Apple Computer Company (AAPL)

Some comments on Apple in the light of recent quarterly results. I will not comment in detail on the results as these have been well covered elsewhere.

Apple was founded on April 1, 1976, by Steve Wozniak, Steve Jobs and Ronald Wayne to develop and sell Wozniak’s Apple I personal computer. Ronald Wayne sold his 10 percent stake in Apple in 1977 for US$ 800. Today, it would be worth about $270 billion. Mr. Wayne is 88 years old. He would be the richest American alive today, had he just held his shares!.

The company's second computer, the Apple II, became a best seller and was one of the first mass-produced microcomputers. The company developed computers featuring innovative graphical user interfaces, including the 1984 original Macintosh (Mac).

In the late 1990s, Apple was seen as an unpromising investment.  The PC (powered by Intel Chips and Microsoft Windows) had a ~90%+ market share in desktop computers and Apple’s devices were seen as only appealing to a niche of creative artists and designers. 

The company was failing and was weeks from bankruptcy in 1997 when Steve Jobs returned. The iPod was launched in October 2001, followed by the iPhone in June 2007 and the iPad in January 2010.

The iPod was very successful and turned round the fortunes of the company. The iPhone through various upgrades has become one of the most in-demand consumer products ever and has largely driven the company’s sales since 2007 and made Apple the largest technology company and, indeed, the largest company in the world with a current market capitalisation of US$ 2.7 trillion. The (slightly dated ) graphic below gives some idea of the relative size of Apple.

Let us start with the standard company description of Apple Computer Co.

Apple Inc. designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players.

The Company sells a range of related software, services, accessories, networking solutions,  third-party digital content and applications, operates a streaming television channel, operates a payment app and offers financial services.  

Its products and services include iPhone, iPad, Mac, iPod, Apple Watch, Apple TV, a portfolio of consumer and professional software applications, iPhone OS (iOS), OS X and watchOS operating systems, iCloud, Apple Pay and a range of accessory, services and support offerings.

Geographical Revenue breakdown

Great China had been a fast growing region but revenues were hit by the severity of China’s lockdowns in response to the covid-19 pandemic.

The company’s key transformational product is the iPhone, which has gone through over a dozen upgrades, and still accounts for the lion’s share of the company’s revenues. In 2002, after the iPod was launched, Jobs realized that the overlap of mobile phones and music players would force Apple to get into the mobile phone business. After seeing millions of Americans carrying separate BlackBerrys, phones, and Apple's iPod MP3 players; he felt eventually consumers would prefer just one device.

Jobs also saw that as cell phones and mobile devices would keep amassing more features, they would challenge the iPod's dominance as a music player. To protect the iPod’s new product line, which by 2007 was responsible for 48% of all of Apple's revenue, Jobs decided he would need to venture into the wireless world.

iPhone

The iPhone was the debut of the touchscreen, which would soon become standard in smartphones. There had been smartphones available from established manufacturers before, but they had physical keyboards and a much smaller screen. This was one of the main aspects in which the iPhone changed the game. The iPhone boasted capacitive touch technology that Apple acquired from a small company known as Fingerworks.

Several enabling technologies made the iPhone possible. These included:

• Lithium -ion batteries, small and powerful enough to power a mobile computer for a reasonable amount of time

• multi-touch screens;

• Energy-efficient but powerful CPUs, such as those using ARM architecture.

• mobile phone networks; and

• web browsers

• A thin, flexible, and transparent material that could avoid the problem of metal keys scratching up phone screens called Gorilla glass.

The iPhone became a must have product and attracted die hard fans who paid a premium to have the latest model, as it was seen as epitome of cool. As the graphic below shows, it is Americas top smartphone with a 50% share

Globally, the iPhone has 20% market share but it is a premium product and accounts for 50% of revenue and an astonishing 82% of the operating profit of the global smartphone market.

Apple designs products but outsources supply of components and Products are assembled by specialist contract manufacturers. For example, the main chips for iPhone are made by Taiwan Semiconductor and Samsung. Contract manufacturers include Foxconn and Pegatron.

Apple Mac

The Mac is Apple's family of personal computers. Macs are known for their ease of use and distinctive aluminium, minimalist  design. They are popular with students, creative professionals, and software engineers. The current lineup consists of the MacBook Air and MacBook Pro laptops, and the iMac, Mac mini, Mac Studio and Mac Pro desktop computers. As of May 2023, all newly sold Mac models except the Mac Pro use Apple silicon chips (M1 or M2) .

Although they were decisively overtaken by the iPhone, Macs remain an important revenue generator in their own right. 

In June 2020, Apple announced it would move away from Intel processors, and Apple would start using their in-house  designed processor. In December 2020, MacBook Air, MacBook Pro, and the Mac Mini became the first Mac devices powered by an Apple-designed processor, called the Apple M1. Currently, they use Apple’s  M2 Pro and M2 Max. This is the latest stage of Apple’s quest to own and develop everything that goes into its products from the bottom up. It’s also reportedly working on its own modem, a chip that combines Wi-Fi and Bluetooth modem capabilities, and its own display technology.

Developing their own chip has reduced their reliance on Chip companies like Intel, Qualcomm, Broadcom, and Samsung. The Wall Street Journal reported this strategy left Apple better prepared to deal with the semiconductor shortage that emerged during the pandemic and led to increased profitability, with sales of Mac computers, that included M1 chips, rising sharply in 2020 and 2021. It also inspired other companies like Tesla, Amazon, and Meta Platforms to design their own chips in-house.  Apple claims the latest Macs give a better performance and battery life than their predecessors running either Intel’s chips or Apple’s own M1 chips.  Apple claims a MacBook Pro with the M2 Pro chip can get up to 22 hours of battery life on a single charge. If true, it would make the MacBook Pro one of the longest-lasting laptops around.  This would make Apple’s hardware  far more appealing to consumers than comparable Windows-based laptops and desktops.

According to Gartner, Apple’s Mac made up just 10.7% of the global market. That is less than Dell at (16.7%), HP ( 20.2%) and Lenovo (24%). There is plenty of market share to go for.  By improving the speed of its chips, and further differentiating what it can do relative to Windows PCs, however, Apple win market share even at a time when PC sales are falling.

Bringing more of the design in-house brings additional advantages. Apple’s Intel-based Macs were known for languishing without receiving upgrades for years at a time. Now with the M-series chips, Apple can bring new models on a regular basis, giving consumers a reason to trade up more often. The move also reduces the complexity of its supply chain and means Apple can head off future slowdowns in its manufacturing process. However, this should not be exaggerated, Apple still outsources the manufacturing of chips to outsiders such as Samsung and Taiwan Semiconductor and final products assembly to contract manufacturers such as Foxconn. 

Apple's latest MacBook Pro comes with either an M2 Pro or M2 Max chip. (Image: Apple)

Apple  iPad

The iPad is Apple's line of Tablet computers which run on iPadOS (iPad Operating System). The iPad was first announced on January 27, 2010. It is mainly marketed for consuming multimedia, creating art, working on documents, videoconferencing, and playing games. The lineup consists of several base iPad models, the smaller iPad Mini, upgraded iPad Air  and the high-end iPad Pro. Apple has consistently improved the iPad's performance, with the iPad Pro adopting the same M1 and M2 chips as the Mac; but the iPad still receives criticism for its limited OS. Apple has sold more than 550 million iPads, though sales peaked in 2013. It is still the most popular tablet computer by sales.

Wearables, Home, and Accessories.

These products include AirPod wireless headphones, AppleTV  digital media players, Apple Watch smartwatches,  Beats  headphones and HomePod Mini smart speakers.  Taken together, the revenue for this segment is more than the revenue of the iPad segment and only a little smaller than the Mac segment.

Services  

Apple has historically been a hardware company and is still mainly so. However, the installed base of over 2bn devices, across geographies and product types, has given them a vast customer base to whom services can be sold.

As CEO Tim Cook noted in a recent conference call, “Over the last seven years, as we've doubled installed base, we've seen a growing engagement of our customers on the platform. That happens first, by customers transacting on the platform and then moving to paid accounts. So starting to pay for some of the services. The percentage of paid accounts tends to grow over time. We've seen it in developed markets, we see it in emerging markets and that is due to some of the reasons that I was explaining earlier including the fact that we made it easier for our customers to get engaged on the platform.”

The services business at Apple has grown strongly since 2015. It was in 2016 that Apple first articulated the so-called “Services Narrative”; after a quarter in which the company’s (then) new iPhone 6S posted relatively disappointing sales, CFO Luca Maestri made the case on the earnings call that it was a mistake to think of Apple as a hardware company, subject to the vagaries of consumer demand.”  Since then statement, the number of paid subscriptions for Apple Services has increased from 150mn to 860mn (See below).

Source: The Science of Hitting (TSOH)

Source : TSOH

Services as a percentage of revenues has doubled from 10% in 2014 to 20% currently.

Source: Statista

Apple Services revenue has reached 21bn per quarter and is larger than the total quarterly revenues of a number of companies.  The annual services revenue at Apple inc was only US$ 20bn in 2015.   

App Store

Sanford C Bernstein. estimates the App Store accounts for about a third of Apple’s total services revenue. There are 1.8 million apps in the App Store  across all of the company’s platforms and more than 28 million registered developers. Apple claims that the store has generated $155 billion for developers since inception.  Apple has had a 30% take. In 2016, Apple lowered it to 15% the cut for  subscriptions purchased for more than a year. Apple has implemented a rate of 15% for small developers, defined as those who earn less than US$ 1mn per year from their Apps.  

Apple has been criticised that for excessive charges and the issue has been probed by lawyers from the US Justice Department. The company has said that 85% of apps found on the App Store are free and aren’t part of the revenue fee system. This could be the subject of future regulatory probes and action.

Source: Chartr

The Apple take is between 15% and 30% and therefore, Apple’s app store revenues are likely to be towards the middle in the range US$ 13bn to US$ 26bn annually.

Apple Pay

Apple Pay has been growing steadily since its launch in 2014. The revenue earned by Apple Pay has been increasing each year. In 2021, Apple Pay revenue amounted to US$1 billion. Global growth has accelerated in recent years. 

The Chart below shows the adoption growth for November 2022  where growth has been at the expense of Paypal and Credit cards. 

Apple Pay's surge seems to be coming at the expense of long-time dominant player PayPal: Apple Pay and PayPal now make up about 5% and 16%, respectively, of global e-commerce purchases.

In April 2023, Apple launched a new high yield savings account offering and interest rate of 4.15% that is administered by Goldman Sachs. It raised almost US$ 1bn in the first four days. It is linked to the Apple Credit Card.

Services are a growing part of total Apple Revenues and are already a huge business. This is important as services Gross Margin is ~71% compared with ~36% average Gross Margin for devices.

Chart 1: AAPL Total Revenues and Stock Return.

AAPL total annual revenues have risen from US$ 5.7bn in 2002 to US$ 394bn in 2022 (69X growth). Revenues grew strongly in 2021 as the Covid-19 Pandemic and the Work From Home (WFH) trend led to a huge increase in demand for Apple’s Products and Services. Between 2002 and 2002, the AAPL stock has given a 521x return.

Chart 2: AAPL Total Revenues and Operating Income.

AAPL operating income has also grown steadily in line with total revenue. As shown below, Operating Income in 2022 was US$ 394bn compared with 55bn in 2012 and just US$ 65mn in 2002. Between 2002 and 2022, Operating income grew 65X.

Chart 3: AAPL Operating Cash Flow and Free Cash Flow.

AAPL has not only been profitable but has also generated significant Operating Cash Flow. As the business model is relatively asset-light, most of the operating cash flow is converted to Free Cash Flow. Free Cash Flow is 90% of Operating Cash Flow.

Chart 4: AAPL Gross Profit Margin.

Gross Profit Margins have been maintained at the 39%-43.2% range which is quite impressive for a Hardware company. This has been supported by the growth in the share of Services which have a ~ 71% gross margin compared with ~ 37% for Services .

Chart 5: AAPL Operating Profit Margin.

The Operating Profit Margin has consistently been in the range of 25% -30%.

Chart 6: AAPL Net Profit Margin.

The Net Profit Margin is currently around 25%.

Chart 7: AAPL Percentage of Sales converted to Operating Cash Flow.

Chart 8: AAPL Profitability: Return on Equity ( ROE (%)) and Return on Invested Capital (ROIC (%)).

Apple has been very profitable for most of the last twenty years. ROE and ROIC have been very high. ROE has risen fast in the last five years as the denominator in the derivation of ROE ( book value of equity) has fallen significantly due to the very high level of share buybacks (see below).

Chart 9: AAPL Balance Sheet -Property, Plant & Equipment (PPE) relative to Total Assets.

PPE is ~ 12% of Total Assets reflecting the capital light business model .

Chart 10: AAPL Balance Sheet - Total Current Assets relative to Total Assets

Current assets are 35% of Total Assets.

Chart 11 : AAPL Balance Sheet - Total Assets Relative to Cash and Short-Term investments and Long-Term Investments.

This illustrates the liquidity of the Balance Sheet. Long-Term Investments are mostly market securities. At December 2022, Marketable securities were US$120bn. This combined with US$ 48bn Cash and Short-Term Investments amount to US$168 bn. This is equal to 48% of Total Assets.

Chart 12: AAPL Cash Flow Statement - Total Annual Share Purchases (US$ Mn)

Apple has consistently bought back shares in recent years. For example, in September 2021, AAPL bought back US$ 85bn worth of shares. Share buy backs are shown as a negative in the above chart as they represent an outflow of cash.

Chart 11: AAPL Balance Sheet- Weighted Average Shares Outstanding.

As a result of the share buybacks, the total number of shares have declined from 24.3mn in September 2014 to about 16mn currently, a reduction of 30%. As Warren Buffet, whose Berkshire Hathaway Conglomerate is the one of the largest shareholders in Apple has noted, this means shareholders’ percentage ownership of the company increases without them having to pay a single dollar out.

Q4 2023 AAPL Results Summary.

The above illustrates the AAPL results for the three months to December 2022. This counts as Q1 2023 as Apple has a September Year-end.

• Total Quarterly Revenue was US$117bn o/w iPhone was US$ 66bn and services was ~US$ 21bn

• Gross Profit was US$ 50.3bn (GPM 43%) , Operating Profit was US$ 36bn (OPM 31%) and Net Profits were US$30.0bn (NPM 26%).

Given this background on the company, we can consider the most Recent results which covered the Q2 2023 which is the three months to March 31 2023.

Latest Quarterly Results

“The Company posted quarterly revenue of $94.8 billion, down 3% year over year, and quarterly earnings per diluted share of $1.52, unchanged year over year. Revenue was affected by the strength of the US dollar. Revenue was up 2% on a constant currency basis. Product sales fell 4.6% but Services Revenue grew 5.6%. “

Comment: Sales were strongly boosted during the Pandemic /WFH phase and there is a clear moderation in growth now.

“We are pleased to report an all-time record in Services and a March quarter record for iPhone despite the challenging macroeconomic environment, and to have our installed base of active devices reach an all-time high,” said Tim Cook, Apple’s CEO.

Comment: Services continues to be strong but the company notes the tough economic environment

“Our year-over-year business performance improved compared to the December quarter, and we generated strong operating cash flow of $28.6 billion while returning over $23 billion to shareholders during the quarter,” said Luca Maestri, Apple’s CFO.

“The Board of Directors has also authorized an additional program to repurchase up to $90 billion of the Company’s common stock.”

Comment: Cashflow continues to be strong and company continues to buy back shares. A buyback of US$ 23bn per quarter implies an annual run rate of US$ 98bn. This would be a new record level.

The Gross Margin was 44.6%, up 0.6% on the same quarter in the previous year.

The Net Income Margin was 25.4%, down 0.3% on the same quarter in the previous year.

Comment: Margins are in line with recent trends.

• The IPhone Segment saw a new March quarter record revenue of US$51.3 billion.

• The Mac segment , recorded $7.2 billion in revenue for the March quarter.

• Wearables, home and accessories, revenue was $8.8 billion.

• The Services segment set an all-time record with $20.9 billion in revenue for the March quarter.

Conference Call Highlights

Comments on Business

“The iPhone 14 and 14 plus continue to delight users with their long lasting battery and advanced camera. And our pro users continue to rave about the most powerful camera system ever in an iPhone.”

“As we noted during our last call, Mac faced a very difficult compare because of the incredibly successful rollout of our M1 chip throughout the Mac lineup last year. And like our other product lines, Mac is facing some macroeconomic and foreign exchange headwinds as well. That said, the advancements we've made in power efficient performance continue to amaze our users.”

Our M2 Mac Mini customers are raving about the pro level powerhouse packed into an ultra-compact design, and users are marveling at the power and speed at the heart of every M2 powered MacBook Air and MacBook Pro, which allowed them to sustain even the most demanding workloads

Services: We achieved all time revenue records across App Store, Apple Music, iCloud and payment services. And now, with more than 975 million paid subscriptions, we're reaching even more people with our lineup of services.

Comment: Paid subscriptions have risen to 975mn. They will have over 1bn paying subscribers soon.

“In March, we also launched Apple Pay Later designed with users privacy and financial health in mind. Apple Pay Later allows users to split purchases into multiple payments with no interest or fees. “

“And last month, we introduced Apple Card Savings Accounts to give users even more value out of their daily cash Apple Card Benefit. “

India was mentioned several times by Tim Cook who had just come back from there. He had attended the opening of the first two Apple Stores in the country. This is a large potential emerging market for Apple. It is dominated by cheap android phones and Apple Products are probably too expensive for most Indians. However, it is likely that sales there will grow in the coming years. They are also looking to manufacture some devices there.

Comments on Finances

“Products revenue was $73.9 billion, down 5% from last year, due to challenging compares on Mac and iPad. iPhone, however, reached a March quarter revenue record thanks to very strong performance in emerging markets from South Asia and India to Latin America and the Middle East.”

Our Services set an all-time revenue record of $20.9 billion, up 5% year-over-year, on top of growing 17% in the March quarter a year ago.

Products gross margin was 36.7%, decreasing 30 basis points sequentially due to seasonal loss of leverage and mix, partially offset by favorable costs. Services gross margin was 71%, up 20 basis points sequentially.

Concluding Remarks

Apple is one of the most remarkable companies the world has ever known. Everybody is currently talking about AI, so I asked a CHAT GPT-linked model for some information about Apple. This is what it came up with:

Diversified Product Portfolio: Apple offers a wide range of products, including iPhones, iPads, Mac computers, Apple Watches, and Apple TV, which helps to mitigate risks associated with dependence on a single product line.

• Robust Ecosystem: Apple's ecosystem of hardware, software, and services, such as the App Store, iCloud, and Apple Music, creates a seamless user experience and encourages customer loyalty.

• Innovation and Design: Apple is known for its focus on innovation and design, which has led to the development of iconic products that have disrupted multiple industries.

• Supply Chain Management: Apple has a complex and efficient supply chain, which enables the company to maintain high-quality standards and meet consumer demand.

• Financial Performance: Apple has consistently delivered strong financial results, with growing revenues, profits, and cash reserves, making it one of the most valuable companies in the world.

• Market Share: While Apple's market share in the smartphone industry is lower than some competitors, it captures a significant portion of the industry's profits due to its premium pricing strategy.

• Potential Growth Opportunities: Apple has opportunities for growth in emerging markets, new product categories, and expanding its services segment.

• Competitive Landscape: Apple faces intense competition from companies such as Samsung, Google, and Huawei, which requires continuous innovation and investment in research and development.

• Regulatory and Legal Challenges: Apple is subject to various regulatory and legal challenges, including antitrust investigations and intellectual property disputes, which could impact its operations and financial performance.

This is quite a good comprehensive list! It highlights the robust ecosystem, Innovative Design, and Supply Chain Management, Market Share and Financial Performance.

One thing it does not mention is Brand. The Brand is the key element behind the strong Moat that an investment in Apple offers. The Brand is very strong and explains why people are wiling to pay a significant premium over rival products to buy Apple Products. Brand Finance Global 500 said Apple brand was the second most valuable in the world ( behind Amazon) and has an estimated value of US$ 297bn. This is an intangible asset and therefore not currently shown on the Balance Sheet.

• The iPhone is a dominant product and is much more profitable that its rivals.

• The most recent quarterly results show that Apple is facing some short term demand challenges due to the current macroeconomic uncertainties (consumers and enterprises are strapped for cash) and the strong recent performance makes further progress from the current level more difficult.

• The Services business is growing fast.

• Margins and profitability are in line with recent trends.

Apple is a very successful strong profitable, capital-light company which generates a lot of of Free Cash Flow and buys back a lot its shares.

All this is well known to the market and the shares are not cheap on the various usual summary valuation metrics as shown below:

Chart 12 : AAPL Summary Valuation Ratios.

Key

Orange Line - Price to Earnings. Currently 33.6 times

Blue Line- Price to Free Cash Flow (FCF). Currently 40.4 times

Purple Line- Price to Sales. Currently 2.5 times

Green Line - FCF Yield. Currently 2.5%.

At an earnings yield of 2.9% and a Free Cash Flow Yield of 2.5%, the shares do not feel like good value, especially in a world in which short-term interest rates have jumped to 5%.

It was much better in 2016 when interest rates were 0.5% and FCF yield was over 6%. Warren Buffet probably invested a significant amount at that time when a temporary sell off, after poor sales numbers in China, saw an FCF yield close to 10%

This is a difficult call. We recommend investing 25%-30% of our ideal final allocation now and then wait and watch for a sell off and/or better valuation. If interest rates fall to ~ 3%-4%, a FCF yield of of 4% to 5% would be like an attractive point to invest more.

We have now written reports commenting on four large tech companies: Apple, Meta Platforms, Microsoft and Alphabet. The graphic below gives a good summary of the revenue sources of these companies.