Pre-Earnings: Is Apple a Buy, a Sell, or a Hold?

iPhone sales, artificial intelligence advancement, and services will be key areas to watch in Apple’s earnings report.

Brian Colello, CPA 27 October, 2023 | 9:08AM
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Apple

Apple (AAPL) shares are up 15% over the past 12 months. Ahead of its fiscal fourth-quarter earnings report next week, here's Morningstar’s take on what to look for in Apple's earnings and the outlook for Apple stock.

Apple Earnings Date: Thursday, November 2, 2023.

By far the most important part of the Apple story is still the iPhone, so we'll get our first insight into demand for the iPhone 15 series. Apple has not provided official revenue guidance in several quarters, but we'll be seeking directional guidance into year-over-year revenue growth in the iPhone, as well as any disclosures regarding sales at the end of September and into October.

Artificial intelligence (AI) remains a priority across technology earnings reports. We anticipate Apple will be keen to promote its AI advancements within existing products but will likely keep its future AI ambitions close to the vest. Investors will still likely seek to understand Apple's AI efforts in more detail.

Services are the next leg of meaningful growth for Apple. We still view services as a bit of a lagging indicator, as many of these services are coupled with earlier purchases of Apple hardware. This still isn't a bad thing, however, as these services create stickiness to the iOS ecosystem, which underpins Apple's wide moat. In addition to iPhone revenue, we'll be interested in any commentary around services, particularly with some macroeconomic concerns and the financial health of consumers worldwide.

Key Morningstar Metrics for Apple

• Fair Value Estimate: $150

• Morningstar Rating: 2 stars

• Morningstar Economic Moat Rating: Wide

• Morningstar Uncertainty Rating: High

Fair Value Estimate for Apple Stock

With its 3-star rating, we believe Apple's stock is fairly valued compared with our long-term fair value estimate (FVE).

Our fair value estimate on Apple stock is US$150 per share. Our estimate implies a fiscal 2023 (ended September 2023) GAAP price/earnings ratio of 25 times. In fiscal 2023, we expect total revenue to be down 2%, as services growth and flat wearable revenue will be offset by modest declines in iPhone and iPad revenue and a sharp drop in Mac revenue. We view the iPhone, iPad, and Mac revenue declines as reasonable following multiple strong years associated with work- and learning-from-home trends owing to Covid-19.

By product, we model iPhone revenue at a 3% compound annual growth rate over the next five years, with such growth coming off a strong fiscal 2022, again because of a spike in sales during Covid-19. We anticipate low-single-digit growth in both iPhone unit sales and iPhone average selling prices over our forecast period. We anticipate flat CAGRs in both iPad and Mac revenue, again off of a strong base in fiscal 2022.

We expect services to grow at a 6.5% CAGR over the next five years as iOS users buy more and more of the firm’s services like Apple TV+, Apple Music, and so on. We model Apple's wearables, home, and accessories segment to grow at a 17% CAGR over the next five years. We anticipate strong growth in Apple Watches and AirPods in the years ahead, while also anticipating the launch of an AR/VR headset over the next five years. Our fair value estimate assumes a launch with minimal revenue in fiscal 2024, but growing to an US$11 billion business by fiscal 2027.

We expect gross margins to remain in the 42%-43% range, thanks to Apple’s exceptional premium pricing strategy and stable iPhone margins. We anticipate product gross margins tracking in the mid-30% range and services gross margins hovering a little over 70%. Although we think the higher-margin services segment will grow nicely, we foresee lower-margin other products, such as the Apple Watch, serving as an offset. We expect operating margins to remain around 30% over our five-year forecast period.

Read more about Apple’s fair value estimate

Economic Moat Rating

We assign a Wide Economic Moat rating for Apple that stems from the combination of switching costs, intangible assets, and network effects associated with its iOS ecosystem. Combined with an asset-light business model, we think it is nearly certain that Apple will generate excess returns on capital over the next decade and more likely than not over the next 20 years.

We think the firm's primary moat source stems from high customer switching costs, based on a variety of aspects of Apple's hardware, software, and services. First, we think about the risk of customers moving away from today's electronic devices, such as smartphones. We view the smartphone as the most essential computing device for users, and despite innovations in other types of electronic devices like smart speakers, AR/VR headsets, and the Internet of Things, we don’t see the smartphone going away anytime soon. Apple's iPhone fostered the industry and has maintained its position as the premier smartphone, and we expect the firm to increasingly monetise its valuable installed base with the iPhone as the catalyst.

Beyond the iPhone, Apple's other key hardware products such as the iPad, Mac, Apple Watch, and AirPods each fill a computing niche that enhances the experience of the user. We do not foresee Apple’s primary electronic devices (smartphones, tablets, PCs, wearables, and "hearables") becoming irrelevant. Perhaps the stickiest aspect of the Apple iPhone is the integration of iOS across multiple devices. Users of ancillary products (including the iPad, Mac, Watch, and AirPods) lose significant functionality when paired with a smartphone other than the iPhone. Furthermore, if an iPhone user were to switch away to an Android device, they would lose significant functionality with other iOS users.

Beyond switching costs, we believe Apple's expertise in hardware, software, semiconductors, and services represents an intangible asset that even the strongest of tech firms have struggled to replicate. While the Android cohort has replicated a similar feel of apps, app stores, and integrated experience, we have not seen third parties within the Android ecosystem work well enough together to deliver devices and services that are clearly superior to Apple's. Apple's intangible assets in hardware, software, services, and chip design give us confidence that the company is unlikely to be left too far behind if any revolutionary technology were to emerge.

Network effects represent another source of Apple’s wide moat. As iOS users gravitate to the Apple App Store to purchase new applications, the increasing size of Apple’s installed base attracts developers to build new apps for iOS. Apple consistently touts when the majority of its user base is on the latest operating system, which in turn allows developers to build for the latest version of iOS and know that their apps are optimised for most of Apple's user base. Although the Google Play app store that supports the Android user base also achieves a similar network effect, we think the iOS user base is more valuable from a developer perspective given this user base skews to richer consumers (the iPhone unit market share is in the mid-teens globally but about 50% in the United States), making them more likely to spend money on in-app purchases.

Based on these three moat sources, we don’t foresee Apple’s captive user base scaling its walled garden anytime soon.

Read more about Apple's Moat Rating

Risk and Uncertainty

We assign Apple a High Uncertainty Rating. As the largest firm in the world, Apple is prone to material competition. Consumer hardware is inherently prone to cutthroat competition as short-product cycles and customers hungry for ever-superior features make market leadership difficult to maintain. Although Apple has done well with its walled garden approach, the firm competes with Chinese original equipment manufacturers and Samsung across all tiers.

We also suspect that many customers are holding on to their phones longer than before, as premium devices are more than good enough for today's needs (web browsing, streaming, and social media). Analogous to the decline of PCs, Apple faces the possibility of smartphone unit stagnation or even declines once emerging markets saturate or consumers gravitate to mid-tier devices. Should it be unable to innovate, Apple may lose its ability to charge premium prices for hardware that is no longer unique relative to devices from competitors.

Read more about Apple’s risk and uncertainty

AAPL Stock Bulls Say

Between greater smartphone penetration in emerging markets and repeat sales to current customers, Apple has plenty of opportunity to reap the rewards of its iPhone business.

Apple's iPhone and iOS operating system have consistently been rated at the head of the pack in terms of customer loyalty, engagement, and security, which bodes well for long-term customer retention.

We think Apple is still innovating with introductions of Apple Pay, Apple Watch, Apple TV, and AirPods; each of these could drive incremental revenue but more crucially help to retain iPhone users over time.

AAPL Stock Bears Say

Apple's decisions to maintain a premium pricing strategy may help fend off gross margin compression but could limit unit sales growth, as devices may be unaffordable for many customers.

If Apple were to ever launch a buggy software update or subpar services, it could diminish the firm’s reputation for building products that "just work".

Apple is believed to be behind firms like Alphabet (GOOGL) and Amazon.com (AMZN) in artificial intelligence development (notably Siri voice recognition), which could be problematic as tech firms look to integrate AI to deliver premium services to customers.

This article was compiled by Adrian Teague.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Apple Inc167.04 USD-0.57Rating

About Author

Brian Colello, CPA

Brian Colello, CPA  Brian Colello, CPA, is director of technology, media, and telecom equity research for Morningstar.

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