Apple Is Stepping Into a New Growth Curve
Apple shares traded down 4% after hours, giving up gains on the day, as investors misinterpreted the company reporting iPhone revenue below expectations, along with a perceived lack of visibility for the December quarter. Adjusting for iPhone timing and Apple’s approach to guidance during the pandemic, reveals a September quarter that was on track to report accelerating revenue growth and a December outlook that was effectively in line with consensus.
As evidence of the strength of Apple’s business, the September quarter concluded a year in which the company had record revenue, EPS, and free cash flow despite the uncertainty.
More important than deciphering near-term stock movement is the reality that Apple’s business is stepping into a new growth curve, which is driven by three factors: First, a new normal that could endure for years, in which the company’s products are foundational to working and learning. Second, a three-year iPhone upgrade cycle powered by 5G. Last, the appeal of Wearables is expanding beyond early adopters into mainstream Apple users, as the everyday use cases strengthen. The combination of these factors equates to a digital transformation in which Apple will be a cornerstone.
September was better than it looks
It’s rare for Apple to miss an iPhone number. It’s even rarer for the company to delay the timing of the release of its flagship product by four to eight weeks, complicating how to benchmark the September iPhone revenue number. Thankfully, Tim Cook reported the one data point needed to baseline the results – the iPhone growth rate in the most recent quarter, prior to the shift in the timing of the new iPhone. Cook suggested the iPhone business was growing double digits until mid-September. If the timing of iPhone 12 was similar year-over-year, it’s likely that double-digit iPhone growth would have been reported for the full quarter. In other words, iPhone was on track to grow 10%, compared to the -21% they reported.
If iPhone had in fact grown at 10%, Apple’s overall business would have been up 17% y/y, which is an acceleration from 11% in the June quarter and flat in the March quarter. This 17% growth would have represented the highest Apple growth rate since September of 2018 when it was 19%.
Implied December guidance appears to be in line with consensus
It was no surprise that Apple continued its policy of withholding guidance during the pandemic. Conversely, it was a surprise that CFO Luca Maestri implied the company expects revenue around $100B for December, which is in line with the Street’s estimate. Maestri said to expect growth in iPhone, but expressed caution due to the staggered release of the iPhone 12 lineup (two of the models will be available for 65% of the quarter, the other two models for just 35% of the quarter). Factoring in that detail, we expect iPhone revenue to be up about 3% y/y in December. Separately, the implied guidance calls for double-digit growth in each of the other four revenue segments and steady gross margins.
While there’s a wide range of outcomes when we consider this “double-digit” signpost, we can use historical trends to better define the guidance. In the end, we expect Mac growth of 20% in the quarter compared to 29% in the just-reported quarter, iPad growth of 37% compared to 46%, Wearables growth of 21% (in line with last quarter), and Services growth of 15% versus 16% in the just-reported quarter.
These variables add up to $101B in revenue for the December quarter. Putting it together, Apple essentially gave guidance in line with the Street and left room for upside based on Mac and iPad.
Stepping into a new growth curve
Apple’s products are foundational to the new normal
The Mac and iPad businesses have benefited from the trends of work and learn from home that have accelerated during the Covid pandemic. In the nine quarters prior to the outbreak, Mac revenue was on average flat, with a range of -5% to +9% growth. In the two most recent quarters, Mac has grown an average of 25%, with a range of 22% to 29%. Over the same two time periods, iPad revenue grew on average 4% prior to the pandemic (range of -15% to +18%) and has been up an average of 39% in the past two quarters (range of 31% to 46%).
The underlying question is how long the step up in iPad and Mac revenue growth is sustainable. We believe growth in these segments will likely continue at similar rates through the upcoming March quarter and then begin to moderate at a level measurably higher than the pre-pandemic growth rates. We envision both segments settling into a 15% growth profile for the next few years. The reason is that while the pandemic will hopefully subside, consumers now have a better understanding of the value of easy-to-use, easy-to-support hardware in the home. Apple is the only consumer hardware tech company that can deliver that experience.
Three-year iPhone upgrade cycle
5G is going to take time and eventually exceed its hype. We continue to expect iPhone demand over the next year to be driven more by an aging iPhone base in need of an upgrade, and less by consumers clamoring for 5G speeds. Our recent survey work has illuminated that not all 5G is created equal. The bad news is that the current low-band 5G is largely marketing hype. The good news is that when mid and high-band 5G begin to roll out in 2022 and 2023, we anticipate iPhone owners will be eager for the impressive speed increases they will bring. This multi-year infrastructure upgrade, sponsored by the carriers, should be the foundation of a multi-year iPhone upgrade cycle. We anticipate that, during this upcoming three-year period, iPhone growth rates will average in the mid-single digits, compared to an average of -1% in the nine quarters preceding iPhone 12.
Wearables becoming more mainstream
Wearables are just getting started. Take, for example, Apple Watch, whose adoption remains nascent and which we believe supports 20%-30% unit growth for the next five years. At the end of Sep-20, we estimate 10% of iPhone owners used a Watch (based on a 3-year expected life). Long term, we believe the attach rate could reach above 40%, which implies about 125m units a year, compared to our estimate of 32m units in CY20. This implies about 12% of Apple’s overall revenue will be from Watch in 2025, up from about 4% today. This assumes Watch will account for $48B of $385B in overall revenue in 2025.
Luca Maestri said that in the most recent quarter, more than 75% of Watch sales went to first-time consumers, a step up from historical commentary around Mac and iPhone adoption, where 50% of sales were driven by new users. Additionally, AirPods, which accounts for about 4% of overall revenue today, could deliver 15%-20% unit growth for the next five years, as the product evolves and becomes a must-have for iPhone owners.