Apple: So Far So Good On Fundamentals
Contributor since 2013 / 2333 Followers
Summary:
- Rapid sales growth days unlikely to return.
- Future appears uncertain on lack of a credible pipeline.
- Security threats could risk key competitive advantage.
- Nevertheless, shares appear undervalued on valuation.
Nikada
Investment Conclusion
When Apple (NASDAQ:AAPL) lost Steve Jobs in 2011, its future appeared uncertain. However, as his final gift to investors, Steve Jobs put Tim Cook in charge. Tim Cook has delivered for AAPL. Though, he clearly lacks the genius of Steve Jobs, he has kept the company together, tinkering with devices Steve Jobs launched, and focusing on smaller items, services, and privacy. Consequently, AAPL products remain as coveted as during the Steve Jobs era, and are still the most secure within their industries.
However, that’s as good as it gets. With a pipeline that appears forced, with AR/VR still an abstract concept, the firm’s mixed reality headset is unlikely to fuel sales growth, and the Apple Car, given its belated entry is likely to be dead on arrival, the current core products signify the final frontier for AAPL.
Given company dynamics, it appears unlikely that AAPL will drive the next leg of technological innovation in the industry. More likely the firm will ride away into the sunset, once the lifecycles of its current core products run their course, as novel technologies take the lead. However, for the time being, as such an eventuality does not appear to be on the horizon, AAPL represents a safe moderate growth investment.
We are initiating on AAPL with a Buy Rating and 1-year Price Target of $193/share, derived from our 10-year Discounted Cash Flow model, which includes a perpetual growth driven terminal value.
If Steve Jobs had lived, AAPL today might have been a different company. Nonetheless, it has not fared too badly for an enterprise that lost its leader, who almost singlehandedly drove its evolution into a technology giant.
Investment Thesis
Apple was founded in 1976 by Steve Jobs and Steve Wozniak, in the former’s garage at his childhood home in Los Altos, California. The firm’s current headquarters are located in Cupertino, California. AAPL operates in 40 countries across the world, with offices in the U.K., Germany, China, Japan, Australia, and Brazil, among others.
The company derives its revenues from two segments, Products (comprised of the iPhone, the Mac, the iPad, and Wearables, Home and Accessories), and Services (which includes Apple Apps, Apple Pay, Apple Card, and Apple TV+). During FY2022, the iPhone accounted for 52.1% of total sales, the Mac 10.2%, the iPad 7.4%, Wearables, Home and Accessories 10.5%, and Services 19.8%. In addition, during the period, 43%, 24.1%, 18.8%, 6.6%, and 7.5% of total revenues were attributed to the Americas, Europe, Greater China, Japan, and the Rest Of Asia Pacific.
There are two predominant issues surrounding the AAPL story. The primary concern is related to the firm’s long-term growth prospects. The secondary element drawing investor attention is associated with APPL’s potential as an investment over an elongated time horizon. We analyze the two topics below.
Return To Rapid Growth Appears Unlikely; Moderate Growth Represents Best Case Scenario
Although AAPL rebounded to solid sales growth in FY2021, the figure tapered off during FY2022, and for F1Q2023, total sales decreased on a year-over-year basis. Undoubtedly, foreign exchange challenges and macroeconomic headwinds played a role. However, based on a 10-year performance overview of the firm’s sales growth drivers, we believe AAPL has a systemic problem in growing the business. In that regard, it is noteworthy that sales associated with the iPhone and the Mac stagnated for years before rebounding in 2021. In addition, iPad sales peaked in 2013, remained tepid until 2020, before accelerating significantly in 2021.
In the context of the iPhone (given softening sales growth), the developed markets appear saturated, particularly the U.S., with an ~211 million active installed base. European sales growth has similarly been declining. The Chinese market is not performing much better, with iPhone sales decelerating for years in the geography, before rebounding in 2021. Given these dynamics, AAPL appears reduced to seeking growth in the segment from relatively less affluent regions of the world, which is likely to be a struggle, considering the low per capital incomes associated with the territories. Consequently, iPhone sales in India and Brazil are unlikely to sufficiently counter the flagging demand in developed markets and China, in our opinion.
Further, with global shipments of smart phones receding in 2022, industry conditions are similarly unfavorable. According to Canalys, smart phone shipments decreased by 17% on a year-over-year basis to less than ~1.2 million units in the fourth quarter. The research firm projects that 2023 is likely to be similarly challenged with respect to smart phone sales, as higher interest rates, weak global economies, and inflation, derail customer demand. Therefore, although the iPhone’s installed base is expanding and the device is capturing market share, a struggling industry is likely to limit sales.
In the context of the Mac, even though the product has 92% customer approval rating in the U.S. as per Apple, the PC market appears well positioned to revert to the negative growth it suffered for a decade, before recovering during the pandemic, as lockdowns forced folks to purchase desktops and laptops to fulfill work and study from home mandates. In that regard, Gartner reported that during 2022, PC shipments on a global basis declined 16.2% compared to 2021, while those associated with the U.S. slumped 20.5% over the final quarter of the year.
Although, anecdotally, it appears that along with strong consumer uptake, enterprise adoption of the Mac is growing, with the device becoming standard at start-ups, and an option at numerous large corporations, the development is likely to be offset by lighter industry demand. Consequently, even though we expect Mac sales to decelerate by less than the market average, the category is unlikely to account for considerable growth at AAPL over the long term.
Similarly, even though the iPad has captured ~49% of the global tablet market, its industry is in a decline. During 2022, based on research conducted by IDC, tablet sales decreased by 3.3% on a year-over-year basis, with the group unwilling to commit to growth in the category over upcoming years. In our judgment, the significant expansion in purchase of tablets during the viral outbreak, has resulted in market saturation, with upgrades cycles being extended, and years away.
Although iPad sales escalated by 30% in F1Q2023, the acceleration was driven by easier comparables, and the introduction of iPad 14 and iPad Pro during the period. Overall, with the segment accounting for on average ~7% of AAPL’s total sales, we do not believe the iPad represents a sustainable strong long-term growth driver for the company.
Moreover, sales of AAPL’s Wearables is eroding, with the Apple Watch and the AirPods experiencing decrease in sales on a year-over-year basis, during F1Q2023. Considering the glut of similar items in the market, these products are largely commoditized. Therefore, given the premium pricing associated with the Apple Watch and the AirPods, we anticipate shrinking customer demand, on a secular basis.
Overall, even though the installed base of AAPL products is expanding and the devices are capturing market share from the competition, with lackluster industry sales growth projections and elements associated with the business, these statistics are unlikely to strongly buoy the top and bottom lines of the company. Therefore, it appears improbable that AAPL’s product category will reverse course, and jump to rapid growth, over an extended time horizon. At the end of 2022, based on reported data, on a global basis, the iPhone had a market share of 25% (up 2%) among smart phones, the Mac had captured 10.7% of the world-wide PC market (up 2.1%), and the iPad garnered 49% of the global tablet market (up 10.7%).
In contrast to our thesis forecasting underwhelming sales growth in core products, we believe AAPL’s Services segment is poised to maintain the strong sales momentum, it has been experiencing for numerous years, into the future. The predominant element driving our favorable outlook is that merely ~935 million of the ~2 billion active users of AAPL products are signed on as paying subscribers to the App Store, indicating a growth opportunity, as more customers begin utilizing the company’s Apps. In addition, considering that the installed base of AAPL products will continue to expand, the growth will create a virtuous cycle, ensuring sustained long-term growth in the segment.
The corporation’s pipeline includes two purported products (because AAPL has not made any announcements on their development), a mixed reality headset and an Apple Car.
The mixed reality headset (also called VR/AR headset) is rumored to be nearing launch (this month or in June), with a likely price of $3,000. Given the premium pricing and the nascent stage of its industry, we anticipate that the device is targeted towards developers, with the objective of supporting the evolution of the VR/AR ecosystem. Therefore, it appears unlikely that the device will majorly impact the firm’s revenues. AAPL’s mixed reality headset will compete with Meta Platforms’ (META) Quest Pro AR/VR headset which was launched in October 2022, and markets at a $999 price point. META’s Reality Labs segment which derives most of its revenues from sales of the company’s AR/VR headsets, generated ~$2.2 billion in sales during FY2022.
In addition, whispers suggest that an Apple Car is in development since 2014. Recent reports indicate that the car is likely to be a semi-autonomous Electric Vehicle (EV), with Full Self Driving (FSD) on highways, and manual control required on busy city streets. Rumors suggest a 2025 launch date and a price tag of $125,000. Considering that the EV industry already appears saturated with supply expected to exceed demand this year, and the tepid demand associated with Lucid Motors’ (LCID) EVs, which given their ultra-luxury profile and similar price range represent potential competition for the product, it is difficult to get excited about an AAPL Car.
The launch (if it unfolds) will be too late to generate anywhere near the buzz evident during the debut of the firm’s legacy products, in our assessment. Technologically too, the AAPL Car will be unable to match the FSD expertise associated with other EVs, given the head start their companies have in gathering real world driving data, which is incorporated into new models of the cars. In addition, with potential AAPL Cars likely to be manufactured by Original Equipment Manufacturers (OEMs), that require an annual production volume of 100,000 EVs (and growing), to be profitable, we view the AAPL Car as dead on arrival, as they are unlikely to achieve that level of demand in the launch year, in our opinion.
Overall, AAPL’s product pipeline is weak. Therefore, the company’s long-term potential appears uncertain. Undoubtedly, we have been hard on Alphabet (GOOG) because it lacks a credible pipeline. The difference is that GOOG’s primary product, its Search Engine, is turning less popular and losing market share. That is not the case with AAPL’s core products. Although, the company does not have a definitive pipeline, its devices remain highly coveted by customers, with growing market share. AAPL products are the best in their respective industries, with superb design, performance, and features. In addition, customer approval rating associated with the iPhone, the Mac, and the iPad, beat that associated with the competition, by a wide margin. Therefore, AAPL’s pipeline issues are significantly less critical than that associated with GOOG.
Although, we would be encouraged if AAPL were to evolve into an incubator for novel technologies, and develop a credible pipeline, the scenario is improbable. The firm’s days of launching game-changing products are behind it. Instead, sales associated with AAPL’s key products are likely to continue to expand at a moderate pace, until novel technology renders them obsolete. Based on a lack of definitive pipeline, AAPL is not a decades long growth story. It will fade when technological innovation catches up. Currently, no such eventuality appears on the horizon. Therefore, AAPL is well positioned to profit over the next five to seven years. Beyond that all bets are off.
Long-Term Financial Outlook Appears Uncertain
Consistent with tapering trends that unfolded over FY2022, AAPL’s F1Q2023 financial performance disappointed with year-over-year sales growth across the entire product category declining to negative territory. In addition, margin compression overtook the business compared to the prior year’s same quarter. As a result, net income and earnings per share came in lighter relative to F1Q2022.
Specifically for F1Q2023, revenues were ~$117 billion, reflecting a decline of 5% compared to the same period in FY2022, net income was ~$30 billion, representing a shortfall of 13.4% relative to F1Q2022, and earnings per share was $1.88 versus $2.10 during the prior year’s same quarter. In addition, on a year-over-year basis, sales associated with iPhones, Macs, and Wearables, Home, and Accessories, decreased by 8%, 29%, and 8%, while that linked to iPads and Services increased by 30% and 6%. As a flow through, sales attributed to the Americas, Europe, Greater China, Japan, and the Rest Of Asia Pacific, decelerated by 4%, 7%, 7%, 5%, and 3%.
Furthermore, as a percent of sales, cost of revenues increased by 80 bps to 43.8%, R&D spending expanded by 200 bps to 7%, and SG&A advanced by 100 bps to 6%. In addition, gross margins decreased by 80 bps to 43%, operating margins contracted by 280 bps to 31%, and profit margins declined by 230 bps to 25.6%. Moreover, operating income associated with the Americas decreased by 1.7% to 36.3%, that related to Europe by 2.6% to 36.2%, that linked to Greater China increased by 30 bps to 43.7%, that attributed to Japan by 80 bps to 47.9%, and that related to the Rest Of Asia declined by 30 bps to 40.4%.
At the end of F1Q2023, AAPL had a cash and cash equivalents balance of ~$20.5 billion and long-term debt of ~$99.6 billion on its balance sheet.
Based on management commentary on the recent Earnings Call, it appears that AAPL is bracing for a deceleration in sales and weak earnings for FY2023, compared to FY2022. However, beyond 2023 and a potential fiscal downturn, we anticipate some resurgence in Apple’s sales performance as improved global macroeconomic conditions drive consumer spending towards upgrades of digital devices in developed markets, and a depreciating dollar reduces prices of the company’s products in foreign markets, supporting customer demand in those regions.
Nevertheless, the sales growth reversion is likely to reflect modest pre-pandemic levels rather than the solid growth that unfolded over 2021. It is not as if AAPL has been a stranger to lackluster sales. The firm has been sales deficient intermittently for a while. In addition to expectations for a year-over-year decline in sales for FY2023, Apple evidenced a decrease in annual sales in FY2016 and FY2019. Further, the company reported sales growth of between 5% to 8%, during FY2017, FY2020, and FY2022.
Therefore, based on elements discussed previously, including a limited addressable market, as a majority of the demographics in under penetrated geographies are priced out due to low per capita incomes, saturation in customer demand for AAPL products in developed economies, and a structural decline in the industries associated with smart phones, PCs, and tablets, we are projecting moderate sales growth for the corporation’s products, over the long-term. In contrast, we are forecasting strong growth on a secular basis, for Apple’s Services segment.
Nonetheless, considering AAPL’s financial performance over the prior 10 years, it appears that the company has evolved into a mature concern, complete with softer revenue growth, offset on the bottom-line through gross margin expansion, operating leverage, and share repurchases (outstanding share count decreased by ~40% between 2013 and the last twelve months). Therefore, we expect margins to increase as Apple squeezes out earnings through a lower cost structure and operating efficiencies. Additional margin improvement will be derived from the persistent growth of the Services category as a fraction of total sales, as the segment generates operating margins of ~70%, versus 37% associated with the Product category. In addition, we anticipate, share buyback programs to remain a feature at AAPL for the foreseeable future.
Overall, based on business fundamentals and declining share count, the firm’s earnings and free cash flows are likely to expand, albeit gradually, on a secular basis.
Incorporating financial inputs derived from elements discussed above into our 10-year Discounted Cash Flow model, we arrive at a 1-year Price Target of $193/share for AAPL. We assume a normalized 10-year revenue growth rate of 7.5%, (vs. the FY2022 revenue growth rate of 8%). Based on our analysis of AAPL’s historic financial reports, we model normalized 10-year operating cash flows as 30% of revenues/year and straight line 10-year capital expenditure as 3% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 7% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 15,955.7 million to arrive at our 1-year Price Target.
Risks
Apple Products Lose Their Superior Security Edge. That AAPL’s products have historically been the most secure within their respective industries is often cited as a key factor in customer purchase decisions. However, over recent years, there have been multiple instances of large scale hacking of iPhones and iPads.
The development that garnered the most attention was the security breach that affected AAPL products due to Pegasus, developed by the Israeli firm, NSO Group. That the malware could be downloaded onto iPhones and iPads through a zero-click method that required no action on part of users of the devices, is concerning. Once downloaded, Pegasus had access to the target’s emails, messages, chats, and phone calls. In addition, the perpetuators utilizing the product’s camera and microphone could secretly film activities and record conversations unfolding around the device.
Apple released update iOS 14.7.1 to patch the security breach, stating that issue had been resolved. Nevertheless, credible agencies such as Amnesty International, confirmed that even iPhones and iPads running most recent iOS versions had been compromised. Cumulatively, the fraction of AAPL’s installed base beset by hacking incidents is undoubtedly expanding. It is imperative that the company focus on improving its privacy features to remain one step ahead of the growing threats.
Apple products are coveted despite their premium pricing, in part due to the superior security they offer. If the firm’s devices keep getting compromised, at rates experienced lately, AAPL risks damaging a key competitive advantage, as consumer awareness of such incidents proliferates.
Bottom Line
Under Steve Jobs, AAPL was a dynamic company. In less than a decade, he launched three game-changing products, which continue to be leaders in their respective industries. Gradually, following his departure, AAPL has turned into a shell of its former self. Given the significant period of stasis, we don’t believe the firm has the chutzpah to ever return to strong growth. AAPL is winding down from its 34,000 feet elevation. It will take some time for the descent to turn critical, but there is no decades long future for the company, in our opinion. The foundation is gone. Therefore, we suggest that investors looking towards AAPL as a ‘Buy And Forget’ investment, reconsider. We believe the company’s best days are undoubtedly behind it.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.