- Apple Inc. is expected to introduce the long-awaited mixed reality headset at WWDC23 this week.
- Anticipation for the device has been cooking for a while, and now risks launching into an economic slowdown with interest in the technology overshadowed by momentum in generative AI.
- But the new device category launch will be of symbolic importance for the stock, even if it is not expected to derive meaningful incremental value to Apple's near-term valuation prospects.
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Unlike last year’s The Apple Worldwide Developers Conference ("WWDC") marketing campaign, which featured a series of hidden Memoji messages via an AR experience that is more on-brand with the anticipated mixed reality headset launch, Apple Inc. (NASDAQ:AAPL) has resorted back to its abstract artwork-based promotions for the 2023 keynote event. When asked the infamous 2015 WWDC headliner question – “Hey Siri, give us a hint” – the smart assistant mirrors management’s tight-lipped stance, with a redirection to the WWDC landing page that features a fluid, mercury-like Apple logo (if you have any idea of what this might imply, please drop a comment below!):
But the long-awaited headset launch will indubitably be the star of the show this afternoon – and anything otherwise would be a disappointment (or an unlikely blockbuster surprise – say, an Apple Car – that might even put investors and consumers alike on the edge of their seats). Meanwhile, Apple risks debuting its new device category into a consumer slowdown, with little momentum left for virtual experience developments as tightening credit conditions shun investors away from capital-intensive projects with the realization of investment returns far out into the future. This all looks to be a classic case of bad timing – if Apple does not unveil the headset at WWDC 2023, it risks disappointing bulls that had placed their bets on a new device category to jumpstart sales; and if it does launch the device, it risks selling into a muted demand environment for discretionary goods.
The mixed near-term prospects for Apple’s upcoming rollout of its new device category is further corroborated by the recent introduction from key rival Meta Platforms, Inc. (META) of the upgraded Quest 3 headset. The overhauled headset boasts a series of upgrades spanning a next-generation Qualcomm Incorporated (QCOM) Snapdragon chipset and new displays, yet has garnered little excitement from investors nor end-market consumers. And the same goes for the Quest Pro launched last year targeting enterprise use cases. This underscores the challenging demand environment that Apple’s flagship mixed reality headset faces, despite the tech giant’s long reputation as a pioneer of disruptive consumer electronics, capable of pushing even the most speculative devices into mainstream interest.
The excitement over AR/VR developments have long been overshadowed by the challenging macroeconomic backdrop that has blighted related investments over the past year. And the more structural shift in interest to generative AI has only further clouded optimism for a near-term break-out in virtual experiences, despite expectations that the two technologies can be complementary to one another. Apple management’s cautious optimism over the widespread application of generative AI also does little to reinforce interest and incremental momentum for the new mixed reality device category.
In a market where profitable growth comes first in investors’ preference, the upcoming debut of Apple’s mixed reality headset is unlikely to do much for the stock given the device category is not expected to become profitable nor contribute meaningfully to the company’s P&L at launch. And any immediate market optimism over the longer-term incremental value-add that the new device category would generate for Apple would likely lack durability as related value accretive factors will take time to ramp up, leaving room for immediate concerns spanning slowing growth and persistent cost pressures to re-emerge as near-term drivers of the stock’s performance.
What to Expect on Apple’s Mixed Reality Headset
It has long been known that the upcoming mixed reality headset will not be Apple’s core focus area with regards to its ambitions in virtual experiences, but rather a prelude to its pursuit of “larger opportunities” in augmented reality. In the meantime, its flagship mixed reality device will likely offer similar features as existing headsets in the market:
- Display: The exterior will be a combination of “glass, carbon fiber and aluminum,” combined with a mixed reality display featuring 4K resolution lenses that integrate with the “video pass-through mode” to enable AR experiences embedded onto real world surroundings.
- User experience: Users can easily toggle between VR and AR modes with the “Digital Crown” that is fixed on the headset, similar to the dial on Apple Watches. The company is targeting a wide range of use cases for the devices, spanning “communication, video consumption, wellness, gaming and productivity.” This underscores substantial adjacent demand opportunities for Apple’s services sales – a key vertical for optimizing monetization and profitability (service sales generate higher margins) of its massive, and still-expanding device installed base. This is in line with Apple’s efforts in recent years to bolster the development of APIs aimed at improving adoption of hands-free features like Siri and Dictation announced during WWDC 2022, as well as SDKs aimed at expanding the use cases of its mixed reality headset.
- Power: The device is expected to charge on an external battery pack that features technology similar to recent MagSafe capabilities developed for Apple’s existing device line-up. The mixed reality headset’s battery pack is expected to be similar in size to the MagSafe battery pack for iPhones, with a “proprietary connector [that is] magnetic and designed to lock into the [device] during use with a twist so it can’t be accidentally detached.” The external battery pack is capable of juicing up the headset for two hours of use before it needs to be connected with a power source again.
- Performance: The new headset will feature Apple’s M2 silicon, boasting 16GB of RAM, which is comparable to the Gen 2 Snapdragon fitted into Meta’s Quest 3. The M2 is built on the 5-nanometer process note, and features “over 20 billion transistors,” underscoring better performance than the M1, enabling a “superfluid” experience when “multitasking and running multiple apps” – a must for the mixed reality headset.
The device is expected to boast an initial sticker price in the $3,000 range, which is steeper than earlier speculations in the $2,000 range before inflation proved itself to be stickier than expected. Such a price tag would put Apple’s introductory headset at 3x the price of Meta’s Quest Pro and 6x the price of the newest Quest 3, catapulting it to the top-three ranks of most expensive consumer-facing mixed reality devices.
The pricey debut is likely to be met with a tepid demand environment that has been further exacerbated by a challenging macroeconomic backdrop blighted by persistent inflationary pressures, rising borrowing costs, and ensuing recession risks that has consumers winding down on discretionary spending. The company is expecting to sell 900,000 units of the mixed reality headsets in their first full year in the market, with longer-term optimism underpinned by use case expansion which hangs on developers’ ability in creating apps that will reinforce consumer interest in the new device segment. This translates to about $2.7 billion in revenue contribution from the headset’s first full year sales – or less than 1% of Apple fiscal 2022 consolidated sales – which is in line with our expectations that the new segment will not have a meaningful immediate impact on the stock’s fundamental nor valuation prospects.
But the bigger opportunity from the headset’s debut likely resides in adjacent services sales. Apple’s more profitable services sales have been a sole bright spot in recent quarters where its product sales have been blighted by weak demand dragged by the deteriorating consumer. The App Store alone is estimated to have brokered more than $1.1 trillion worth of in-app transactions – spanning digital ads, and in-app goods and services sales – during 2022, representing a 29% expansion from 2021. The company, which charges as much as 30% in commission fees on in-app transactions brokered through the OS operating system, said “90% of the $1.1 trillion went entirely to businesses,” underscoring App Store’s predominant revenue contribution in services segment sales.
The upcoming debut of Apple’s mixed reality headset and ensuing demand ramp up is expected to drive incremental App Store transactions and further bolster growth in service sales – the company’s emerging cash flow engine – marking tremendous valuation prospects beyond device sales over the longer-term. Pushing the headsets’ use case into the mainstream would also complement Apple’s ongoing efforts in optimizing monetization of its massive device install base by bolstering subscription sales, which is fast approaching 1 billion paid subscribers.
…we saw increased customer engagement with our services during the quarter. Both our transacting accounts and paid accounts grew double digits year-over-year, each setting a new all-time record…paid subscriptions showed strong growth. We now have more than 975 million paid subscriptions across the Services on our platform, up 150 million during the last 12 months and nearly double the number of paid subscriptions we had only three years ago. And finally, we continue to improve the breadth and the quality of our current services offerings from new content on Apple TV Plus to great new features available in Apple Pay and Apple Music, which we believe our customers will love.
Source: Apple F2Q23 Earnings Call Transcript.
Fundamental Analysis Update
Adjusting our fundamental forecast for Apple for the company’s latest March quarter results and management’s commentary on the underlying business’ forward outlook, consolidated revenues are likely to pare full-year declines at about 2%. The anticipation for sequential improvements in the second half of fiscal 2023 will be primarily driven by an upgrade cycle across the Mac line-up, which is expected to complement well with upcoming back-to-school seasonality demand trends, and coincide with likely improvements in the tepid PC market that industry estimates to have bottomed during the March quarter. Meanwhile, services sales are likely to maintain growth in every quarter of fiscal 2023 despite looming macroeconomic challenges with recent economic data pointing to escalating recession risks, reflecting the strength of Apple’s device install base and the ensuing stickiness of its ecosystem.
Notwithstanding incremental AR/VR headset sales, which are expected to be nominal over the near-term, Apple is expected to expand at 6% CAGR over the next five years, driven primarily by the higher margin services segment.
On the profitability front, management is expecting to preserve current gross margin trends at the 44% range despite ongoing headwinds to the top-line. However, Apple’s internal opex forecast of $13.7 billion at the mid-point – which is in line with results during the March quarter – implies elevated R&D and sales and marketing spend as a percentage of revenue relative to historical levels in the current quarter, underscoring a potential uptick in near-term expenses to accommodate the new device segment’s launch.
Based on a discounted cash flow analysis on projected cash flows taken in conjunction with our fundamental forecast for Apple, with the application of an 8.6% WACC in line with the company’s capital structure and risk profile, the stock’s current price at about $181 apiece (June 2 close) implies a 4% perpetual growth rate. This approximates the pace of economic expansion across Apple’s core operating regions, with a slight premium that is reflective of the company’s contributions as a growth company with a leading moat in key next-generation technologies alongside robust cash flows.
Meanwhile, under the multiple-based valuation approach, Apple continues to trade at a slight premium to the broader tech peer group at about 7x estimated sales and 29x estimated earnings.
i. Sales Growth vs. P/S Multiple – Nasdaq 100 Tech Sector
ii. EPS Growth vs. P/E Multiple – Nasdaq 100 Tech Sector
Considering the slight valuation premium observed across the different valuation methods, it is unlikely market has priced material incremental value stemming from the upcoming debut of Apple’s mixed reality headsets into the stock. This is in line with our expectations that the upcoming product debut will be more of figurative importance in maintaining market confidence in the company as a leading innovator in tech with a robust balance sheet, rather than of pragmatic impact on resolving near-term macroeconomic challenges facing Apple’s immediate-term growth prospects.
Based on back-of-the-napkin calculations, assuming unit sales of 900,000 mixed reality headsets at $3,000 apiece in the first full year of market availability, Apple is expected to generate related sales of about $2.7 billion in the 12 months following the device’s initial go-to-market expected later this year – a schedule that would give developers time to build-out an app ecosystem to facilitate the device category’s demand ramp up without forfeiting holiday season interest, similar to timelines observed in its historical new segment launches. Applying a 6x estimated sales multiple on AR/VR category’s initial annual sales rate of about $2.7 billion, in line with Apple’s average historical trading levels, the headsets demonstrate potential in adding about $16 billion in incremental value to the stock, taking the company closer to the $3 trillion mark from the current $2.85 trillion level. However, the durability to such estimates are likely unsustainable within the foreseeable given slim margins at take-off, alongside substantial uncertainties to the demand environment considering current market observations of tepid take-rates for rival offerings.
The device will cost around $3,000 and Apple isn’t planning to make much money from it. It could be one of the few Apple products to not provide a big margin as Apple doesn't want to completely price itself out of the market.
Source: Bloomberg News.
The Bottom Line
AR/VR device sales typically benefit from seasonal demand during the December-quarter holiday shopping period. This is in line with speculation over Meta’s Oculus App downloads whenever Christmas rolls around as market looks to it as a barometer on end-market interest in virtual experiences. The upcoming holiday season should be a telling tale on where Apple Inc. stands in an AR/VR arms race that appears to have lost the market’s attention in preference to the burgeoning momentum in AI – any delays with the go-to-market strategy would likely be a disappointment. In the meantime, the new device launch is not expected to drive significant changes to the stock’s prospects, despite the critical symbolic role of the event in preserving investors’ confidence in the underlying business’ innovation and cash flow moat.
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Livy Investment Research is a technology sector research analyst providing long investment ideas by uncovering hidden value ahead of the tech innovation curve.Livy runs the investing group Livy Investment Research. They provide deep-dive coverage, interactive financial models, industry primers and community chat. Livy covers companies that are playing a fundamental role in tackling existing technology hurdles capable of capitalizing on long-term growth frontiers. They include electric and autonomous vehicles, semiconductors, cloud-computing, AI/ML, cybersecurity, and analytics – all of which are disrupting legacy norms and contributing towards a more efficient, value-adding economy. Learn more.
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