Summary
- Apple is up 25% from its June lows.
- Margins remain impressive but seemed to have peaked and Services has slowed.
- Headwinds from the macro environment have yet to be felt, and Apple can’t be immune from it forever.
Introduction
Apple’s performance through what many forecasted to be a challenging quarter was applaudable. With rapid Fed rate hikes, GDP contraction, and high inflation, the macro environment has been a top concern. Apple was asked about it multiple times, but stated that the iPhone was seemingly unaffected and just slowdowns in Services advertising and wearables could be attributed to macro headwinds. In fact, Apple projects accelerated revenue growth into Q4’22.
While last quarter’s results were a big relief for investors, no one is out of the woods just yet. Despite a second consecutive GDP contraction, a recession has yet to be called. Earnings have been better than feared but if you believe recessions are inevitable (as they have always been), Apple will have a lot of work to do to justify a $2.65T market cap sporting a P/E of 26.9.
Peak Margins
Mostly due to foreign exchange headwinds, Apple’s margins fell 40 basis points to 43.3%, but going into Q4 Apple projects gross margins to be in the range of 41.5 to 42.5%. There is still reason to believe that Apple’s gross margins will continue to contract over the next year and I don’t suspect that the high gross margins from Services will provide relief as the sector is slowing.
Apple is still an iPhone company
Apple’s Services growth over the last few years has helped investors feel diversified from the iPhone, which has been the most impressive product in history but is ultimately a risky one to rely on. All it takes is one competitive product to put a dent in Apple’s iPhone sales. While I don’t see one yet, it’s still a serious risk and declining growth in Services revenue is a concern when compared to the other trillion-dollar tech giants.
Apple’s Services business has grown to $19.6, a record quarter and a figure that has doubled over the past five years. However, growth slowed to 12% last quarter while Google, Microsoft, and Amazon posted cloud Services growth of 35%, 20%, and 40% respectively. Apple Services, which include Music, iCloud, TV, AppleCare, the App Store, Apple Pay and more may not be an apples-to-apples comparison to other cloud services but these divisions all serve as high-margin, high-growth businesses to maintain profits and boost margins.
For Q2’19, Apple’s Services division made up 19.74% of its total revenue (iPhone was 49.7%). Unfortunately, not much has changed as that number last quarter was 20.37% (iPhone 51.99%). Although growth in Services was enough to offset the declines in Product revenues, last quarter was a pleasant surprise from the perspective of iPhones. Unfortunately, this makes it clear that Apple is still an iPhone/hardware company. I'd like to emphasize that this is not a bad thing, but with a P/E of 26.9, it is comparable to Microsoft’s 29 P/E, which as a whole has a much higher gross margin of 68.4% and churned out 12% revenue growth for the quarter versus 2% from Apple.
Will The Next iPhone Cycle Hurt Margins?
Looking forward to Apple’s upcoming iPhone lineup, investors may find it less appealing to Apple’s bottom line.
Today, the sizes of the current flagship iPhone lineup are, in order:
- iPhone 13 Mini ($699)
- iPhone 13 Pro ($999)
- iPhone 13 ($799)
- iPhone 13 Pro Max ($1099)
In September, this will change to
- iPhone 14 & iPhone 14 Pro
- iPhone 14 (Max?) & iPhone 14 Pro Max
On the plus side, this will streamline manufacturing from having four screen types/sizes to just two--Unless there will be a difference between the Pro iPhone displays and non Pro devices. It may also help that R&D costs by mitigating development of a lower-margin, unpopular mini iPhone. The iPhone Mini is an engineering marvel as the smallest, lightest phone of this performance and although as a user I'm sad to see it go investors will probably be relieved.
On the downside, for the first time since the introduction of the iPhone XS Max (released in 2018), consumers will be able to buy the largest available iPhone without a starting price of $1099. The Max model iPhones are very popular due to their screen size, but going forward consumers will need to justify spending more for "Pro" features, like an additional telephoto camera, LiDAR, and more. The iPhone 14 "Max" might be one of Apple's most popular devices, as it will most likely cost less than the smaller iPhone 14 Pro, and much less than the Pro Max model.
Another concern is pricing and costs. Earlier this year Apple raised the price of its iPhone SE from $399 to $429 to likely offset higher costs. I expect that the upcoming iPhone lineup will have some higher price adjustments as well. Unfortunately, unlike the past, price increases will no longer mean higher margins due to rising costs and FX. Instead margins would be flat in a strong sales environment and investors would have to hope for stable iPhone sales in what is likely to be a turbulent iPhone cycle due to the macros.
Conclusion
The last time I wrote about Apple, I suggested that it was historically a bad time to buy due to Apple’s volatile history where it has stumbled after reaching new all-time highs. Although I was briefly correct, the stock is up nearly 25% from its June lows and it is arguably much deserved after a stellar quarter. This might be a good time to consider an exit strategy and for speculators, a better entry point could be on the horizon. After all, Apple is historically a volatile stock.
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