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Morningstar | Apple Exhibits Strong Execution in Non-iPhone Segments; Shares Undervalued Relative to $200 FVE

Apple reported fiscal first-quarter results in line with the firm’s revised guidance from Jan. 2. Positively, non-iPhone segments (services, Mac, iPad, and wearables/accessories) grew 19% year over year led by stellar services and wearables growth. After factoring in near-term iPhone headwinds in China and emerging markets, management’s outlook for the second quarter was relatively consistent with our expectations. Shares rose nearly 6% during after-hours trading, as we believe the market was expecting far worse. We are maintaining our $200 fair value estimate for narrow-moat Apple, as we anticipate the firm resumes mid-single-digit sales growth from fiscal 2020 onwards following a modestly lower fiscal 2019.

First-quarter revenue fell 4.5% year over year to $84.3 billion, as iPhone sales fell 15% and non-iPhone sales grew 19%. CEO Tim Cook attributed the iPhone challenges to negative foreign exchange fluctuations (as a stronger dollar made iPhones more expensive in many emerging regions), reduced carrier subsidies, Apple’s battery replacement program that prolonged upgrades, and the aforementioned weakness in China. While the first three factors appear more transitory in nature, we have significantly cut our iPhone unit forecasts for China going forward as we anticipate a more competitive environment despite the current tepid macroeconomic backdrop in the region and U.S.-China trade tensions.

We note the firm’s active installed base for iPhones surpassed 900 million devices (up nearly 75 million in the past 12 months) and supports our thesis of a rich and loyal customer base from which Apple can extract services and wearables revenue. Second-quarter sales are expected to be in the range of $55 billion and $59 billion, with the midpoint implying a 7% year-over-year decline. CFO Luca Maestri cited $1.3 billion in foreign exchange headwinds along with a weaker macroeconomic climate, particularly in emerging markets.

Services revenue for the quarter was $10.9 billion, up 19% year over year. The firm achieved all-time quarterly sales records across a bevy of subsegments in services, including App Store, Apple Pay, cloud services, and App Store ad business. Paid subscriptions from Apple and third parties surpassed 360 million, up 120 million from a year ago, with Maestri expecting this number to reach half a billion during 2020. Notably, of the more than 30,000 third-party subscription apps, the largest only accounts for 0.3% of total services revenue, thus illustrating the diversification Apple enjoys.

Mac revenue grew 9% year over year to $7.4 billion thanks to the firm’s new MacBook Air, and the new iPad Pro fueled iPad revenue growth of 17% to $6.7 billion for the quarter. Wearables, home and accessories rose 33%, with AirPods and Apple Watch growing nearly 50%. Gross margins were effectively flat during the quarter (sequentially) at 38%. For the first time, Apple provided gross margins for products and services in aggregate, coming in at 34.3% and 62.8%, respectively. Product margins rose 60 basis points sequentially due to positive leverage from higher product volumes partially offset by higher cost structures related to new product launches and foreign exchange headwinds. Services margins rose 170 basis points sequentially thanks to a more favorable mix and leverage modestly offset by negative foreign exchange effects. For the second quarter gross margins, Maestri expects a midpoint of 37.5% with a 60 basis point foreign exchange hit partially offset by commodity cost savings (likely due to lower memory prices).