Proceed with Caution: Insights on AAPL Earnings

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Apple has announced its Q2 2023 earnings, and this led to the jump in price of the stock by nearly five percent on a single day making it look like the market was very happy with AAPL earnings. However, if we dive deep into its earnings report it suggests that Apple stock is now getting very expensive. Let’s analyze Apple’s earnings carefully to find out why my reasoning deserves consideration.

Apple’s Revenue by its Segments and Products

AAPL Earnings

The iPhone saw its revenue increase by 2% YOY and then the Services also saw its revenue increase by about 5% YOY. However, Mac saw its sales decline by 31%, iPad sales are down by 13% and Wearables are down by 1% YOY which means that the total net sales for Apple is down by about 3% YOY.

Although Apple’s revenue declined year over year, there are some positive developments to note. The Services revenue is still growing quite significantly and this has been a massive growth driver for Apple’s business over the past decade.

Apple’s Revenue by its Geography

AAPL Earnings

Apple’s revenue from America is down quite significantly year over year and the operating income is also down year over year. However, its revenue from Europe is slightly up year over year, as is the operating income. Revenue from Greater China and Japan are down year over year, but the Asia-Pacific region is up significantly, with a growth rate of over 10% year over year, and the operating income has also increased.

Currently, Apple is experiencing growth in Europe and the Asia-Pacific region, while every other region is seeing a decline in revenue. This has made Apple stock buyers very bullish on the Asia Pacific region.  In fact, this region is expected to be a major source of growth over the next two to three decades and this could provide a long-term Tailwinds for Apple’s business.

The Services and Products Gross Margin

AAPL Earnings

Their gross margin for products amounted to approximately 27 billion dollars, with their services generating a gross profit of about 14.8 billion. It is interesting to see that the services gross margin or gross profit is about half of the product revenue but overall, the services revenue isn’t nearly as high as the product revenue, and this ultimately means that the services business has a much higher gross margin.

The services revenue has a gross margin of 71% whereas that of products is only about 36.7%, which means that the service revenue growing is going to continue contributing a lot more to Apple’s overall gross profit and operating income over time as this business continues becoming larger and larger.

Over time, it is possible that Apple’s margins may continue to expand, with the Services revenue leading the way. It is commendable that Apple maintains complete transparency regarding this aspect.

Apple’s Services revenue on a quarterly basis over the past decade also shows that in the first quarter of 2013 it was around three to four billion dollars and now it is at over 20 billion dollars a quarter. It just had a record quarter for revenue. This proves that this segment of the business is growing quite significantly which promises pretty high margin. It is this aspect of the business that has made investors go bullish over it.

Apple’s Cash Flow Statement

The cash generated by operating activities for Apple in the past six months has been about 62.6 billion dollars which is down quite significantly. It’s down about 13 billion dollars year over year. So, Apple’s operations are not generating nearly as much cash as they were in 2022.

Then we also see that the capital expenditures were about 6.7 billion dollars this year versus about 5.3 billion last year. What this ultimately means is that Apple’s free cash flow is down quite significantly year over year. It’s probably down by about 14 billion dollars year over year.

Honestly what we’re overall seeing with apple in this quarter is revenue is going down year over year and profits are going down year over year as well. The operating income is down, operating cash flow is down, free cash flow is down and overall revenue is declining. These are some of the things which are quite concerning.

Now, Apple, in the first six months of their fiscal year which actually starts in the fourth quarter of last year, produced about 55 billion dollars of free cash flow. The dividend payments for the first six months were about 7.4 billion and then the repurchases of common stock were about 39 billion. This means that they returned about 46.4 billion dollars to shareholders in the first six months of their fiscal year which is almost all of the company’s free cash flow.

What Apple is actually doing is it is returning about 80 to 90 percent of its free cash flow to investors and it’s just a free cash flow machine for its investors. It buys back a lot more shares than it pays dividend.

Apple’s Share Buyback Program

Apple announced that over the next year they are planning to repurchase up to 90 billion dollars’ worth of shares. This is one of the reasons why the market was so excited about this quarter because this is a massive share buyback program. On top of that, the company also raised its quarterly cash dividend from 23 cents per share to 24 cents per share which makes it a dividend growth stock.

Current Scenario

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Apple is now trading for a market cap of about 2.75 trillion dollars. A 90 billion dollar share buyback program sounds like a massive amount of money but on the overall valuation of 2.75 trillion dollars it is only about a 3% return to shareholder. In terms of your yield or your actual return it’s really not that significant.

Apple’s trailing 12 months free cash flow is now sitting at about 97.4 billion and again on that 2.75 trillion-dollar valuation today that’s a price to free cash flow of about 27. Over the past decade, Apple’s price-to-free-cash-flow ratio has grown dramatically and significantly.

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In 2013, it was around 9, but currently, it stands at approximately 27. This is close to the highest level the stock has ever traded at. This is actually where a large portion of Apple’s returns have come from over the past decade. It’s worth noting that the price-to-free-cash-flow ratio has grown at a compounded annual growth rate of 10.5 percent over time.

This suggests that Apple’s share price has seen a 10.5 percent annual return, not due to an increase in free cash flow, but rather from the multiple expansion as reflected in the price-to-free-cash-flow ratio. While it’s true that Apple has grown its free cash flow and bought back shares over the same time frame, the multiple expansion actually contributed more to the company’s overall share price growth.

To gain clarity, we need to analyze Apple’s price-to-free-cash-flow ratio, stock price, shares outstanding, and overall free cash flow growth rate over the past decade. Apple’s free cash flow has grown at a 9.1% compounded annual growth rate, the price-to-free-cash-flow ratio has grown at 10.5%, the shares outstanding have declined by about 5% per year and the stock price has grown by about 26% per year.

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Thus, the stock’s actual returns over the past decade, which amount to a compounded annual growth rate of 26%, have been largely driven by multiple expansion alone and this is where it gets less attractive for Apple investors.

If Apple continues to experience the same growth rates over the next decade, its price-to-free-cash-flow ratio could reach levels as high as 60, 70, 80, or even 90, which would be an astronomical price for Apple’s stock. This suggests that Apple may not be able to achieve the same returns over the next decade as it has in the past, given the massive multiple expansion that has already occurred. It seems unlikely that another 10% compounded annual growth rate to the multiple would occur over the next decade.

There is also skepticism about whether Apple will be able to generate the same amount of free cash flow growth in the coming decade as it did in the previous one. Given its current valuation, Apple appears to be quite expensive, which further raises doubts.

Future Projection

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A reverse discounted cash flow analysis, based on a 13% compounded annual growth rate in free cash flow, a 4% annual share buyback rate, and a price-to-free-cash-flow ratio of 20, projects the fair value for Apple over the next five years roughly equivalent to its current market price.

As an investor, it is important to analyze the DCF calculation to determine whether the current pricing of the stock is realistic, pessimistic or optimistic. In Apple’s case, it appears to be overly optimistic because the company’s overall revenue, operating cash flow, margins across the board and free cash flow are currently declining.

The company would need to ensure that its profits stop declining, change course immediately, and grow at a 13% compounded annual growth rate over the next five years to justify the current stock price, which does not seem likely to happen.

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We can also see that for Apple to grow its free cash flow at 13% per year over the next five years, the company would have to produce 180 billion dollars in an annual free cash flow by 2028. The company is currently producing about 97.4 billion dollars in annual free cash flow. It would almost have to double its free cash flow over the next five years to be about fair value right now.

Reminder to Exercise Caution

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Apple stock is quite expensive because the market is currently pricing in a lot more growth than what is realistic for this business over the next five years. Apple may grow its free cash flow by about 6% annually over the next five years on an average basis, which means that the fair value for the stock would be about 126 dollars a share or about 27% below where the stock is currently trading.

A lot of the Mega cap stocks are also becoming quite expensive, and these are stocks that make up a large portion of the S&P 500. It is not sure how much returns the S&P 500 would produce for investors over the next five to ten years because the largest components and the largest contributors of the S&P 500 are very overvalued today. It does not seem that these stocks returns are going to be high.

Intelligent investors say that the market goes through periods where investors are willing to pay any price no matter how high it is for the largest and best stocks in the market, and that is clearly Apple and Microsoft at right now. They also warn investors of these types of situations because these scenarios tend to produce lower returns in the future.

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