- Despite stronger-than-expected fiscal Q3 results and positive commentary on Apple's forward outlook, management continues to caution against the "cocktail of headwinds" facing the business that remains in flux.
- However, the company's robust results have also demonstrated that management's positive view of upcoming quarters' performance did not come lightly.
- Core drivers of resilient F3Q results represent the myriad of strengths within Apple's possession to help it beat the near-term consumer slowdown and macro pressure on margins.
- The following analysis will provide a brief overview of immediate downside risks that Apple faces, as well as pillars of strength that have proven effective in safeguarding sustained growth within its existing business.
Apple Inc. ( AAPL ) and Amazon.com , Inc.'s ( AMZN ) positive results released Thursday evening closed off a tough second quarter earnings week across big tech bellwethers in cloud-computing, digital ads, and innovative consumer electronics on a strong note. The Apple stock has gained more than 15% since the start of calendar Q2, and rose more than 4% overnight in late-trading Thursday. The company's stronger-than-expected showing for fiscal Q3, alongside management's expectations for sequential growth acceleration in fiscal Q4 underscores further momentum ahead for its shares.
While management has conservatively warned again of the same near-term headwinds faced in the first half of calendar 2022 - spanning FX headwinds, consumer weakness, ongoing supply constraints, and adjustments to exiting the Russian market - overall qualitative commentary leans on positive improvement in coming quarters.
Strong emerging market share penetration observed in fiscal Q3 is expected to continue into fiscal Q4, and further strengthen into fiscal 2023 ahead of a strong slate of planned new product releases in September across all major categories. Apple is also experiencing a favorable revenue mix that involves an increasing share of higher-margin services sales to offset the near-term macro pressure on profit margins. The continued migration towards its proprietary Apple silicon designed in house is also poised to improve product performance and promote greater enterprise demand, providing partial insulation from the near-term consumer PC market slowdown.
Commentary from Thursday's earnings call has implied that Apple's strengths are quickly overcoming the near-term headwinds, supporting a strong calendar 2H despite expectations for an economic recession in early- / mid-2023. We continue to view Apple's resilience amid a precarious economic backdrop as positive progression towards its sustained long-term growth trajectory.
Reviewing the 3 Downside Risks
Management had previously guided $4 billion to $8 billion in lost sales for Apple's fiscal third quarter due to ongoing macro headwinds spanning industry-wide chip supply shortages, logistics bottlenecks, rising inflation, COVID lockdowns in China, and the ongoing war in Russia. However, actual results came in better-than-expected. Lost sales stemming from related headwinds came in below the lower range of guidance at just under $4 billion, extending a continuation of Apple's ability in wowing investors quarter after quarter with stronger-than-expected results.
Despite the upbeat sentiment on Apple's fiscal Q3 performance and fiscal Q4 outlook, management was prudent in cautioning investors of the "cocktail of headwinds" that is still weighing on the overall business:
1. Supply Constraints vs. Consumer Slowdown
Although, ongoing supply constraints that have led to billions of lost product revenue are expected to show improvement in the September-quarter, management warned that the situation remains fluid and inventories have yet to normalize. Additionally, the ongoing supply constraints has also "masked whether consumer demand is softening." as the company has yet to get its hands on sufficient inventory for hot products like the iPad.
However, Apple appears to have fared better than most of its peers in the PC market, which continue to reel from a worsening double-whammy of supply shortages and a broad-based consumer slowdown. Specifically, Apple was the "only vendor to experience growth in the [calendar] second quarter of 2022, driven by the popularity of the M1 device," while global PC shipments continued to stage accelerating declines in the first half of the year - first quarter volumes dropped by 6.8% compared to the prior year to 78 million units, while second quarter volumes dropped by more than 15% to 71 million units.
This continues to provide confidence that the company is headed towards better days when it comes to supply chain management in coming quarters. It is also consistent with management's acknowledgement of greater concerns over impacts of consumer weakness on its fast-growing services business (e.g., digital advertising) during the fiscal Q3 earnings call, than on its products business:
When you look at the product categories, on iPhone, there was no obvious evidence of macroeconomic impact during the June quarter besides FX, obviously. Mac and iPad were so gated by supply that we didn't have enough product to test the demand. And Wearables, Home and Accessories, as you mentioned and as Luca mentioned, we did see some impact there that we would attribute to a macroeconomic environment.
When you then look at Services, there were some Services that were impacted, for example, like digital advertising was clearly impacted by the macroeconomic environment. And so it's a mixed bag in terms of what we believe that we saw. Overall, we are very happy with the results. And when you think about the number of challenges in the quarter, we feel really good about the growth that we put up for the quarter.
2. FX Headwinds
With more than half of its revenues generated outside of North America, the continued strength of the dollar poses extreme FX headwinds for Apple. During the fiscal third quarter, Apple reported more than 300 bps of unfavorable currency exchange impact on its revenues. In its services segment alone, the combined adverse impact from FX headwinds and Russia-exit was as high as 500 bps.
For the current fiscal fourth quarter, management has guided 600 bps of y/y FX challenges, which would translate to roughly $5 billion. Yet, management's qualitative commentary on its fiscal fourth quarter outlook is that there is great confidence in sequential growth acceleration.
3. Russia Exit
Apple swiftly pulled its business out of Russia in early March following the onset of the Russia-Ukraine war. The company experienced 150 bps in lost sales during the previous March-quarter as a result of its exit from the Russian market. Considering 9% year-on-year growth observed in the March-quarter, Apple is estimated to have lost about $1 billion in sales as a result of pulling out operations from Russia, which is immaterial from both a fundamental and valuations point of view.
While we also consider Apple's immediate exit from the Russian market following the onset of the Russia-Ukraine a prudent move, which precluded the company from exposure to impacts pertaining to ensuing sanctions levied on Russia by the U.S. and its allies, the ongoing impact on its fundamental performance goes beyond just lost sales from the region. The ongoing chip supply shortage created by increased demand in the face of accelerating cross-industry digitization has now been exacerbated by raw material supply constraints due to the Russia-Ukraine war, adding further complexity to the fluid situation. Recent market estimates show that Apple is expected to lose more than $1 billion in iPhone sales alone this year due to its Russia-exit, and the number is likely much higher when also considering the war's direct impact on component shortages that continue to hamper product sales.
4 Key Pillars of Growth in Apple's Existing Business
1. Strong Market Penetration and Share Gains
Apple reported a record quarter for sales in the Americas, Europe, and APAC (ex-Japan). And despite stringent mobility restrictions enforced in Greater China during the bulk of the June-quarter to stem COVID infections, Apple still achieved net sales of $14.6 billion in the region, narrowing y/y declines to just a little over 1%. Emerging markets demonstrated the strongest acceleration, with double-digit y/y growth observed across Brazil, Indonesia, Vietnam, and India (almost doubled) during the fiscal third quarter.
Continued growth in new customers across all of its product segments also corroborates robust market share gains for Apple. More than half of purchases across each of its iPhone, Mac, iPad, and Wearables, Home and Accessories segments were made by customers new to the product. Meanwhile, the installed base across each of its product categories also reached record-levels, substantiating a sticky demand environment for its ecosystem of offerings. This accordingly bolsters confidence in the tech giant's resilience against softening demand for discretionary goods like consumer electronics due to the worsening inflationary pressure on household budgets.
Apple's continued market share gains in the consumer electronics market are also corroborated by strong PC and iPhone shipment growth despite the industry slowdown as discussed in earlier sections. Key component supplier, Qualcomm ( QCOM ), has also provided positive commentary on Apple's iPhone take-rates earlier this week. Specifically, Qualcomm pointed to observations of slowing demand for smartphones - especially "low-end and mid-tier phones running on Android" - while premium devices like the iPhone continue to generate strong interest in the consumer end market. Apple's resilient iPhone sales during the fiscal third quarter also beat key rival, Samsung Electronics ( SSNLF / SSNNF ), which missed quarterly profit expectations and warned of a worsening decline in consumer demand for its PCs and mobile phones as economic uncertainties spill into the second half of the calendar year.
2. New Product Slate
Enhanced OS upgrades, new service roll-outs, and improved product launches announced during WWDC 2022 continue to corroborate a strong long-term growth trajectory for Apple. Improved privacy features, and streamlined integration of third-party apps and products within Apple's ecosystem also remain core drivers of its new innovations, underpinning the continued expansion of its market share gains as discussed in the earlier section.
The company has recently introduced a revamped MacBook Air and 13" MacBook Pro fitted with its latest M2 silicon during WWDC 2022 last month. The new products, which started to ship this month, are expected to be core drivers of Mac sales in the fiscal fourth quarter, as they represent some of the segment's best-selling computing devices. The two new product revelations, alongside the series of software and service announcements during WWDC 2022, have also laid breadcrumbs about what to expect at Apple's upcoming launch event in September - it is currently speculated to be one of its largest launch events yet, including a spate of new computing devices powered by next-generation Apple silicon, and potentially a first look at the long-awaited mixed reality headset , in addition to the iPhone 14.
3. Greater Enterprise Take Rates
Improved computing performance enabled by Apple's next-generation silicon designed in-house, as well as the company's seamlessly integrated ecosystem of software, are also spurring greater demand from the enterprise sector, providing the company with partial insulation from weakening consumer demand for discretionary goods. In addition to Alaska Airline's ( ALK ) replacement of its legacy check-in kiosks with Apple's iPad Pros during the March-quarter, Apple has ramped up its commercial partnerships in the June-quarter by adding Bank of America ( BAC ) and IT consulting firm Wipro ( WIT ) to its roster.
While consumer discretionary spending is sputtering in the face of rising inflationary pressure, commercial demand has remained resilient, buoyed by robust corporate investments into improving their technology stacks and infrastructure to accommodate the idea that "hybrid and remote work is the new reality." Digital transformation trends have enabled many corporate environments to adopt a " location-agnostic " work arrangement, giving employees full autonomy on deciding where they want to work.
And continued improvement to the quality and performance of Apple's computing devices will reinforce its penetration into enterprise opportunities. Considering floating speculations that the company is already working on the next-generation M3 chip , with its debut to come through the 2023 13" and 15" MacBook Air and iMac models, as well as a potential 12" MacBook still in early development, Apple is well-poised for greater market share gains ahead. In addition to bolstering its products' appeal to professionals within creative capacities already dominated by Apple iOS/macOS, improved performance and power capabilities enabled by new Apple silicon are also expected to boost Apple to the likes of the corporate workforce currently dominated by Window OS.
4. Favorable Mix of Services Revenues
As mentioned in earlier sections, weakening consumer spending is expected to drive a slowdown to Apple's fast-growing services segment. And we are not going to discount management's worries considering the U.S. has now entered into a technical recession following a second consecutive quarter of economic contraction and consumer sentiment drops to an all-time low , while Apple's services segment sales growth in fiscal Q3 also fell short of the average consensus estimate (actual $19.6 billion vs. estimate $19.7 billion).
Yet, the ongoing macro headwinds are no surprise to investors, and Apple has proven resilience still. Despite the slight miss, services revenues increased by 12% y/y still during fiscal Q3, marking the continuation of robust double-digit growth in the segment. Apple's net paid subscription adds have also exceeded 160 million over the past 12 months, underscoring a continued contribution of high-margin sales to its consolidated performance, effectively offsetting the near-term macro cost headwinds discussed in earlier sections, while also enabling gradual margin expansion over the longer-term.
Final Thoughts
Apple's latest results and positive forward commentary is solid evidence of its resilience against the looming economic downturn. We are maintaining our price target on the stock at $210, which would represent upside potential of almost 30% based on the shares' last traded price of $163 at the time of writing (July 29).
Apple Valuation Analysis (Author)
Apple Valuation Analysis (Author)
Outside of the anticipation of renewed growth acceleration from the introduction of new product segments like in the growing AR/VR and autonomous mobility capacities, we view Apple's increasing focus on furthering monetization of its ecosystem's installed base through complementary services as a strong plus. And this is well demonstrated through its resilience in the most recent economic downturn - Apple's massive product installed base and complementary software offerings have effectively created a mutual reinforcement of demand to overcome the near-term slowdown.
While adjacent service industries like video and music streaming, and digital advertising are seeing deceleration due to consumer weakness, the strong link in Apple's ecosystem is expected to provide some stickiness to demand and reduce the company's exposure to related economic risks. The company's continued success in integrating its service and product offerings will also continue to be a big help to offsetting near-term pressures on its profit margins, and drive favorable cash flow growth needed to support a continued valuation uptrend over the longer-term.
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