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Apple: Services Boost Earnings
Revenue growth has stalled but margins continue to expand
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Apple (AAPL) recently reported its Q4 FY23 earnings (ending in September).
While overall revenue growth showed signs of stalling, profits continued to expand. The Services segment was once again the star of the show for the world’s biggest company. Let’s put it in context.
Today at a glance:
Apple’s Q4 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
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1. Apple Q4 FY23
Here is the bird’s-eye view of the income statement.
Revenue declined by 1% Y/Y to $89.5 billion (in line with expectations).
Products (75% of overall revenue) fell -5% Y/Y.
📱 iPhone (49% of total revenue) grew +3% Y/Y.
💻 Mac (9% of total) declined -34% Y/Y.
🖊 iPad (7% of total) dropped -10% Y/Y.
⌚️ Wearables (10% of total) fell -3% Y/Y.
Services (25% of overall revenue) grew +16% Y/Y.
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 (estimated at $20 billion per year).
Here’s a breakdown of Apple’s quarterly revenue in the past five years. While hardware revenue follows the ebb and flow of new product releases, the Services segment has grown consistently.
The charts below show the steady rise of Services, reaching 25% of revenue (a record for the September quarter).
Gross margin was 45% (+3pp Y/Y).
Operating margin was 30% (+3pp Y/Y).
EPS (earnings per share) grew +13% to $1.46 (a $0.07 beat).
Operating cash flow in FY23 was $111 billion (29% margin, -2pp Y/Y).
Cash, cash equivalent, and marketable securities: $162 billion.
Total debt: $111 billion.
Q1 FY24 Guidance (December quarter):
CFO Luca Maestri provided the following directional insights:
Revenue is expected to be flat year-over-year despite having one less week. In 2022, the December quarter spanned 14 weeks instead of the usual 13 weeks, boosting revenue by roughly 7 percentage points last year.
iPhone revenue is expected to grow, excluding the extra week last year.
Mac is expected to accelerate significantly sequentially. Apple just unveiled the next generation of Apple silicon with M3 chips.
Meanwhile, iPad and Wearables are expected to decelerate due to the timing of product launches. New iPads, AirPods, and Watches were launched in the December quarter a year ago.
Services are expected to maintain a similar double-digit growth as Q3.
So what to make of all this?
Apple is still growing, but the strong dollar adversely impacted revenue throughout FY23. In Q4, revenue grew by 1% Y/Y in constant currency. It perfectly matched the guidance provided last quarter. All geographic regions grew on a constant currency basis. Emerging markets saw double-digit growth for both iPhone and Services.
Apple continued to grow its install base of over 2 billion active devices. The installed base of active iPhones reached an all-time high thanks to new switchers.
📱 iPhone revenue was ahead of expectations, driven by strength in emerging markets, including a record in India. Tim Cook highlighted the iPhone 15 Pro and Pro Max are still constrained due to high demand.
💻 The 34% Y/Y drop in Mac sales is misleading due to a difficult compare. In 2022, the June quarter was supply-contained, leading to pent-up demand in the September quarter. In addition, the MacBook Air launched in the September quarter of last year, compared to the June quarter in 2023.
🖊 iPad revenue was down 10% Y/Y, for similar reasons. Half of the customers purchasing an iPad in Q4 were new to the product.
Wearable, home, and accessories declined 3% Y/Y. Two out of every three Apple Watch buyers were first-time buyers.
Services reached a new all-time revenue record of $22.3 billion, growing +16% Y/Y, accelerating from +8% Y/Y in the previous quarter. Apple set new records in every Services category. The growth was attributed to double-digit growth in transacting and paid accounts. Apple now has “well over 1 billion paid subscriptions.”
How big are Services? To put the $22.3 billion revenue into perspective — it was more than the combined revenues of Netflix, Mastercard, Spotify, Electronic Arts, Dropbox, and Peloton in the same quarter.
Services accounted for 40% of Apple’s gross profit (+4pp Y/Y). If you are a regular reader of this newsletter, you know the story by now. Services, which are digital products, have a higher gross margin profile than hardware products. As a result, they make a larger share of gross profit. The “Apple-as-a-Service” thesis continues to play out. Services are slowly making a larger share of the revenue, resulting in a gradual improvement in the margin profile of the business. Analysts predict Apple's profit growth will continue to outpace its revenue growth.
Apple returned $93 billion to shareholders in FY23: $15 billion in dividends (+1% Y/Y) and $78 billion through stock buybacks (-13% Y/Y). Apple continues to return most of its cash to shareholders via buybacks, which explains why the earnings per share (+13% Y/Y) is growing faster than the net income (+11% Y/Y).
2. Recent business highlights
🔎 Google’s exclusive deal at stake
In the US v. Google antitrust trial, we learned that the search giant paid $26 billion in 2021 to be the default search engine everywhere (Safari, Firefox, and more).
Google pays Apple an estimated $20 billion annually to keep its search engine the default on Apple’s Safari web browser. That would make it nearly a quarter of Apple Services revenue in FY23. 👀
For Alphabet, it’s a Traffic Acquisition Cost (TAC) — see cost of revenue breakdown in the chart below.
For Apple, that payment is part of Services revenue. Think of it as a minimum guarantee. Some of it involves a revenue share, and I imagine Apple categorizes it as advertising revenue (unfortunately, they don’t break it down for us).
When asked about what caused the acceleration in Services revenue growth in Q4, Maestri said the growth was coming from everywhere:
“From a category standpoint, literally, we set records in each one of the big categories. We had all-time record for App Store, for advertising, for cloud, video, AppleCare, payments and a September quarter record for Music. So it's hard to pick, one in particular because they all did well.
And really then, we step back and we think about why is it that our Services business is doing well and it's because we have an installed base of customers that continues to grow at a very nice space and the engagement in our ecosystem continues to grow.”
In short, Apple is growing its install base of active devices, and the engagement on these devices is increasing. These effects can compound and are the main force behind the double-digit growth across all service categories, from TV+ to Apple Arcade to iCloud.
Since Google’s TAC payment is included in Services, it could be another contributing factor in the recent accelerating growth.
💳 New prices across Services
Another factor contributing to the Services growth in the next quarter will be the recent price hike across several categories:
One: $16.95 → $19.95/month.
📺 tv+: $6.99 → $9.99/month.
🕹️ Arcade: $4.99 → $6.99/month.
📰 News+: $9.99 → $12.99/month.
A price hike implies management is happy with the current conversion and churn. It’s an indication of the pricing power of its flagship paid subscriptions.
🇨🇳 Apple and China
Greater China was nearly 19% of Apple’s revenue in FY23, making it a critical market to watch. Apple grew revenue in China by 4% Y/Y in constant currency in Q4 FY23.
Tim Cook explained:
“If you look at the categories, iPhone actually set a September quarter record in mainland China. And the -- what pulled down the performance was a combination, largely of Mac and iPad.”
Mac and iPad faced the same challenging comparisons in China as the other territories, but it was more than offset by the growth of iPhone and Services.
Huawei exited the smartphone market in 2021 due to US sanctions that prevented it from accessing key technologies. The company is back in the market in 2023 thanks to its own operating system, HarmonyOS, and growing semiconductor manufacturing capabilities. While Huawei’s exit benefited Apple in 2021, its comeback is now a headwind for the Cupertino giant.
Questioned on Huawei's return in the high-end phone space, Cook added:
“I don't know what every quarter will hold. And obviously, we just give a bit of color on the current quarter. But over the long term, I view China as an incredibly important market and I'm very optimistic about it.”
Data from Counterpoint Research reveals a 3% dip in China's overall smartphone sales year-over-year, a softer decline than in Q2, indicating that we could be closer to a bottom.
Counterpoint tracked a 10% decline in smartphone sales for Apple despite the iPhone hitting a new record during the quarter. So, the price mix may have played a role. A clear trend emerges: Huawei is back with a bang, with an estimated 37% growth year-over-year thanks to the Mate 60 launch.
3. Key quotes from the earnings call
In February 2023, Apple disclosed a 2 billion active devices install base, a 150 million increase or +8% Y/Y. While we didn’t get an exact number since then, the growth story has been all about high retention and people switching to iPhones.
Management always highlights customer satisfaction with the iPhone, which 451 Research recently measured at 98% in the US. In short, iPhone sales have slowed down, but it’s not because users are leaving Apple. They are merely delaying their next upgrade.
An essential factor in the growing install base and improving gross margin has been the financing options offered by Apple. Maestri explains:
“One of the things that we've done well over the last few years is to offer more affordability solutions to our customers in the form of instalment plans, trading options, and spend -- low-cost financing in general.
And what that has accomplished is reduced the affordability threshold for our customers and therefore, they can, buy at the top of our product ranges. That has been a big factor in the reason for our margin expansion.”
Tim Cook expanded on India:
“We grew very strong double-digits. It's an incredibly exciting market for us and a major focus of ours. We have low share in a large market, and so it would seem there's a lot of headroom there. […] We see an extraordinary market, a lot of people moving into the middle class, distribution is getting better, lots of positives. We put two retail stores there, as you know. They're doing better than we anticipated..”
Tim Cook provided some color on the new record for the segment:
“We achieved all-time revenue records across App Store, advertising, AppleCare, iCloud, payment services, and video, as well as the September quarter revenue record in Apple Music.”
On Apple TV+:
“We're proud to say that since launch, just over four years ago, Apple TV+ has earned nearly 1,600 award nominations and nearly 400 wins.”
The company stays away from sharing any subscriber numbers. Based on the latest data from Nielsen, Apple TV+ is still a tiny portion of US TV time (less than 0.8%). We cover it in more detail in our recent review of Netflix earnings.
Highlighting their MLS partnership, Cook added:
“Subscriptions to MLS Season Pass have exceeded our expectations and we're excited to continue that momentum next year.”
While the numbers may be ahead of expectations, Antenna's data shows that the interest in the MLS remains relatively low.
CFO Lucas Maestri on margin gains:
“We're obviously experiencing very strong levels of gross margin. The 45.2% was a record for the September quarter. And then, the guidance for Q1 is obviously strong at 45% to 46%. Our gross margins are affected by multiple factors. […] obviously, growth in Services for us is favorable, and that has helped our company gross margin.”
4. What to watch looking forward
🤖 Generative AI
With so many announcements around Generative AI from the other Magnificent 7, Apple has been relatively quiet. Tim Cook explained:
“In terms of generative AI — obviously, we have work going on. I'm not going to get into details about what it is, because — as you know, we don't — we really don't do that. But you can bet that we're investing, we're investing quite a bit, we're going to do it responsibly and it will — you will see product advancements over time that where the — those technologies are at the heart of them.”
While Google has introduced many products several months before they become generally available (like Bard and the Search Generative Experience), Apple likes to announce new software products only when they are ready to ship. So it’s not surprising to see Apple keep Generative AI developments close to its chest.
Bloomberg reported that Apple is developing its own AI chatbot, similar to OpenAI's ChatGPT. Codenamed "Ajax," Apple is purportedly trialing an internal tool dubbed "Apple GPT." But Ajax is rumored to be less powerful than OpenAI’s latest models.
Apple Vision Pro
We gave you a full breakdown of what you should know about the Apple Vision Pro on our YouTube channel.
Tim Cook provided an update:
“Apple Vision Pro, which has gotten such an amazing response from developers who are currently creating truly incredible apps. We're excited to get this magical product in the hands of customers early next year.”
The launch will look different than a typical Apple product:
“There's never been a product like the Vision Pro. And so, we're purposely bringing it out in our stores only, so we can really put a great deal of attention on the last mile of it. We'll be offering demos in the stores and it will be very different process than a normal grab-and-go kind of process.”
According to the Financial Times, Apple has a target of 400,000 units in 2024, a slashed forecast from one million units due to manufacturing challenges. That would represent roughly $1.4 billion in revenue or 3% of the Wearables category.
This V1 of the product will help Apple iterate and refine its approach. We are probably many years from a significant product adoption, and it will require multiple iterations before it can reach a mass appeal.
As always, there is more to Apple than the headlines about declining revenue growth. As Services drive margin expansion, the real story is in the ecosystem and its exceptional retention.
Warren Buffett touched on the company’s brand power:
“If you're an Apple user and somebody offers you $10,000, but the only provison is they'll take away your iPhone, and you'll never be able to buy another, you're not going to take it.”
That’s it for today!
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Disclosure: I am long AAPL in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members.
Author's Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization's views.