If Apple (AAPLWealth Strength IndexAAPL is Moderately Flat and trending Up) hadn’t climbed to become the first $1 trillion company by market cap, these flaws probably wouldn’t be worth talking about. But when investors and traders have driven a stock’s valuation up to these levels–in clear anticipation that someone not too far down the road is going to be willing to pay more for these shares–it’s worth looking at any signs that, well, cracks might be showing up in the company that could change assumptions about the company’s unlimited upside.
Here are the amazing numbers Apple reported on Tuesday, July 31, for the fiscal third quarter.
Revenue grew by 17% to $53.3 billion. That’s at the upper end of the company’s forecast of $51.5 to $53.5 billion in revenue. And it marks the eighth straight quarter where Apple has improved its revenue growth rate. Apple grew iPhone revenue by 20%. Service revenue climbed by 31% to $9.95 billion, above estimates, and the company announced that it was track to double revenue from services by 2020 to $50 billion a year from $24 billion in 2016.
At $2.34 a share, earnings for the quarter were 16 cents a share better than Wall Street projected.
And the company also raised guidance for the next quarter–the fiscal fourth quarter–to a range of $60 to $62 billion for the period. Wall Street projections were for $59.4 billion for the quarter.
So where are the flaws in this quarter that you should pay attention to?
Flaw #1 came in iPhone shipments. iPhone revenue was up so strongly for the quarter because the average selling price for an iPhone climbed 19% year over year to $724. iPhone unit sales, however, were up just 1% year over year to 41.3 million units against 41 million in the third quarter of fiscal 2017. (Unit sales came up just short of Wall Street estimates of 42 million.) So Apple was able to show such strong growth in its bread and butter iPhone product line because it sold such a high percentage of the iPhone X at high prices. But the smartphone market–not just for Apple but for everyone–just isn’t growing right now. And that is a problem in the long term for Apple. What growth there is in markets such as China is occurring at lower price points in the market. Business history is full of examples of companies and industries that went under because they thought they could ignore the low end of the market. (The United States once had a tire industry, for example.) Apple needs to figure out a way to respond in the middle and lower end of the market.
Flaw #2 is visible in Apple’s declining profit margin from operations. In the 12 months that ended in June, Apple made 26.6 cents in profit from operations for each dollar of sales. That’s the lowest operating profit margin since 2009, according to Bloomberg. Writing on Bloomberg.com Shira Ovide pins the problem on Apple’s rising R&D spending. Five years ago, Apple spent 3% of sales on R&D. In the last 12 months, R&D spending has climbed to 5.3% of sales. An increase in R&D spending like that is a good thing if the research turns into the development of products that sell well on the market. (At 3% of sales five years ago, Apple’s R&D spending was far lower than that of other U.S. technology companies. If anything Apple was spending too little on R&D.) But if that R&D spending winds up just burning cash without a contribution to future sales then an increase in R&D spending is a bad thing. And it takes years to tell if R&D spending was a good or a bad investment. It’s clear right now that companies in the smartphone sector have increased spending because they are looking for the “magic feature” that will reaccelerate sales. At this point, no one has found that feature. But the increase in spending illustrates how important–and tough–this problem is for the sector.
I wouldn’t say that these flaws are a reason not to own Apple. The stock is still a member of my 50 Stocks long-term portfolio and I’m not thinking of selling it. But they are a reminder that trees don’t grow to the sky. And they are something to watch as Apple continues to grow and to gain in price.