- Apple beat Q3 expectations but reported declining revenues and unit sales.
- The market is pleased to see that the slowdown halted, and the company has shifted focus to services.
- However, challenges in China, FX headwinds, and sliding unit sales and margins should keep investors alert.
The tech giant Apple Inc. (NASDAQ:AAPL) reported its FY 2016 Q3 earnings results recently with better than expected results, outperforming the market’s low expectations and temporarily silencing the growth concerns. In the previous article that was published before the earnings were released, I mentioned that the market has consciously lowered expectations and so Apple could, in fact, deliver satisfactory results and trigger a short-term upside. Even though the company reported a YoY decline in unit sales and revenue, it was still better than the consensus for both top line and bottom line, suggesting that the company might succeed to halt the prolonged decline.
Apple continued shifting focus from its traditional products, such as the iPhone, iPad, and Mac to services like Apple Pay, Apple Music, and iTunes, emphasizing the importance of the services segment to the company. As Apple is going through a transition phase between the peak of the iPhone business and the ramp-up of the autonomous vehicle business, the company is focused on expanding its eco-system. Services like Apple Pay and Apple Music will not drive the company’s growth but will help to strengthen the Apple ecosystem across different devices and potentially increase brand loyalty across the eco-system.
As shown in the chart below, the only segment that keeps growing each quarter is the services segment, which grew 19% YoY while the traditional products and other products declined by 19% and 16%, respectively, YoY. The iPhone segment delivered slightly more units than the market expected (40.4M vs. 40.02M expected) but it experienced a drop in ASP due to the iPhone SE launch, and together with a YoY volume decline, the revenue slumped 23%. The iPad was the biggest surprise in the traditional products which registered YoY revenue growth for the first time in ten quarters. This was driven by an ASP increase, thanks to the iPad Pro sales that offset a 9% YoY decrease in volume. The Mac continues to deliver steady revenue that revolves around $6B per quarter.
With the Mac generating around $6B every quarter, it is impressive that the services segment makes a similar figure. However, unlike the Mac, which is expected to continue to stagnate, the services segment is expected to grow partially due to the Pokémon Go revenue that Apple is projected to report next quarter and partially due to continuous growth in iTunes revenue, Apple Pay, Apple Music, and iCloud growth. According to CEO Cook, the uptrend in service will continue to create a meaningful business, saying: “In the last twelve months, our services revenue is up almost $4 billion year over year to $23.1 billion, and we expect it to be the size of a Fortune 100 company next year.”
Even though it seems that Apple’s slowdown might have halted, the company expects some challenging quarters ahead with declining financials. Apple's gross margins decreased YoY from 42% to 38% and is expected to remain in that territory in Q4, according to the company’s guidance. The revenue outlook for the next quarter reflects a 10% decline YoY while operating expenses are projected to rise. Looking at Apple’s worldwide operations, the company has a serious problem in the Asian market where local competitors are rising while Apple’s devices are hurt from foreign exchange fluctuations (CNY depreciated 7% in the last year).
In China, the company is facing intensified competition from Lenovo, Xiaomi, Huawei, and other local players alongside Samsung and LG that offer devices across price points. Apple has tried to strengthen its presence in China by expanding its retail stores in greater China and is pouring $1B into the ride-hailing giant and the biggest competitor to Uber – Didi Chuxing. In India, Apple opened a new accelerator to support iOS app developers, established a new R&D facility, and is looking to expand its retail stores there to strengthen its position in India. YoY Apple increased its iPhone sales in India by 51%, and the company strives to increase that further.
Apple continues to hold a large pile of cash—$231B—that increases exposure to financial risks like interest rate hikes and FX fluctuations and fuels speculations of possible massive acquisitions. However, as time goes by and the company continues not to put this money to work, Apple becomes a massive money manager, which is not the reason investors purchase this stock. Even though the company returned $13B to investors in the last quarter through buybacks and dividends, the company is clearly not utilizing its resources efficiently.
The vast majority of Wall Street’s sell-side analysts are very bullish about Apple, and the average price target has recently been hiked to $120. However, investors should keep in mind that even though the company has a massive amount of cash and plenty of growth potential, it is expected to continue delivering declining revenues and unit sales figures for the near future. I am bullish on Apple’s stock, and I believe Apple will continue to thrive and deliver alpha; however, in the short term, the road might be bumpy, and investors should keep that in mind.