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  • KPB & Co Research

Apple recently presented its Q3 of FY-20 results, which came in better than market consensus but also manifested signs of lingering challenges in the business. To a large extent, management has anticipated the changes in the industry and the impact it would have on their business, but it appears that the solutions are either not enough or may take a longer time to mature. Just to recap, a decline in the sales of the company's leading product - the iPhone - has forced Tim Cook to consider alternatives to replace the revenue that will be lost. The solution that has been proposed is to place more focus on wearables and services.

As can be seen from the chart below, sales of iPhones declined by 15% (US$19.1Bn) in the 9 months that ended on June 2019 relative to the same period a year earlier. Some of this decline in sales has been offset by growth in the sales of Macs 4.4%(US$0.8Bn), iPads 15.2% (US$2.2Bn), Wearables and Home devices 36.3% (US$4.8Bn), and Services 16.2% (US$4.7Bn)

A significant part of the decline in Apple's revenues is due to weakness seen in China. In the 9-month period that ended in June 2019, revenues coming from China declined by about 20%. Europe also showed some amount of weakness, with sales declining by 3.3%. All the other geographies recorded marginal growth or declines. The decline in the China business reflects more competition, stricter regulations against foreign companies, and a much slower economic environment beginning in Q4.

The decline in revenues is followed by a much sharper shrinkage in margins: gross profits, operating income, cashflow from operations. Gross profit margins declined from 38.4% to 37.8% of revenues on account of more difficult market conditions. Sale of the high priced phones >US$1,000 have faced resistance, and the company had to bring a cheaper mix of products to market. Operating income faced a much steeper decline, coming from 27% of revenues to 24.6%. This decline in operating income reflects more spending on "research and development", and "selling general and administrative" items, as the company invests more in its services business to expand product offerings such as video streaming services, the Apple card, Apple arcade, and others.

The company still has a remarkably strong balance sheet with cash and cash equivalents of US$50Bn and marketable securities of US$160.1Bn. Total debt on the balance sheet amounted to US$108Bn leaving the company with free liquid securities of about US$52Bn. Over the last 4 years, the company has done a remarkable job of reducing the excess cash on balance sheet through aggressive stock buybacks, and the payout of dividends.

Investors wait with eagerness to see if the recently announced initiatives in the services business will lead to an inflection in the revenues and cashflows. Some of these services, we expect, will gather steam as we head into fall 2020. Apple's foray into original content production for tv shows, the launch of the Apple card, extended rollout of the Apple pay infrastructure, subscription gaming, and podcasts all have high impact potential. On the other hand, there is stiff competition already in place in many of these industries which means the company has to come to the table with a differential service offering. Certainly, the company's over billion install base puts it in an advantageous position.

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