Apple Stock: Why We Think Valuation Is Still Justified (NASDAQ:AAPL)

Color version Apple iPhone 14 Pro Space Black

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Apple Inc. (NASDAQ:AAPL) designs, manufactures, and markets smartphones, personal computers, tablets, wearable devices, and accessories worldwide. In July 2022, we published an article about Seeking Alpha, titled: “3 reasons why we think Apple could be attractive in Current Ratingsand we rate Apple stock a “buy.”

The reasons for our buy rating were:

  • Apple has historically performed well in times of low consumer confidence, due to its loyal customer base, strong brand recognition, and diversified product portfolio.
  • The easing of COVID-19 restrictions in China may boost demand growth going forward.
  • Strong track record of paying safe and sustainable quarterly dividends, while the company has also repurchased a substantial portion of its shares.

Since our last writing, Apple’s stock price has been relatively stable, however it slightly outperformed QQQ.

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Data by YGraphics

Today, we have decided to review our analysis on Apple, as there have recently been significant developments related to the company’s manufacturing capabilities, especially in relation to operations in China. Also, our earlier point regarding the easing of Covid restrictions in China may no longer be valid. In this article, we’re going to give an up-to-date look at why we still think Apple stock could be a good buy today.

But, first let’s start with the recent developments.

recent developments

The recent developments we are going to focus on here are those related to Apple’s production capabilities in China. It is important to understand that production capacity in China is mainly influenced by political decisions related to the containment of Covid-19 outbreaks and not by technical limitations.

Last month, Chinese President Xi has reiterated his intention to maintain the country’s zero Covid policy. This development has two potential impacts on Apple’s business:

1.) Demand for Apple products may not grow as fast as expected, due to possible lockdowns.

2.) Production of Apple devices may be affected due to potential factory closures.

In fact, the second point has already materialized to some extent. In early November, the largest iPhone manufacturing plant came under Covid-19 restrictions. Foxconn is responsible for the production of 70% of iPhones worldwide. It also assembles devices in India, but its Zhengzhou factory builds most of its global production. In the Zhengzhou complex, 200,000 employees work and live as it also contains a dormitory, allowing workers to live at their workplaces. The aim of this scheme is to limit external contact and reduce the likelihood of Covid outbreaks. However, this measure did not attract workers, and thousands were trying to flee the installations.

In our opinion, it is key that the production of iPhones remains uninterrupted since this product represents more than 50% of Apple’s total revenue.

income

Income by source (businessofapps.com)

While the revenue share has been gradually decreasing over time (which we think is beneficial), it still represents a very significant percentage. Any interruption in iPhone manufacturing or decreased demand for the iPhone could have a significant impact on the company’s financial results.

Several analysts and Apple itself have already acknowledged the negative impacts of the lockdowns in China. In early November, Apple Announced that its iPhone shipments will be lower than previously thought. “They now expect lower iPhone 14 Pro and iPhone 14 Pro Max shipments than we previously anticipated, and customers will experience longer wait times to receive their new products.”

JP Morgan has also lowered the forecast for iPhone shipments in the December quarter. This reduced forecast would result in decreased revenue year-over-year.

We believe that in the near future, as China’s anti-covid policies are in place, such news may have a material impact on Apple’s business and its share price. The share price has shown a significant reaction to all the news mentioned above.

So why are we still optimistic?

First, despite the difficult economic environment, demand for Apple products remains high, due to exceptional customer loyalty. In our opinion, as long as there is demand, Apple will be able to find a way to supply enough products. In fact, they are already working to move a substantial part of iPhone production from China to India, which has more reasonable Covid policies. We see this as a long-term opportunity, as Apple is now forced to diversify its manufacturing, which may result in a much stronger business and supply chain in the future.

What exactly are Apple and Foxconn doing?

apple has associated with a Taiwan-based company, called Pegatron, to make iPhones in India, in an effort to reduce reliance on China. This factory will mainly focus on the manufacture of iPhone 14 and iPhone 12 models.

On the other hand, Foxconn has also started a substantial expansion of its manufacturing capabilities in India. the signature Announced They plan to increase the workforce up to four times in the next two years. With this measure, the number of workers would reach 70,000 in Tamil Nadu, India, which is still substantially lower than the 200,000 employees in Zhengzhou.

Additionally, Foxconn has Announced they have been working to adjust production in order to meet the demand for the holiday season.

However, moving away from China is not a quick process. JP Morgan He suggested Apple may move about 25% of its iPhone production to India by 2025, and it anticipated that 5% of its iPhone production this year will move to the country.

Overall, we believe that Apple and its suppliers are making significant efforts to continue to meet demand for iPhones and other Apple products around the world, despite the Covid-related disruptions in China. However, investors should keep in mind that moving away from Chinese manufacturing can take years, and the road to reaching the ultimate goal is likely to be bumpy.

However, moving away from China is not the only factor that could improve Apple’s financial performance in the long run.

Increase revenue from services

On the latest from Apple Profits results, we can see double-digit annual revenue growth in the “Services” category.

table income\

Net sales (millions of dollars) by category (Apple)

This increase has been mainly driven by increased revenue from advertising, cloud services and the App Store. While growth has slowed from 27% to 14%, we believe this is mainly due to the current macroeconomic environment and is likely to be temporary. Ad revenue and the app store are likely to be directly impacted by the poor consumer sentiment seen in the United States and around the world.

But why do we care so much about the growth of the services segment?

Because the “Services” segment has the highest gross margin.

gross margin table

Gross margin (Apple)

While products have had gross margins between 31-37%, “Services” have had a significantly higher range of 66-72%, gradually increasing every year over the last 3 years. With increased revenue from the “Services” category, we expect total gross margin to expand, resulting in increased net income over the long term, potentially unlocking substantial value for investors.

Valuation

Based on traditional price multiples, Apple is trading at a valuation substantially above the industry median.

titration table

Rating (Seeking Alpha)

On the other hand, the current multiples are in line with the company’s own 5-year averages.

In our opinion, the current premium to the industry median is justified. The gradual shift away from Chinese manufacturing and increasing revenue from the “Services” segment are factors we believe will make Apple’s business stronger in the long run, even if near-term headwinds related to the macroeconomic environment are slowing. its growth now. .

key takeaways

China’s Covid policy has a significant impact on both the supply and demand of iPhones. Recently, the largest iPhone manufacturing complex in China was shut down, which will likely cause iPhone production for the December quarter to be substantially below expectations, leading to year-over-year revenue declines.

On the other hand, Apple and its partners and suppliers are working hard to reduce reliance on manufacturing in China. Foxconn has announced significant workforce growth in India over the next two years, while Apple has further strengthened its partnership with Pegatron to increase iPhone production volumes.

While we believe Apple’s stock price may be volatile due to Covid-related news in the short term, we expect the company to benefit from current developments in the long term. In addition, the gradually decreasing dependence on iPhone sales in terms of revenue and the increasing revenue from the “Services” category is a good sign, in our opinion.

The firm is currently trading at price multiples close to its 5-year averages and respective sector medians. We believe this assessment is justified and maintain our “buy” rating on Apple.

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