Netflix’s business is a mixed bag. On one side, the company is seeing the impact of competition in the form of increasing domestic churn. On the other side, international continues to outperform expectations, suggesting that the underlying growth opportunity is intact.
Shares of NFLX were up 2% in the aftermarket following the company’s Q4 earnings report. Netflix guided to a strong Jun-20 quarter, suggesting the company’s spring content release schedule will help combat increasing competition. Factoring in a typical March quarter beat and the June guidance, Netflix is maintaining its outlook for paid sub adds for the first half of 2020. This is a directional positive — a sign that Netflix is successfully navigating increased competition and the associated pricing pressure.
Netflix Will Meet Paid Net Add Expectations
We continue to believe that, despite the threat of increased competition, Netflix will achieve analysts’ paid net add estimates in 2020. The Street is expecting paid net adds of 26.6m in 2020 (2.7m domestic, 23.9m international), exiting the year with a base of 192.5m paid subscribers, up from the reported 167m at the end of 2019.
We Remain Cautious Longer Term
Apple TV+ and Disney+ are essentially free today through various promotions. Netflix has historically increased paid subs despite competition from Amazon’s Prime Video offering, which is also essentially free. Including video offerings with other paid products and services creates a temporary perception of value in the minds of consumers and an opportunity for video providers to hook viewers, but, eventually, that perception changes.
In 2021 consumers will have to make more thoughtful streaming decisions. Promotional pricing from Apple TV+ and Disney+ will come to an end. We believe the increased competition will ultimately weigh on the Street’s paid net add estimates of 26.1m in 2021 (2.5m domestic, 23.6m international) exiting the year at 218.6m.
- Apple reports Tuesday, January 28th. We expect the takeaways to be that the iPhone business has stabilized and strength in Services and wearables continues (which combined will approach 30% of revenue in FY20). The guidance for Mar-20 will likely leave investors with increased confidence that overall revenue growth in FY20 will meet Street expectations, rebounding to 4-6% growth, compared to down 2% in FY19. The easier comps this year give us confidence overall growth will finish at the high end of the 4-6% range.
- We expect an active installed base of 1.5B plus devices, up 8% year over year. The last time Apple updated the metric was in Jun-19 at 1.4B devices.
- The underlying theme for FY20 will be marking time to iPhone 5G, which we expect to be announced in the fall. While 5G will emerge as a measurable positive for Apple shares, it’s only part of Apple’s long-term story, which deserves a higher multiple inline with other large tech companies.
- We continue to believe Apple will be the top-performing FANNG stock in 2020. We expect AAPL’s earnings multiple to increase in 2020 as investors increasingly recognize Apple’s combination of hardware and services as a high-visibility and sticky business. While AAPL has made progress towards a proper tech multiple over the past year, a gap remains. To illustrate, applying Google’s forward earnings multiple to Apple’s next 12 months earnings yields a $400 AAPL share price today.
High Level on Dec-19 & Guidance
- For Dec-19, we expect revenue and earnings slightly ahead of the consensus of $88.3B and GAAP EPS of $4.53, implying revenue up 5%, compared to up 1.8% in Sep-19 and up 1.0% in Jun-19.
- Dec-19 will be representative of what to expect in FY20 – the overall business growing at 4-6%, comprised of iPhone revenue up 1%, Services up 15%, and wearables up close to 50%.
- For guidance, we expect the high end of the Mar-20 revenue outlook to be in line with the Street’s $62.3B estimate. We would view this as an inline guide, given Apple typically comes in at the high end of its guidance range. We expect gross margin guidance between 37.5% and 38.5%, setting up for the 16th consecutive quarter of essentially 38% gross margin.
- Dec-19 will mark a stabilization in the iPhone business after being down in each of the previous four quarters (down 14% in FY19). The stabilization is attributed to the average 3.25-year iPhone upgrade cadence that translates into an FY20 revenue tailwind.
- Apple is slowly diversifying away from the iPhone, likely accounting for 58% of revenue in Dec-19, down from 62% in Dec-18 and 69% in Dec-17. For FY20 we expect iPhone will be 52% of revenue, down from 55% in FY19 and 62% in FY18.
- We believe iPhone 5G will take a year to gain traction and will drive a step-up in iPhone revenue as a percentage of sales starting in FY22 through FY24.
- In Dec-19, Apple needs to grow Services at 16-18%, which would be consistent with the Sep-19 growth of 18% and overall FY19 growth of 16%. Our confidence in this range comes from Apple’s comments related to App Store revenue in this most recent holiday period.
- We believe, in the past three years, Services growth has outpaced iPhone unit growth by an average of 28%, confirmation that Services growth is benefiting from Apple’s existing users increasing their spend within the Apple ecosystem as well as the company acquiring new Services customers through secondary iPhone sales.
- Products margin will likely continue its slight declining trend, ending at 33.5% in Dec-19 compared to 34.4% in Dec-18. For Services, we expect a year over year margin increase to 64.5% up from 62.8% in Dec-18. Putting it together, the decrease in Products margin (82% of revenue) is offset by the increase in Services margin (18% of revenue).
- How to think about Wearables growth in FY20. We estimate the segment’s growth in the Sep-19 quarter was 65% (company reported “greater than 50% growth”), up from 51% in Sep-18 (company also reported “greater than 50% growth”) driven by both AirPods and Apple Watch.
- Lingering China trade concerns.
- Thoughts on the 5G rollout. We see the 5G rollout for Apple as one step back, three steps forward.
- Apple’s privacy-first approach shelters them from most headline risk around consumer data practices, but investors will want to gain a more informed view on how the company would respond to greater government oversight on tech.
- As for the timing of achieving net cash neutral, the company has not disclosed a timeframe to date.
We believe Apple will be one of 5G’s biggest beneficiaries. The company has potentially four initiatives that will benefit from 5G: iPhone, augmented reality, healthcare, and the long shot wild card of autonomous vehicles. While multiple Apple segments will gain, the iPhone is the most obvious 5G beneficiary (likely 52% of revenue this year). In the midst of the rising hype, we are keeping conservative expectations about the first year of iPhone 5G and see modest risk to Street estimates in FY21, followed by three years of likely upside to estimates.
Our iPhone 5G Roadmap
- FY20: iPhone 5G launches in September.
- FY21: Step back. Potential disappointment related to soft initial uptake of iPhone 5G, given the lack of carrier coverage in the US and globally. We see a modest risk to the Street’s 8% FY21 iPhone revenue growth estimate and expect actual growth closer to 2%.
- FY22: Step forward. iPhone 5G revenue lift begins creating upside potential to estimates.
- FY23: Step forward. iPhone 5G biggest upgrade year creating measurable upside potential to estimates.
- FY24: Step forward. 3-year iPhone upgrade cycle rounds out creating upside potential to estimates.
During a typical upgrade cycle, Apple experiences a 1-year revenue tailwind followed by a 1-year revenue headwind. This variability has historically weighed on AAPL’s multiple. We believe the company will have a measurable tailwind to revenue and earnings growth for at least 3 consecutive years (FY22-FY24) related to 5G. This should translate to an increase in revenue and earnings visibility and is further justification that AAPL’s earnings multiple has room to move higher.
One Step Back: Modest Risk to FY21 Estimates
We recently detailed why 5G in the US will take a year longer to roll out, as limited coverage will likely dampen initial mobile demand. If we’re correct, that would be a step back for a growing group of Apple investors anticipating an increase in iPhone demand in 2021 driven by 5G. Currently, the Street is expecting flat iPhone revenue growth in FY20, increasing to 8% in FY21. Given our conservative view on the initial iPhone 5G year, we believe the current FY21 iPhone revenue growth estimate of 8% is aggressive, and are expecting growth closer to 2%.
Three Steps Forward: Upside Potential to FY22-FY24 Estimates
Starting in FY22, we believe Apple is positioned to have three years of 5-10% annual iPhone revenue growth, above FY22 Street estimates of -3%. Beyond FY22, FactSet is not reporting iPhone revenue estimates but does report overall Apple revenue estimates through FY24. Between FY22-FY24 the Street is expecting a consistent 5% annual revenue growth for Apple. Since overall revenue growth is outpacing iPhone growth due to Services and wearables, that implies investors are expecting flat-ish iPhone growth throughout those years. Given the compelling user experience around 5G (suggesting it lives up to the hype), we expect higher than average iPhone upgrade rates over that 3 year period.
Additional Apple Initiatives That Will Benefit from 5G
Ultimately, we believe 5G’s impact on Apple will go beyond the iPhone and benefit potentially three additional initiatives. They include:
The fierce debate around the future of AR is understandable, given the technology has limited applications today, but its long-term potential is easy to imagine. AR has been described as painting the world with data. Massive data throughput is needed to unlock its potential. Ubiquitous, low-latency connectivity will enable what we think of as true AR, shifting from the small window of your phone to a wearable capable of spatial computing. Based on acquisitions and patents, it’s clear that Apple is developing AR glasses. Our best guess is that they will be released in CY22. We believe this could result in a gold rush for developers creating AR experiences and for Apple, who would take a cut of the revenue generated from these applications in the App Store. We believe that none of the AR 5G lift is priced into shares of AAPL.
While healthcare can materially benefit from 5G, Apple’s approach to the industry is largely unknown. No-latency wearables will create new ways for consumers to track and manage wellness, but that would only have a small impact on Apple’s business. Wearables will likely account for 15% of revenue in five years, compared to ~8% last year. Tim Cook has commented that their impact on health will be “Apple’s greatest contribution to mankind.” While “greatest contribution” doesn’t necessarily mean “biggest business,” it may mean Apple would pursue a path toward improving personal healthcare by leveraging wearables, AI, and their user-centric hardware/software to tie together payers, providers, and consumers. We believe that none of the healthcare 5G lift is priced into shares of AAPL.
The Wild Card: Autonomous Vehicles
Autonomy needs 5G. A vehicle can drive itself without the 5G network, but for things like V2V communication, teleoperations, and other enablers of mass adoption, full coverage and instantaneous data are required. Like healthcare, Apple’s go-to-market in autonomy is unknown. Our current thinking is in the five years that Apple will work with an auto manufacturing partner, likely an existing auto OEM, and help design a vehicle (car or bus). This is less likely to take the form of an Apple-branded vehicle, which is a tall order given Apple’s well-documented and turbulent history of trying to approach the auto market. We believe that none of the autonomous vehicle potential is priced into shares of AAPL.