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Apple earnings: iPhone sales impress, but China slowdown weighs on stock price

Quarterly iPhone revenue and gross margin exceeded our expectations, but 2024 will see a weaker adoption cycle.

Mentioned: Apple Inc (AAPL)


Key Morningstar metrics for Apple

  • Fair Value Estimate: $160.00
  • Morningstar Rating: 2 stars
  • Morningstar Economic Moat Rating: Wide
  • Morningstar Uncertainty Rating: Medium

 

What we thought of Apple’s earnings

We maintain our $160 fair value estimate for shares of wide-moat Apple (NAS: AAPL) as we lower our short-term revenue forecast but raise our expectations for profitability. Apple’s December quarter iPhone revenue and gross margin exceeded our expectations. Still, we believe the iPhone will see a softer adoption cycle this year and lower our fiscal 2024 forecast for iPhone revenue to a modest decline. Apple is also facing revenue headwinds in China.

In the short term, we see demand headwinds for Apple relating to elongating personal device replacement cycles and more aggressive domestic alternatives in China. In the long term, we maintain our view that Apple can drive growth from its unique combination of hardware, software, and services that also elicits steep customer switching costs and underpins our wide moat rating. Apple shares went about 3% lower following results, likely due to weaker China results and lower iPhone expectations, but we continue to see the stock as overvalued.

December quarter revenue rose 2% year over year to $119.6 billion. Growth was led by iPhone and Apple’s services, up 6% and 11% year over year, respectively. We think that iPhone growth represents a solid uptake of the new iPhone 15 lineup, and we believe there is an ongoing mix shift toward the more premium Pro models that benefit revenue. Within services, we believe Apple saw broad-based growth, including from rising App Store revenue. The firm’s wearables segment declined 11% year over year, likely due to patent issues with Apple’s Watch lineup that temporarily took the newest line of products off shelves in the quarter.

A gross margin of 45.9% was impressive and driven by record gross margins for both products and services. Expansion likely came from mix shifts toward more premium iPhone models and strength in high-margin portions of the services business like the App Store and Apple’s search agreement with Google.

Business strategy

We believe Apple has cemented a long-term position atop the consumer electronics industry with a focus on a premium ecosystem of tightly integrated hardware, software, and services. We see the flagship iPhone as the linchpin of this ecosystem, from which Apple derives pricing power, switching costs, and a network effect. In our view, every other Apple device and service sees its greatest value from further locking in customers to this walled garden.

This approach earns the firm a wide economic moat rating.

We are impressed with Apple’s core design prowess, across both hardware and software, that we think is the product of immense cumulative research and development investments. We like Apple’s latest push to bring most of its chip development in-house. To us, this gives the firm more opportunity for product customization and a better ability to differentiate. In our view, Apple reduces its own cyclicality compared with other consumer electronics players by melding its semiconductors, hardware, and software together.

Over the medium term, we expect Apple to focus on progressing its internal chip development, artificial intelligence capabilities, and further developing new form factors like its Vision Pro headset. Each one of these initiatives will hedge the firm against disruption risk, in our view. We also anticipate the company will continue returning tremendous amounts of cash back to shareholders, which is supported by its strong balance sheet.

We hold concerns over geopolitical and regulatory risk for Apple but don’t see these threatening the firm’s moat. Apple’s supply chain is heavily concentrated in China and Taiwan, and disruptions to the status quo in these regions could limit its supply. Apple has thus far been adept at managing its complex supply chain and is actively diversifying into new regions.

Apple has also been targeted by regulations, particularly out of Europe, which chip away at its differentiation by opening up its App Store and iMessage services. We don’t foresee more damaging regulation on the horizon and believe the firm is adequately reinforcing its stickiness with customers by adding new devices and services with which to lock them in.

Moat rating

We assign Apple a wide economic moat rating, stemming from customer switching costs, intangible assets, and a network effect. In our view, Apple’s iOS ecosystem extends far-reaching, sticky tendrils into customers’ wallets, entrenching customers with software capabilities and integration across disparate devices like the iPhone, Mac, iPad, Apple Watch, and more. We also see immense design prowess at Apple, most impressively from deep integration of hardware, software, and semiconductors to create best-of-breed products.

Finally, we see a virtuous cycle between Apple’s affluent customer base and vast ecosystem of developer partners. These moat sources elicit great profitability and returns on invested capital. In our view, Apple can leverage these moat sources into continued economic profits over the next 20 years, more likely than not.

Apple’s most important moat source to us arises from the switching costs for its ecosystem of software, driven by iOS on the iPhone. Apple enjoys terrific customer retention and satisfaction, even despite pricing its products at a significant premium to its competition.

First, Apple offers software capabilities that are only available to iPhone users: iMessage messaging and FaceTime calling, AirDrop sharing, Apple Pay digital wallet, and location sharing are among the most used.

Apple’s products become even more entrenched when a customer adopts two or more. Users that combine the iPhone with a Mac, an iPad, and/or an Apple Watch are offered more features that in turn create a higher cost to switching. Among these, we highlight iMessages shared across devices, health data shared securely between the Watch and iPhone, seamless transfer of media, copy and paste between devices, and complementary app interfaces across multiple devices.

In our view, Apple’s ability to widen its portfolio of user devices helps augment its existing switching costs. The Apple Watch and AirPods are good recent examples of new products we see raising stickiness of customers. A Watch user can answer calls, read and respond to messages, and keep a tab on notifications, but must have an iPhone to use these capabilities. AirPods connect with marked ease to Apple devices but have to be manually re-paired each use if joined to a non-Apple device. As customers use more point devices, we believe they are less likely to leave Apple’s ecosystem. We view Apple’s nascent push into augmented and virtual reality (AR and VR) as the next step in this strategy. The firm’s Vision Pro headset offers yet another auxiliary form factor that relies on the iPhone as the focal computing point.

Furthermore, we see Apple’s adept ability to introduce and succeed with new form factors (like smartwatches and VR headsets) as defending the firm from disruption risk. After Apple itself disrupted the mobile phone market by creating the modern smartphone, we believe it is critical for the firm to stay on the cutting edge and stave off disruptive threats to its own portfolio. We believe developing auxiliary products integrated with the iPhone is doing just that.

Beyond locking customers into a software ecosystem, we believe Apple’s design expertise represents significant intangible assets that allow the firm to deliver top tier performance for its devices across hardware, software, and semiconductors. We see an enormous research and development budget totaling in the tens of billions of dollars enabling and maintaining this design prowess.

Apple boasts impressive semiconductor design capabilities with which it augments the performance of its iPhone, Mac, iPad, and Watch offerings. We see chips as the highest-value component of consumer electronics.

In designing its own chips, Apple is able to customize its specific devices for performance, power efficiency, and available features. Its A-series chips for the iPhone integrate neural engines for artificial intelligence, or AI, capabilities like facial recognition and are optimized for power efficiency to deliver best-in-class battery life. Its M-series chips for the Mac offer more memory than standardized PC chips from Intel or AMD, helping enable quicker compute and graphics performance. Owning its chip design also allows Apple to prioritize security. It embeds Secure Enclave in every Mac chip, which is a totally encrypted and physically separated part of the chip that protects biometric data and encryption keys.

By owning its chip design, Apple tightens the integration between its hardware devices and its sticky software ecosystem. Apple’s custom chip families allow for common platforms across devices and new software features that further rope in customers.

For example, Apple’s focus on featuring significant neural engines on its chips allow for AI applications on devices, including facial recognition, voice assistance (Siri), live transcription, autocorrect, and highly adaptable software suggestions based on user preferences and history. We believe the common platform across chips for iPhone, Mac, iPad, and Watch also aid third-party app developers to create more integrated experiences for customers. Offering a better platform for developers leads to more apps designed for Apple devices, more features on third-party apps across devices, and a stickier proposition to customers,

in our view.Apple’s chip capabilities are bolstered by a robust relationship with Taiwan Semiconductor, or TSMC, the largest foundry in the world. In our view, this relationship enables Apple to pursue more powerful and more efficient chips ahead of its competitors. Apple’s iPhone is typically the first product to feature the newest process technology from TSMC, like the iPhone 15 Pro in 2023 being the first to feature 3-nanometer chips. Additionally, Apple pays TSMC for dedicated capacity, enabling Apple to be guaranteed a certain level of supply to meet demand for new iPhones, Macs, and the like.

We see Apple’s chip design and software design prowess as impressive when taken separately but even more valuable in tandem. We believe the firm stands to benefit from quicker time-to-market for new features across both hardware and software by developing the two together and specified for its own devices.

This compares with taking more general chips from the likes of Intel and being reliant on another firm’s development for your own software ambitions (as Apple used to be for its Mac lineup before introducing the M-series chips). This integrated approach also stands out against Apple’s primary smartphone competitor, Samsung, which owns its hardware assembly but outsources its chips and software to Qualcomm and Google (Android), respectively.

Apple focuses on the premium ends of its markets with best-of-breed devices that it sells at significant premiums. Customers have shown a consistent desire to pay up for this performance, generating unit market share gains for Apple even as its prices rise compared with competitors. Apple’s share gains have been broad-based, across both developed and emerging markets (like China and India), consumers and enterprises, and every major product line, including iPhone, Mac, and iPad. We believe further share gains are in Apple’s future, particularly as it sees the strongest preference among younger users.

Apple’s moat is reinforced with a network effect between its large, committed user base and expansive ecosystem of application developers. We believe that more developers and more talented developers are drawn to Apple’s large install base, while consumers are drawn to the wide selection of applications to which they gain access by purchasing an Apple device.

In our view, this is accentuated by a richer base of Apple users, compared with those of competing PC or mobile vendors that spend more on apps and generate more developer profits. We also think that Apple’s unified software ecosystem across iPhone, Mac, iPad, Watch, and more is an attractive proposition for developers. A developer can more easily gain multiple footholds in a user with tight integration and overlap between Apple’s products and OSes, compared with designing disparate interfaces for an Android phone and Windows PC, for example.

We think this network effect can be enhanced with more touchpoints in the Apple ecosystem, like the Vision Pro, that plug right into the existing development frameworks. We don’t believe Apple’s network precludes the existence of a network effect for a competing app store, like Google Play, but see Apple’s rich network augmenting its user experience and supplementing its switching costs.

Apple’s ability to deliver cutting-edge products with tightly integrated hardware and software, along with its software ecosystem’s ability to lock in customers, results in impressive profit margins. On top of 45% gross margins, which are impressive for a consumer hardware provider, Apple’s asset-light model with outsourced manufacturing generates robust returns on invested capital, to the tune of roughly 50%. In our view, Apple’s sticky ecosystem and phenomenal engineering capabilities will enable it to continue earning strong economic profits over the next 20 years.



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