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David Rolfe Comments on Apple Inc.

- By Holly LaFon

Apple (AAPL)

"You have to go back to Rockefeller and Standard Oil to find a company so dominant in a business so large," says David Rolfe (Trades, Portfolio), chief investment officer at Wedgewood Partners, which manages $5 billion. "Other companies settle for unit sales or revenues, but in many quarters, Apple collects more than 80% of gross profit across the smartphone industry."


Barron's

December 23, 2017


Apple enjoyed a stellar 2017 on both the product front and on the financial front. Revenue growth accelerated all four quarters in 2017. The Company's fiscal year-end (September) ended on a high note of record revenue across all product categories, plus notable product momentum and market share gains in most products and in most geographies around the globe. China was notable, with market share gains for iPhone, iPad and the Mac. Specifically, Apple posted record revenue in China for its services business and the Mac. The Company's fiscal fourth quarter posted record year-over-year September revenue of $52.6 billion (+12%) and record earnings per share of $2.07 (+24%).

Given the size of the Company's iPhone franchise, the results in any given quarter or calendar year are dominated by the fortunes (or lack thereof) of the iPhone. The iPhone really is the straw that stirs the Apple drink. The iPhone celebrated its 10-year anniversary in 2017. Since the launch of the first iPhone, Apple has sold 1,250,432,000 iPhones. These sales have generated nearly $800 billion. It is estimated that 800 million of these iPhones remain active.

Over the past 10 years, the average selling price of the iPhone has, to the surprise of many, been remarkably steady for a technology hardware product. Over the years, the selling price has averaged about $638. No doubt carrier-subsidized cost over many of the past 10 years has been part and parcel of ASP stability. In recent years, the acceptance of smartphone users that their very personalized phones have become indispensable in their daily lives so much so that millions of users now allocate as much monthly budget for their smartphones as they do for housing/rental, transportation, cable and electric bills. Dare we include food too? Remarkably, the utility and functionality of modern smartphones, with their myriad of Apps and capabilities (communication, social networking, entertainment, financial management, shopping, health tracking) are nothing short of daily human subsistence.



The surprise over the next couple of years might be a spike in iPhone ASPs. Apple could well sell 250 million iPhones each year over the next three years. As the user base (plus new users) upgrades to the iPhone 8 and the iPhone X, ASPs could easily exceed $700 - and even approach $750. The Company now offers six iPhone configurations between $650 and $850

- iPhone 7 and 8. The iPhone X (currently $1,000 to $1,150) really gets into ASPs next year.

In fiscal 2017 the Company sold nearly 217 million iPhones, a gain of just +2% over 2016 - and less than the 231 million iPhones sold in 2015. As seen below, the apex of iPhone sales was recorded back in late 2015 during the incredible success of the new, larger iPhone 6 era. Pent -up demand for the larger iPhone 6 (particularly in China) drove iPhone unit growth of +22% and revenue growth of +36% in fiscal 2015. Since the tough comparison from 2015, plus the realities of replacement demand for new iPhones driving unit sales, with new iPhone user growth losing its forming tailwind, unit growth was welcomed back in 2017.

China was key to the renewal of consistent iPhone growth during 2017. Kantar reports that iPhone market share fell from 25.3% in November of 2015 to 19.9%. By March of 2017 iPhone market share in China had tumbled to just 12.4%. That would mark the nadir of iPhone market share. Fast forward to today, and iPhone market share has steadily improved back to approximately 20%.


That first iPhone was truly revolutionary. Here is what we wrote on the iPhone launch back in April of 2007:

The hype and hyperbole over the iPhone has been such that a skeptic might suspect that expectations are so high on this so- called "revolutionary" device that it is doomed to disappoint all but the most die-hard Apple fans. Perhaps. But we don't think so. In fact, despite the early glowing reviews thus far, and the gee-whiz ads (see for yourself: http://www.apple.com/iphone/usingiphone/guidedtour.html and here http://www.apple.com/iphone/ads/ad1/), we believe the iPhone will be in fact a quantum leap in the ever-evolving description and maturation of the "smartphone" market.

The iPhone raises the bar across all applications. It truly is a revolutionary cellphone; Apple's best iPod to-date and the first truly useful web browser device. How did they accomplish so much in a single device? Simple answer; but hard for competitors to copy: cutting-edge software, delivered on very powerful hardware (three microprocessors within the iPhone). At the iPhones' core runs a full version of Mac OS - with first- in-class integration of iPod software and Safari (web browser) software. Elements of the operating software in the BlackBerry Pearl, LG Prada, Motorola Q9, Nokia N95, Sony Ericsson W810i and Treo 750 are certainly robust, but the means to both next-generation application integration and user-experience superiority resides in best-in- class operating systems which is the Mac OS. We would not discount what Jobs said, the iPhone could well be years ahead of its respective competitors.

To mark the 10-year anniversary, Apple pulled out all the skunk-works stops in designing the iPhone X. Heretofore, every new iteration of the iPhone was certainly evolutionary, rather than revolutionary. Every new generation of the iPhone boasted the latest cutting-edge hardware and software marque features from Apple. "S" generation iPhones haven't garnered the enthusiasm from the user base, new customers or the press too, but they no doubt pushed enough elements of the Company's technological prowess. New generations of iPhones that promised new design aesthetics and new form sizes have been seminal new product announcements. The all-glass iPhone 4 and the larger iPhone 6 come to mind on this score. The introduction of the App Store in the summer of 2008 with an initial 500 Apps fundamentally turned the iPhone into what would become a uniquely personal computing device. The App Store offerings continue to fundamentally change the way we communicate via social media, change our shopping habits, how we bank - and much more.

The iPhone X is not, in our view, a truly revolutionary product in the same sense as the first iPhone, but we do think of it as much more than an evolutionary improvement. Compare the iPhone 8 to the iPhone 7 and the evolutionary cadence is clear. The iPhone X is a new direction, an inflection point, as it were, toward a different iPhone future. The two design changes of the iPhone X that standout versus the iPhone 8 are Face ID and the elimination of the front-facing home button. Removal of the home button not only frees up more space, but is a new, more intuitive gateway into the iPhone's software via a swipe. Face ID is Apple's entry into biometric authentication. From our experience using Face ID, we happily report that it works well - and it's very fast. Apple reports that the typical iPhone is unlocked 80 times per day. Just in terms of unlocking an iPhone, compared to the early years of 4 and 6- digit PIN numbers, to Touch ID and now to Face ID, the daily time savings is apparent immediately to new iPhone X users.

Again, the iPhone X may not be revolutionary, but it does represent a paradigm shift in software interaction and presents the pathway for the development by both Apple and outside developers in the new, new world of augmented reality. Relatedly, last September Apple announced their latest processor, the neural engine A11 Bionic chip. This 4.3 billion transistor, 6 -core chip is notable not only for its power (exceeding the power of current laptop PCs), but also the inclusion of the Company's first-designed GPU solution. Following this processor roadmap, 2018 could bring the announcement of a system on a chip (SOC) that offers hardware acceleration for artificial intelligence (AI) processing.

Rounding out the other products and services that make up the Company's best-in-class ecosystem, we find more good news to report. The iPad was awakened from its multiyear slumber in 2017. A mix of the larger, 10.5-inch iPad Pro, plus more attractive price points for the 9.7-inch iPad reignited growth. In all, iPad sales were up +15% in fiscal 2017 and the iPad global market share rebounded to 4-year highs. NPD reports that iPad market share in the U.S. jumped to 54% from 47% over fiscal 2017. Revenues in the all-important U.S. education market gained +32% during the fourth quarter. Unit sales were up +25% in China and +39% in India.

2017 was a significant year for Apple Watch. The Apple Watch was first introduced in September of 2014 and became available for sale in April of 2015. Today, and in very short order, Apple can boast that they have become the world's largest watchmaker. Rolex, founded a few years ago in 1905, ceded its #1 ranking to Apple last quarter. Apple reports that their Wearables (Watch, AirPods and Beats headphones) business in units was up +75% year-over-year in the fourth quarter of fiscal 2017 - and was now the size of a Fortune 400 business. Apple Watch ended the fiscal year having grown at +50% for three consecutive quarters. As 2018 rolls in, Apple Watch's revenue run-rate looks to be approaching $5.5 billion - driven by the launch of the LTE cellular-enabled Series 3 Watch, as well as repositioning the Watch as a best-in-class cardiovascular wearable. All told, the Company sold 18 million watches in 2017 - and has sold 33 million since its initial launch. The Watch story could well be in the very early innings of growth, as the adoption of the Watch within the iPhone user base is just 5%.

Even the Mac had its best-ever revenue year in 2017, reaching $25.8 billion. During the September quarter, Mac revenues grew +25%, and grew +10% for fiscal 2017. These results sparkle even more against the backdrop of a punk industry environment that IDC reports shrank by -1% on a global basis. Apple's long-held position in the premium PC segment continues to serve them well. Note the stability and the ASP of Macs in the first graphic. The recently introduced iMac Pro is a wonder of desktop horsepower - a well received addition to the Mac lineup after the lackluster launch of the latest MacBook Pro in late 2016.

Apple's Services business may have been the bright spot during 2017. Long in the making, Services is the glue of Apple's incredible ecosystem. Key elements of the Services business - App Store, iCloud, AppleCare, Apple Pay, Apple Music, plus add in Apple Maps and Siri - are the connective tissue between the Company's connected hardware to enhance the customer experience.

Today, Apple's ecosystem has grown to over 900 million customers and over 800 million active devices and over 300 million devices sold per year. This ecosystem is no doubt giant, as well as global in size, scale, and scope. While Apple outsources the manufacturing of its hardware products, the Company has long owned a staggering amount of equipment located in their manufacturing partners' plants - $54 billion of machinery, equipment and internal-use software on Apple's balance sheet certainly attests to the enormity of the scale and financial resources it takes to manufacture and sell +300 million gadgets per year. On this score, Apple is unmatched.


For example, Apple is the best-selling western brand in China. Greater China (including mainland China, Hong Kong, and Taiwan) revenues eclipsed $10 billion in 2011 and soared to $59 billion in 2015. After two years of decline, the Company's recent Greater China revenue acceleration may challenge the 2015 high -water mark in 2018.

The Company's nonstop efforts to improve their ecosystem delivers, prospectively, stickier customers, halo effects, and annuity-like revenues. Like most technology company ecosystem efforts (think Software as a Service and the sort), the Company's Services is a bastion of stellar revenue growth, but unlike most, a profit machine.

Services revenue reached an all-time quarterly record of $8.5 billion last quarter (+34%) - reaching a $30 billion annual run-rate. The business is now the size of a Fortune 100 business. Across all of the Company's Services offerings, the number of paid subscriptions has reached 210 million. Paid subscriptions for Apple Music have reached 30 million in just 27 months - it took Spotify 74 months to reach that mark. Over the course of 2017, Apple Pay users have doubled and annual transactions went up +330%. The AppStore set a new record in 2017 and enters 2018 as the Company's fastest-growing and highest-margin business. The Company's AppStore gross margin is as high as 90% on Net Apps purchases.

In fact, as of this writing, the Company just reported that the AppStore's New Year's Day purchases of $300 million set a new record. In addition, during the week starting on Christmas Eve, a record number of customers both purchased and downloaded apps from the AppStore, to the tune of $890 million during those seven days. Lastly, on app purchases during 2017, the Company reports that they paid out $26.5 billion to iOS developers - a +30% increase.


Late in 2017 brought the significant news that the cash problem of the 1st National Bank of Cupertino was fixed when President Trump signed the "Tax Cuts and Jobs Act" into law on December 22. Under the current U.S. tax system, Apple owes 35% tax to the federal government on all revenue earned - both in the U.S. and abroad. The new law enacts a deemed repatriation of overseas profits at a rate of just 15.5% for cash and equivalents and 8% for reinvested earnings. Goldman Sachs estimates that U.S. companies hold $3.1 trillion of overseas profits.

As of September 30, Apple alone holds $252 billion in tax-deferred foreign earnings, 94% of its total cash and marketable securities. This is most welcome news for shareholders. Heretofore, Apple has needed to borrow heavily to fund capex, buy back stock and pay dividends. Their U.S.-only operating cash generation wasn't footing the bill.

Now, before you think Apple wants for cash, a little perspective is in order. We have chronicled Apple's prodigious cash generation for over a decade now, so let's get caught up: Over the past ten years, Apple has generated $450 billion in operating cash flow and $373 billion in free cash flow. Over just the past five years, they have generated $324 billion in operating cash flow and $267 billion in free cash flow.

In fiscal 2017 alone, Apple generated nearly $64 billion of operating cash flow, about as much as that of Alphabet, Amazon and Facebook combined. On a free cash flow basis, which is a measure of how much cash is generated after taking into account such items as capital expenditures and other expenses associated with running the Company, Apple's $51 billion of free cash flow was $2 billion greater than free cash produced by Alphabet, Amazon and Facebook combined.

In 2013 and 2014, Apple began taking on both long-term and short-term debt to offset their international earnings. Today the Company has $113 billion in debt, netting out their cash and liquidity to approximately $150 billion. After repatriation, Apple will be sitting on a cool +$213 billion in U.S. cash. Net of debt, the Company will have about $100 billion.


The Company began returning capital to shareholders back in 2012, first as a dividend. Share buybacks started in 2013. To date, the Company has returned $234 billion of their current $300 billion capital return program. While the shares are still reasonably valued we would prefer the Company to continue to buy back stock. The Company has been buying back stock to the tune of $6 billion to $10 billion per quarter (dividends are almost $3.5 billion per quarter). Perhaps a $50 billion to $75 billion Dutch Auction stock buyback is in order.

In sum, we hope to convey that the State of Apple is quite healthy - and growing. Recall that the Company's recent financial peak was fiscal 2015 when the Company generated $81.3 billion in operating cash flow. We expect that level to be breached in the next couple of years. Capital spending has clocked in around $13 billion over the past few years. Even if the Company spends $45 billion in capex over the next three years, the Company will generate many billions more than they need to keep the lights on. iCash indeed!
This article first appeared on GuruFocus.