Apple Stock: Upgraded To Buy Rating Despite Smartphone Headwinds (NASDAQ:AAPL)

While Apple’s (NASDAQ:AAPL) wearables business is the strongest among its products businesses driven by its smartwatches and AirPods, we see the rest of Apple’s product segments (consisting of iPhones, iPads, Mac) having low margins and catering to mature markets. However, we believe Apple’s iPhone revenue will grow faster than the overall smartphone market given the continuous improvement in iPhone specs, robust consumer interest in its new products and high brand loyalty.

With the recent headwinds in the markets such as covid disruptions and geopolitics issues, global smartphone shipments are expected to contract this year. We analyzed each of these issues to determine how much they impact Apple and if Apple can continue to significantly outperform the market to still finish the year with positive smartphone sales growth.

We continue to see its Service segment as the company’s biggest strength with its margins continuously increasing and more than twice higher than its products segments, while growing at 20%+ by being supported by its rising installed base and increasing revenue per user due to the rise of its subscription and apps such as Apple TV and Apple Music.

To project its average revenue per user growth and subscriber growth, we analyzed each of its major service subscriptions based on its share of the installed base. This gave us a comprehensive understanding of the future of Apple’s strongest segment.

Lastly, as the company’s products segment has low margins and its services business segment has more than twice higher its product margins, we forecasted its weighted margins based on our revenue and cost projections while also taking into account the margin benefit from Apple’s shift towards in-house chip manufacturing.

Smartphone Market Headwinds

Based on the smartphone market share chart, Apple overtook Samsung in Q4 2021 following the launch of its iPhone 13 and was overtaken by Samsung again in Q1 2022 as the company launched its new flagship S series. Based on its earnings briefing, management explained that certain geographic regions such as the Asia Pacific had a later launch for its iPhone 13. Apple’s market share in Q4 2021 and Q1 2022 combined had been higher than the previous year’s quarters. However, in Q1 2022, the smartphone market shipment growth declined by 11% YoY and is forecasted to decline by 1% to 2% for the full year by Strategy Analytics due to several headwinds.

To analyze the impact of the headwinds, we examined each factor attributed to it such as geopolitics risks, component shortages, price inflation and covid disruptions.

Geopolitics Risk

For the geopolitical risk concerning the Ukraine-Russia conflict, Trendforce estimates between 3% to 4% of sales from the region. Based on the forecasted smartphone market, we estimated the number of shipments impacted. Based on that, we determined Apple’s impact from its market share at only 3.5% of its total smartphone shipments and a revenue impact of $6.96 bln.

Total smartphone market (‘mln’)	1,399.6
Russia-Ukraine share of sales	3.5%
Shipments Impacted (‘mln’)	49
Apple Share	17.5%
Apple Shipments (‘mln’)	8.6
Apple Total Shipments (‘mln’)	245.2
% of Total iPhone Shipments	3.5%
Apple Average Phone Price	$810.5
Revenue Impact ($ mln)	6,955

Source: Trendforce, IDC, Khaveen Investments

Component Shortages

Moreover, regarding component shortages, the semiconductor market is facing supply constraints as foundries operate at maximum capacity. By the end of 2021, the average wait time for electronic components had increased to 22 weeks from 13 weeks since the start of 2021. According to Counterpoint Research, it estimated the supply shortage to affect 10% of smartphone production forecasts. This translates to an estimated 139 mln in impacted shipments from our smartphone market forecast. However, Counterpoint Research expects the shortage to improve significantly in the second half of 2022.

Based on Apple’s earnings briefing, its CEO highlighted the shortage of legacy node semiconductors in the company. Previously, Apple was reported by Bloomberg to have an impact on 10 mln iPhone 13 models in 2021 due to supply chain issues from an expected target of 90 mln in production. According to Counterpoint Research, several chips such as display drivers were short in supply last year and are expected to continue being affected along with power management chips and Wifi chips but positively expects shortages for seven other components to ease throughout the year. Also, Apple’s recent Q2 2022 days inventory had improved rising by 16%. Thus, we forecasted Apple’s estimated impact based on the affected production reported at 11% reduced by a factor of 0.5 assuming the shortage improves by H2 2022 and 16% for an estimated impact of 4.7% of total iPhone shipments assuming the shortage ease by the second half of 2022.

Estimated Impact	4.7%
Total iPhones (‘mln’)	245.2
Estimated Iphone Shipments Impacted (‘mln’)	11.4
% of Total iPhone Shipments	4.7%
Apple Average Phone Price	810.5
Revenue Impact ($ mln)	9,279

Source: Apple, Gurufocus, IDC, Khaveen Investments

Price Inflation

In terms of price inflation, we examined the impact in terms of the product price and exchange rate. The exchange rates against the US dollar had been volatile over the past 1 year. To estimate an exchange rate revenue impact on Apple, we obtained the 1-year average exchange rate for 4 international geographic segments including Asia Pacific which we based on the US dollar index. Then, we calculated the % difference between it and Apple’s last quarterly period to derive the % change. Overall, we calculated a weighted average revenue impact of -0.6% based on the % change and its sales breakdown.

Exchange Rates	Expected Exchange Rate (1-year Average Exchange Rate)	Current Exchange Rate (31st March 2022)	% Change	Sales Breakdown
Europe	0.90	0.90	-0.1%	24.4%
China	6.39	6.55	-2.5%	18.7%
Japan	119.57	118.63	0.8%	7.8%
Asia Pacific	95.29	98.31	-3.1%	7.2%
Weighted Average Revenue Impact			-0.6%

Source: Apple, OFX, Khaveen Investments

Moreover, we examined the price difference between the iPhone 13 with the iPhone 12. To obtain the price change, we calculated the price difference in 7 countries namely the U.S., China, UK, Italy, Germany, Japan and India and calculated the weighted average based on its geographic sales breakdown. From the table, China had the largest price change between the iPhone 13 and 12. We obtained a weighted average product price change of -2%.

Product Price	Sales Breakdown	Price Increase
Americas	41.9%	0.0%
Europe	24.4%	0.1%
China	18.7%	-11.8%
Japan	7.8%	1.4%
Asia Pacific	7.2%	0.1%
Weighted Average		-2.0%

Source: Apple, Khaveen Investments

In total, we calculated the inflation impact with our estimate for its weighted average product price impact (-2%) and positive exchange rate impact (0.6%) to obtain the net revenue impact of -1.4% to Apple.

Inflation Impact	Impact
Product Price	-2.0%
Exchange rate	0.6%
Net Impact	-1.4%

Source: Khaveen Investments

In Q2 2022, the company’s Products segment gross margin declined by 200 basis points to 36.4% and management guided its total company margins to be between 42% to 43% in the next quarter compared to its total company margins at 43.7% in Q2 2022. In the quote below, Apple’s CEO highlighted the inflation impact on its gross margins and reflected in the guidance.

From an inflation point of view, we are seeing inflation. It is or was evident in our gross margin last quarter and in our OpEx last quarter and it is assumed in the guidance that Luca gave for this quarter as well. – Tim Cook, CEO

COVID Disruptions

Lastly, another factor of the supply chain disruption is COVID shutdowns such as in China. In April 2022, Shanghai implemented a lockdown to curb the COVID-19 spread which affected Pegatron, Apple’s second-largest EMS provider which suspended production of two plants but was eased from the end of April. According to Technode, 48% of Apple’s suppliers are based in China while 10% within China from Shanghai. Based on this, we estimated its production impact based on its share of production in Shanghai prorated by a factor of 0.5 months based on the suspension period. According to Apple’s management in its earnings briefing, its constraints were primarily in Shanghai but its final assemblies’ factories had restarted.

Total Apple Iphones (‘mln’)	245.2
Apple’s China share of production	48%
Shanghai Share of production	10%
Covid Shutdowns Shipments Impact (‘mln’)	0.49
% of Total Apple Shipments	0.2%
Average Price per Phone	810.5
Revenue Impact ($ mln)	389

Source: Apple, Khaveen Investments

Overall, based on our analysis of the smartphone market outlook by geopolitics risks, component shortage and COVID disruptions, we expect the headwinds from the supply-related factors to result in an impact of 4.9% of revenue. While demand issues are expected to impact 3.5% of revenue, the more significant supply issues balance it out, leading to an overall impact of 4.9%.

Apple Smartphone Impact	Shipment Impact (‘mln’)	Revenue Impact ($ mln)	% of Revenue
Geopolitics (Demand)	8.6	6,955	3.5%
Component Shortage (Supply)	11.4	9,279	4.7%
COVID Disruptions (Supply)	0.5	397	0.2%
Total Demand Impact	9	6,955	3.5%
Total Supply Impact	12	9,677	4.9%
Total Apple (Without Impact)	245	200,504
Total Apple (With Impact)	233	188,106

Source: Khaveen Investments

We updated our projections for its iPhone segment considering shipments impact from our previous projections and taking into account our estimate of a -2% product price impact as well as revenue impact from exchange rate impact on its net revenues.

iPhone Revenue Forecasts	2019	2020	2021	2022F	2023F	2024F	2025F	2026F
ARPU (Accounts for 2022 price impact)	765	726	800	784	794	804	814	825
Growth %	0.4%	-5.0%	10.2%	-2.0%	1.3%	1.3%	1.3%	1.3%
Shipments (‘mln’)	186.2	189.7	239.9	244.0	253.0	262.4	272.1	282.1
Growth %	-14.5%	1.9%	26.5%	1.7%	3.7%	3.7%	3.7%	3.7%
Exchange Rate Impact ($ bln)				1.2
Revenues ($ bln)	142.38	137.8	192.0	192.53	200.90	211.00	221.60	232.74
Growth %	-14.1%	-3.2%	39.3%	0.3%	4.3%	5.0%	5.0%	5.0%

Source: Apple, Khaveen Investments

Overall, we analyzed the company’s smartphone business as the smartphone market is forecasted by Strategy Analytics to decline this year by 1% due to supply chain disruptions. We looked into the geopolitics risk, components shortages, inflation, exchange rate and COIVD disruptions to determine the shipments and revenue impact on Apple (4.9%). Notwithstanding, we still see Apple’s smartphone shipments growing at a flat forecasted rate of 1.7% instead of a decline and revenue growth at 0.3% with the revenue impact.

Subscriber Growth Across all Services

While its iPhone business remains its largest segment accounting for more than 58% of revenue in 2021, its services business segment is its second-largest segment and has the highest average growth. In the past 9 years, its Services business segment had been its highest growth with an average growth rate of 20.5% compared to its total company average growth rate of 10.6%. In our previous analysis, we believed its rising installed base growth supports the growth of its services business.

To forecast its Services segment, we examined its subscription services including Apple Music, Apple TV, Apple News and its App store. Based on its share of installed base growth, we calculated its average growth in share to forecast its subscribers for each service. Then, we factored in their respective pricing by taking the average pricing for each service to derive their revenues. For the App Store, we estimated its average revenue per user, based on the App Store revenue of $85 bln in 2021 and Apple’s installed base, which we assumed to grow at its 5-year average rate of 13.6%.

Apple Services	Average Pricing
Apple Music	$ 79.44
Apple TV	$ 59.88
Apple News	$ 119.88
App Store (ARPU)	$ 47.28

Source: Apple, BusinessofApps, Khaveen Investments

Based on the chart of subscribers, Apple TV+ had the fastest subscriber growth based on a 2-year average (370.3%) as it was only launched in 2019 but quickly grew as its market share in the US increased to 5% by Q4 2021 from 3% in 2020 as competitors such as Netflix (NFLX) and Amazon Prime Video’s (AMZN) market share declined. We forecasted its subscribers to have the highest average growth rate (57.8%) and estimated its share of paid subscribers at around 21.2% of its total subscribers. Furthermore, Apple Music is the next fastest growing service (46.4%) in the past 6 years as the second-largest music streaming service (15% market share) behind market leader Spotify (SPOT) (31% market share). Though, we see Apple Music’s advantage in terms of its large music library with more than 90 mln songs compared to Spotify’s 70 mln songs as well as higher music quality and support for lossless streaming and spatial audio according to Tom’s Guide. Based on our projections, we derived a subscriber growth forecast at a 5-year average of 44.7%. Lastly, we expect its Apple News subscribers to grow at a 5-year average of 18.7% which is close to its past 4-year growth rate of 18% with an estimated paid subscribers as % of the total of 9%.

We summarized our revenue forecast for its Services segment including Apple Music, Apple TV+, Apple News+ and App Store based on our subscriber forecast and average pricing in the chart below. For its other service revenues, we assumed it to grow based on our forecast of its installed base as discussed in our previous analysis.

Overall, we forecasted its total Services segment revenue to grow at a 5-year average of 23%. This is driven by its Apple TV+ service with the highest forecasted average growth rate of 57.8% with the fastest share of its installed base growth rate of 44.5%. Additionally, we forecasted Apple Music with the second-highest growth rate of 44.7% followed by Apple Store (23.9%) and Apple News+ (18.7%). Though, the App Store is still expected to remain its largest contributor to its segment revenue at 38.8% of revenue with Apple Music trailing behind in second place. Meanwhile, we see Apple TV+ as its third-largest subscription service followed by Apple News+.

Margins Keep Rising

Gross Margins %	2017	2018	2019	2020	2021
Product	35.70%	34.40%	32.20%	31.50%	35.30%
Service	55.00%	60.80%	63.70%	66.00%	69.70%
Total	38.50%	38.30%	37.80%	38.20%	41.80%

Source: Apple, Khaveen Investments

Over the past 5 years, Apple’s gross margins had improved in 2021 driven by an increase in its Products segment gross margins as the company incorporated its M1 chip into its Mac products. Also, its Services segment continued to increase its margins as it had continuously increased in the past 5 years.

To project the company’s gross margins, we forecasted its margins by its Products and Services segment. For the Products segment, we based its margins growth on the average change % for its gross margins in the past 5 years except in 2021 as its margins jumped as it switched to its M1 chips. Whereas for its Services segment, we based our projections of its margins on the Services segment cost per installed base for the company with our forecast of its installed base through 2026 based on a 5-year average. Overall, we estimated its product margins to reach 28.3% by 2026 and 79.9% for its Services segment by 2026 which is below the highest software company gross margin of 91.68% (Autodesk).

Margins	2017	2018	2019	2020	2021	2022F	2023F	2024F	2025F	2026F
Product
Revenue	199.3	227.1	213.9	220.8	297.4	307.9	326.5	346.6	366.5	385.7
Growth %		14.0%	-5.8%	3.2%	34.7%	3.5%	6.0%	6.2%	5.7%	5.2%
Gross Margin %	35.7%	34.4%	32.2%	31.5%	35.3%	33.9%	32.5%	31.1%	29.7%	28.3%
Change		-1.3%	-2.2%	-0.7%	3.8%	-1.4%	-1.4%	-1.4%	-1.4%	-1.4%
Services
Revenue	30.0	38.5	46.3	53.8	68.4	84.8	105.6	128.7	153.5	181.7
Growth %		28.3%	20.4%	16.2%	27.2%	24.0%	24.5%	21.8%	19.4%	18.3%
Gross Margin %	55.0%	60.8%	63.7%	66.0%	69.7%	72.4%	75.1%	77.1%	78.6%	79.9%
Total installed base (‘bln’)	1.3	1.4	1.5	1.7	1.8	2.0	2.2	2.4	2.6	2.8
Cost per installed base	0.010	0.011	0.011	0.011	0.012	0.012	0.012	0.012	0.013	0.013
Growth %		3.8%	4.0%	-1.1%	3.9%	2.67%	2.67%	2.67%	2.67%	2.67%

Source: Apple, Khaveen Investments

Additionally, besides its gross margins, we examined its operating expenses including its SG&A and R&D costs which represented 12% of its revenue in 2021. The company’s R&D expenses had been increasing from 2012 at 2.2% of revenue to 6% in 2021 but stabilized with an average of 6.4% in the past 3 years as the company focused on the development of its custom chips such as M1. According to Bloomberg, Apple is reported to be continuing its focus on greater in-house production. Thus, we expect the company to continue investing in R&D.

Also, its SG&A expenses had been highly stable as a % of revenue with a 10-year average of 6.5%. According to Interbrand, Apple was ranked as the top brand for the 9^th year in a row which highlights its strong branding. Therefore, we expect the company’s SG&A expenses to remain stable given its solid branding. For our projection of its net margins, we assumed an R&D and SG&A as a % of revenue based on these averages at 6.4% and 6.5% respectively.

Earnings & Margins	2021	2022F	2023F	2024F	2025F	2026F
Gross Margin (%)	41.78%	42.09%	42.61%	43.35%	44.38%	45.77%
Net Margin (%)	25.88%	25.44%	25.08%	25.71%	26.59%	27.78%

Source: Khaveen Investments

Overall, with the rise of its Services segment which has superior gross margins than its Products segment, we believe its gross margins could continue to increase going forward with a projected total gross margin for the company of 45.77% by 2026. Furthermore, we believe its net margins could be supported by its stable operating expenses including R&D and SG&A and forecasted its net margins to grow to 27.78% by 2026.

Risk: Exchange Rate Volatility

Given the volatility of the exchange rates, we see the risk of a price impact being greater than our forecast. Based on the Federal Reserve’s dot plot projections from Bloomberg, interest rates could go higher going forward. We believe this could present a risk to Apple from the exchange rate volatility. Thus, we estimate the revenue impact on Apple based on a scenario analysis with assumptions of 5% to 10% of US dollar exchange rate appreciation. We calculated the revenue impact and the net revenue to the company in the table below.

Exchange Rate Volatility	Impact ($ bln)	Net Revenue ($ bln)
0% Assumption	0	391.8
5% Assumption	-19.6	372.2
10% Assumption	-39.2	352.6

Source: Khaveen Investments

Valuation

We summarized our updated revenue projections for the company for its iPhone and Services segments as discussed in the points above.

Apple revenues ($ bln)	2019	2020	2021	2022F	2023F	2024F	2025F	2026F
iPhone	142.4	137.8	192.0	192.53	200.90	211.00	221.60	232.74
Growth %	-14.1%	-3.2%	39.3%	0.3%	4.3%	5.0%	5.0%	5.0%
Mac	25.7	23.7	35.2	36.25	37.52	38.84	40.20	41.60
Growth %	1.5%	-7.8%	48.4%	3.0%	3.5%	3.5%	3.5%	3.5%
iPad	21.3	28.6	31.9	33.18	34.54	35.96	37.44	38.98
Growth %	14.5%	34.5%	11.3%	4.1%	4.1%	4.1%	4.1%	4.1%
Wearables, home and accessories	24.5	30.6	38.4	45.89	53.51	60.79	67.25	72.38
Growth %	40.8%	25.0%	25.3%	19.6%	16.6%	13.6%	10.6%	7.6%
Services	46.3	53.8	68.4	83.96	103.32	126.90	155.74	191.63
Growth %	20.4%	16.2%	27.2%	22.7%	23.1%	22.8%	22.7%	23.0%
Total	260.2	274.5	365.9	391.8	429.8	473.5	522.2	577.3
Total Growth %	-2.0%	5.5%	33.3%	7.1%	9.7%	10.2	10.3%	10.6%

Source: Apple, Khaveen Investments

We valued the company with a DCF valuation as the company has strong free cash flows. We updated our terminal value based on the average of the software and technology hardware companies at a weighted average of 14.39x.

EV/EBITDA	Revenue ($ bln)	Weight	Weighted Average
Product (Hardware)	297.4	81.3%	9.45x
Service (Software)	68.4	18.7%	35.84x
Total	365.9	100.0%	14.39x

Source: Apple, SeekingAlpha, Khaveen Investments

Based on a discount rate of 8.7%, our model shows its shares are undervalued by 21%.

Verdict

All in all, despite the record quarter for the iPhone in Q2 2022, we expect the smartphone market headwinds to pose a threat to its iPhone revenue, the company’s largest segment. Based on our analysis of the industry geopolitics risks, supply shortage, inflation, and COVID disruptions, this is expected to impact 4.8% of smartphone shipments and with a revenue impact of 4.9%. Though, we expect continued robust growth for its Services business segment with a projected growth rate of 22.7% in 2022. Additionally, we expect its segment’s superior growth to drive its gross margins higher to reach 45.77% by 2026 and net margins at 27.8%. Since our previous coverage, we revised lower our revenue forecast, discount rate and EV/EBITDA. With the share price decreasing around 22% YTD, we believe this now presents a buying opportunity for Apple shares. We upgrade our rating on the company to a Buy with a target price of $173.00.