- Amid macro concerns and supply disruptions, Apple has delivered a negative total return of 24% so far in 2022.
- Supply challenges caused by Covid-19 related disruptions and semiconductor shortages will likely ease further in 2023.
- Going forward, growth from services is expected to outpace product sales.
- Apple’s industry-leading margins are a testament to the strength of its brand and its loyal customer base.
Like many in the tech sector, Apple (NASDAQ:AAPL) has been affected by the more challenging macroeconomic environment in 2022. Year-to-date, investors have seen a negative total return of 24% from Apple’s stock, amid concerns about lingering supply chain disruptions and the growing risk of a hard landing for the economy in the coming year.
Despite the challenges, however, Apple looks well-prepared for a comeback in 2023. And here are three compelling reasons why.
End In Sight For Covid-19 Related Disruption
Supply challenges caused by Covid-19 related disruptions and an industry-wide semiconductor shortage continued to impact Apple’s ability to meet customer demand for its products in 2022. More trouble could be yet to come, as Apple warned in November about lower iPhone 14 Pro and iPhone Pro Max shipments, following Covid-related labor shortages which have disrupted production at Foxconn’s main iPhone assembly facility in Zhengzhou, China.
But in an effort to improve supply chain resilience, Apple is diversifying its supply chain beyond China. With more production shifting to India and Vietnam and increased procurement from the US, Taiwan and elsewhere, the company will in future be better protected from localized manufacturing risks, as well as trade and geopolitical tensions.
The supply issues aren’t over yet, but the end is clearly in sight. As chip makers have ramped up production to meet demand, silicon-related supply constraints have already eased significantly during the course of the year. The supply position for iPads and MacBook Pro, which had been considerably constrained throughout most of 2021 and during the first half of 2022, has also improved significantly since then.
Moreover, with China now moving away from its zero-Covid policy, pandemic-related supply disruption issues may soon finally be no more. Things might get a little worse in the short term, as rising infections temporarily exacerbate existing supply challenges and Covid-related labor shortages. In the longer term, however, the benefits will rack up – as a shift away from strict social controls and unsustainable ‘closed-loop’ manufacturing operations will eventually lead to an enduring improvement in the supply situation.
The same could be said on the demand side too. In the short term, there will be a hit to consumer spending, as people across China choose to stay at home either because they have become unwell with Covid or are trying to avoid catching the virus. After a couple of months though, a return to normality should eventually lead to higher economic activity, and in particular, increased consumer spending.
We’ve seen the same pattern across the globe as other countries have abandoned their strict Covid-containment strategies and learned to live with the virus. Pent-up demand and an improvement in consumer confidence, driven by better job security and increased employment opportunities, would likely lead to a resurgence in Apple’s sales growth in China too.
Demonstrating the recent depressed demand, Apple’s sales growth in Greater China, which includes Hong Kong and Taiwan, slowed to just 9% in the year to September 24, 2022, down from 70% in 2021. This was largely attributable to macro factors, as Apple extended its market share lead in its most important market – premium smartphones. In the $600-plus smartphone space, its market share rose to 70% in China in the second quarter of 2022, up from 58% in Q1, according to data from market research firm IDC.
And while a recovery may only be noticeable from the second half of 2023, it’s important to remember that investor sentiment usually improves before the temporary disruption is over – as investors will likely anticipate a recovery before it actually takes place.
Service Revenue Opportunity
iOS Services and Apple TV+
Although product sales generate a substantial majority of revenues, it’s clear that services are of growing importance to Apple’s growth.
Of course, the opportunity from services is inextricably linked to the size of its user base – things from the App store and other related services simply cannot sell well unless people are spending time on the company’s devices. But that doesn’t mean revenue from services won’t continue to outpace product sales – as demand for digital content, sold through its App Store, Apple Music and other digital content stores, is expected to hold up well in a still rapidly expanding market.
Services are a higher margin business too – Apple generated a gross margin of 71.7% from services in 2022, compared to 36.3% for device products. Looking ahead, recent price increases on Apple Music, TV+ and its One bundle will likely drive revenue growth and further margin improvement in coming quarters. These pricing changes were only announced in late October, and have yet to show up in its latest financial results.
On the downside, competition and regulatory risks, particularly those relating to its App Store, is a potential headwind. The proposed EU Digital Markets Act could force Apple to open up the distribution of apps on iOS devices.
The potential impact to Apple’s bottom line would likely be limited, however, as the proportion of users opting to purchase products from other sources is expected to be very small. As we can see from Android users, who can already install apps outside of Google’s Play Store, only a small minority of users actually choose to take advantage of the extra competition, due to network effects, security concerns and sticky behavioral patterns. This reflects a ‘winner takes all’ market that demonstrates the value of scale in attracting customers and developers alike.
Advertising & Fintech
Beyond this, Apple is looking to exploit growth in other services. It has a growing presence in the mobile advertising market – Apple Search Ads on its App Store is a relatively new entrant that has great potential. Its ads business has seen particularly strong growth, at a time when its competitors have been negatively affected by the introduction of its privacy changes last year, namely Apple’s App Tracking Transparency framework. And going forwards, there’s scope for more ad placements in more of its iOS apps, such as Music, Books, Fitness and Podcasts, as well as on its Apple TV+ streaming service.
Apple is looking at opportunities to grow in the financial technology (fintech) space too. Apple Pay, its mobile payments service, is currently its biggest success, but its ambitions do not rest there. The company partnered with Goldman Sachs to launch Apple Card in 2019, and has plans to launch Apple Pay Later – a buy now pay later (BNPL) service that directly competes with the likes of Klarna (KLAR), Affirm (AFRM) and Afterpay.
The global fintech market is projected to grow by a compound annual rate of about 25% over the next five years, and reach a market value of approximately $324 billion by 2026.
Finally, improving margins is another reason to be bullish on Apple. The company’s industry-leading margins are a testament to the strength of its brand and its loyal customer base. It gives the company an element of revenue visibility that other businesses simply don’t have.
And such is Apple’s wide moat that the company enjoys strong pricing power – which continues to deliver for its gross margin. It has enabled the company to hike prices not only for services, which were discussed above, but also for its products. Higher prices for its iPhone 14 devices were seen in a number of markets outside of the US and China, as the company sought to offset FX headwinds from the stronger dollar.
Source: Apple’s 2022 Annual Report
Apple’s gross margin has increased by 150 basis points over the past year, to 43.3%. This reflected stronger margins for both products and services, as well as a favorable shift in the revenue mix towards higher margin services.
Widening margins benefit Apple’s bottom line as it enables earnings growth to outpace revenue growth. This combined with the benefit of stock buybacks, which reduces Apple’s share count and further raises its earnings per share.
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.