and it could be argued that Apple’s brand, ecosystem and connected together services would provide a far greater value proposition to credit card users.

Specifically, taking a mobile first approach allows Apple to deliver an outstanding experience to millennials. Providing intuitive apps to manage the rewards programme as well as invoicing and application aspects allows Apple to offer a sleek and modern service compared to traditional competitors. Akin to the banking sector, a modern approach is sorely needed and its tech companies that are seizing the opportunity to disrupt as traditional players struggle with underinvestment and legacy technical infrastructure.  

It is worth noting that Apple is not going into this area alone, partnerships with Goldman Sachs and Mastercard provide the basis and expertise in terms of the backend infrastructure and logistics while Apple maintains control over front end aspects. This in theory allows it to develop an extremely modern and innovative user experience while benefiting from the pre-existing networks in a relatively cost effective way.

App Store & Arcade

With 500bn weekly active users with gaming apps being the most popular, Apple is making inroads into the lucrative and high growth video game industry. The growth of mobile gaming is nothing short of spectacular in recent years, now worth 51% of the global market with strong growth specifically across Asia, mobile gaming is an evolving and exciting market that traditional competitors have largely struggled to embrace.

 

 Mobile-Games-Statistics

(Source: Newzoo, 2019)

Apple Arcade uses the gaming as a service business model, providing users with unlimited access to a large catalogue of titles across mobile and desktop. It appears to be largely catered towards casual gamers. By working with established developers such as SEGA and brands such as Disney, Lego and Cartoon Network, Apple hopes to build an attractive GaaS proposition along the same lines as EAs Origin subscription model.

Success will largely depend on the IP and catalogue of titles available, and so both the frequency and quality of releases will remain of material value in gauging the short to mid term success of this service.

Owning the distribution platform does allows Apple to profit off the success of others, and with the gaming industry as fickle as the movie industry this is a low-cost way to gain exposure to the segment. How Apple further develops its expansion into the gaming arena remains unclear, but this is a good start in exploring a $137.9bn market.

Apple TV

The introduction of a streaming service comparable to Netflix has been the most contentious product of the launch. This market remains highly competitive while creating original content is expensive. Current competitors include Netflix, Amazon Prime and traditional cable providers while Disney is expected to launch its own streaming service relatively soon, providing further competitive pressures on both existing and new market entrants.

 Apple-iPhone

(Source: Apple, 2019)

Financials

Special Items:

Research & Development:

As the table below illustrates, aggregated spending on R&D at Apple continues to grow aggressively while Microsoft’s spend has slowed considerably in recent years. Historically, Microsoft has outspent competition by a substantial margin. It is difficult to specifically pinpoint the value of this, but it is a reasonable assumption to assume a substantially higher rate of spend relative to competitors is working as a catch-up mechanic for Apple to explore new technologies and innovation at a scale previously reserved for Microsoft.

Microsoft

R&D Spend

Apple

R&D Spend

2015

$12bn

2015

$8.1bn

2016

$12bn

2016

$10bn

2017

$13bn

2017

$11.6bn

2018

$14.7bn

2018

$14.2bn

(Source: Microsoft & Apple, 2018)

DCF Model

 

 

2018

2019

2020

2021

2022

Revenues

$265.59

$286.84

$309.78

$334.57

$361.33

Operating Profits

$59.53

$64.29

$69.44

$74.99

$80.99

Tax at 19%

$11.31

$12.22

$13.19

$14.25

$15.39

Actualised Free Cash

$48.22

$52.08

$56.24

$60.74

$65.60

Discounted Cash Flow

$45.92

$47.24

$48.58

$49.97

$51.40

 

 

2023

2024

2025

2026

2027

Revenues

$390.24

$421.46

$455.17

$491.59

$530.92

Operating Profits

$87.47

$94.47

$102.02

$110.19

$119.00

Tax at 19%

$16.62

$17.95

$19.38

$20.94

$22.61

Actualised Free Cash

$70.85

$76.52

$82.64

$89.25

$96.39

Discounted Cash Flow

$52.87

$54.38

$55.93

$57.53

$59.18

 

 

Assumptions:

 

Discount Rate

5%

Growth Rate

8%

Tax Rate

19%

               

10 Year Present Value

$523.01bn

 

(Karl Ahlstedt & Apple, 2019)

Firstly, it is worth noting the figures in the table above are in billions of dollars. Other assumptions going into this model include a growth rate of 8% which is projected based on the past five years of sector performance. This provides a reasonable foundation to project forward, which aggregates to around $523bn in added value over the next decade.

This is, in the authors opinion, a reasonably positive outlook for the decade ahead. It would provide aggregated added value of above 5% per year while providing exposure to opportunities involving AI, driverless cars, and technology yet to be announced. Should Apple perform reasonably well over the next decade, the outlook above, again in the authors opinion, remains conservative. However, the upside would have been substantially higher if shares were purchased at recent lows of circa $150, some 25%-30% lower than today’s price of $199.91.

Conclusion

Firstly, it should be noted that this report does not cover Apples flag iPhone line, its ambitions in healthcare, or its PC hardware ranges. These are all important segments of the business that should be scrutinized further, and are widely covered by other authors on Seeking Alpha. 

The move towards services represents is material change in direction for Apple, as it deals with headwinds in its flagship iPhone product line it believes strengthening the core Apple ecosystem by way of services will deliver substantial long-term growth and profitability a decade from now.

Expected cash flow generation remains stable and growing, providing acceptable returns to investors based on current market prices. However, to reiterate an earlier point, an entry point at the $150 lows seen recently would have provided additional upside.