Apple Beats Q2 Earnings: I’m Staying Long (Rating Downgrade)

Summary:

• Apple Inc. just released its fiscal second quarter earnings.
• The release beat on revenue as well as on earnings per share.
• I was expecting good things from Apple’s Q2 release because I thought the Foxconn slowdown stories were overblown.
• In the end, Apple delivered a satisfactory, but not amazing, earnings release.
• In this article, I explain why I keep holding Apple stock after its reasonably good Q2 earnings release.

Apple Inc. (NASDAQ:AAPL) just released its fiscal second quarter earnings, beating analyst estimates on revenue as well as on EPS. The release was highly anticipated. In the weeks before it came out, Apple was plagued by a rumor that Mac sales had crashed 40%, and a confirmed story that Foxconn had seen a 10% slowdown in orders.

I was a little more optimistic than most people heading into Apple’s second quarter release. Going into it, I knew that Macs were a small percentage of Apple’s total sales, and that Foxconn’s sales slowdown could be explained by Apple moving production to other markets.

Nevertheless, I was a bit surprised by the strength of Apple’s second quarter earnings release. iPhone sales increased slightly and services revenue grew 5.4%. The growth in iPhone sales was remarkable because we have credible experts saying that smartphone sales on the whole are weak right now. It was, on the whole, a very strong quarter. The growth was not very high, but this environment was known to be a tough one for tech companies well before the release came out. Given this, the release was satisfactory.

Apple stock rallied significantly in the lead up to its second quarter earnings release. Year-to-date, it was up 32.55% prior to the release coming out. Expectations were high and in the end, Apple delivered.

In this article, I’ll explain why I continue holding Apple stock, despite the steep valuation it has reached. I’ll review the recent earnings release, and explain why I consider it a win. I’ll go over Apple’s competitive position and why I consider it a strong one. Finally, I’ll explain why I have no desire to sell AAPL stock even though it is very expensive.

Earnings Recap

Before going into my big picture take on Apple stock, I need to explore the details of its Q2 earnings release. The release was a beat, but it’s not enough to know how Apple fared compared to expectations. We also need clear details on the figures it released, so we can use them to value the stock.

In the second quarter, Apple delivered:

• $94.8 billion in revenue, down 3%, a beat.

• $24.16 billion in net income, down 3.3%, a beat.

• $1.52 in diluted EPS, unchanged, a beat.

• $28.3 billion in operating income, down 5.4%.

• $62.5 billion in six-month cash from operations, down 7.3%.

Overall, it was a fairly strong release. We saw a slight decline on the top line, and no change on the bottom line. As far as segment results go, the 5.4% growth in services stood out, as that’s an important segment seen as key to Apple’s future. The very slight positive growth in iPhone sales was a positive too, given the weakness in the global smartphone market. On the whole, the release didn’t deliver anything that would give an investor pause.

Competitive Landscape

Having looked at Apple’s recent earnings release, we can now turn to its competitive position.

Apple is well known for its valuable brand. Many surveys rank Apple as the world’s #1 brand, others have it in second place. Almost all of them have it in the top three. The source of Apple’s brand strength is its reputation as a lifestyle brand. Apple products are considered “cool,” and this gives Apple a lot of popularity with younger people. As proof, we can point to multiple studies that have shown that the overwhelming majority of Gen Z members own iPhones, and plan on getting another iPhone for their next phone.

A second advantage that Apple has is the fact that it only has one competitor in smartphone operating systems: Alphabet Inc. (GOOG). Although some companies customize their Android operating systems enough that they could be said to be “their own,” the smartphone OS market is a duopoly. Android has more installs, but Apple does far more revenue from its app store, because it dominates the high-income U.S. market.

A third advantage that Apple enjoys is its interconnected ecosystem. Apple’s products are “linked together,” via software that is similar across devices, and automatic syncing via iCloud. The minute you set up a new MacBook with your Apple ID, your contacts, chat transcripts and even iCloud documents are automatically added from your other devices. You can technically achieve this level of integration with Windows and Android devices but it isn’t as automatic, you need to set up all of the apps to sync with each other separately. So, Apple is without a doubt the strongest “tech ecosystem” company on earth.

Valuation

Having looked at Apple’s latest earnings release and its competitive position, we can turn to its valuation. This is probably the sourest point of the analysis for Apple. Few would argue that Apple isn’t a great company, but this great company isn’t cheap. It closed the trading day today at the following multiples:

• 28.4 times earnings.

• 6.95 times sales.

• 46.76 times book value.

• 24.3 times operating cash flow.

• 27.3 times free cash flow (this multiple calculated by the author, the rest are from Seeking Alpha Quant).

None of these multiples are low. The price/book multiple is actually extremely high. Apple’s valuation is not the steepest in big tech. If you compare it to NVIDIA Corporation (NVDA) for example, it actually looks relatively cheap. Nevertheless, it has a higher earnings multiple than the NASDAQ 100-Index (NDX) weighted average (23.72), so it’s pricier than its benchmark.

Before concluding the section on valuation, I should note that a few of the multiples above were changed by the earnings release we just got. Revenue shrank slightly and EPS stayed the same, so the price/sales ratio has changed from what was reported on Seeking Alpha Quant at market close. However, the revenue contraction was not very extreme, so the multiples after being adjusted for the recent earnings release should be in the same ballpark as those listed above. The P/E ratio was unchanged because one quarter with $1.52 in earnings per share was replaced by another, leaving TTM earnings the same.

Risks and Challenges

As we’ve seen, Apple just put out a strong earnings release that beat expectations. Personally, I’m content holding AAPL stock at this point in time. It has a great competitive position and isn’t even that expensive by big tech standards. However, I only rate the stock “hold” currently (I mean a literal “hold,” not a weak “sell”), because I think it’s roughly fully valued based on trailing 12 month earnings. There are also some risks and challenges investors will need to keep in mind if they plan to own Apple stock long term.

• Supply chain risks. Most of Apple’s supply chain is in China, which is a problem because U.S./China relations are currently very icy. The U.S. has been slapping export restrictions on China for years. It banned U.S. chip companies from selling to China, it lobbied to have ASML Holding N.V. (ASML) stop selling its best equipment there, and in the Trump era, it even slapped tariffs on a full $300 billion worth of Chinese exports. If these measures escalate, then it could cause trouble for Apple. Not only is Apple directly vulnerable to export controls, it has another supplier, Taiwan Semiconductor Manufacturing Company

  Limited (TSM), which could be affected by Chinese military action against Taiwan. China is well known to be interested in reclaiming Taiwan, which it considers a rebel province, and has not pledged to take military force off the table as an option for doing so. If China were to attack Taiwan, then Apple’s supply chain would come under severe pressure.

• Valuation. As I covered in the section on valuation, Apple is a fairly pricey stock. It was at 28.4 times earnings at market close, it will be near 30 times earnings if the after-hours rally continues into tomorrow. It’s quite common for stocks with these types of valuations to fall in price. Particularly when the companies being valued so richly are delivering negative revenue growth. However, NVIDIA Corporation’s 26 times sales valuation never stopped its march upward despite falling revenue, so you never know. Perhaps Apple has a ways to run yet.

• Succession. Tim Cook is thought to be gearing up for retirement sometime between 2025 and 2028. This is a risk of sorts because he is one of the keys to Apple’s success. After Steve Jobs died, Tim Cook took the helm, overseeing successful product launches such as the Apple Watch and wireless AirPods. He also made big investments in Apple’s services, which have been critical to the company’s growth. It’s not clear who, if anyone, could run Apple as well as Cook has. So, succession could be thought of as a risk factor for Apple.

The Bottom Line

The bottom line on the Apple Inc. second quarter earnings release is that it was satisfactory. Not amazing, but satisfactory. It was ahead of analyst estimates and about in line with my personal estimates. After reading the release, I plan to continue holding my Apple Inc. shares. I wouldn’t actively be buying more shares now, though, as this stock has gotten quite pricey.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAPL, GOOG either through stock ownership, options, or other derivatives. 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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