📱 Apple: Diving into Mixed Reality
A groundbreaking announcement might be in store at the June conference
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It's almost time for a new earnings season, and we haven't yet reviewed the latest quarter of the world's largest company, Apple (AAPL). So let's fix that today!
Remember, Apple's fiscal year ends in September. So, when I mention Q1 FY23, it refers to the quarter ending December 2022.
The Apple-as-a-Service story continues to thrive, with Services accounting for 18% of Apple's Q1 FY23 revenue (+2pp Y/Y). For context, Services made up just 10% of Apple's revenue in Q1 FY18.
While the iPhone remains the majority of Apple's top line, its share has decreased.
So, how big are Apple Services now?
With $20.8 billion in Q4 calendar 2022, it surpassed Netflix, Mastercard, Spotify, and Warner Bros. Discovery's DTC segment (including HBO Max) — combined!
Recent AI announcements from Microsoft and Google have taken the spotlight, but Apple might soon steal the show. Rumors suggest a big reveal at the next Worldwide Developers Conference (WWDC) on June 5. Although WWDC typically focuses on software, Apple could unveil its long-awaited AR/VR headset (AKA “mixed reality” or “XR”).
Could this mark the beginning of the post-iPhone era? A robust xrOS and a new software development kit for developers could pave the way for a thriving ecosystem (more on that in a minute).
With a milestone of 2 billion active devices (+8% Y/Y), Apple has the power to shake up the tech world with its product releases.
Today, we’ll cover the following:
Apple’s Q1 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
Also, check out our second video on the How They Make Money YouTube Channel! This video dives into Apple's AI initiatives that you might have missed in recent months, including Stable Diffusion.
Let’s look at the most recent quarter.
1. Apple Q1 FY23
Here is the bird’s-eye view of the income statement.
Revenue declined -5% Y/Y to $117 billion (a $4.5 billion miss).
Products (~82% of overall revenue) fell -8% Y/Y to $96 billion.
📱 iPhone (56% of total revenue) declined -8% Y/Y to $66 billion.
💻 Mac (7% of total) declined -29% Y/Y to $8 billion.
🖊 iPad (8% of total) grew +30% Y/Y to $9 billion.
⌚️ Wearables (12% of total) declined -8% Y/Y to $14 billion.
Services (~18% of overall revenue) grew +6% Y/Y to $21 billion.
It includes the App Store, Apple Music, Apple Pay, AppleCare, Apple TV+, Apple Arcade, Apple Fitness+, iCloud+, and more. They also include that juicy annual payment from Google to remain the default search engine on Apple devices.
Gross margin was 43% (-1pp Y/Y).
Operating margin was 31% (-2pp Y/Y).
EPS (earnings per share) decreased by 10% to $1.88 (a $0.07 miss).
Operating cash flow was $34 billion (29% margin, -9pp Y/Y).
Cash, cash equivalent, and marketable securities: $165 billion.
Total debt: $109 billion.
Q2 FY23 Guidance:
Apple hasn’t provided guidance since 2020, citing uncertainty.
CFO Luca Maestri provided the following directional insights, assuming the macro outlook and COVID-related impact don’t worsen from here:
Overall Y/Y revenue growth in Q2 FY23 is expected to be the same as in Q1 FY23. It implies an acceleration because Q1 FY23 benefited from an extra week compared to Q1 FY22. Management expects a 5pp fx headwind.
Services would grow, but not as fast (due to macro headwinds in digital advertising and mobile gaming).
iPhone is expected to re-accelerate following the inventory shortages in Q1 FY23.
Mac and iPad are expected to decline double digits year-over-year because of tough comparisons and macro headwinds.
So what to make of all this?
The strong dollar adversely impacted the recent performance, with over 800 basis points of negative foreign exchange impact in Q1 FY23. So while revenue declined by 5% Y/Y, it grew +3% Y/Y on a constant currency basis. The iPhone revenue was flat fx neutral.
Apple saw growth in active devices across all product categories and geographic segments. In addition, the installed base of active iPhones reached an all-time high.
Supply shortages for iPhone 14 Pro and iPhone 14 Pro Max lasted through December. So the flagship iPhone models with the highest ASP (Average Selling Price) were supply constrained.
Services reached a new all-time revenue record of $20.8 billion, growing +6% Y/Y, or +13% Y/Y in constant currency (a better representation of the long-term growth profile of the segment).
Services accounted for 29% of Apple’s gross profit (+3pp Y/Y). The Apple-as-a-Service thesis isn’t new, but it continues to materialize. Services are slowly making a larger share of the revenue, resulting in a gradual improvement in the margin profile of the business. As a result, most analysts expect earnings growth to outpace revenue growth in the coming years.
Is the business sustainable?
Analysts expect operating cash flow to increase steadily in the coming years (in the high single-digit). In Q1 FY23 alone, Apple generated $34 billion in cash from its operations.
The company is returning most of its cash to shareholders. To illustrate, Apple continues to use the majority of its cash generated from operations toward stock buyback ($19.5 billion) and, to a lesser extent, toward dividends ($3.7 billion in Q1 FY23). As a result, the EPS (-10% Y/Y) didn’t decline as much as the net income (-13% Y/Y).
2. Recent business highlights.
💳 Apple Pay Later
Apple Pay saw a record-breaking number of purchases during the holiday shopping season, and the company now has over 935 million paid subscriptions across its services platform.
CFO Lucas Maestri:
“We started off primarily in the United States. Now we've taken it to 70 markets, millions of merchants.”
Apple Pay Later just launched in the US after a slight delay from its original September 2022 plan for technical reasons.
✅ Select users invited to pre-release.
✅ Full rollout to eligible users coming soon.
So, how do Apple Pay Later loans work?
💰 Range: $50 to $1,000.
💳 Managed within Apple Wallet.
💸 No interest or fees for 6-week payments.
While this feature is free for the consumer, Apple will gain from merchant fees.
🇨🇳 Apple and China
When asked about China, Tim Cook acknowledged a 7% decline on a reported basis but said the company grew on a constant currency basis. In addition, he noted an increase in demand as COVID restrictions eased in December.
Cook just visited China for the first time since the pandemic:
"Apple and China... grew together and so this has been a symbiotic kind of relationship that we have both enjoyed. I am thrilled to be back in China. It means the world to me and I feel really privileged to be here."
With 95% of iPhone supply coming from China, Apple is reportedly exploring options to expand assembly operations beyond its current focus.
3. Key quotes from the earnings call
Tim Cook updated the numbers on Apple’s install base of active devices:
"[...] we now have more than 2 billion active devices as part of our growing installed base, double what it was just 7 years ago. This is an incredible testament to our products and services and the strength of our ecosystem."
That’s good for a 150 million increase or +8% Y/Y. Part of this success is attributed to the switchers to the Apple ecosystem.
CFO Lucas Maestrri added:
“Installed base is the engine for Services growth. And the fact that the installed base is growing very nicely, and it's growing in a lot of emerging markets, it's growing even faster, that gives us a larger addressable pool of customers.”
Numerous analysts during earnings calls emphasize the growth of specific hardware and the effect of the average selling price (ASP) on revenue to determine whether the company will meet expectations next quarter. However, the true long-term narrative is best reflected by the growth of the overall install base.
Engagement is growing faster than the install base:
“Both our transacting accounts and paid accounts grew double digits year-over-year, each setting a new all-time record.”
CFO Lucas Maesti:
“We now have more than 935 million paid subscriptions across the services on our platform, up more than 150 million during the last 12 months alone and nearly 4x what we had just 5 years ago.”
Tim Cook addressed the challenging macroeconomic environment, including inflation, the war in Eastern Europe, and the ongoing impacts of the pandemic. He emphasized Apple's ability to adapt quickly to circumstances outside its control:
"[...] our approach is always the same. We are thoughtful and deliberate. We manage for the long term. We adapt quickly to circumstances outside our control while delivering with excellence in the things we can."
Cook acknowledged that the ongoing macroeconomic challenges and foreign exchange headwinds affected Apple's financial performance but remained confident in the company's long-term potential.
“We saw very good results in our cloud services business in payment services. Music was very strong. So we had a number of categories that set new records, all-time records. And they did a bit better than we were expecting at the beginning of the quarter.”
Management doesn't provide a detailed breakdown of Services revenue, but keeping an eye on the subtle clues they offer us is essential.
Cook highlighted their partnership with Major League Soccer, Fitness+ updates, and the introduction of Apple Business Connect to help small businesses:
“This new tool gives business owners even more control over how billions of people see and engage with their products and services every day. Businesses of all sizes can now customize key information for users across Apple Maps, Messages, Wallet, Siri and other apps.”
iPhone: Cook praised the iPhone 14 lineup's camera capabilities, battery life, and health features. He expects a rebound after the recent shortages.
Mac: Revenue was in line with expectations, despite difficult comparisons to the previous year's M1 MacBook Pro launch. Tim Cook touched on the opportunity ahead:
“Over the long run, we have a market that is a reasonable-sized market, a big market. And we have low share, and we have a competitive advantage with Apple silicon. And so strategically, I think we're well positioned in the market, albeit I think it will be a little rough in the short term.”
iPad: Revenue grew +30% Y/Y, with customers praising the versatility of the iPad Pro and iPad 10th Generation.
Wearables, Home, and Accessories: This category was flat on a constant currency basis. Cook mentioned the next-generation HomePod and praised Apple Watch Series 8 and Apple Watch Ultra.
4. What to watch looking forward
🤖 Apple’s AI potential
Apple may not tout AI/ML technologies as much as competitors, but if you’re an Apple user, you’ve interacted with their AI daily.
📱 Apps: Language translation, on-device dictation, health features (sleep and hand washing), portrait and cinematic mode, the list goes on.
♿ Accessibility: Sound detection capabilities, fall detection, natural language processing and voice recognition (Siri), or image detection and computer vision (Face ID).
🎧 Content: They recently launched AI-voiced audiobooks.
🎨 Generative AI: Stable Diffusion is an open-source deep learning, text-to-image model released in 2022. Apple released optimizations that allow Stable Diffusion to run on Apple Silicon using Core ML, Apple's framework for ML models. Stable Diffusion is already an impressively small model that could run locally on an iPhone. Now, developers can use Apple Neural Engine hardware to run Stable Diffusion about twice as fast as the previous Mac-based method. It has significant ramifications because it allows using the model without an internet connection and eliminates server costs. It also fits Apple’s “privacy” brand.
As explained in our latest YouTube video covering Apple and AI:
“It seems likely that future Apple chips will be tuned for Stable Diffusion. Just like the other big tech companies, their success is going to depend on how well they can vertically integrate AI into their own tech stack from chip to software, to capture day to day consumers to get things done more easily on Apple products, and even ML developers to run ML workloads on their hardware.”
While Microsoft is trying to complete its colossal $69 billion investment in Activision Blizzard, Apple has yet to employ its substantial cash reserves for a significant acquisition.
Given Apple's ability to serve an installed base of 2 billion devices, any strategic acquisition could have monumental implications, unlocking tremendous value for the acquired business. Analysts love discussing potential targets. But for now, it’s all speculative.
Apple’s mixed reality (XR)
Here is what to expect for the June 5 event, according to Macrumors:
“Apple's AR/VR headset will combine augmented and virtual reality, and it is expected to be priced around $3,000. It will feature 4K micro-OLED displays, a comfortable headband, a mesh material that goes against the face, and high-end features like iris scanning for authentication and facial expression detection.”
Bloomberg suggested this week the headset will be a “risky, but potentially monumental launch for Apple:.”
“The showcase at WWDC, the Worldwide Developers Conference, will likely include the headset itself, but also its onboard xrOS operating system, accompanying services, and — perhaps most critically — a software development kit and platform that will let developers write new types of apps.”
Several analysts went as far as speculating that the WWDC graphic could evoke the curved shape of the expected Apple headset. 🧐
According to the Financial Times:
“Apple’s famed industrial design team had cautioned patience, wanting to delay until a more lightweight version of AR glasses became technically feasible. Most in the tech industry expect that to take several more years. In deciding to press ahead with a debut this year, Cook has sided with operations chief Jeff Williams, according to two people familiar with Apple’s decision-making, and overruled the early objections from Apple’s designers to wait for the tech to catch up with their vision.”
After all, it took a few generations for the iPhone to become the massive hit it is today. The iPhone 3G in 2008 comes to mind. Each subsequent generation brought new features, improvements, and refinements that attracted more customers and solidified the iPhone's dominant position in the smartphone market.
So the first XR headset doesn’t have to be perfect.
That’s it for today!
Stay healthy and invest on!
Disclosure: I am long AAPL in the App Economy Portfolio. I share my AAPL rating (BUY, SELL, or HOLD) with App Economy Portfolio members here.