Tuesday, Jul 31st 2018

Thesis Strengthens on Apple


Apple posted strong fiscal Q3 results Tuesday, demonstrating the continued pricing power of the iPhone and the stickiness of the company's software & services ecosystem. At the after-hours price on Tuesday, it reached $995 billion in market cap and could shortly become the world's first $1 trillion public company.

The company grew its quarterly revenue and EPS by +17% and +40% year-over-year, in line with Wall Street estimates. Next quarter's guidance was also above estimates.

More important for Apple's future business and financial prospects is the complexion of that performance. Let's dive into how this quarter and management's guidance reflect Apple's two most fundamental moats: brand equity and network effects.

First, on the hardware front:

Many were hanging high hopes on Apple's flagship handset (the iPhone, which is 60% of Apple's revenue) and its climbing ASP. This quarter, the company delivered. The 41.3 million iPhones shipped during Q3 is basically flat from last year, but the average selling price of $724 is a notable jump. This bump is likely due to an increasing mix of the pricier iPhone X, which starts at $999.

Our main takeaway from this robust pricing growth is that Apple continues to improve its brand equity and expand its pricing power.

In a world of ever-increasing selection of lower-priced Android phones and already-high Apple penetration, Apple is undoubtedly seeing its iPhone unit sales growth slow. But the company is building digital services and a suite of other gadgets around the device. Those newer businesses, along with higher price iPhones, are widening Apple's brand equity and supporting continued pricing power and revenue growth. And pricing power, as Buffett often puts it, is the "holy grail" in investing.

Next, on the software front:

Investors have been watching closely as Apple ups its software and services revenue -- a catch-all category that includes the App Store, Apple Care, Apple Pay, iTunes, and iCloud services. This segment has been outpacing iPhone revenue growth for several quarters.

Apple positively surprised with $9.55 billion in software and services revenue this quarter (+31% growth). We think there's still tremendous opportunity left for growth in this sticky, high-margin app/developer ecosystem. The reason (and the moat): network effects.

As Apple acquires more iPhone users from a hardware perspective, it grows the distribution channel through which app developers sell/offer their apps. This is great for developers because it widens their consumer audiences, and it's great for consumers because it widens the selection of apps, software and other services to make the smartphone experience more rich and engaging. As each side of the network grows in size, so does the value that each side of the network gets out of it.

CEO Tim Cook said in January 2017 that the company hoped to double services revenue to more than $14 billion per quarter by 2020. That's almost 50% higher than Apple's current sales for that segment. Oh and it's a much higher margin business than iPhones too (because it costs almost nothing to plug a new developer into the App Store ecosystem, vs. the hardware that goes into an iPhone).

Finally, on the forward-looking guidance:

Apple expects Q3 revenue to come between $60-62 billion (+23% growth), edging out Wall Street predictions of $59.5 billion.

Recall that the company's recent quarterly results have been weighed down by concerns that it has saturated the smartphone market, marking the end of the iPhone "supercycle." The next quarter (fiscal Q4) is when Apple typically introduces new iPhone models -- usually in mid-September. Therefore, Q4 guidance is arguably the most important operating forecast that management provides to investors to gauge how the business and its product cycles will fare.

The company's strong guidance today suggests that multiple new hardware devices are coming in the fall (up to three new iPhone models). Per Tim Cook, "we are very excited about the products and services in our pipeline."

Overall, our thesis has become even stronger on Apple. Similar to Warren Buffett's investment case, we believe Apple is truly a consumer brand at heart (vs. a classic technology or hardware company). Steady-growing consumer brands not only warrant higher prices and profits over time, but they tend to command higher public market valuations (given the predictability and secular growth of their earnings) than the hardware companies (which tend to be more cyclical, harder to predict and more susceptible to commoditization/price erosion from competition).

At only 14x P/E on Wall Street's 2019 earnings estimates, AAPL still appears too cheap for a growing consumer brand with pricing power and network effects.

As of this writing, AAPL was a portfolio holding of Titan. This security may cease to be a portfolio holding at some point in the future.
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