This is a guest contribution by Bob Ciura and Ben Reynolds of Sure Dividend.
Technology giant Apple, Inc. (AAPL) released better-than-expected earnings results on August 1st, sending the stock up 6% in after-hours trading.
Apple shares have increased by more than 50% over the past year alone, accompanied by an expanding valuation.
AAPL data by YCharts
And yet, Apple might actually still be undervalued. It has a long runway of growth potential up ahead.
It has also been a very strong dividend growth stock.
Since initiating a dividend in 2012, Apple has increased its dividend for five years in a row. It is halfway to becoming a Dividend Achiever, and will surely get there.
The Dividend Achievers are a group of stocks with 10+ consecutive years of dividend increases. You can see all 265 Dividend Achievers here.
This article will discuss Apple’s most recent quarterly results, and why dividend growth investors should still view the stock favorably.
Business Overview
For the fiscal third quarter, Apple reported adjusted earnings-per-share of $1.67, on revenue of $45.4 billion. Analysts had expected earnings-per-share of $1.57, and revenue of $44.95 billion.
Apple managed a beat, despite the fact that iPhone sales missed estimates by about 100,000 units. Average selling price also missed expectations. ASP of $606 came in significantly below forecasts of $628.
While Apple was not able to meet analyst forecasts, overall iPhone revenue still increased 3% from the same quarter last year. This is very impressive, particularly since it is likely to release a new iPhone model in September. There was reason to think consumers would delay purchasing new phones until the iPhone 8, but this was not the case.
For the quarter, total revenue increased 7% year over year. Earnings-per-share increased 18% for the quarter, a very strong performance.
As a result, Apple’s enormous cash hoard rose again. Cash, short-term investments, and long-term investments now total $261.5 billion.
All five product segments reported revenue growth for the quarter. This indicates Apple is still seeing healthy demand for its products and services, which bodes very well for the future.
Growth Prospects
Investors should consider the new iPhone to be Apple’s most important catalyst. The iPhone alone represents more than half of Apple’s total revenue.
- iPhone (56% of revenue)
- iPad (10% of revenue)
- Mac (12% of revenue)
- Services (16% of revenue)
- Other (6% of revenue)
As a result, the upcoming iPhone 8 will be a major driver of future growth in the short-term. The effects of a new iPhone release can be seen when Apple released the iPhone 7. The first full quarter (Q1 2017) of the release, Apple’s iPhone segment revenue surged 93% versus the previous quarter (Q4 2016).
But iPhone 8 isn’t Apple’s only catalyst. iPad and Mac revenue increased 2% and 7% last quarter, respectively. It’s a good sign to see these devices return to growth. Even more impressive is Services, which is Apple’s second-most important growth catalyst.
Services, which includes the App Store, Apple Pay, iCloud, and iTunes, grew revenue by 22% last quarter, year over year. The rapid growth of the Services business has been nothing short of amazing. Services is likely to generate close to $30 billion in revenue for fiscal 2017. Here’s how:
- Service revenue of $7.2 billion in Q1 (18% YoY Growth)
- Service revenue of $7.0 billion in Q2 (18% YoY Growth)
- Service revenue of $7.3 billion in Q3 (22% YoY Growth)
- Estimated Service revenue of $7.6 billion in Q4 based on 20% year-over-year growth
All told, this comes to expected service revenue of $29.1 billion for fiscal 2017.
For context, Apple expects its Services business to be the size of a Fortune 100 company by the end of the fiscal year.
The underlying driver behind Apple’s strong performance is its brand strength. Service revenue fro Apple will continue to grow as consumers continue to use their iPhone’s. The strength of Apple’s service network is only increasing.
There are real switching costs in the form of being ‘used to’ the iPhone when moving from an iPhone to a competitor product. The App Store, Apple Pay, iCloud, and iTunes make leaving the Apple ecosystem difficult. This creates ‘sticky’ customers who are likely to upgrade when Apple releases its new iPhone, making continued growth over time likely.
Apple’s continued growth is the reason why, not only is the stock not overvalued, but it could be argued that it is still undervalued.
This is because Apple’s price-to-earnings ratio is well below the market average of 24.7. Apple’s growth prospects and strong brand should command a higher valuation relative to the ‘average’ S&P 500 stock. Apple is priced like a mediocre business despite generating excellent results.
Competitive Advantages & Recession Performance
Apple has all the makings of a long-term dividend growth holding, thanks largely to its competitive advantages. First, Apple has an incredible brand.
In fact, according to Forbes, Apple has the most valuable brand in the world. Apple’s brand is reportedly worth $170 billion, a 10% increase from last year.
Apple is perceived as a symbol of luxury, which fuels its brand strength. This compels customers to pay high prices for Apple’s devices, which gives the company pricing power.
Apple’s brand loyalty and high-quality product line is the result of huge research and development spending over the past few years:
- 2014 research & development expense of $6 billion
- 2015 research & development expense of $8.1 billion
- 2016 research & development expense of $10 billion
Apple’s willingness to spend heavily on R&D provides the company with the innovation to keep developing the best products.
Consumers simply can’t do without their devices, and Apple has developed a reputation for making the best phones. This keeps customers buying, even during economic downturns. Apple is surprisingly recession-resistant, particularly for a tech company, which are usually more sensitive to recessions.
- 2007 earnings-per-share of $0.56
- 2008 earnings-per-share of $0.77 (38% increase)
- 2009 earnings-per-share of $0.90 (17% increase)
- 2010 earnings-per-share of $2.16 (140% increase)
Even during the worst recession since the Great Depression, Apple’s earnings-per-share rose each year, as shown in the bullet points above.
Valuation & Expected Total Returns
In the past four reported quarters, Apple generated earnings-per-share of $8.81. Based on its trailing earnings, Apple stock now trades for a price-to-earnings ratio of 18.
This certainly does not appear to be too high, given that the S&P 500 Index has an average price-to-earnings ratio of 25.
Still, Apple’s valuation multiple has expanded considerably in recent years. For example, from 2011-2016, Apple held an average price-to-earnings ratio below 13.
From this perspective, value investors might start to worry about the stock. But it could just as easily be argued that Apple deserves an even higher multiple than what it has now.
Apple may not earn a market multiple, based on its huge size. The company has a market capitalization nearing $800 billion. But a price-to-earnings multiple of 20-22 is not out of the question.
This is a reasonable valuation in today’s market for a high quality business with strong growth prospects – which Apple certainly is.
Huge company as it is, Apple still generated 8% earnings growth through the first three fiscal quarters. Keep in mind that growth stands to accelerate next year, thanks to the new iPhone.
A price-to-earnings ratio of 22-24 would represent a 22%-33% return.
Plus, Apple will generate returns from earnings growth and dividends. A reasonable breakdown of Apple’s future returns is as follows:
- 6%-8% revenue growth from continued Services segment growth and the ongoing iPhone cycle
- 1% margin expansion through efficiency gains
- 2%-4% share repurchases
- 1.6% dividend yield
Based on these assumptions, Apple would generate total returns of approximately 11%-15% per year, plus any returns from an expanding price-to-earnings multiple.
Cash distributions to shareholders play an important role in Apple’s future returns. Apple returned $34.6 billion to investors over the first three fiscal quarters through share buybacks and dividends according to the company’s year-to-date cash flow statement.
Final Thoughts
When a stock climbs to a valuation level above its multi-year average, it is reasonable to question whether the stock has become overvalued.
Apple has enjoyed a tremendous rally, which could tempt investors to take profits off the table. But Apple can still be a rewarding hold, on multiple fronts.
The company should increase its dividend by at least 10% per year going forward, thanks to its huge cash flows, and low payout ratio. And, the stock still offers the potential for double-digit total annual returns.
As a result, long-term dividend growth investors have plenty of reason to stay invested.
