Apple Q1 Preview: Will The iPhone 12 Deliver For Apple Stock?

Apple (NASDAQ:AAPL) is slated to publish its Q1 FY’21 earnings on January 27, reporting on a quarter that saw the launch of its much anticipated 5G iPhone 12. We expect Revenues to come in at about $100 billion for the quarter, growing by about 9% versus last year, with EPS likely to grow by about 7% to around $1.35 per share. Our estimates are marginally below the consensus. So what are the key trends that are likely to drive earnings? Firstly, Revenues should see a bump driven by strong demand for the 5G iPhones, which saw multiple models remain back-ordered through the holidays. Apple should also see higher average selling prices for the iconic smartphone, as it raised base pricing on the iPhone 12 versus the iPhone 11, while nudging customers toward the more premium iPhone Pro models (priced at $1,000 and up), which appear to be a better value compared to last year. Apple’s Services business is also likely to have had its strongest quarter yet, driven by the App Store. In fact, Apple provided a data point indicating that between Christmas Eve and New Year’s Eve, a total of $1.8 billion was spent on apps, up 27% versus last year. ^[1] App sales growth over the same period last year was about 16%. That said, Apple’s margins could see some pressure, as the new iPhones are likely to be more expensive to produce compared to last year as 5G components are pricier.

Apple stock has rallied by about 65% over the last 12 months, driven largely by anticipation surrounding the 5G iPhones. Apple stock now trades at 33x projected EPS, making it look pricey compared to historical levels. The Q1 FY’21 earnings should give investors a good sense of how the device is faring and could be key to Apple’s stock trajectory in the near-term. See our pre-earnings analysis Apple Earnings Preview: Will Apple Beat Expectations? for more details on Apple’s recent performance and what’s driving its valuation.

[12/9/2020] Apple’s Services Will Overtake The iPhone By 2024

Apple’s (NASDAQ:AAPL) Services business is likely to emerge as its most profitable (and valuable) business within the next four years, likely eclipsing even the iPhone –  which is seen as one of the most lucrative consumer products of all time. Here’s how we expect this to play out. We expect Services sales to grow at a rate of about 11% a year (down from a rate of 22% each year over the last 4 years) to $81.5 billion in FY’24, driven by the continued growth of the AppStore and subscription services. On the other hand, we expect iPhone Revenues to grow at an average rate of about 5% each year over the next four years to about $167 billion (iPhone Revenue remained almost flat between 2016 and 2020). Now Apple’s services have much thicker margins compared to hardware products. Over FY’20, Apple’s product Gross Margins stood at 31.5% versus about 66% for Services. If we assume that margins remain flat at current levels, Services Gross Profits would stand at about $54 billion in FY’24, compared to about $53 billion for the iPhone. In fact, Operating Profits could actually be much higher for Services, considering that much of Apple’s Services sales come via commissions, with little marketing or development expenses involved.

Our dashboard Breaking Down Apple’s Services Revenue estimates the revenue figures for AppStore, Apple Music, Apple TV+, iCloud, Third-party Subscriptions, Licensing, Apple Care, and Apple Pay.

However, there are a few caveats. Firstly, Apple’s Service business is quite dependent on fees Google pays Apple for being the default search engine on its iDevices (an estimated 20% of Services Revenue, and a larger percentage of profits). There’s a possibility that the U.S. Justice Department’s antitrust lawsuit against Google could jeopardize these payments, hurting Apple’s services growth. Secondly, Apple is increasingly investing in content production with services such as AppleTV+ and these offerings could also have lower margins.

So what does this mean for Apple stock? Internet services led companies have typically commanded higher valuation multiples compared to hardware plays on account of their thicker margins, and associated platform related lock-ins. However, in Apple’s case, this is likely already baked into its valuation. Apple’s trailing P/E multiple has soared and almost doubled over the past year to levels of around 38x currently – which is in line with other Internet players such as Alphabet.

[Updated 11/23/2020] What’s The Impact Of The AppStore Commission Cut?

Last week, Apple (NASDAQ:AAPL) indicated that it would be cutting its commissions on app sales and in-app purchases from 30% to 15% for smaller developers, who earn less than $1 million annually from the AppStore. Apple has been facing significant criticism that its AppStore practices hurt smaller developers and tech giants, including Apple, face increasing scrutiny from regulators regarding their market power. This move should help Apple’s image to a large extent. App analytics company Sensor Tower estimates that about 98% of the developers that pay Apple commissions will benefit. ^[2]

However, will reducing commissions by half impact the performance of Apple’s highly lucrative and fast-growing Services business? After all, the AppStore is estimated to account for roughly a third of Apple’s Services Revenue. Not really. Apple earns a bulk of its AppStore revenue from the largest developers, with Sensor Tower indicating that developers who benefit from this program accounted for under 5% of App Store revenues last year. Moreover, the discounted fee will only apply until developers cross the $1 million threshold, after which Apple will bill them at the higher 30% commission rate.

[Updated 8/17/2020] How The Epic Lawsuit Impacts Apple

Last week, Epic Games sued Apple (NASDAQ:AAPL) for antitrust violations, after its popular Fortnite game was removed from the AppStore shortly after Epic let players bypass Apple’s in-app purchase system, avoiding the 30% commission on sales. Although Apple has had spats with developers in the past, the Epic lawsuit is noteworthy for a couple of reasons. Firstly, the Epic lawsuit comes at a time when tech giants, including Apple, have been facing increasing scrutiny from regulators regarding their market power. Secondly, Apple is more dependent on its Services business than ever before, with hardware growth slowing (profits from Services grew 5x as fast as hardware profits over the first three-quarters of FY’20), and Epic’s lawsuit targets Apple’s commissions, which we estimate are Apple’s single most profitable revenue stream.

Apple made roughly about $360 million in commissions from Fortnite over the last two years per Sensor Tower –  a relative drop in the bucket for Apple which pulled in $260 billion-plus in revenues last year. ^[1] However, if Epic sees a favorable judgment, and if Apple is forced to reduce its commissions or change the terms of its AppStore, this is very likely to set a precedent, causing other developers to demand similar terms.

So what could be the financial impact of Apple reducing commissions across the board? Apple takes a 30% cut on App sales and subscriptions (15% from the second year of subscriptions) and we estimate that total commission revenues stood at almost $20 billion in FY’19 (out of a total of about $46 billion in Services Revenue).  If Apple reduced commissions to say 20% from 30%, it would reduced total commissions by about $7 billion to roughly $13 billion. Although the revenue impact would be limited for Apple (under 3% of Apple’s Total Revenue) the impact on profits would be more pronounced given that commissions are likely to be almost entirely profit. We estimate that Apple’s Operating Income would be about 10% lower if commissions were reduced, considering Apple posted about $64 billion in Operating Income in FY’19.

Now commissions of 30% are actually pretty standard across the industry – Alphabet’s (NASDAQ:GOOG) Google, which also faces a similar lawsuit from Epic, as well as Microsoft and Amazon, charge roughly the same fees on app sales on their respective market places. However, Apple has the most to lose from this given the sheer scale of its business. AppStore revenues are roughly twice as large as Google’s Playstore.

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1. Apple Press Release [↩]
2. New York Times [↩]