Apple’s Earnings Conceal Hidden Achilles Heel as Stock Rebounds

Apple Inc.’s (AAPL) better than expected earnings results and rallying stock price have caused investors to overlook an Achilles heel that clouds the company’s long-term outlook. Apple’s sharp slowdown in sales growth and higher costs have caused a drastic dip in operating margins – a key measure of profitability – to 21.5% in the third quarter, its lowest in more than a decade, according to data from S&P Capital IQ, per a detailed column in the Wall Street Journal as outlined below.

Apple’s slowing sales and lower margins largely reflect pressures from the steep decline in sales of iPhones, which contribute about half of the company’s sales. As a result, operating margins on an annual basis are forecast to fall 11 percentage points from their 35.3% peak in 2012 to below 24.3% for this year, the lowest since 2008, according to Apple and FactSet, per the Journal. Falling margins may make it increasingly difficult for Apple to boost its earnings and share price.

In the fiscal third quarter, Apple posted revenue up a mere 1%, weighed down by a 12% dip in iPhone sales. Investors were relieved by the better than expected results, driven largely by Services and other hardware segments. Nonetheless, Apple is forecasting another revenue decline in the fiscal fourth quarter. 

A sharp increase in costs for Apple has made its sales slump more of an issue. In fiscal Q3, the company’s operating expenses rose 11% over the same period last year as it spent a record $4.3 billion on research and development. Still, it’s noteworthy that Apple has kept costs down by investing much less on R&D than its other large tech companies. Apple’s R&D expenditures have averaged less than 5% of annual revenue over the past five years. For comparison, Alphabet Inc. (GOOGL), Microsoft Corp. (MSFT) and Amazon.com Inc. (AMZN) have allocated between 12% and 16% for R&D purposes over the same period, per the Journal.

As the pressure builds for Apple to turn away from iPhones and diversify into new businesses like entertainment, augmented reality and driverless cars, investors will be keeping a close eye on how its margins hold up. 

To be sure, many investors and analysts see Apple paving a smooth path to a new leg of growth by diversifying from legacy hardware to focus on Services, wearables and other businesses. Wedbush analyst Daniel Ives called the latest quarterly results a “major feather in the cap for the bulls,” set to drive Apple’s stock to new highs over the coming months, per Bloomberg. That optimism will face a stern test. The latest quarter also was a watershed in that it was the first period in at least six years that the iPhone did not account for the majority of Apple’s revenues.