Wealthy customers will help Apple withstand the effects of inflation

The last time Apple faced an inflationary environment like this, it had been a public company for less than a year and its best-selling product was the Apple II home computer.

In May, the US annual inflation rate was 8.6%, the highest since 1981. Other major markets for Apple sales are seeing similar or even higher inflation rates.

Apple faces rising costs from global logistics and rising employee salaries, as well as the possibility that consumers will put off their iPhone upgrades because of falling spending power. Apple is also facing supply shortages related to this year’s China shutdowns, which could result in an $8 billion drop in sales.

Many companies, particularly those with pricing power, are able to pass increased costs on to their customers through price increases, especially when demand is strong. Apple hasn’t increased the prices of iPhones in the US, but regularly adjusts prices around the world in response to currency fluctuations. In a few years, Apple has changed its product pricing structure for its line of new fall devices.

Apple could also eat up some of the costs, hurting its margins while prices remain stable so as not to hurt demand.

“From an inflation perspective, we see inflation,” Apple CEO Tim Cook told investors on a conference call in April. “It is or was evident in our most recent quarter gross margin and most recent quarter OpEx, and is assumed in the guidance [CFO] Luke [Maestri] also gave for this quarter. So we’re definitely seeing a level of inflation that I think everyone sees.”

Cook said there are at least two places that inflation shows up on the company’s balance sheet: gross margins and operating expenses.

Apple’s gross margin for the quarter came in at 43.7%, ahead of analysts’ expectations but slightly below the December quarter, which was the highest since 2012, according to FactSet data.

Apple’s margin will decline in the June quarter, landing between 42% and 43%, Maestri said. But Apple’s margins rose during the pandemic, and they’re still at elevated levels on a historical basis.

Operating expenses for the quarter were $12.58 billion, up nearly 19% year over year. For the June quarter, Apple forecast a sequential increase in operating expenses to approximately $12.8 billion.

Freight costs are a source of these costs.

“Freight is a huge challenge,” Cook said in April. “From an inflationary perspective and from an availability perspective.”

Further rising costs are linked to silicon shortages caused by China’s Covid-19 lockdowns in the first half of the year and a general shortage of less advanced chips needed to complete its products. However, Cook said some components are getting cheaper.

Apple could also face increased labor costs. The company is raising salaries for its corporate and retail employees in response to market conditions after some peers, including Google, Amazon and Microsoft, made changes to their pay earlier this year to attract and retain top tech talent.

“Other companies we follow lack margins on cost inflation, but Apple views its basket of costs as relatively stable, with lower raw material costs offsetting higher labor and freight costs,” said Katy Huberty, an analyst at Morgan Stanley, in a note following the earnings report.

But increased costs aren’t the worst-case scenario for Apple. The bigger risk is that inflation and other macroeconomic conditions will hurt demand for Apple’s products.

During a recession or in the face of falling purchasing power, consumers have traditionally put off buying durable goods, including electronics, economists say.

In Apple’s case, that could mean consumers who bought a phone two or three years ago might not upgrade to the latest model this year, deferring costs until economic conditions improve.

“Sometimes you just exercise caution and postpone buying,” says Jim Wilcox, an economist at the University of California Berkeley. “Waiting is a very sensible financial strategy.”

Investors have largely come to terms with the fact that Apple customers are loyal and therefore likely to continue upgrading their devices regularly, but an inflationary slowdown could challenge that belief and hurt Apple’s earnings multiple.

“In Apple’s case, they have a very strong ecosystem, their customers are very loyal,” Bernstein analyst Toni Sacconaghi said on CNBC this week. “But most of their revenue is generated from product sales and that’s largely driven by loyal customers and when you go into a recession, customers may delay purchases or upgrades. So this revenue stream isn’t exactly recurring, it’s mostly transactional. “

Apple hasn’t signaled weakness yet. In April, it said demand remained strong and indicated there were no signs of a deterioration in consumer confidence. The bigger problem was producing enough supply to meet the demand for its products.

But the smartphone and laptop markets are showing some signs of slowing down. The high-end portion of the smartphone market, where Apple sells, is holding up better than the bargain box, although overall phone sales are starting to fall. Micron Technology, a provider of memory for Apple devices, warned on Thursday that both smartphone sales and PC sales would be significantly lower than previously thought due to weaker consumer demand, partly caused by rising global inflation.

According to the latest estimates from Counterpoint Research, unit shipments of so-called premium devices costing $400 or more fell 8% in the first quarter, compared to 10% for the broader market.

Apple can afford some additional costs. Its sales have grown over the past two years and it maintains a healthy margin that is the envy of its hardware competitors.

But Apple may not have to bear these higher costs at all.

Customers typically have significant disposable income compared to Android device buyers, who tend to choose on price.

In the “ultra-premium market,” or phones priced above $1,000, Apple grabbed 66% of unit shipments in the first quarter, according to Counterpoint.

“With global inflation rising, entry-level and lower-priced segments are likely to be hit more,” the Counterpoint researchers wrote.

According to a June survey by Morgan Stanley, 70% of US consumers plan to rein in spending over the next six months due to inflation. But wealthy households – Apple’s customers – were more positive about their finances and the development of the economy.

“Households with incomes over $150,000 are more resilient; the highest increase in austerity plans is seen among the middle-income cohort,” Morgan Stanley analysts wrote.

Apple has increased the price of its iPhones several times over the past five years.

In 2017, Apple introduced a high-end $1,000 iPhone model that attracted a significant segment of customers willing to pay for a more powerful device. More recently, Apple quietly raised prices in 2020 when it raised the starting price of its top-selling mainline model — then the iPhone 12 — from $699 to $799.

Reuters noted on Friday that Apple has raised the price of its flagship phone by nearly a fifth in Japan, with the entry-level iPhone 13 now priced at $870.

Could the company raise prices more broadly again this year? Cook hasn’t ruled it out.

CLOCK: China lockdown could cost Apple $8 billion