Financial Report Preview | iPhone sales in China hit a low point, can AI and service business save Apple?

According to the financial news app Zhitong Finance, Apple (AAPL.US) will announce its third-quarter earnings after the US stock market closes on August 1st. Market expectations are that the company's Q2 revenue will reach $84.39 billion, compared to $81.8 billion in the same period last year, with earnings per share of $1.34, up from $1.26 in the same period last year.

Performance Review

In the previous quarter (Q2), Apple's revenue was $90.75 billion, exceeding the expected $90.01 billion, with earnings per share of $1.53, higher than the expected $1.50. At the same time, the company announced the largest ever $110 billion share buyback authorization, a 22% increase from the previous year's $90 billion. The company also approved a dividend of 25 cents, leading to a 7% surge in the stock price after the financial report was released.

However, iPhone sales, as Apple's largest revenue source, declined by 10.5% year-on-year to $45.96 billion, below the market's expected $46 billion. In particular, the company's sales in its third-largest market, Greater China, dropped by 8% to $16.37 billion. Fierce competition in the Chinese market has caused Apple to lose some market share, but this number still exceeded analysts' expectations of $15.25 billion.

Apple saw positive growth in its Mac product line, especially with the new MacBook Air featuring the M3 chip driving sales up by 3.9% to $7.451 billion. However, sales of iPads and other hardware products such as wearables, home, and accessories did not perform well. iPad sales fell by 16.7% to $5.56 billion, below market expectations.

The services business continued to perform well, with revenue growing by 14.2% to $23.9 billion, surpassing market expectations of $23.37 billion.

Third Quarter Outlook

In the Q2 earnings report, Apple did not provide guidance, but CEO Tim Cook hinted during the conference call that the overall sales growth rate for the third quarter is expected to be in the "low single digits."

Will AI be Apple's next "ace in the hole"?

Based on the performance of the previous quarter, investors are expected to closely monitor the performance of the iPhone business, especially as the company continues to face challenges in China. The market currently expects the business's revenue to further decline to $37.7 billion.

According to the latest report released by Counterpoint on July 15th, global smartphone sales have seen a 6% year-on-year growth for the third consecutive quarter.

However, Counterpoint's report predicts that Apple's global iPhone sales will remain stable, with strong growth in Europe and Latin America being offset by weak sales in China, due to intense competition from local Chinese companies including Huawei. The latest report released by research firm Canalys also shows a significant decline in Apple's shipments in the Chinese market in the second quarter of this year, causing it to fall out of the top five.

In April 2024, Huawei launched the Pura 70 series smartphones, continuing to challenge Apple's growth in China. In the 2023 fiscal year, the Greater China region accounted for over 18% of Apple's total revenue, making China still a very important market for Apple.

According to the consensus expectations compiled by Visible Alpha, analysts expect Apple's sales in the Greater China region to decline by 2.6% in the third fiscal quarter.

However, CFRA analysts suggest that the third quarter may mark the end of Apple's sales decline, followed by a recovery. The analysts believe that Apple's "fate in the region is changing" as price discounts have driven an increase in iPhone shipments in China.

CFRA expects that Apple's sales data in China will represent a low point in the company's revenue until the expected launch of the new iPhone 16.

Even more optimistically, Morgan Stanley analyst Samik Chatterjee has included Apple in the "Positive Catalyst Watchlist" ahead of the earnings report. The analyst states that Apple is well positioned to leverage the upcoming artificial intelligence cycle, especially through iPhone and overall revenue performance.

Chatterjee said, "We expect Apple to assure investors that the upcoming artificial intelligence upgrade cycle will officially begin in the 2025 fiscal year (end of September) and further progress into the 2026 fiscal year, leveraging a stronger starting platform in the 2024 fiscal year to bring better-than-expected revenue drivers."

He expects both iPhone sales and total revenue to exceed market expectations, which could alleviate investor concerns about Apple's valuation. Chatterjee forecasts that Apple's third-quarter revenue will reach $85.3 billion, with an estimated earnings per share of $1.38, both higher than the market's general expectations.

Strong Growth in Services Business

Driven by growth in App Store sales and subscriptions, the services business is expected to continue to grow strongly. With a sales mix of high-quality products and higher service sales, the gross profit margin of this business may also increase.

In the previous fiscal quarter, the services business accounted for over 26% of total revenue, leading analysts to see the potential for this business to become Apple's new growth engine in the near future. This is because Apple has significant advantages in the services market, including:

The large user base of devices allows Apple to further develop its subscriptions, app store, payments, and other services, as only Apple has the ability to leverage its devices to expand its services business; Apple has been integrating artificial intelligence into its applications, hardware, and service ecosystem. On June 10th, OpenAI and Apple announced a collaboration to integrate ChatGPT into Apple's experience, including iOS, iPadOS, and macOS systems. In the future, Apple may integrate more artificial intelligence features into its operating systems and hardware to drive more subscription revenue growth.

Investors will also be watching for updates on Apple's proprietary generative AI software, Apple Intelligence, which could trigger a significant device upgrade cycle.

Recently, a study by Counterpoint Research also showed that by 2025, Apple's services business may account for a quarter of the company's revenue.

According to the research, 2025 could be the first year that Apple's services revenue surpasses the $100 billion mark annually. Analysts believe that despite regulatory challenges, Apple's total revenue is expected to surpass $400 billion for the first time in 2024, mainly driven by growth in its hardware and services divisions.

While the iPhone will still account for half of Apple's revenue, its services strategy is proving effective. In 2019, Apple announced several new services, and a year later, the company launched the Apple One subscription service, dividing all its services into three different tiers.

Counterpoint stated that the App Store, Apple Care+, Apple Music, and the bundled subscription Apple One have brought Apple turning-point growth. Additionally, the growth of the iPhone in emerging markets will also contribute to the growth of other Apple products in the future, as many consumers entering the iOS ecosystem as new users are increasingly reliant on the Apple ecosystem, potentially spending more time and money on other Apple products.

This means that even as iPhone sales slow down, Apple's services business will continue to add value to the company and its products.

However, it is worth noting that ahead of the financial report, there were reports that Apple Intelligence would be released later than expected, unable to be released at the same time as the iPhone and iPad software updates, now planned to be rolled out to customers before October. Apple previously stated that these new features could help boost sales of this year's new iPhones.

Nevertheless, Chatterjee believes that the artificial intelligence cycle presents untapped opportunities for Apple, especially in improving profit margins, increasing iPhone sales, and the possibility of extending the upgrade cycle beyond the 2026 fiscal year