Apple: 3 Key Headwinds
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Summary:
- Shares of Apple Inc. are down 10% from their all-time high set at the beginning of 2022 – impressive, considering the reversion back to pre-pandemic growth the company is experiencing.
- That growth was approximately 7% at both its net sales and net income lines for the five years prior to pandemic, yet the company enjoys a forward P/E of 27.7.
- With FY23 earnings slated to be down 2% as the company experiences demand headwinds for its core products, the recent ‘insider selling’ by CEO Tim Cook merited a deeper dive.
- A full investment analysis follows below.
Valeriy Ermakov/iStock via Getty Images
Those who wish to change the status quo must first be willing to change themselves ― Herman Ntladi
Today, we take a look at one of the main components of the NASDAQ and probably the most well known name in the market, Apple, Inc. (NASDAQ:AAPL). The shares are up more than 30% in 2023 year to date, a key driver in the NASDAQ’s surprising 20% return this year despite growing concerns about the economy and falling economic growth forecasts.
However, the company faces some key headwinds and the stock looks overpriced given Apple’s near term growth prospects. Are the shares overpriced at current trading levels, which would make both AAPL and the NASDAQ vulnerable to a pullback? An analysis follows below.
Company Overview
Based in Cupertino, California, Apple is the largest company in the world by market capitalization and number three on the Fortune 500, manufacturing smartphones, personal computers, tablets, wearables, and accessories, as well as providing digital subscription services. With an installed base of over two billion active devices, it is arguably the most iconic brand in the world punctuated by intense customer loyalty, truly obviating the necessity for introduction. Its stock closed the April 14th, 2023 trading session at $165.21 a share, translating to a market cap of $2.61 trillion.
The company operates on a 52- or 53-week fiscal year (FY) ending the final Saturday of September. For the avoidance of doubt, FY23 refers to the 53-week period ending September 30, 2023.
From a product perspective, Apple’s primary revenue generator is its portfolio of Smartphones, which accounted for 50% to 52% of its top line during FY20, FY21, and FY22. Personal computers have contributed 10% to the company’s revenue line each of the past three fiscal years. Over that same period, its iPad Tablets were responsible for 7%-9% of its top line. Wearables, Home, and Accessories, which include Apple Watch, Apple TV, and AirPods (amongst others), accounted for 10%-11% of revenue. That said, the company’s second largest top-line contributor is Services, which includes the App store, subscription based digital content – including Apple Arcade, Apple Fitness+, Apple Music, Apple News+, and Apple TV+ – and payment services, amongst others. Services was responsible for 19%-20% of the company’s net sales over the past three years and generated approximately double the gross margins versus its products (66% to 72% as compared to 32% to 36% in the prior three fiscal years).
In the five-year period preceding the pandemic (FY14-FY19), Apple grew its net sales and net income lines at 7.3% and 6.9% CAGRs, respectively. Despite those relatively pedestrian statistics, shares of AAPL gained 117% (not including dividends) in the five-year period ending September 27, 2019. With the onset of the pandemic, the company was clearly a beneficiary, experiencing 12.8% and 20.2% CAGRs at its net sales and net income lines (respectively) from FY19 to FY22. Seeing this spurt, investors bid its stock to $182.94 on January 4, 2022, representing a 234% rise. With the company forecasted to generate FY23 net income of $94.8 billion (down 5% vs FY22) on net sales $388.7 billion (down 1%), its stock has retreated 10% from that all-time intraday high, but it is still up 202% since the end of FY19, representing a PE ratio of 27.7 and a price-to-sales of 6.8 on those consensus estimates.
Some Key Headwinds
With stout valuations, Apple requires a bright outlook, but it appears to be facing significant headwinds instead.
Extended Phone Replacement Cycle
Of increasing concern is the replacement cycle for its iPhones. Epitomizing its cultish brand loyalty were the long lines outside Apple Stores for the latest version of the iPhone. As its phone batteries become more durable and its offerings less innovative – how many new camera capabilities can a phone have? – the need to replace an iPhone from a performance decline or vanity standpoint decreases. New releases are losing luster with each iteration and carriers such as AT&T (T), are offering three-year plans. These subtle undercurrents as well as the current macroeconomic backdrop will conspire to increase the replacement cycle for phones. Add to the algebra the fact that iPhone sales surged 39% FY21 vs FY20 (and 7% FY22 vs FY21) as the pandemic pulled the replacement cycle artificially forward and it is easy to understand why 1QFY23 net sales were down 8% as compared to 1QFY22. It should also be noted that 1QFY23 included an extra week versus 1QFY22.
Reversion to Pre-Pandemic Growth
The same concept applies to Apple’s personal computing devices (PCD). With industrywide global shipments down 19.8% calendar 4Q22 vs 4Q21, it wasn’t surprising to see the company realize a 29% decline in PC sales 1QFY23 vs 1QFY22. This drop was somewhat mitigated by a 30% increase in iPad Tablet sales to $9.4 billion, but the prior year quarter was artificially lower due to supply constraints. With annual PCD shipments for calendar 2022 still above pre-pandemic levels at 453.7 million units, demand should be a concern as most users have relatively new PCs and tablets and would be less inclined to spend on an upgrade, especially in the current macroeconomic backdrop. So far in 2023, that expectation is actuating with calendar 1Q23 global shipments down 29% versus the prior year period. Apple’s performance was even worse, experiencing a 40.5% freefall from calendar 1Q22.
Can Services Carry the Day?
With growth prospects challenging for Apple’s iPhones and PCDs, the company believes it can return to significant bottom line growth by increasing its high-margin Services business as a percentage of the whole. That said, these offering have flatlined at 19%-20% of total over the past three years. Raising this metric would require the onboarding of significantly more digital subscriptions relative to device sales or a large uptick in subscription pricing – and to a certain degree, the continued expansion of its installed base. And for the avoidance of doubt, the number of paid digital subscriptions increased ~19% year-over-year to 935 million in 1QFY23. On an absolute basis, net sales from subscriptions reached a quarterly record of $20.8 billion – a quarter with significant currency headwinds. Factoring out the currency noise, it grew by low double digits, but the question becomes, “is that enough growth – from one-fifth of the company – to justify optimism worthy of a 27.7 PE multiple on FY23E EPS?” And is Services growth sustainable with PCD and iPhone sales facing significant demand headwinds?
Balance Sheet & Analyst Commentary
That said, Apple’s balance sheet is worthy of a premium multiple, reflecting cash and marketable securities of $51.4 billion and debt (at extremely low interest rates) of $111.1 billion (as of December 31, 2022), after delivering operating cash flow of $34.0 billion in 1QFY23. Approximately $3.8 billion of that cash was returned to shareholders in the form of a $0.23 quarterly dividend (for a current yield of 0.56%) and an additional $19.5 billion was employed to repurchase 132.6 million shares of AAPL, leaving $41.7 billion remaining on its authorization.
Reflecting demand concerns, in the three months ending December 31, 2022, inventories increased from $4.95 billion to $6.82 billion versus a decline from $6.58 billion to $5.88 billion in the three months ending December 25, 2021.
The Street is very favorably disposed to Apple, featuring 26 buys and outperform ratings versus one underperform and four holds. However, their median price objective of $175 suggests limited upside. On average, analysts expect Apple to earn $5.96 a share (GAAP) on net sales of $388.7 billion in FY23, followed by $6.61 a share (GAAP) on net sales of $415.9 billion, representing a decline of 2% at the bottom line (FY23 vs FY22), followed by an 11% gain.
CEO Tim Cook had options totaling 111,329 shares vest on April 1, 2023. Instead of selling enough shares (55,257) to cover his tax burden, he elected to sell the entire amount, technically constituting an insider sale – his first since he executed a similar transaction representing 5.04 million shares in August 2021.
Verdict
Owing to its seemingly indefatigable ability to continuously grow earnings, the market bestows a generous valuation on Apple’s stock. Before the pandemic, the company was growing earnings in the mid-to-high single digits. Owing to the pandemic pulling forward its sales – as well as its emphasis on high-margin Services revenue – those earnings grew abnormally (20% per) for three years. With surplus inventory, declining demand, and an uncertain macro backdrop, Apple’s bottom line is now in the process of reverting back to pre-pandemic growth, meaning a 27.7 multiple is simply too rich. Even if Street analysts’ FY24 earnings estimate of $6.61 is correct, a 25.0 multiple on an 11% rebound is still a bit of a reach.
At this stage, Apple has much more downside than upside. The upside comes from Services taking an ever-increasing part of a growing net sales pie. As for the downside, the rule of 20 has more or less applied to the S&P 500, which states that the market PE and inflation equal 20. Obviously, stocks with above average growth prospects enjoy better multiples. However, Apple’s growth prospects are not above average. In fact, at its current market cap, it is ~7% of the S&P 500. With inflation at 5%, a case can be made for a ~$100 stock (a 15 PE on FY24E EPS of $6.61). As such, the recommendation is to avoid the equity at these trading levels.
A fine line separates revolutionary ideas from ridiculous ones. ― Carmine Savastano
Analyst’s 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.
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