This week has brought the news that Apple Inc. (AAPL, Financial) is facing a chip shortage that could impede iPhone production. The announcement follows hot on the heels of the company’s decision to appeal a court ruling in the Epic Games case that would allow developers to direct customers outside of the tech giant’s app store ecosystem to make purchases, making it possible to bypass the 30% cut that Apple takes from in-app purchases.
Combined with a higher-than-usual valuation and slowing growth metrics in all but the services business, which is where the danger from the Epic Games court ruling lies, it seems that troubles are beginning to pile up for Apple. If the company begins to disappoint investors on the earnings front, could this be the point where the stock begins to stagnate?
Chip shortages reveal key vulnerability
Apple has often been criticized for a business model that drives frequent replacement of its products. Through a combination of scheduled product upgrades and planned obsolescence, the company incentivizes customers to make frequent purchases to replace their outdated Apple devices.
This model has worked very well for the company so far. However, the global chip shortage is causing issues around the world, and the companies most affected by semiconductor supply constraints will be those who need more semiconductors than others. Since Apple’s products are designed to be frequently replaced, the company will naturally feel more pain from the chip shortage as opposed to companies that earn more revenue for less hardware.
On Tuesday, Bloomberg reported that Apple will likely cut iPhone 13 production by as many as 10 million phones in 2021; it previously planned on making 90 million phones this year. The production cut comes as Broadcom Inc. (AVGO, Financial) and Texas Instruments Inc. (TXN, Financial) are having trouble delivering the needed components.
On the other hand, Apple isn’t the only consumer device maker that builds things to break someday. This is more of an industry-wide problem than a company-specific one, so the key determiner of whether Apple can keep its market share will be how much it has to cut production compared to its competitors. Samsung (XKRX:005930, Financial) has also had to cut back on smartphone production due to chip shortages.
Trying to play it cool on app store revenue
Many on Wall Street have been arguing that Apple now deserves to trade at higher earnings multiples than it did in the past. The main reason most cite for this is its services revenue, which is primarily driven by the 30% cut it takes from in-app purchases.
“The multiple expansion for the stock was the big theme of 2020,” Krish Sankar, senior research analyst at Cowen, said. “It was always viewed as a hardware name and that that sentiment started shifting. ... Services drove the multiple higher.”
Built on a base of around a billion devices, Apple has high hopes for its services business. While app store revenue has been the key driver of services growth so far, Apple has been trying its best to expand its service offerings with things like iCloud storage, Apple Music and Apple Care.
Let’s be real, the elephant in the room is the app store revenue. Apple takes a 30% cut from all in-app purchases, with the exception of some small developers who only need to pay 15%, which is like skimming the icing off the cake in terms of making a significant profit with relatively little ongoing investment. The legions of developers building iPhone apps are doing the lion’s share of the work in terms of brining Apple more app store revenue.
While Apple does not disclose how much revenue its App Store brings in, we can get an estimate by referencing the total that Apple has paid to developers. Using this reference point, along with the assumption that Apple takes a 30% cut of all sales, we can estimate the company brought in $64 billion in App Store revenue in full-year 2020. This would represent a whopping 23% of the $274 billion in total revenue for fiscal 2020.
On Sept. 9, a judge handed down the final ruling in the long-fought court case between Apple and Epic Games. One of the rulings stipulated that Apple can no longer force developers to use in-app purchasing. Going forward, developers will be allowed to provide links or other communications to customers that allow them to purchase their products outside of Apple’s ecosystem. In other words, the company's key growth engine and the source of more than 20% of its revenue is in jeopardy.
Apple tried to play it cool at first, but it has now decided to appeal the court’s decision, sending a clear signal of desperation. The company knows that this would significantly eat into its cash cow; perhaps it initially thought that its growth in other areas could make up for it, but that doesn’t seem to be the case now.
Even if Apple’s appeal is ultimately unsuccessful though, it should buy the company time. As long as it can keep the issue tied up in courts, the infrastructure for developers to direct payments out of the app store infrastructure can’t be implemented. The delay tactic could buy Apple the time it needs to build out its services business and quit relying on third-party developers to boost its numbers.
Conclusion
This week has revealed that Apple’s chip shortages and the outcome of the Epic Games case could have more of an effect on its revenue than it initially let on. This could spell trouble for the company’s growing valuation multiples, which analysts say are justified primarily by the services business.
While Apple appears to be taking the steps it needs to in order to mitigate these troubles, if it cannot build out its services revenue in a meaningful organic way that doesn’t involve taking a cut of third-party profits, the bull case for higher valuation multiples on this maturing tech giant could fall apart.
