- Apple just released its earnings and missed expectations.
- The release missed expectations on revenue as well as on earnings per share (“EPS”).
- Prior to the release, Tim Cook took a voluntary pay cut, leading many to speculate that the release would be bad.
- The release confirmed rumors to be true.
- I personally plan to keep holding Apple stock, as I think a turnaround is likely, but I’m reducing my rating to ‘hold’ as short-term investors could get burned here.
Apple (NASDAQ:AAPL) just released its fiscal first quarter earnings and missed on both the top and bottom lines. The release came in $4 billion short on revenue and $0.07 short on earnings per share. On the operational front, Apple revealed that major supply constraints (likely Chinese factory closures) held back its sales. Overall it was a mixed quarter.
There was a lot of speculation about what Apple would reveal prior to its earnings release. Tim Cook took a 40% pay cut before the release came out, leading to speculation that the company would miss estimates.
With the release out, we now know that Apple did indeed miss. However, there were some bright spots in the report, including continued positive earnings growth in services. The revenue picture was undeniably bad, mainly due to currency impacts.
I have been bullish on Apple stock for most of the last 12 months. The stock got expensive during the 2021 tech bubble, but it came down quite a bit this year. At today’s prices, it is not exactly cheap but, as I will show in later sections, has an economic moat that justifies a premium price.
Apple’s Q1 release has not changed my opinion on the stock. As usual, the company is highly profitable, seeing modest revenue growth, and continues growing its services business. For these reasons I remain personally bullish on AAPL. However, I’m reducing my rating to ‘hold,’ mainly due to the likelihood that short-term oriented investors could lose money on it in the aftermath of the Q1 earnings.
In its most recent earnings release, Apple delivered lukewarm results. Some highlight metrics included:
$117 billion in revenue, down 5% (about flat on a constant currency basis).
$36 billion in operating income (“EBIT”), down 13%.
$29.9 in net income, down 12.7%.
$1.88 in diluted EPS, down 10.5%.
Additionally, Apple posted the following segment results:
iPhone: $65.7 billion, down 8.2%.
Wearables: $13.4 billion, down 8.2%.
Services: $20.7 billion, up 6.2%.
It was a pretty lukewarm quarter. Services were a bright spot, but apart from that, it was misses all around. If you’re a short-term trader, I definitely would not go buying Apple calls hoping for a jump tomorrow. I’d have to imagine the short-term reaction to this release will be negative. However, I remain optimistic about Apple in the long term, for reasons I’ll outline below.
One of the reasons why I was bullish on Apple heading into its first quarter earnings release is because the company has a strong competitive position. I’ve covered this topic extensively in past articles, but to summarize, Apple has:
The strongest brand in the world as measured by leading several marketing research firms.
#1 market share in tablets and smart watches.
#2 market share in mobile operating systems by installations.
#1 market share in mobile operating systems by revenue.
How does Apple manage to enjoy such a dominant market position in so many different verticals?
It comes down to the first bullet point: brand strength.
Apple’s brand is associated with premium quality and creativity. As a result, many people think that Apple products are “cool.” The company enjoys a good reputation with Gen Z consumers, 83% of whom own iPhones. That latter point bodes well for the future, because consumption habits formed young tend to last.
Another competitive advantage Apple has is an interconnected ecosystem. There are various software tie-ins that connect MacBooks, iPhones, iPads and Apple Watches together. For example, if you use Apple Watch to track your heart rate, the data is immediately available in Apple fitness on your iPhone. This interconnectedness incentivizes buying multiple Apple products instead of just one. The only other company that does this is Alphabet (GOOG) (GOOGL), which technically has an ecosystem; however, not many people use the Pixelbook, so one component of the “Google ecosystem” is missing in practice. This leaves Apple mostly unchallenged as a tech ecosystem company.
Having looked at Apple’s most recent earnings release and its long-term competitive position, we can now turn to its valuation.
At today’s prices, prior to the Q4 earnings release, Apple traded at:
23.8 times earnings.
5.98 times sales.
45 times book value.
18.8 times operating cash flow.
The book value multiple might look frighteningly high, but remember that Apple is far from a future bankruptcy case where you’re thinking about its value in liquidation. It’s very much a going concern. Apart from that, Apple’s multiples were low prior to the Q4 release.
Speaking of which: since the Q4 release showed declines, the multiples above are now higher using today’s closing price of $150 as the “P.” So, we might expect the stock to fall tomorrow, unless investors’ approach to valuation fundamentally changes.
As for free cash flow:
In the three quarters prior to today’s release, Apple had $1.30, $1.29 and $1.58 in free cash flow per share. Those amounts sum to $4.17. Q4’s cash flow came in at $34 billion, which is $2.09 per share. So we’ve got $6.26 in 12 month cash flows per share. Assuming no future growth, the terminal value estimates here are:
$179 at the current 10 year treasury yield of 3.5%.
$78.25 at an 8% discount rate (treasury yield plus a large risk premium).
So, we get a pretty wide range of estimates here. Averaging them out, we get the sense that Apple is fairly valued. It therefore makes sense to pay attention to interest rates when investing in a stock like AAPL. Just slightly higher interest rates would make an investment in this stock a lot less sensible.
Risks and Challenges
As we’ve seen, Apple is a high quality company with a strong competitive position that’s putting out so-so earnings. It looks like a good stock. Indeed, for me it is, as I continue holding my AAPL shares. Nevertheless, there are many risks and challenges for investors to look out for, including:
Slowing growth. Apple is simply so big at this point that it’s hard to imagine really high growth will continue indefinitely. There’s a concept in economics called “diminishing marginal returns” which says that at some point extra investment ceases to increase marginal profit. Additionally, simple math says that it takes more dollar growth to achieve a given amount of percentage growth, after a certain amount of dollar growth has already occurred. As we saw in the first quarter release, AAPL’s growth even on a constant currency basis was near 0%. That’s to be expected given its size plus the slowing economic climate. Apple is the biggest company in the world by market cap, and one of the biggest by revenue. So, truly rapid price appreciation from this point onward is unlikely.
The supply chain. Apple’s single biggest supplier, Foxconn, is located in China, and U.S./China relations are icy right now. The two countries strongly disagree on the status of Taiwan. China wants Taiwan to become part of itself, America wants Taiwan to remain quasi-independent like it is now. Sometimes this dispute leads to real military concerns. For example, just Yesterday, Taiwan scrambled its fighter jets after China allegedly crossed into its territorial waters. Were the Taiwan issues to spill over into all-out war, it would be hard to imagine the U.S. simply allowing Apple’s open trade with China to continue unimpeded. So, geopolitical tensions with China are a risk for Apple.
Anti-trust. Anti-trust lawsuits have been a concern for Apple for much of its history. As mentioned in the section on competitive dynamics, the company has high market shares in several verticals. This is in principle a good thing, but it does increase anti-trust risk. Current FTC Chair Lina Khan is known to be an anti-trust hawk. She has launched numerous actions against Meta Platforms, and has strongly criticized Amazon (AMZN). Apple is not in the crosshairs just yet, but there’s nothing to say it can’t find itself in them.
The Bottom Line
The bottom line about Apple’s Q1 release is that it just confirmed what investors have always known about the company:
That it’s a highly profitable organization with great brand loyalty and a moderate level of growth. At this point, it would be unwise to expect Apple to keep up its past rates of growth and returns going forward. As Warren Buffett likes to say, “size is the anchor of performance.” However, the company is at least profitable, which stands out by the standards of tech companies in 2023. Overall, I’m quite happy holding Apple stock.
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.