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You’ll Want to Take a Bite

By Scott Chan on August 21, 2017

Apple (Nasdaq: AAPL), the largest company by market capitalization, has set a new record high this week, before pulling back slightly along with the overall market.

Earlier this month, the iPhone specialist beat earnings expectations for the 5th time in 6 quarters, and the 18th time out of 19. Third fiscal quarter revenues were 7.2 percent higher than the year-ago quarter, and earnings of $1.67 a share represented 17.6 percent growth. It was the third-consecutive quarter of revenue growth acceleration.

The company experienced year-over-year volume and revenue growth across all its product categories (iPhone, iPad, and Mac) and Services revenue reached an all-time quarterly record, growing 22 percent year-over-year. iPhone sales were up 3 percent year over year, iPad sales 2 percent, and Mac sales 7 percent. While the iPhone is Apple’s bread and butter, we were pleased to see iPad and Mac sales were strong, too. The solid non-iPhone sales figures prove that Apple is more than a one-trick pony.

Moreover, the record services revenues is also an excellent sign for the company. Customers who use Apple’s services—e.g. iTunes, apple Music, the App Store, iCould, Apple Pay and others—tend to stay with Apple longer, thus providing higher lifetime value to the company. As part of the Apple ecosystem, Services provides a steadier revenue stream compared to the sales of the hardware, which tend to be seasonal in nature—for example, nearly 40 percent of iPhone sales occurred in the December quarter, during the Holiday Season. On the other hand, customers consistently use apps like iTunes and Apple Pay regardless of season.

Interestingly, Apple projects fourth-quarter sales in the range of $49 billion to $52 billion, a stronger guidance than most analysts expected for the fiscal fourth quarter (ending September), which raises the possibility that the company may release the iPhone 8 sometime before the end of September, ahead of The Street expectations for an October or November launch. Apple management is notoriously secretive when it comes to release dates of new models, so analysts are usually left guessing.

Although the market has gone through stretches where it trades AAPL as though the company’s growth will slow significantly, Apple has proven the skeptics wrong.

Apple enjoys tremendous brand equity, and it is almost a monopoly among the most wealthy consumers. The richest smartphone tend to own an iPhone, not any other smartphone. Additionally, the company tries to be very responsive to customer feedback and is clearly dedicated to creating products and changes that consumers demand. Also in terms of protecting its customers’ privacy, Apple is among the best. It uses encryption for communications and it never sells customer data or ads. And as the San Bernardino iPhone lock case showed, it’s willing to fight the U.S. government, whose best intelligence experts could not crack its security.

In China, a key growth market and Apple’s second largest market, however, Apple’s stance is more nimble, preferring to cooperate with Beijing. The company has made a concerted effort to abide by Chinese laws. For example, it has moved user data onto servers operated by a state-owned telecom, which opens the door to the Chinese government gaining access to said data. Recently, the company also announced plans to build a data center in China, the first such endeavor for a U.S. tech company, in order to store information within China’s borders in accordance with a new law passed this year that observers fear will intrude on privacy and increase censorship. Currently, Chinese Apple customers’ data is stored outside of China, but that will change soon.

Politically, Apple’s ready willingness to please Beijing may be infuriating to some, but from an investment and business perspective, there’s no doubt that Apple is doing the smart thing. If Apple wants a piece of the Chinese market—and it does—it has to play by the local rules. There’s no way around it.

We are still somewhat wary of the Chinese market because Beijing holds such sway, and for affordability reasons Chinese consumers still opt for phones in the lower-end of the price spectrum where Apple does not compete (the iPhone’s share of the Chinese smart phone market is estimated to be below 15 percent). However, well positioned as a premium brand, the iPhone is very well-regarded among affluent Chinese citizens. Provided Apple doesn’t ruffle Beijing’s feathers, we expect the company to continue to maintain a toehold in the Chinese market.

The company is entrenched as the premium brand in mobile. It encourages “stickiness” through its ecosystem and regular important updates to its key products software and updates. In a world of increasing interconnectivity and the Internet of Things, Apple’s products are sure to play an increasingly key role. As mobile devices become more central to consumers’ lives, they could be more willing to pay a higher price for such devices, which would be a positive for Apple’s high-end products.

Even though Apple now trades at an all-time high, it still only trades at a below-market forward P/E of about 15. Given the company’s size, its growth rate may not match those of the smaller high flyers, but its risks are far lower and the stock provides a high floor. Depending on how the upcoming iPhone 8 fares, we think annual earnings growth rates of 10 percent or higher is achievable for the next several years.


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Here’s What’s Really Going to Crush the Market

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