Apple’s Underlying Prospects Have Never Been Stronger

Apple's services continue to pick up momentum and transition Apple towards a higher margin business.
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Apple  (AAPL) - Get Report on the surface reported a mixed Q2 2020 result. While looking ahead into the next quarter, Apple admits that it continues to face headwinds as its iPhone sales are expected to be down year-over-year. However, Apple's pivot towards being a service company continues to pay dividends, and its Service segment may be more sticky than many investors believed at first.

Furthermore, seeing that Apple trades for just 27 times trailing free cash flow, investors right now are getting a rare investment opportunity, as Apple is on sale. Here's why:

The Most Challenging Global Environment In Its History

Apple had to endure massive global disruption in its supply chain during the March quarter. CEO Tim Cook noted that during the first five weeks of its March quarter, Apple had been on target to reach a record quarter, at the very high end of its own expectations.

Given that, most investors had already come to terms with just how unprecedented the current environment is, and there’s overall optimism that we are now over the worst.

The one segment that was able to shine during the quarter was Apple's Services, where Apple reported an all-time revenue record of $13.3 billion, up 17% compared with the same period a year ago. Within this segment, there were records set across its App Store, Apple Music, Video, cloud services and its App Store search ad business.

In what has been a running theme across all of Apple's large peers reporting the past few days and weeks, from Netflix  (NFLX) - Get Report to Alphabet  (GOOGL) - Get Report, consumers' demand for content and cloud services spiked during the March quarter.

One aspect of the quarter which reminds us of the strength of Apple’s funneling system was that iPhones' active installed base reached an all-time high. Similarly, Apple’s paid accounts for digital content hit an all-time high during Q2 2020 and its Wearables, Home, and Accessories segment was up strongly to $6.3 billion in revenues, an increase of 23% compared with the same period a year ago.

Lack of Guidance Forces Questions

Apple decision not to issue guidance for the current quarter raises two questions. First, how weak does Apple expect its June quarter to come in at? CFO Luca Maestri admitted that this coming quarter would see Apple’s iPhone sales, which make up 50% of its total revenue, to worsen relative to its March quarter. 

Given that for its March quarter, iPhone sales were down 7% year-over-year, this could translate into its June quarter seeing iPhone sales being down close to 10% year-over-year.

Secondly, Apple stated that within its Services segment, its App Store, Video, Music, and cloud services, should continue to see the strong performance continuing into its June quarter.

This is noteworthy because this is the opposite of what Netflix believes should happen with its performance, given that as work-from-home trends ease up, the demand for Netflix’s content should tail off slightly over the near-term, as customers that haven’t adopted its platform during the confinement are less likely to seek it out subsequently. While difficult to discern right now, this trend could be very bullish for Apple shareholders.

Strong Fiscal Position Driving $50 Billion Share Repurchases

Apple finished the quarter with a net cash position of $83 billion. Note, this is after Apple returned $22 billion to shareholders over the quarter.

Given Apple’s ability to continuously generate free cash flow, Apple has set out a brand new share repurchase program of $50 billion on top of the $40 billion outstanding under its current share repurchase agreement. This demonstrates that it is serious about bringing down its net cash position further and that Apple strongly believes its stock is undervalued.

Valuation - Under Valued Stock

Despite having to navigate punishing conditions, Apple still increased its free cash flow compared with the same period a year ago. In fact, over its trailing twelve months, Apple’s has now generated approximately $48 billion in free cash flow. 

As a result, investors are only asked to pay 27 times Apple's trailing free cash flow, which is in no way expensive given its medium-term prospects of diversifying away from a pure-play hardware company and towards a high-margin service ecosystem that will continue to improve its margins over the next few years.

The Bottom Line

Apple had a mixed quarter, and its June quarter is set up to be challenging too, as the economy dramatically contracts. However, Apple’s underlying prospects have never been stronger, and it continues to make strong headway into diversifying its operations away from iPhone sales.

For now, this strong cash producing company remains cheaply valued at just 27 times trailing free cash flow, backed by one of the strongest balance sheets in the world. Apple’s stock doesn’t stay on sale for too long, making now a unique investment opportunity. 

Apple is a holding in Jim Cramer’s Action Alerts PLUS Charitable Trust Portfolio. Want to be alerted before Cramer buys or sells AAPL? Learn more now.