Apple (NASDAQ:AAPL) reported earnings last week, then broke records as the first U.S. company to reach a trillion dollars in market cap. Yay! Meanwhile, Fitbit (NYSE:FIT) announced earnings and proceeded to sell off about 10%.
In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu dive into the reports from both companies and the long-term stories behind them. Fitbit's report was pretty lame, but it wasn't all bad -- what should hopeful investors watch out for?
Apple turned down the opacity filter on its wearables segment, but is still keeping tight-lipped about its potential video-streaming offering. Fitbit's new Versa smartwatch is doing a lot better than the ill-fated Ionis, but what will it take for the company to really turn its ship around? Tune in and find out more.
A full transcript follows the video.
This video was recorded on Aug. 3, 2018.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, August 3rd, and we're talking Apple and Fitbit. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, what's going on?
Evan Niu: Not much. Going to the mountains again this weekend.
Lewis: Another big weekend for you! You've been living large this summer.
Niu: That's what you do in the summer in Colorado. The mountains are an hour away, so it's very accessible. It's also my wife's birthday.
Lewis: Where specifically are you going?
Niu: We're going to Keystone.
Lewis: This time, you'll have the kids with you, though?
Lewis: So maybe not quite as adventurous a hike, then, with the young ones.
Niu: It'll still be a good time, though.
Lewis: I'm going to be relaxing here in D.C., because I've gone through three weekends now of me and my girlfriend meeting associated parents. I cannot wait to sleep in and relax and not have to entertain anybody.
Niu: [laughs] It's getting serious!
Lewis: Dan Boyd behind the glass puts up three fingers. Yes, my parents are separated, Dan. [laughs] That's how that math works. Before we get on to enjoy all of that, though, we're going to talk a little bit about Apple earnings and Fitbit earnings.
I want to talk about Apple first. Evan, this is a company we love, it's in the news. It's probably the biggest market story of this week, if not the month. We have a trillion-dollar company, finally, on our hands.
Niu: Yeah, the first U.S. company to hit a trillion dollars. I remember, years ago, when this whole conversation started. But then they had that big 45% pullback that lasted a year. [laughs] That set them back a little bit.
Lewis: That point you make about it being the first U.S. company is a good one to make. A lot of the coverage that we have seen has said that Apple is the first trillion-dollar company. That's not technically true.
Niu: Right, PetroChina hit that in 2007. But, they're also down to $200 billion, so they've lost almost 80% of their value since then.
Lewis: Yeah, I doubt that Apple will follow the same fate. But, certainly big news, certainly something that's interesting for us to talk about. Really, this big number that they finally hit was because they put up some pretty good numbers in their earnings report.
Niu: Right. I think that was definitely the catalyst to the upside.
Lewis: The company reported revenue of $53.2 billion, which beat Street estimates. Ditto for earnings per share, which came in at $2.34. I think the necessary context here, when you think about a company this size and the numbers they're putting up, this is Apple's fourth consecutive quarter of double-digit growth, and the company's strongest growth rate of the past 11 quarters. Going back to that little dip you were talking about earlier, I remember doing a show at some point with you in mid-2016, something like that. There were a lot of naysayers -- what's going on with Apple's stock, have they peaked? I think it's safe to say now, $500 billion in market cap later, no, the company is doing just fine.
Niu: What's crazy is, they're able to hit this valuation, and their P/E ratio is something like 17X, it's ridiculously cheap. Even at a trillion dollars, they're so profitable that they're still very cheap, even at such an insanely high absolute valuation. It's really kind of unheard of. It's one thing if you get up there and you're overhyped and overvalued or whatever. But no one is going to argue that Apple is overvalued when they're trading at 17X earnings.
Lewis: We haven't really seen a company like this ... maybe ever. It's historically cheap, it continues to hum along and grow. I look at it now and I'm like, how could it double? But I could have said that two years ago, and this is where we are now.
The big catalyst for this business, and something that is always focused on with earnings, is the iPhone unit. This most recent quarter, we saw more of the same. Units trudged along a little bit, nothing too crazy on the growth side. Most of the growth we're seeing from revenue comes from an increase in average selling price.
Niu: Right. iPhone units were up less than 1% to 41.3 million units, but iPhone revenue jumped 20% because ASPs jumped to $724. They noted on the call that they gained share in the quarter, which speaks to the broader state of the smartphone market. IDC says the smartphone market actually contracted in the second quarter. Not a lot, it was something like 1-2%. So, basically, anything that's remotely positive, like .7% growth for Apple, is enough to gain them share on the unit side.
On the revenue side, the iPhone X starting at $1,000, has really been the big driver over the past three quarters in terms of being able to deliver some of this growth. That's where the majority of the growth is coming from, just iPhone X pricing alone.
Lewis: I think that's only going to continue. I think we're only going to see average selling prices go up. Just anecdotally, looking around and seeing people, whether it's on the Metro or at work, I see a lot of people that are still working with iPhone 6, 6s, 7. I think there are still a lot of people who haven't quite migrated to the more expensive lines for them.
Niu: Right. I think the big question going forward is, there has been all this talk about, iPhone X pricing is a little too high for a lot of consumers, which is certainly true. $1,000 isn't a cheap phone. Obviously, they're doing quite well overall. But, certainly, there are a lot of people who just can't afford it, or don't want to afford it, don't think it's worth it. I think the big question with this upcoming iPhone release for 2018, which will probably be next month, is -- what are they going to do on the pricing side? Are they going to walk it back a little bit to try to grow units more? Are they going to stand pat at $1,000 for the flagship? I think that's a big thing to keep an eye out for next month. But, so far, it's going quite well.
Lewis: Thinking a little bit about the new release that'll be coming up, it always comes in the fall, we saw a pretty big change in form factor with the iPhone X. I don't know that people should necessarily expect something radical this fall.
Niu: Right. People are expecting the same form factor. Certainly, the iPhone X was just released, so they'll probably do no dramatic changes there, just bump the specs, make things faster, the usual refresh there. Then, there's also supposed to be a bigger iPhone X. No one knows what they're going to call it. Last year you had 8 and X. What do you do this year? 9 and 11? 10s? You know what I mean? The naming has been so messed up for many years. Whatever they call it, there's supposed to be an iPhone X Plus, a larger version.
Lewis: Why don't we talk a little bit about what's going on on the Services side of Apple's business? The installed base, this massive group of people with iPhones, gives them the ability to create a lot of high-margin Service revenue, and we are seeing that segment take off. It seems like they are on their goals to making that segment double between 2016 and 2020.
Niu: They're still on track. Services continues to grow at this nice clip. It grew 31% this quarter to $9.5 billion. That does include a one-time benefit of about $230 million from lawsuit settlements. They had a pretty litigious quarter, they had a bunch of stuff going on. That's obviously not a recurrent thing, it's a one-time item. But, in general, even if you back that out, the Services business is growing very well.
One thing that's very nice about the Services business is, there's no seasonality to it. The iPhone, and most consumer electronics, are very prone to seasonality. People buy stuff in the fourth quarter, they don't buy as much in the summer. But if you look at Services, it marches higher every single quarter, even on a sequential basis. Every quarter is just more and more. It's a very steady rise.
And, like you mentioned, this is a very profitable business. There are now 300 million paid subscriptions running through their stores. They've added 30 million subscriptions basically every quarter for the past three quarters. It seems pretty consistent, the clip at which they're adding these subscriptions. This business is executing very well. On a trailing 12-month basis, it's now a $35 billion business.
Lewis: Which is absolutely insane. Any time you look at the scale that Apple operates on, it's staggering. One area that we're always desperate to get more clarity on, and always have to settle for vagaries, is what's going on with Apple's Wearables business. We got some help there, some update there from management, but it's still not as granular as we would like.
Niu: Right. This time, they did say that on a trailing 12-month basis, Wearables has exceeded $10 billion in revenue. We knew that was pretty close, because last quarter, they said it was the size of a Fortune 300 company, which is their roundabout way of saying it was about $9.3 billion. So, it was already on that cusp of hitting $10 billion. Not really surprising that they hit it this quarter.
It's the same kind of story. They're doing well growing the Apple Watch, as well as these wearables that they include in Wearables, which is audio products like AirPods and Beats. It's questionable whether or not those are really wearables, but that's what they call it.
Lewis: Putting it all together and looking at Apple's guidance for the fiscal fourth quarter, which is calendar Q3, they're looking at revenue in the range of $60-62 billion. We talked about growth rates a little bit before. That guidance represents 14-18% year over year growth. It's crazy that they're able to put double-digit revenue growth up when they're at this size. It's incredible to me, Evan.
Niu: That's one of the big things that's encouraging investors. Like we mentioned before, their growth had been tapering off for a little bit. Now, they're guiding for a fifth consecutive quarter of double-digit growth, and it's really accelerating. The fact that they're able to accelerate growth on this massive business is a hugely positive narrative for investors. Most companies can't do this. Again, it's really coming from iPhone X pricing and Services. I think that's largely what has encouraged investors to bid up the stock above $1 trillion.
Lewis: The big question mark for this company, looking at the next two quarters, is, at what point will the launch of the new iPhone come out? Will it be something that plays into their fiscal Q4 results? Or, will it be something that plays into fiscal Q1 for next year? That release date will give us a little context into what they're actually expecting with year over year growth. If that doesn't launch until fiscal Q1, and they're still expecting that 14-18% year over year growth, then the party's on. The growth story is just going to continue.
Niu: Longer-term, bringing it back to the Services piece, they had the clearest clues yet that Apple was building a video streaming service. That's been pretty obvious if you look at how much stuff they're buying in Hollywood. But, they haven't talked about it. On the call, Tim Cook referenced the two TV execs they hired. They said, "They're working on a project that we're not ready to share all the details of." That's the most direct reference that we've heard yet that they do have some type of video streaming service in the works. We've also heard other reports of a premium news service that they might be working on, because they acquired a digital magazine service earlier this year.
Longer-term, when you look at these other potential offerings that they're going to come out with in ... maybe a year or so, who knows when they'll do it, those just have even more potential to really juice the Services business even more. The Services business is fundamentally very scalable. I think longer-term, there's a lot to look forward to.
Lewis: As you're looking at this business, you're a shareholder, I'm a shareholder. I know that I'm a little bit less inclined to add to the position that I have with Apple than I might have been two years ago. I look at them at a trillion dollars and I say, it's going to be a lot tougher for them to double and give some of the growth that we've seen over the past two years, five years. That said, I think you could do a lot worse than buying Apple if you're looking for exposure to the tech space.
Niu: It's a safe play, even if you don't think there's a lot of growth in store. Their earnings multiple is so cheap, it's fairly safe. They can't really go down too much when they're making this much money. I've always looked at it as a fallback, if I have some extra money, I'm not going to be too worried about it. But, I also wouldn't expect it to have incredible gains going forward, since they're already so high.
Lewis: I was thinking a little bit about what they're doing on the share repurchase side and the dividend side and thinking about their capital allocation. Even if their market cap stays at around $1 trillion, they're planning on aggressively buying back shares somewhere in the neighborhood of $40-50 billion a year, something like that, and they maintain a decent dividend yield. Think about them buying back shares, returning capital with increased ownership for people who currently own shares, you could be looking at 4-5% growth without any actual market cap growth, which is kind of incredible.
Niu: They've been buying back shares at a crazy pace ever since tax reform last year. They've bought back $44 billion over the past six months, which is a mind-blowing figure to think about, two quarters' worth. They're just going to keep doing it. They've said that they're trying to implement this net cash neutral goal. Right now, their net cash is close to $150 billion. That implies, over time, they're going to be buying back hundreds of billions more in the years to come.
Lewis: There's a lot of debate as to what companies should be doing with that cash. You could very well argue that it might be better spent, from an economic perspective, giving some growth opportunities with employment and creating things here in the United States. But, if you're a shareholder of the company, you have to be pretty thrilled that they are aggressively rewarding people who hold Apple shares.
Niu: Right. They're buying so much that it's highly accretive to long-term shareholders. Their EPS growth has been nuts because they're buying back so much. Long-term shareholders are really getting a huge benefit from it.
Lewis: Switching gears over to Fitbit, these companies might not seem to go together, but I think, when we talk about, Apple is a hardware company that has, over the past couple of years, really blossomed this wonderful and margin-happy Services segment, that's ideally what Fitbit wants to be doing. That's what we keep hearing from management on the call. They're not there yet, though, looking at their current results.
Niu: Right. They reported second quarter earnings. Revenue was about $299 million, a loss of $0.22 per share. Both of those were declines from a year ago. They've been really struggling, as this wearables market broadly transitions from these basic activity trackers toward more full-featured smartwatches. It's very much what you saw play out with flip phones and smartphones. It's also not at all surprising, because why would you buy a device that can do just one thing vs. spending a little bit more money -- and, smartwatch prices keep coming down and becoming more affordable -- and it can do so much more.
Their basic fitness tracker sales have been really falling for the past one or two years. The good news is, they recognized this early on and started investing in and acquiring these companies that they could use to make a smartwatch. They're in the midst of that pivot. The first smartwatch, Ionic, did not do well. But this newest one, the Versa, which is a little bit more affordable, it has a much more approachable, friendly, mainstream design that's designed to appeal to mass-market, it's doing well. It's doing much better. I do think there's light at the end of the tunnel.
Lewis: Thinking about how that shakes out to some of the operating metrics that Fitbit provides, what we're seeing is similar to the same story we're seeing with the iPhone. Average selling price is going up, even though units may not be necessarily going as high as the company or investors might like. Putting the two numbers together, average selling price is $106 from this most recent quarter, they sold 2.7 million units. Devices alone, simply device sales, make 95% of revenue. That remaining 5% is primarily Accessories, with a little bit of Service revenue, as well.
Niu: They've been trying to grow this Services business for years. Even when they first went public a few years ago, they kept talking about how they wanted to grow these various types of services, from subscription-based training things that you can do on your phone to all these other things. But they really have not made any progress on that front, at all. Every filing they've had since going public has this line mentioning that less than 1% of revenue comes from Services.
Up until now, they have not been able to execute on growing that business. Whether or not they can going forward ... They just bought Twine Health as a way to build a more digital health platform. That's encouraging. But, again, we're not seeing the numbers quite yet.
Lewis: They cite these figures that software and services-type revenue was up 34% in the most recent quarter, and up 30% in the quarter before. So, there's some acceleration quarter-to-quarter. But, that's pretty low growth, given what a tiny portion of the overall revenue mix this is for the company.
Niu: Yeah, they're coming off of such a tiny base. Like you said, they should be able to grow it at higher rates if they're coming off of almost nothing. But, not many people are signing up for these services, obviously.
Lewis: Which is tricky, because I totally see the integration. I understand the fitness coaching, some of the more advanced health services that they might be able to offer. I think there's just a very natural fit with Services and their hardware product, they just haven't cracked that nut yet.
Niu: Right. They're still trying to build out the smartwatch platform in general. They're getting more third-party apps on there, they're trying to develop their operating system more. They still have a lot of work to do on the platform side. That could also help boost this third-party platform revenue, or, ideally, these subscriptions.
The first time ever, they did say that smartwatches are now over half of revenue. It was 55% of total revenue in the quarter. They're making progress on a number of fronts. I'm not super confident in them long-term, but they are making progress.
Lewis: Something that was a little curious to me with this earnings release was what management said about guidance. Fitbit's management said they're expecting Q3 to come in somewhere between $370-390 million, which would have them down slightly year over year. They also reiterated full-year guidance for revenue, which is roughly $1.5 billion. We have Q1 and Q2, we have their guidance from Q3, and that gives us the ability to then say, "This is roughly what they're expecting for Q4." At the midpoints for that Q4 estimate that we back into, they're roughly flat. But, management has also said that they expect to return to growth and profitability in the second half of 2018.
I appreciate them being somewhat conservative in reiterating guidance, but I also think they're giving some dummy guidance here. If I'm a Wall Street analyst and I'm working through all this, and I hear this, I'm thinking they're going to sandbag a little bit on one of their quarterly ballparks and actually expect more when I'm building out my models. I say all of that to say, they might be in a situation where they hit guidance in Q3 and Q4 and the market isn't particularly happy about it.
Niu: Yeah. They did mention on the call that they're trying to take a more conservative approach when they issue these forecasts. Like you mentioned, in the past, they've over-promised and under-delivered. I think they're trying to avoid that. At the same time, I think they're going to try to shift toward these fall product releases to coincide better with the holiday shopping season. That could be, potentially, if they have a successful product launch in the fourth quarter, there could be a little upside there, relative to their guidance.
Lewis: I just think that exercise of, "We're reiterating our guidance, but we're expecting a return to growth in profitability," is kind of like, "We're reiterating our guidance, wink!" Like, "You should expect more!" It's something to be mindful of if you're watching this stock over the next six months. They might hit all the numbers that they say they're going to hit, and Wall Street still might not be particularly happy about it, because of some of the comments that they're making.
Big picture, looking at Fitbit, I think, if you're a shareholder, you have to be happy about the Versa smartwatch. This is them really firing well on a product after the miss with the Ionic. They actually said they were supply constrained during the past quarter, and that they sold out of the product. Given some of the struggles they had in the past in consumer hardware, you have to love that.
Niu: Yeah, that's certainly a good sign. That watch looks so much better. The Ionic was too niche of a product.
Lewis: Somewhat relatedly, the company's inventory is under control. They've talked a little bit about operating expenses. By all indications, tracker inventory is more or less in line with demand. Given that, in the past quarters, they've had to eat charges related to inventory and slightly mis-estimating demand, that's another thing that you have to like.
Niu: Right. They've learned their lessons. You don't want too many devices in the retail distribution channel that aren't actually moving. If people aren't buying your stuff, that's a bad thing, clearly.
Lewis: The thing I come back to with this company, though, is, to your point earlier about Services providing a good, consistent floor of revenue for Apple because it's not as seasonal, when I look at Fitbit, it's still a somewhat seasonal business that's highly reliant on new product launches. The subscription revenue, the service revenue or software revenue, just isn't there yet, and I'm still not seeing a lot of traction.
Niu: Right. They're competing with Apple, too. That's one of their main competitors. Like you said, this entire business is all hardware. It's all going to be based on consumer spending patterns throughout the year, product launches, how well these products are being received in the market. At the same time, your total market cap is a few billion dollars. Apple makes ten times your market cap in a single quarter. [laughs] It's really hard to imagine them being a really strong competitor, just in terms of sheer size. How do you compete with that?
Lewis: For my money, I'm still staying away from Fitbit. If you're a shareholder, I think that you need to really buy into the idea that they're going to build a Services revenue segment that is viable long-term. I think that not only helps them out financially, but, if they're able to build out really valuable software and services, that makes their product offering a lot more valuable. It makes it a lot stickier, and it keeps people engaged.
Niu: It's a huge part of the investing narrative. I thought this report was actually pretty decent because they're starting to show some signs of progress. But the market didn't. The stock went down something like 9-10% that day, so, obviously, investor sentiment is still very poor. Though, in my opinion, there are some encouraging signs. They have a lot of work to do, in terms of shifting investor sentiment. Growing the Services business would do a lot of good on that front.
Lewis: Hopefully they'll figure it out. I know a lot of Fools follow this stock. Evan, thanks for hopping on and talking with me today!
Niu: Thanks for having me!
Lewis: Of course. Have a good time on the mountain this weekend and tell your wife I said happy birthday!
Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say hey, you can shoot us an email at firstname.lastname@example.org, or you can tweet us at @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for all his work behind the glass, subbing in for Austin Morgan today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!
Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Fitbit. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.