Apple 1Q FY19 Commentary

On Tuesday, Apple reported “disappointing” 1Q FY19 results, as total revenue fell 5% y/y to only $84.3 billion. Net income was $20 billion, essentially flat y/y, while earnings per share were an all-time high of $4.18 (+7.5% y/y), although this growth was helped by a reduced share count due to buybacks. The fall in revenue was mainly attributed to iPhone revenue (61.7% of total revenue) falling 15% y/y, and management explained that this was entirely due to weakness in Greater China. Guidance for the next quarter also wasn’t very remarkable, with gross margins expected to decrease and operating expenses expected to grow. So why did the Apple’s stock price increase by almost 7% the next day?

If we dig a little deeper, there’s plenty for investors, us included, to be happy about when it comes to Apple’s results. The company posted stronger-than-expected results in virtually every region outside of China and Japan, the latter of which was hurt by decreases in iPhone subsidies provided by telecom operators. The Americas segment (44% of total segment revenues) grew 5% y/y, and new sales records were also reached in Western Europe, Central and Eastern Europe and the rest of the Asia-Pacific segment. Even in China, Apple generated record Services revenue and Wearables revenues were up over 50%.

Besides the weakness of the iPhone, the rest of their business grew 19% to an all-time record. The Services segment grew 19%, up in all of the company’s five geographic segments (including China) to an all-time record of $10.9 billion and posted a gross margin of 62.8%. Wearables, Home and Accessories also reached all-time highs, growing 33%, thanks to the amazing popularity of the Apple Watch and AirPods (demand was so high that Apple was having trouble supplying them to consumers towards the end of the quarter). And while phone revenues will likely continue to fall, the meaningful growth in their other products and services will allow for further monetization of the company’s existing user base.

Looking at the services segment, some were concerned that Netflix’s decision earlier this month to drop support for iTunes billing, cutting out Apple as the middle man and their 15-30% cut of subscription costs, would deal a meaningful blow to Apple’s growth in paid subscriptions going forward, one of their engines for growth. However, Apple reported that it has over 30,000 third-party subscription apps available on the App Store, and the largest of them (Netflix) only accounted for 0.3% of total Services revenue. The company also reported a total of 360 million paid subscriptions across their Services portfolio, an increase of 120 million from a year ago, and they expect to surpass 500 million subscriptions during 2020. In other words, it doesn’t seem they’re too concerned by Netflix jumping ship. It’s also important to remember that while Netflix could afford to leave thanks to their pull with consumers, most other third-party subscription apps depend on being a part of the Apple ecosystem for their survival.

It’s also worth noting that Apple’s Wearables and Services segment revenues accounted for $18.2 billion dollars of during the quarter, which is more than Netflix’s revenue for the entire fiscal year ($15.8 billion). Despite this, however, the combined revenue growth of Apple’s Wearables and Services segment during the quarter was comparable to that of Netflix:

The above chart examines quarterly revenue growth of Apple’s Wearables and Services segment, compared to Netflix and some notable S&P 500 companies with similar total quarterly revenues. The only company that is growing its entire business faster than Apple’s Wearables and Services business is Facebook (4Q18 revenues of $16.9 billion +30.4% y/y). The same Facebook that was recently left in disarray after Apple suspended their access to internal iOS apps. At the other end, the consumer staples giant Procter & Gamble (4Q18 revenues of $17.4 billion) has exhibited low or no growth over the past few periods, but is still trading at a higher P/E than Apple (23.5x vs 13.7x). While many market commentators are harping on the slowdown of the iPhone business, it’s the growth of Wearables and Services business that is just as important going forward. And not only is this business growing at an impressive pace, but it is bringing in more revenue than a number of companies do in total.

With strong growth in Apple’s complementary services and products segments, expect Apple to continue to introduce new products in these categories that will not only help them continue to grow, but also broaden future revenue diversification. Maybe the most important vector is health-related services, as Tim Cook himself has stated that Apple’s greatest contribution will come from its work in healthcare. Given the current health-related abilities of the Apple Watch, ranging from heart-rate monitoring and workout tracking to fall detection and emergency SOS, it’s likely that we see more features and other products being added that continue to exude luxury, while also providing indispensable health benefits.

One way that Apple is making sure that these benefits are known is through its partnerships with two of America’s largest health care providers, Aetna and UnitedHealthCare, which collectively provide insurance to more than 70 million customers. Both have recently announced promotions in which eligible customers can earn a free Apple Watch (paid for by the healthcare companies) by wearing it and reaching specific activity goals. On a business level, this is certain to boost Apple Watch adoption, introduce some non-Apple users into the Apple ecosystem and further cement Apple’s lead in the wearables category. And with this boost in users, Apple will receive far more biometric data that could be used for predictive analytics in some innovative health application somewhere in the not too distant future.

Because of these future growth possibilities, in the health vector and elsewhere, demonstrated growth in their non-iPhone categories, and the continued strength and value of the Apple ecosystem, the course ahead looks as strong as ever. And while these other segments have picked up the slack while iPhone sales have weakened, we can’t discount the strong positive effect that the release of a brand new iPhone (as opposed to an incremental update like the latest models) could have on demand, particularly in China. Once there’s more clarity on the next generation of this must-have product, expect sales growth to return to the iPhone vertical, and with it, further upside to Apple’s stock price.