Apple (NASDAQ:AAPL) will report its FY2022 Q2 earnings this Thursday after the bell. Given the ongoing global geopolitical and macroeconomics uncertainties, its earnings will be of importance not only to AAPL stock itself but also be viewed as a market event.
Specific to AAPL, its deliveries and sales in China will be in focus. It reached its highest ever market share in China in 2021, with iPhone grabbing a record 23% market share during CY2022 Q4. However, since then, the market is concerned about the interruptions of the components shortage, the lockdown in key cities like Shanghai due to the resurgence of Covid-19 cases, and the normalization of consumer demand and upgrades. The China market is a key market for AAPL, and these effects will not be negligible, and most likely, will linger longer beyond the quarter-to-quarter fluctuations.
Its capital allocation direction is another focus. Analyst Jim Suva noted that “AAPL could boost its share buyback program between $80 billion and $90 billion and raise its dividend between 5% and 10% when it reports fiscal second-quarter earnings on April 28”. Such a sizable share repurchase and dividend program can impact shareholders’ returns both in the short term and longer term (as shown in the following chart), and we will revisit and elaborate more later. At the same time, besides boosting shareholder returns, the allocation decision is also important to gauge AAPL’s future product lineups. It would shed light on AAPL’s progress and future plan in the new product categories, such as augmented reality headsets, wearable electronics, and the rumored Apple car.
China in focus
As shown in the chart below, AAPL surpassed Vivo in Q4 CY2021 to become the #1 brand in China. Its market share reached a record 23% in Q4 2021, representing a spectacular QoQ market share growth of 79% and YoY growth rate of 32%. Its market share led Vivo by a whopping 400 basis points during Q4 2021.
However, market concerns have started growing since then. The disruptions of the global supply Chain persisted and were even exacerbated by the breaking out of the Russian-Ukraine war. The shortage of components also persisted. To make things worse, China has also suffered a resurgence of COVID cases and had to put some of its key cities like Shanghai (a major port city of China) under shutdown mode, not only impacting demand but also China’s import/export throughputs. As summarized by analyst Ivan Lam (the emphasis is added by me),
“The market in China continues to decline due to various factors in both the supply side and the demand side. Firstly, the ongoing component shortages are impacting shipments of all OEMs. Secondly, China’s average smartphone replacement cycle is becoming longer. Smartphone designs within brands have also become more homogeneous, especially in hardware, failing to motivate consumers to upgrade. Lastly, China has been experiencing a complex economic environment where exports are driving the growth and domestic spending remains lackluster.”
The China market is a key market for AAPL, and these effects will not be negligible. And most likely, the ripple effects will linger longer and create higher-order and nonlinear effects. For example, other players such as vivo and Huawei (Apple’s main competitor in the premium market) could catch up and take market share. And the update on the China front could decide the stock price movement after the earnings.
Capital allocation directions
AAPL enjoys tremendous capital allocation flexibility. The business is in such a strong financial position. And as such, the question here is only about how much it decides to return to shareholders, how much it decides to reinvest, and whether it can find enough high-margin opportunities to invest. This is why I would pay closer attention is its capital allocation directions in the upcoming earnings report.
The following chart provides a summary of AAPL maintenance and growth CAPEX spending in the past few years (and details are in my earlier article here). Its CAPEX expenditures have been consistently above $10B in recent years ($13B in 2020 and $10B in 2021). The beauty of AAPL is that, as you can see from the following chart, it does not need to spend too much on maintenance CAPEX. And the majority of its CAPEX spending is growth CAPEX. Its growth CAPEX has been growing rapidly in recent years. The growth CAPEX spending investments has almost quadrupled since 2018 – from about $1.3 billion in 2018 to about $4 billion this year.
Strong cash generation and low maintenance CAPEX requirements are such a potent combination. As a result, AAPL could pursue high-risk and high-return futuristic products (such as augmented reality and autonomous cars) AND at the same time generously reward its shareholders by share buyback program and dividends, as detailed next.
Economics of AAPL’s share repurchases
In recent years, AAPL has been actively engaging in share repurchases. As shown in the first chart that opened this article, it spent a whopping $85B last year on share repurchases, about 78% of its operating income.
The economics of share repurchase is quite simple – not only for AAPL but for any business. It is always a good idea to repurchase your own shares whenever your cost of capital is lower than your return on capital. All the trouble is in estimating the cost of capital. As Charlie Munger famously commented:
“I’ve never heard an intelligent discussion about ‘cost of capital.'”
Munger is absolutely right. And it is beyond the scope of this article to analyze the different ways of estimating the cost of capital and their problems (e.g., how much variance they can generate in their estimates). But fortunately, in the case of AAPL, the economics is really simple because of its astronomically high return on capital. As a result, it does not matter which method we use to estimate its cost of capital and how much variance is among these methods – its cost of capital will be much lower than its return on capital for sure.
Now with all the pieces ready, the WACC for AAPL over the past decade is calculated and shown in the last row of the table below. As an example, the next chart shows its cost of capital estimated by the method of Weighted Average Cost of Capital (“WACC”). As seen, it has been quite stable in the range from 8.3% to 9.3%, with an average of 8.8% over the past decade.
The chart also compares the WACC against the ROCE (return on capital employed) and ROE (return on equity) for AAPL as detailed in my other articles. As seen, both the ROCE and ROE have been systematically higher than WACC by a really wide margin. Against, whether we believe WACC to be an accurate estimate of its “cost of capital” or not, this comparison shows that the business can sustainably earn a healthy return on capital far exceeding the cost of capital raised – which makes share repurchase potent and accreditive in AAPL’s case. Shareholders should be happy that AAPL is investing their capital (which cost about 8.8%) in a business that earns more than 100%.
Conclusions and risks
You have good reasons to be anxious about AAPL’s upcoming earnings announcement. It is going to be important both for AAPL shareholders AND also as a market event, especially against the backdrop of macroeconomics and geopolitical concerns. Specific to AAPL, I would watch closely the following two issues,
- Its China market. Besides being a key market for AAPL, developments in China can generate nonlinear ripple effects. For example, other players such as vivo and Huawei (Apple’s main competitor in the premium market) could catch up and take market share. The update on the China front could decide the stock price movement after the earnings.
- Its capital allocation directions are the next item that has long-term relevance. The business has been spending between $10B to $13B during the past few years, and most of it is to fuel growth, leaving plenty of firepower for share repurchase and dividends. I would watch for comments regarding its investment in future directions, such as augmented reality, wearable electronics, and autonomous cars.
Finally, besides the market share risks mentioned above in China, AAPL also faces a few other risks at this moment.
- Short-term volatility risks. Regardless of its scale and business fundamentals, the valuation is at a premium level and the overall market itself is also near a historical record valuation. Such a combination of volatility and high valuation certainly could cause some short terms risks.
- Competition in China market. The China market is always highly dynamic and evolving. All major players and OEMs in China are embracing advanced technology. Especially in recent years, under the background of heightened competition between China and the U.S. in advanced chips and electronics, major China players (vivo, OPPO, Huawei, and Xiaomi) all launched self-developed chipsets and customized software, specially tailored for Chinese users. It is uncertain whether Apple’s success in the premium segment can sustain.