The case against Apple (NASDAQ:AAPL) is reasonably simple. Yes, Apple stock looks reasonably cheap. But given that earnings are potentially at a peak, AAPL shares should be cheap. Not only that, it can still get even cheaper.
It’s a case I’ve made for some time now. The iPhone over the past four quarters has generated 58% of total revenue. Yet sales may well have peaked. Per the 10-Q, iPhone revenue already has fallen nearly 16% year-over-year in the first half of fiscal 2019.
That’s unlikely to change. The U.S. market is saturated, and replacement cycles are extending. Apple is not going to be able to institute the same pricing increases that drove revenue growth in recent years. And as is the case with all consumer hardware, whether it’s TVs or PCs, the gap between iPhones and lower-cost Android alternatives inevitably will narrow over time.
The bullish response is that even if iPhone sales drop, its Services business — including the profitable App Store — and growth in China can keep earnings stable at worst. With the AAPL stock price only about 15 times FY19 earnings estimates plus its cash hoard, that should be good enough.
However, that bull case has taken a clear hit recently. And while Apple stock has moved in response, falling almost 10% since a pop after Q2 earnings, it hasn’t moved far enough. Thus, AAPL stock can get a lot cheaper from here.
The Services Problem for the Apple Stock Price
The argument for Apple stock is that the underlying company can pivot from hardware to services. Certainly, management can leverage its enormous installed-user base to accomplish this transition. Wedbush analyst Daniel Ives in a note this week indicated that his firm valued the Services business between $400 billion and $450 billion. Many other investors and analysts see Services as driving the next phase of Apple’s growth.
To be fair, there are reasons for optimism toward the business. Apple doesn’t break out operating margins but they’re no doubt enormous. The company takes a piece out of the overall transaction for offerings like iTunes, the App Store, and Apple Music. It does this at little cost.
In fact, we know that margins are strong because some of Apple’s customers are rebelling. Netflix (NASDAQ:NFLX) cut off in-app subscriptions in an effort to get around the 30% “Apple tax”. It hasn’t been the only company to look at ways around the App Store.
But now, the Services business faces a real risk. The Supreme Court this week allowed a lawsuit against Apple to proceed. That suit alleges that the App Store acts as a monopoly toward Apple users. Because developers raise prices to account for Apple’s 30% fees, consumers are theoretically harmed.
The suit hasn’t been won, and will take years to play out. But Spotify Technology (NYSE:SPOT) has filed a complaint with the European Commission on similar grounds. And other big companies may follow Netflix’s lead.
Services growth isn’t going to stall out instantly. But with analysts like Wedbush assigning a 10x revenue multiple to the business, it’s an enormous part of the bull case here. An already tricky situation got even riskier with the Supreme Court decision.
China Conflict Weighs on AAPL
Suddenly, the recently escalating trade war raises another problem for the Apple stock price. The company is enormously reliant on China for its production. That’s even more true given that the hyped entrance of its supplier Foxconn Technology Group into Wisconsin has proven to be something close to a fraud.
Wedbush, which has an AAPL stock price target of $240, estimated the impact of the new tariffs. They forecast a hit of 50 cents for earnings per share in a base scenario. That ramps up to $1-plus if Apple can’t or won’t pass the costs on to consumers. JPMorgan Chase (NYSE:JPM) appears to see a similar effect. Another view sees Morgan Stanley (NYSE:MS) modeling a worst-case scenario hit of $3 per share.
But this isn’t just a cost problem. Again, Chinese growth is a big part of the bull thesis here. Wedbush noted that roughly 20% of pending upgrades come from Greater China. Chinese state-owned media is unlikely to help the company maintain those sales and neither are Chinese consumers.
The problem — the Q2 report’s perhaps most underappreciated aspect — is that sales in the region already are plunging. Revenue in Greater China fell over 21% year-over-year in Q2. Operating income dropped more than 27%. That comes after a somewhat promising rebound in fiscal 2018. And it undercuts yet another leg of the bull thesis for AAPL stock.
Could the AAPL Stock Price Head to $150?
In Wedbush’s bull model, Services account for over 40% of the valuation of Apple’s business. Greater China on the whole accounts for 20% of total operating income.
Both aspects of the business have taken a big hit just in recent days. And that comes after a Q1 report that, while initially well-received, didn’t seem to help the bull case much to begin with. Indeed, the Apple stock price gave back the post-earnings gains relatively quickly, even before the external news this week. Services revenue was essentially in line with expectations and the drop in China was much greater than modeled.
It’s hard to see the last two weeks as doing anything other than providing a significant hit to the bull case for AAPL. And while 14x earnings plus cash might seem cheap, it’s not cheap if earnings are peaking. Sales performance of iPhones still suggests that’s likely at least in the near term. EPS is expected to decline this year even with substantial help from share repurchases.
In the long term, China and Services are supposed to drive earnings to new heights. Investors can’t ignore the fact that news this week undercuts that thesis. And it in turn suggests a valuation closer to 10x to 12x EPS plus cash. That gets the Apple stock price under $150, and back to December/January lows.
Fundamentally, there are real problems here. And if the trade war continues, and Services optimism moderates, the growth narrative starts to crumble. This is a worrisome week for Apple stock, and it could signal more trouble to come.
As of this writing, Vince Martin has no positions in any securities mentioned.
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