Growth Stocks: Apple Inc.

How will Apple (AAPL.US) stock respond to the presentation of the new iPhone15 at “Wonderlust”?

That is the question that those interested in the company are asking themselves right now. It's likely to experience a drop, based on past events, but this latest product launch will further solidify Apple's dominant position in the market. Specifically, Apple is positioned to take the lead with its controversial pricing strategy aimed at boosting revenue in a maturing iPhone market.

Historically, Apple stock tends to decline after the introduction of new iPhones. About 75% of the time, the stock price drops after the reveal of a new iPhone (source: build.com). Over the last decade, this percentage has been even higher. Generally, most investors are already aware of rumors about new products and trade the stock in advance, which often leads to disappointment during the event since it is discounted. However, given that Apple shares fell about 5% last week, most investors may already be anticipating this phenomenon. However, the recent price drop was mainly related to various developments related to China.

China's veto, the trade war continues

China's recent directive ordering government agencies to ban the use of iPhones in the workplace has raised concerns about the vulnerability of Apple's Chinese revenue. However, this concern could overshadow a more important threat: the fact that the vast majority of Apple's product manufacturing has, to some extent, roots in China. The diversification process to escape this dependency will require a lot of time and effort. While it seems unlikely that these long-established relationships would abruptly unravel, the mere possibility of such an event could cast a shadow over the company's stock.

Experts estimate that it will take years, if not decades, for Apple to move its manufacturing and supply chain operations out of China. Such a change could have adverse effects on profit margins. These concerns come at a time when Apple is trading at a premium valuation, indicating minimal margin for error. Although a growing number of challenges loom over the company, the strength of its ecosystem can still provide some support to mitigate potential downsides to the stock's performance.

Apple's financials and valuation show the substantial contributions of Europe and China to the company's overall revenue. Together, these regions account for a significant 44% share of the company's total revenue in the fiscal third quarter of 2023.

Revenue by geography of Apple Q3-23. Apple, own creation.

While the current situation in both scenarios may not seem too alarming, there is an imminent risk that this may only be the initial phase. The real concern lies not in the potential loss of revenue but rather in the disruption of the supply chain. As stated in Apple's 2022 10-K filing.

"substantially all of the Company's manufacturing is performed in whole or in part by outsourced partners located primarily in Asia, including mainland China, India, Japan, South Korea, Taiwan and Vietnam."

We should note that China tops the list, as expert estimates suggest that most products are still partially manufactured in China. Bloomberg Intelligence estimates that moving just 10% of production out of China would take eight years, underscoring the potential severity of this scenario. Apple had deepened its manufacturing ties with China to increase margins at the unit level, with little anticipation that geopolitical tensions could reach a point where this mutually beneficial relationship could be compromised.

But recent events, including the war between Russia and Ukraine and China's iPhone ban, have changed the calculus. Even if Apple could financially address that transition, the costs would likely be exorbitant. Investors may rightly argue that such a scenario seems highly unlikely. However, it is essential to understand that stock markets are influenced by sentiment and fear, not just mathematical realities. The mere possibility of a negative impact could cast a shadow over the stock's valuation, especially given its current rich valuation.

In the current climate of higher interest rates, many recurring income companies are trading at lower valuations, such as 11x to 14x earnings for net lease REITs, 12x to 14x earnings for health insurance companies, and gains of x8 to x10 times for midstream gas pipelines, among others. others. It's not hard to imagine the stock repricing down to 20x-25x earnings multiples to account for China-related risk.

Even at the high end of this range, Apple could potentially remain stable for the foreseeable future, without even considering potential profits affected by supply chain disruptions.

Wonderlust

But let's focus on the spotlight. This year's event appears to be predictable, with no rumors of surprise product reveals. With the launch of this new iPhone, Apple's main objective is to maintain its strategy of encouraging its customers to opt for higher-priced models, thus increasing its average sales price and its profit margins.

Apple started this pricing strategy in 2019 when it introduced the first iPhone Pro. The goal was to make the Pro versions more attractive to customers, inviting them to upgrade to these more expensive models. Since then, iPhone revenue has increased or remained stable, although overall unit sales have stagnated. iPhone Pro models feature the latest chipset, improved cameras, and additional features. This year will follow the same pattern.

This pricing strategy is set to trigger a 20% rise in Apple shares in the coming months, according to the market. While prices for the base models will remain unchanged, a $100 increase is justified for the new iPhone 15 Pro and Pro Max models due to the improved chip, battery, and photo technologies. He also anticipates constant discounts and promotions from US carriers and notes that 25% of the 1.2 billion iPhone user base has not upgraded their iPhone in four years. Before delving into this thesis, let's first summarize what we can expect from Apple's announcements.

What we already know about the Apple event

This Tuesday's Apple event will focus on the new iPhone, but we don't know much else about the upcoming product line. As tradition dictates, the focus will be on the new iPhones but, as far as we know, we will see the following content:

iPhone 15 and iPhone 15 Plus

The speculation mainly revolves around minor improvements for the standard iPhone models: the iPhone 15 and iPhone 15 Plus. Historically, these models are expected to feature the A16 chipset, following in the footsteps of the iPhone 14 Pro series. Rumors also suggest a slimmer bezel design, the integration of a dynamic island, and a revamped rear camera with a large upgrade. 48 megapixel wide angle. In particular, the familiar Lightning port connector may give way to a more conventional USB-C counterpart, although this change may not be universally accepted. Location-based capabilities across the new iPhone lineup could get a boost with the addition of a U2 ultra-wideband chip, marking the first significant update to the U1 since its debut in 2019. Apple's plan includes introducing U2 on their new iPhones before extending it. its use to other devices.

iPhone 15 Pro and iPhone 15 Pro Max

The iPhone 15 Pro models are set for more substantial improvements. These devices are anticipated to have a slightly larger form factor due to thinner edges, accompanied by a titanium chassis to improve durability and reduce weight by approximately 10%. Most significantly, the Pro variants will be powered by the cutting-edge A17 chipset built on an innovative 3-nanometer production process. This new chipset is expected to offer improvements in both battery life and overall performance. Additional updates may include new telephoto and ultra-wide-angle camera lenses. It's worth noting that the traditional mute switch can be replaced on Pro models with a versatile "action button" with multiple configurable functions, possibly serving as the camera's shutter button. The iPhone 15 Pro Max is expected to receive the most substantial update, with a 5-6x optical zoom lens. Importantly, the new Pro models are expected to have a higher price.

Apple Watch Serie 9

Expectations for the Apple Watch Series 9 suggest relatively minor changes, with more significant updates potentially scheduled for next year. A possible addition could be the Apple Watch Ultra. Both the Ultra 2 and Series 9 are likely to benefit from new processors and color options.

Airpods

Once again, the prospects for the new AirPods are not too transformative and will possibly be limited to the introduction of a separate USB-C charging case.

Other bets

Beyond the major product announcements, other possibilities emerge for Tuesday's event. These may include a closer look at the Vision Pro (remember the $3,500 price tag), the possible launch of a new HomePod mini, and perhaps an updated iPad Mini. While these developments may not create a sensational stir, there is always the remote possibility of an unexpected "Apple Surprise."

Strategic consultation: Will customers transition to more expensive Pro models?

Apple has devised a solid iPhone pricing strategy, keeping prices for the base model stable while gradually increasing prices for the Pro versions, incentivizing customers to upgrade. This approach bolsters the average selling price of iPhones and makes it easier for “budget-conscious” customers to enter the Apple ecosystem. This strategy takes on greater importance this year, as the base iPhone 15 is not expected to feature dramatic improvements.

iPhone 15 price rumors have varied, but the predominant expectation is a price increase for the Pro models, with most sources predicting a $100 increase for both Pro versions, with some suggesting a more substantial increase for the Pro Max. Recent price estimates indicate the following possible price adjustments (source: New iPhone 15, iPhone 15 Pro Price Changes Leak):

• iPhone 15: from $799 (no changes)
• iPhone 15 Plus: from $899 (no changes)
• iPhone 15 Pro: from $1,099 (up $100)
• iPhone 15 Pro Max: from $1,299 (up $200)

The reason behind the high price comes from the inherent higher costs associated with titanium compared to stainless steel, along with the added expense of integrating the "periscope" lens upgrade for the Pro Max. Apple's confidence in convincing customers to opt for the more expensive Pro variants is based on several compelling factors:

1. Improved performance: The upcoming A17 chip promises faster speeds and, more importantly, longer battery life.
2. Premium Materials: Some consumers may be drawn to the appeal of the new titanium casing.
3. Superior Cameras: Pro models feature improved ultra-wide-angle and telephoto lenses, improving photography capabilities.
4. Pro Max Previews: The iPhone 15 Pro Max, with its expanded hardware zoom lens, justifies the potential $200 price increase, making it especially appealing to photography enthusiasts. This may even convince previous users of the Pro model to migrate to the new Pro Max.
5. Financial Flexibility: Upgrade, subscription and leasing programs mitigate the impact of price increases by spreading the increase over slightly higher monthly payments.
6. Incentives for carriers: Many US carriers are expected to offer discounts on iPhone Pros as a means of attracting new customers.
7. Prestige Factor: Pro versions have a distinct prestige value.

Recent sales projections underline the growing popularity of iPhone Pro models. According to 2023 iPhone sales estimates from technology research firm Omedia, the first half of 2023 witnessed the following iPhone sales figures:

• iPhone 14 Pro Max: 26.5 million
• iPhone 14 Pro: 21.0 million
• iPhone 14: 16.5 million
• iPhone 13: 15.5 million

If these sales trends continue, the annualized figures could result in revenue increases ranging from approximately $10 billion to $15 billion, taking into account price increases of $100 or $200 for the Pro Max. While this might not be a radical change, it does mean a notable increase for Apple, which is eager to sustain its iPhone revenue.

Apple stock performance

AAPL.US D1. Source: xStation

Apple has been one of the most prominent large-cap players over the past two decades. The first decade was characterized by groundbreaking innovation, and the following decade saw an increase fueled by an aggressive share buyback program. The recent rally over the past five years has arguably been driven by the expansion of its price-earnings multiple, as investors began to recognize the value of its dedicated ecosystem.

In a climate where U.S. investors appear increasingly wary of Chinese stocks (as evidenced by Alibaba's (BABA) valuation), it's intriguing to note Apple's ability to maintain premium valuations even while being significantly exposed to potential fallout. of the tense relations between the United States and China.

Key metrics of Apple

Apple Q3-23 Update, Source: Apple

During the third quarter, Apple effectively managed to maintain stable operating expenses. Although there was a 9.5% increase in Research and Development (R&D) spending, this was partially offset by a slight drop in selling, general and administrative (SG&A) costs. Additionally, a decrease in the income tax rate from 15.7% to 12.5% contributed to a 2.3% year-over-year increase in net income.

Apple encountered a challenging comparison with previous quarters in terms of Mac and iPad sales, which showed limited growth. On the contrary, the segment that stood out was Services, which registered a growth rate of 8.2%. The Services division, characterized by high profit margins and recurring revenue, remains a key bullish driver. This resilience is particularly notable considering the difficult economic conditions prevailing.

At the end of the quarter, Apple had an impressive cash reserve and investments of $166.6 billion, compared with debt of $109.3 billion, underscoring its strong net cash balance sheet position. The company allocated $18 billion for share buybacks in the quarter and share buybacks are anticipated to remain substantial in the near future as part of Apple's goal of achieving a leverage-neutral position.

Looking ahead, Apple management expects headwinds to persist into the third quarter. Unlike some of its tech counterparts, who forecast currency tailwinds, Apple expects currencies to negatively impact growth by more than 2 percentage points.

During the conference call, management indicated that Mac and iPad sales are expected to maintain current challenges, while iPhone and services are anticipated to witness a sequential acceleration in growth. To increase market share, management emphasized the strategy of improving affordability, noting that more than 50% of iPhones are sold through various programs, trade-ins, installment plans or financing options. In response to the challenging economic climate, Apple could leverage even more promotional activities if conditions worsen.

Regarding generative AI, management revealed that they have been conducting research on various AI technologies for an extended period, but emphasized their reluctance to discuss future products in the pipeline until they are ready for release. It appears that Apple is following a measured and deliberate approach, similar to its strategy for building its ecosystem.

Valuation

Apple Historical valuations: Source: seekingalpha

We have already briefly commented on this valuation ratio at the beginning. The current earnings multiple could look quite expensive compared to consensus projections for modest to high single-digit revenue growth for the foreseeable future. However, the key insight here is that Apple has earned a premium valuation similar to that of consumer staples stocks. Apple has a dedicated and expanding user base, a loyalty that not only improves customer retention during device upgrades but also bolsters its service revenue stream.

What makes this even more compelling is that Apple has the potential to introduce additional products and services to its loyal ecosystem. Its foray into consumer banking has been successful: customers have deposited more than $10,000 million. Apple Pay is quickly gaining traction and accounts for approximately 12.6% of online payments.

Conclusión

Apple's pricing strategy is set to remain effective, at least in the short and medium term. Apple acknowledges that it has largely saturated the iPhone unit sales market, making iPhone revenue a critical focal point. The pricing approach represents the most strategic means to maintain or increase iPhone revenue.

This pricing strategy should underpin revenue growth for fiscal 2024 and potentially beyond. Consequently, the market prediction of a 20% increase in share price over the next year may actually be plausible if it manages to steer customers towards the higher-priced variants.

Initially, the market reaction to these price increases may be negative as many investors may not understand the importance of the pricing strategy. Immediately afterwards, a drop in the share price could occur due to these unfavorable reactions. However, in the long term, it is a sustainable strategy to improve income.

As for China, it is critical that investors not underestimate the extent to which the Chinese government is willing to limit Apple's presence in the market. This is especially relevant in the context of growing technological competition between the United States and China. About a fifth of Apple's revenue is potentially at stake in China. While Apple expresses optimism about its growth prospects in India, the company will need to demonstrate that revenue expansion in this region can offset any revenue losses incurred in China.

Given the increasing international risks facing Apple, it may be prudent for investors to temporarily refrain from purchasing Apple stock. Amid the ongoing revolution in generative AI, Apple is the only member of the Magnificent 7 group that has yet to outline its strategy to thrive in this new era. Without a doubt, Apple's potential in this area is substantial. However, considering that other Magnificent 7 companies are already demonstrating (or at least showing great promise for) their ability to excel in AI, investors may find it more attractive to allocate additional capital to those stocks rather than Apple.

Darío García, EFA
XTB Spain