Apple (AAPL, Financial) is one of the most influential consumer electronics companies in the world today. It is renowned for its innovative designs, user-friendly software and sleek hardware. It has been a leader in the technology industry for several decades, and it is not surprising that it has become one of the top tech leaders worldwide.
In fact, Apple's business model and reputation are so strong that the stock is up over 15% in the last month, despite its recent quarterly report missing the mark compared to analysts' estimates.
Apple's profits have been rising steadily over the years, showing no sign of slowing down. With a growing service revenue source, Apple's profitability could continue improving.
Both supply chain and demand issues have hurt high-end iPhone sales in recent years due to a wide variety of factors, most notably Covid and the ongonig economic slowdown. Nevertheless, with healthy financial liquidity and an enduring business model, I believe Apple is still undervalued compared to its long-term potential.
Don't judge Apple on just one bad quarter
In 2022, the macroeconomic environment became quite challenging. Rising inflation and interest rates have hurt consumer buying power, which is a big problem for the U.S. economy because a weaker consumer means less spending on non-essentials. It's also bad for companies that rely on debt to keep the lights on, but fortunately Apple does not fall into that category.
Amid this backdrop, it is not a surprise that Apple missed the mark when it delivered its earnings report on Feb. 2. The quarter wasn't easy for Apple. Furthermore, Apple faced supply shortages in October and November as it saw limited production from supplier Foxconn (TPE:2354, Financial). Many would-be iPhone buyers have been impacted the Covid production challenges, which lasted through most of December. CEO Tim Cook said Covid-related challenges "significantly impacted" the delivery of its iPhone 14 Pro and iPhone 14 Pro Max set throughout December.
Nevertheless, analysts were expecting more from Apple this time around. Revenue fell 5% in its fiscal first quarter to $117.15 billion, down from $123.95 billion last year, and net income declined more than 13% to $30 billion from $34.63 billion.
Generating substantial cash flow from operations is vital for Apple since its long-term debt has been rising for several years and now stands at close to $100 billion. Operating cash flow came in at $35 billion. While Apple has a history of creating shareholder value, these figures are worrying.
A positve was that Apple's total revenue included a record $20.8 billion from its services business, up 6.4% year-over-year. The segment has become a significant revenue spinner for the company in recent quarters and will help tremendously in margin improvement. Once the user gets locked into the Apple ecosystem, the key is to get the user to spend more money. Hardware upgrades are less frequent, but services will be purchased more frequently. Apple understands this, which is why it is focusing on this model.
Bringing production in-house
A potential red flag is that Apple's liquidity ratios have been on the decline since 2020. The company's current and quick ratios show that it is struggling with an increasing debt load, which could make it more sensitive to interest rate hikes. The current ratio is a simple measure of the company's ability to cover its current liabilities with its current assets. The quick ratio excludes the inventory from the calculation and therefore provides a more stringent benchmark for the company's financial strength. The current ratio for Apple stands at 0.94 as of this writing, which is far worse than the average of 2.3 it has recorded in the last 10 years. At the same time, the quick ratio is 0.89. Again, this compares unfavorably with the 10-year average of 1.89.
What's behind Apple's newfound debt problem? Part of it is due to more investments in research and development. Starting with certain models in 2020, Apple started using its own proprietary silicone chips in some of its products.
The advantages of this approach are certainly there for all to see. Not only does Apple benefit from cost savings, but it also gains significant expertise from keeping this aspect of its business in-house. Overall, I think this investment has and will continue being worth the upfront costs.
After this experiment's success, Apple is planning on adding its chips to more products. Previously, Apple relied on Intel (INTC, Financial) for its chip needs. However, Apple is moving towards self-reliance.
In a connected move, Apple will reportedly stop acquiring Wi-Fi and Bluetooth chips from Broadcom (AVGO, Financial) by 2025. The company will also use its modem instead of the one sourced from Qualcomm (QCOM, Financial). More than 20% of Qualcomm and Broadcom revenues come from Apple.
While Apple will likely lower costs with its modems and Bluetooth chips, it will need to ensure that all of its replacement parts work as well as the existing ones, which could take some time. Nonetheless, the move should pay off long-term and help margin expansion.
U.S.-China tensions are a concern
The U.S.-China trade war encompasses every sphere. However, the focus on technology has been acute, with the U.S. recently restricting its companies from selling the most modern chips, equipment and technology to China. Since China is currently where the vast majority of chips are actually produced, this is a huge blow to the entire semiconductor industry, but especially to U.S. companies that outsource their chip production to China.
The company has heavily invested in its China-based partners to manufacture some of its premier products, including iPhones. With deteriorating trade conditions between the two countries, Apple is looking to shift its manufacturing base. Countries like India and Vietnam are likely candidates for new factories. However, this will take considerable time and cost. All the while, Apple still relies on China for its products, with the added bonus of the U.S. government restricting operations.
There is no quick fix for this issue. It is a concern the tech giant will have to manage, and it will likely cost Apple dearly to re-establish huge chunks of its supply chain.
Takeaway
The mixed earnings report is a rare misstep for Apple, which has otherwise had a consistent record of growth. Many of the issues Apple is facing are outside of its control. Once the supply chain issues improve and the broader economy comes back to life, Apple will also benefit.
On the bright side, Apple is shifting its focus on in-house produced components, which should benefit its profitability in the future. The one concerning factor is its reliance on China, which will continue to be an issue amid U.S.-China tensions. However, I do not think these issues are substantial enough to dent this enterprise in the long term.
