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Apple Q2 2022 earnings (AAPL): The new strategy is great

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when apple (Nasdaq: AAPL) reported its earnings last month, markets were not particularly affected. The stock fell 4% hours immediately after the release, and regained some ground in the days that followed. although Revenue and profit reported exceed expectationsInvestors were left confused by guidance, which forecast $8 billion in supply restrictions.

Shortly after Apple’s results were released, a file . appeared The New York Times He published an article saying that Apple had “lost its soul” with the departure of former chief design officer Jony Ive. The article described an internal power struggle at Apple as it gradually lost influence as CEO Tim Cook emphasized services on hardware. The article eventually concluded that Apple’s design team is no longer the company’s innovation driving force.

In his New York Times article, Tripp Mickle essentially took a negative view of Apple’s turnaround. Viewing the recent changes as a departure from Apple’s original vision, he said the company had lost its way. From a product perspective, he was probably right. Apple’s product launches were world-changing events, changing the trajectory of product development not only at Apple, but in the technology industry as a whole. The launch of the iPhone, for example, paved the way for mainstream smartphone adoption, and the original MacIntosh helped make computers more accessible. Apple’s recent launches have been gradual, and the last really big one is the Apple Watch from Ive. It was a success, but it didn’t completely change the industry as it did in the Jobs era.

For creative Apple users, perhaps Cook’s reduced focus on hardware was a real cause of frustration. But for investors, it was a blessing. Apple’s new strategy, focused on services and chips, builds on Tim Cook’s strengths as a leader. It places a strong emphasis on quantifiable business and technology decisions that Apple executives can objectively “correct,” rather than taking a taste-based approach in the age of jobs. This does not mean that design should go aside. On the contrary, it is still one of the most important factors that distinguishes Apple. But by focusing on chips and software, Apple can now focus more on “concrete” measurable goals, rather than worrying about whether its design team still has the magic of functionality. Over time, this can result in a company that performs and delivers significant shareholder value.

Competitive scene

To understand Apple’s new strategy, we need to look at how the company defines itself in relation to the competition. Design has always been a huge distinguishing factor for Apple, but there are other factors as well, and the way they all interact is what gives the Apple brand its immense value.

So, who are Apple’s competitors?

Directly or indirectly, most manufacturers of smartphones and laptops, as well as developers of operating systems and creative applications. Some of the most direct competitors are:

  • the alphabet (GOOG), a competitor and partner of Apple. Google’s Android operating system competes with iOS. The two companies also have a partnership in which Google pays Apple $15 billion annually to be the original search engine for IOS.

  • Samsung (OTC: SSNLF), the leading manufacturer of Android phones.

  • Microsoft (MSFT), whose Windows machines compete with Macs.

  • Adobe (ADBE), whose Premiere Pro app competes with Final Cut Pro.

  • spotify (SPOT), Apple’s main competitor in music streaming.

This list can go on for a long time. In addition to the companies just named, we can include chip makers such as Intel Corporation (INTC), whose sales have been affected by Apple’s move to design its own chips. But the competition here is indirect, and less important than “face to face” Competition with the above-mentioned companies.

Apple generally ranks first or second in most of its markets.

Its iOS is the second most installed operating system globally after Android, and first in the United States. It is the number one in terms of revenue worldwide, by a wide margin. Although Android has more users, Apple dominates the US market, with consumers spending more money on apps.

Apple ranks first in the world in connecting smartwatches and tablets. Its leadership in tablets has been strong since the iPad launched in 2010, while leadership in smartwatches is dwarfed by new entrants at lower price points.

Apple is second only to Adobe and Spotify in creative apps and music streaming, respectively. Apple doesn’t compete head-to-head with Adobe’s full suite of services, but Final Cut Pro is a direct competitor to Premiere Pro. Apple Music is the second streaming app after Spotify.

The position of Apple Music in relation to Spotify can be seen as a challenge for Apple. Music is a huge part of Apple’s strategy, and it’s a very successful strategy. AirPods alone generated more revenue than Twitter (TWTR), Spotify, Square (SQ) combined in 2021. So the Apple music system on the whole is very successful. However, the fact that Apple is second only to Spotify in streaming may become a strategic issue in the future. Apple Music is a major platform for selling AirPods, as the pods allow users to listen to spatial audio. If more people use Spotify than Apple Music, fewer people think of spatial audio than they do of Spotify or Joe Rogan’s algorithm, so it’s strategically better for Apple to rank #1 in streaming music rather than #2.

Apple’s new strategy

As we have seen, Apple has a strong competitive position. It ranks second in at least every sector in which it operates, working in many different sectors. However, there are clear cracks in Apple’s dominance of the tech industry. Its music streaming app, for example, is nowhere near as popular as its headphones, and if users don’t use the app and headphones together, they won’t get the experience they could have. This does not prevent AirPods from dominating the headphone industry, but it may hinder sales somewhat.

This is exactly why Apple’s new service-based strategy is so clever. By focusing on the service side of the equation, Apple is promoting the software and hardware integration that has always been its main selling point. When Apple acquires another subscriber of services, it acquires:

  1. Direct service revenue.

  2. Potential platform to sell more products.

To give you an example of how this works, I went to my Apple Music app and clicked Browse. I immediately saw a distinct content box that pushed the spatial sound. For users who already have AirPods, this may just be a prompt asking them to listen for the first time. For users who don’t have AirPods, this may be the first time they’ve heard of “spatial sound.” Seeing the advertised spatial audio in Apple Music might cause them to search for “spatial audio” on Google, which could lead to them discovering and buying AirPods.

Apple Music ad for spatial audio

Apple Music ad for spatial audio (Apple Music)

Apple needs services for this to work. Arguably it needs it more than it needs major innovations in industrial design. At this point, Apple’s design philosophy (skinny, light, and simple) was well established and well-liked by the company’s customers. There will always be room for incremental improvement, but the pace of innovation will be slower in the future than in the past. With services, it’s a different story. There are obvious ways Apple can improve its service ecosystem, including:

  • Get Apple Music recommendation algorithm on par with Spotify.

  • A must watch to get the exclusive “Hit” on Apple TV Plus.

  • Expand your iCloud storage options.

The improvements that can be made in these areas are somewhat “obvious”. They don’t count on having one key individual in a company with Steve Jobs or Johnny Ives paying attention to detail. Therefore, they are projects that a logistics and results-oriented leader like Tim Cook could undertake. As I’ll explain in the next section, it’s already paying off.

Apple’s financial statements

If you want to know how much contribution Apple Services makes to Apple these days, just take a look at the company’s recent earnings. In the second quarter, Apple provided:

  • $92.27 billion in revenue, up 9% (exceeding expectations).

  • $77.47 billion in product revenue, up 6%.

  • $19.82 billion in services revenue, up 17.2%.

  • $25 billion in net income, up 5.84%.

  • $1.52 in diluted EPS, up 8.57%.

As you can see, the growth in the quarter was generally “so”. But the growth in services has been very strong. At 17.2%, it contributed significantly to the overall growth. It also accounted for 21.4% of the total revenue. If service growth remains strong, it will make up a larger and larger percentage of total revenue, and can accelerate sales growth.

With a broader view of Apple’s earnings, we see clear signs of financial strength. The above earnings yield a net profit margin of 27%. Alpha Quant research has similarly strong payout ratios on file for the subsequent 12-month period:

  • Gross margin: 43.3%.

  • EBIT Margin: 30%

  • Net margin: 26% (slightly different from what you calculated as this refers to 12 months, while it was the last quarter).

  • Enhanced Free Cash Flow Margin: 26%.

All very strong profitability metrics, plus satisfactory growth. Despite all that, Apple stocks aren’t incredibly expensive. Trading at 25x earnings, 6.7x sales and 22x operating cash flow, it’s a far cry from the most expensive tech stock out there. It sure doesn’t have the rock bottom complications you see from Ali Baba (BABA) or ID pads (FB), but Apple’s profits haven’t fallen like those companies. Therefore, it can be argued that the slight premium is justified.

Risks and Challenges

As we’ve seen, Apple is a strong company with solid results in its service area that can sustain sales growth long after Apple devices saturate the market. It definitely looks like a promising buy. However, there are some risks and challenges to consider here, including:

  • Loss of major design talent. As I explain in this article, services are driving more growth for Apple these days than devices. This is a good thing in principle. However, the loss of top designers like Joni Ive remains a risk for the company. Without it, Apple may lose its edge in elegant and simple design. If this happens, “Apple design” will be less important in the future than it has been in the past. Apple once estimated the cost of Jony Ive’s loss at $50 billion. That number may be an exaggeration, but the company could definitely lose some of its luster if you stop consulting with it.

  • competition in services. Apple’s growth in services is undoubtedly explosive, but in the end the company will face stiff competition if it wants to continue developing these applications. Apple’s 15% market share in music streaming is much smaller than Spotify, which is a similar story with services like Books and TV Plus. To continue developing these services indefinitely, Apple will have to persuade some customers to switch from existing players, whose services are already popular. It won’t be easy.

  • slowing down. The revenue slowdown presents a risk to Apple shareholders in that it calls the company’s valuation into question. 25 isn’t a ridiculous dividend multiplier, but it’s not a low multiplier either. There are banks whose sales are growing faster than Apple this year, and they aren’t trading at 25 times the profit. Ultimately, investors may wonder if Apple really deserves the premium valuation it currently has, then sell the stock.

The above risks are worth taking seriously. But when we look at Apple as a whole, we see that it’s a solid value. The company has a solid brand, a growing service business, and a valuation that is far from overkill. Overall, Apple seems like a worthy addition to almost any wallet.

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