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Apple Inc. (NASDAQ:AAPL) has long been watched as the bellwether for consumer strength amid rising recession risks in recent months, and its latest resilience demonstrated in the September quarter with a double beat, paired with positive commentary on the business’s strengths, sets a positive tone for fiscal 2023 despite looming macro uncertainties.
Apple’s September-quarter results suggest that affluent spend on premium products remains resilient, despite risks of overall consumer confidence deterioration in the near term with buckling budgets amid rising interest rates and inflation. This is further corroborated by stronger iPhone 14 Pro model sales compared with relatively lackluster take-rates on the new smartphone family’s base model equivalents.
We believe Apple’s resilience demonstrated in the September quarter is also a result of prudent business management imposed at the decision-making level. This includes pulling forward the iPhone 14 launch to improve fiscal 2022 performance while allowing Apple to take advantage of earlier-than-expected holiday-season shopping trends this year as consumers spread out spending habits as budgets tighten amid an inflationary environment. Time and again, the value of Apple’s prudent management at the decision-making level has shone through, playing a critical role in mitigating some of the impact from worsening consumer weakness observed in recent months that could have led to softer fundamentals.
Meanwhile, management’s allusion to “strength of [Apple’s] ecosystem, unmatched customer loyalty, and [an] active installed base of devices [reaching] a new all-time high” kicks off fiscal 2023 with a strong positive note, underscoring the value of its pervasive ecosystem of high-demand hardware and complementary services that have become increasingly entwined with many aspects of daily personal settings, big and small. It is also consistent with rising investors’ concerns about the impact of a slowing economy in China – a critical market for Apple that showed signs of cracking after the company unleashed a rare round of discounts to attract demand over the summer.
But sustained growth in the higher-margin Services segment continues to demonstrate the value of Apple’s sprawling influence over the consumer end-market. This is further corroborated by Apple’s earnings beat, underscoring the strength of Services’ margins despite the tough consumer backdrop during the September quarter.
While the stock has not lost as much of its value compared to its tech peers and the broader market amid this year’s selloff, which raises concerns that it may become more “vulnerable” to further multiple contraction in the near-term given increasingly fragile market sentiment, we believe it will continue to fare better than most given the underlying business’ robust fundamentals. Specifically, the robust momentum in Services maintained throughout the rising competition and deteriorating consumer sentiment in the third quarter continues to support its potential in ultimately accounting for half of Apple’s valuation over the longer term, which reinforces the stock’s $3 trillion thesis. Paired with Apple’s upbeat F4Q22 results and management’s positive tone on the forward prospects despite looming macro challenges, any near-term market volatility would likely continue to create compelling entry points for capitalizing on longer-term upsides.
Profitable Growth is Key – And Services is Here For It
Apple’s Services segment demonstrated slower-than-expected but sustained growth in the September quarter, with sales increasing 5% y/y (inclusive of FX headwinds) and margins maintaining in the 70%-range despite inflationary pressures and consumer weakness. As discussed in our previous coverage on the stock, Apple’s Services segment is becoming increasingly core to the company’s long-term growth and profitability trajectory, especially with improved technological advancements in recent years and overall consumer weakness in the near-term lengthening upgrade cycles on devices.
This is also music to investors’ ears, as preference migrates from growth to profitability amid a souring macroeconomic outlook.
In 2017, Apple – under the leadership of Tim Cook – vowed to double its services revenue by 2020. Since then, the segment has delivered with a multi-year compounded annual growth rate (“CAGR”) of more than 20%, boasting close to $68.5 billion in annual revenues during fiscal 2021, and approaching $80 billion in the current fiscal year ending this week. Earlier this year, Wall Street predicted that Apple’s services segment amounts to a $1.5 trillion value on its own, similar to our own predictions which will be discussed in further detail below.
Although services sales growth has decelerated from its heights last year due to the moderation in demand from pulled-forward subscriptions during the pandemic era alongside broad-based macro weakness, the segment continues to boast robust double-digit expansion, reinforcing the bullish thesis surrounding Apple’s sustained long-term growth and profitability trajectory.
Source: “Apple Services Is On A Critical Mission“
We see Services’ critical role in safeguarding Apple’s bottom line continuing into the upcoming holiday season, despite light growth and a slight miss as expected during the fiscal fourth quarter. We see our previously discussed base case where Services will continue to lead growth alongside hardware sales as a highly likely scenario as Apple navigates through macro challenges in the near term. And the company’s recent decision to raise prices on some of its core Services offerings – including Apple TV+, Apple Music and the Apple One bundle – will likely give the segment’s momentum another leg up heading into fiscal 2023, as opposed to weighing further on weakening consumer sentiment since Apple has a strong value proposition to do so.
Apple TV+
Apple raised the monthly Apple TV+ subscription rate from $4.99 to $6.99, and annual subscription rate from $49 to $69, which went into effect earlier this week. While the price hike for Apple TV+ is not small – a whopping 40%+ – it remains competitive relative to rival streaming platforms spanning Netflix (NFLX), Disney+ (DIS), and HBO Max (WBD), to name a few, including their respective ad-supported tiers that are / will be marketed as a “cheaper” alternative.
We also believe Apple has the right value proposition for jacking up Apple TV+’s pricing, which will effectively help reduce potential churn in the aftermath. Specifically, Apple TV+ was “introduced at a very low price because it started with just a few shows and movies.” But now, it has grown into an extensive library of “award-winning and broadly acclaimed series, feature films, documentaries, and kids and family entertainment,” which is further corroborated by its rapidly rising global market share of more than 6%, putting rival platforms on notice.
Yet, at the new price tag of $6.99 per month, Apple TV+ – which is currently ad-free and offers unlimited access to its entire catalogue of scripted and non-scripted content, alongside live sporting events such as “Friday Night Baseball” – the streaming platform still beats equivalents in the pricing segment. This includes Netflix and Disney+’s upcoming ad-supported tier priced at $6.99 and $7.99 per month, respectively, and HBO Max’s ad-supported tier priced at $10 per month, with some not even offering access to live sporting events, which is a key demand driver in streaming that Apple TV+ is benefiting from. This continues to underscore Apple TV+’s pricing advantage amid weakening consumer sentiment, with its latest price hike still more competitive than similarly-priced offerings by peers, while contributing meaningfully to the Services segment profit margins over the longer term.
Apple Music
The monthly subscription rate for Apple Music will increase from $9.99 to $10.99 for individuals, and the annual subscription rate from $99 to $109. This would effectively make the service more expensive than key rival Spotify’s (SPOT) equivalent which is currently priced at $9.99 per month still.
The price hike was implemented to compensate for increasing content licensing costs for creators. Although the price increase for Apple Music subscriptions may seem like it will be another blow to the service’s already laggard market share (~15%) compared to Spotify’s (>30%), we believe it will give Apple a leg up from a business and valuation perspective.
Specifically, Spotify currently reels from narrowing profit margins due to the same cost increases identified by Apple, underscoring that similar price hikes will likely be coming soon anyway. As such, we view the increase to Apple Music prices as a strategic move that will not only contribute positively to the Services segment’s bottom line but also without the risks of material churn despite consumer weakness.
Apple One Bundle
The Apple One bundle – which allows up to six service subscriptions at a discounted price – has also implemented price increases across all of its variants offered. The standard bundle (individual subscription for Apple Music, TV+, Arcade, and iCloud+ with 50GB storage) will have its monthly subscription rate increase from $14.95 to $16.95; family bundle (five-people subscription for Apple Music, TV+, Arcade, and iCloud+ with total 200GB storage) from $19.95 to $22.95; and Premier bundle (same as family bundle, plus News+ and Fitness+) from $29.95 to $32.95.
The Apple One bundle has been a key contributor to overall growth observed in Apple’s service subscription volumes and overall traction since its introduction in fiscal 2021, attracting new users to pay for subscription services that they otherwise would not have subscribed to without the bundle discount. The bundle discount – even after the recent price increase – adds another positive touch to the service-specific value propositions for subscribers as discussed in the earlier section, which we view as a critical factor to mitigating risks of churn, while further bolstering Services growth.
The pricing advantage in Apple’s Services segment is expected to contribute positively towards its longer-term valuation of about $1.5 trillion alone. Not only would it further improve the segment’s profit margins – an increasingly prominent driver of Apple’s free cash flows – but also help bolster the funding needed to support further expansion into additional services and upgrades that will aid penetration into a broader subscriber base over the longer term.
Near-Term Investment Risks to Consider
China Risks: China’s economy continues to reel from sporadic COVID disruptions and a worsening property crisis that sees no respite in sight. This has led to further deterioration in its economy, with retail sales growth decelerating rapidly to a mere 2.5% in September. This has accordingly introduced demand risks to one of Apple’s most core operating regions – China currently accounts of about a fifth of the company’s consolidated sales and a quarter of the consolidated income. Concerns of said demand risks are further corroborated by the rare sighting of a direct pricing discount on certain devices introduced over the summer in China. Even during seasonality promotions – like back-to-school, Black Friday, and/or holiday-season sales – Apple has hardly ever offered direct pricing discounts, opting for gift card rebates on bundle purchases and/or gift-with-purchases instead.
In addition to demand risks, Apple also faces supply risks and geopolitical risks in the region. On the geopolitical front, fraying U.S.-China relations has recently led to a myriad of direct impacts on operations within the private sector – spanning an export ban of advanced technologies to China levied by the U.S. government, and an order to “dump foreign PCs” levied by the Chinese government on state-owned enterprises and public agencies. This means Apple could potentially experience restrictions on key manufacturing technology availability in its core assembly base in China in the future, while also risking loss of a meaningful market for its hardware sales across China’s public sector.
And on the supply front, sporadic COVID lockdowns and other regulatory headwinds have already led Apple to shift to a “China-plus-one” strategy that includes building out supply chains in “nations aligned with Washington” such as India. However, the strategy could take years to materialize, meaning Apple will still be exposed to risks of having to shoulder supply chain cost inefficiencies in China, while also forking out billions simultaneously to build new supply chains in additional regions, adding pressure on its hardware profit margins.
Yet, we believe Apple has a few levers to pull still that can compensate for the said risks. On the supply front, Apple’s importance to suppliers worldwide gives it leverage needed to compensate for supply-risk-driven cost efficiencies stemming from China. This is consistent with Apple’s power in price negotiations with key suppliers like Taiwan Semiconductor (TSM), as well as previous observations that the tech giant’s “size and importance to suppliers” was able to help it secure key components better than peers during the peak of supply shortages. Meanwhile, on the demand front, increasing momentum in Services as discussed in the foregoing analysis is expected to partially shield Apple from hardware demand risks in China within the foreseeable future, especially with robust market share gains observed across core operating regions like the U.S. and Europe.
Macro Risks: FX and consumer slowdown are the biggest macro risks facing Apple today. FX risks are inevitable given the company’s massive overseas operations amid a surging dollar environment as the Fed remains fixed on an aggressive rate hike trajectory to counter runaway inflation. And on the consumer slowdown front, Apple’s upbeat showing for the September quarter also supports continued resilience relative to peers spanning PC/smartphone makers and service providers that have been losing market share.
In our view, we believe Mac and iPad sales are most susceptible to the near-term consumer slowdown, despite better-than-expected performance in the fiscal fourth quarter. First, the segments have already benefited from pulled-forward demand in the pandemic era, meaning forward momentum will likely remain moderate, especially with the looming economic downturn. Second, lost sales driven by supply chain constraints (most prominent in iPad segment) will likely see some of it becoming permanent instead of delayed due to consumers dialing back on discretionary spending amid deteriorating economic conditions. Lastly, previous expectations for stronger commercial IT spending that have benefited enterprise demand for Apple devices will likely moderate as well as budgets pullback to brace for near-term macroeconomic uncertainties. Worsening market trends are also contributing to anticipated challenges on Mac and iPad demand within the foreseeable future – the latest tally of global PC shipments in the calendar third quarter showed an accelerated decline this year, falling 6.8% y/y in 1Q22, 15% y/y in 2Q22, and 20% y/y in 3Q22, with 4Q22 numbers expected to worsen as consumers shun big-ticket items due to weakening spending power.
Yet, momentum in Services paired with Apple’s pricing advantage as discussed in the foregoing analysis remains a key business strength that is expected to partially cushion some of the near-term impact on the macro-driven slowdown in product demand. Product upgrades, such as the latest introduction of a new Mac and iPad line-up retrofitted with next-generation Apple silicon, will likely help salvage product demand as well. This is further corroborated by Apple’s rapid climb to the top, dethroning legacy PC makers like Lenovo (OTCPK:LNVGY), HP (HPE), and Dell (DELL) to become the industry leader in the first half of the year.
Lengthening Product Cycle Risks: Improving technology at Apple is also lengthening the upgrade cycle on its line-up of devices, which will potentially stagger the Products segment’s growth outlook over the longer term. But Apple still has many levers to pull from a pricing and technology point-of-view to counter risks of growth slowdown due to lengthening product cycles in our opinion. For instance, Apple’s transition to in-house designed silicon is a key advantage that will help attract demand stemming from both upgrades and switches and partially offset the growth slowdown in Products given their lengthened lifecycles. The company’s potential introduction of a device subscription service would also drive improved economics for its Products segment over the longer term.
Nonetheless, hardware sales are expected to imminently grow slower than Apple’s services sales, given product revenue cycles are comparatively lengthier. For services, recurring revenues stemming from subscriptions come on a monthly or annual basis. But for products like iPhones and Macs, their lifecycles have grown from two years in the past to now about three to four years and more than five years, respectively, thanks to continuous technological improvements. To put into perspective, the standard iPhone 14 starts at $799, which translates to about $266 in revenue per share if broken down based on a three-year lifespan. Comparatively, an annual subscription for the Apple One Bundle starts at [$203.40 per year (or $16.95 per month)], which is not too far off from the average annual revenue per iPhone, while boasting significantly more profitable margins. And while Apple’s iPhone sales may be benefiting from broader industry tailwinds stemming from 5G transition, its large installed base is bound slow in growth based on the law of large numbers, signalling the double-digit multi-year CAGRs it once enjoyed are no more. It is no wonder that the company has been reportedly working on the launch of a product subscription model to safeguard better economics over the longer term.
Source: “Apple Services Is On A Critical Mission“
Final Thoughts
Market sentiment is becoming increasingly fragile, with many investors looking to the performance of large and mega caps – especially Apple – for hints on what forward consumer sentiment might look like and what they mean for the broader tech sector and the economy overall ahead of rising recession risks. This is especially true given Apple, along with its mega-cap peers spanning Alphabet (GOOG/GOOGL), Microsoft (MSFT), and Amazon (AMZN), account for “nearly a fifth” of the S&P 500’s value today, or more than 30% of the tech-heavy Nasdaq 100 (Apple alone is the largest influence, accounting for 15% of the weight of the Nasdaq 100).
While Apple’s valuation remains lofty at “23x forward earnings, above both its long-term average and the market overall,” which potentially exposes it to further volatility as market sentiment remains fragile over coming months in anticipation of a cascading economy, we believe its strong F4Q22 performance and positive tone heading into fiscal 2023 reinforces the company’s fundamental strength. This means any market-driven volatility in the Apple stock over the near term will continue to create a compelling risk-reward opportunity.
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