In a letter to shareholders released after the market closed yesterday, Apple (AAPL) CEO Tim Cook surprised the market by stating the company is lowering its financial guidance for its December quarter. The company now expects revenue to come in at $84 billion for the December quarter. Previously, Apple’s revenue guidance was $89 billion to $93 billion and analysts were estimating $91.3 billion, on average. This news was disappointing and a shock to many investors and the stock sold off almost 10% today. Given this volatility, we wanted to provide our clients with an in depth look into Apple’s real numbers and discuss some of the headwinds that Cook cited in his letter in more detail.
Tim Cook cited both macroeconomic and Apple-specific factors as the leading causes of this lowered guidance. Not surprising, the primary macroeconomic headwind that Tim Cook mentioned was the slowdown in China. Cook mentioned China 11 times in his letter as he clearly wanted to make the point that most of this lowered guidance stems from the China/U.S. trade tensions. Cook did not provide too many details on the Apple-specific issues, but we can deduce that the Apple-specific issues are really just the slowdown in iPhone unit sales.
Most analysts have known for some time that iPhone sales growth was starting to slow down in developed markets. Apple also clearly noticed this trend and has been attempting to move analysts away from valuing the company strictly on iPhone unit sales and towards overall earnings and revenue growth. Apple took this a step further when they announced that they will no longer be reporting total iPhone unit sales in their earnings releases going forward. This was always going to be a choppy process and the timing could not have been worse for Apple.
In Cook’s letter, he stated that “lower than anticipated iPhone revenue, primarily in Greater China, accounts for all of the revenue shortfall in our guidance and for much more than our entire year-over-year revenue decline.” In an exclusive interview with CNBC, he stated that Apple saw economic growth in China decline more than expected in the second half of the year. The company also pointed to the trade tensions between the U.S. and China as something that put additional pressure on the economy.
While he did not come out and say this outright, Tim Cook did allude to some Chinese consumers boycotting Apple products due to the trade war with the U.S. Simply put, some people are not purchasing Apple products simply because it is an American company. The recent arrest of the Huawei CFO may have helped stoke the fire for Chinese citizens and caused them to boycott Huawei’s largest U.S. competitor, Apple. The Chinese government has been very careful to state that they are not calling for any type of boycotts for any U.S. companies because this would give the U.S. a stronger position at the negotiating table. The Chinese absolutely do not want President Trump to call for a boycott of Chinese products. This could be very devastating for the Chinese economy and the companies in China that sell most of their products to the U.S. Our expectation is that there is some truth to this as we have seen evidence of anti-U.S. sentiment picking up over the last few months. We anticipate that this will be a temporary theme that should dissipate over time as trade tensions ease.
In addition, competition from Chinese smartphone makers has also played a role in this slowdown as Apple viewed the Chinese market as one of the best opportunities to continue iPhone unit sales growth. It now appears that competitors like Huawei may be more of a threat to this strategy than Apple originally anticipated. These competitors have been able to produce a viable smartphone at lower price points. This may cause Apple to rethink their strategy for iPhones going forward and may cause them to produce much lower priced units to compete in different geographic regions where disposable incomes are much lower. Apple has also not been able to “crack” into the India market that has over 1.3 billion people. Very few people in India have an iPhone and this includes India’s luxury marketplace. If Apple can go from around their current zero percent to around a 5% market share in India that would have a huge effect for Apple and allow them to diversify their Emerging Market exposure away from China. In the past, Cook has recognized the opportunities with India and other emerging markets and we hope they are working on strategies to engage these markets going forward. The first step towards getting exposure to India’s markets may have already been announced with the new Apple Foxconn factory opening in India. Hopefully, Indians will be more willing to buy iPhones that are manufactured in India.
Cook also acknowledged that while iPhone sales were most disappointing in China, they were also not as strong as anticipated in developed markets. The main reason for this is consumers are waiting longer to upgrade their iPhones. To combat the lengthening replacement cycle facing the iPhone, Apple is undertaking an initiative to make it simple to trade in a phone at its stores so that a consumer can trade in their older iPhone and upgrade to a newer iPhone at a lower price. They are also working on implementing a program that will allow consumers to finance their phone purchase directly with Apple. This will allow consumers to pay for their phones over time, which is what most of the wireless carriers did over the past years to get consumers in the door. This should help Apple’s iPhone sales going forward as giving consumers more choices on how to buy the phones is very important when talking about a higher end product.
Despite these short-term hiccups, Apple is still very well positioned for the long term. The company is growing every other piece of its business. All remaining categories (Services, Mac, iPad, Wearables/Home/Accessories) combined to grow almost 19% year-over-year. For example, wearables grew almost 50% year-over-year. Cook stated that “Apple Watch and AirPods were wildly popular among holiday shoppers.” The newly launched MacBook Air and Mac mini is driving the Mac to year-over-year revenue growth and the launch of the iPad Pro will drive iPad to double-digit revenue growth. Just a few years ago, there were worries that falling iPad and Mac sales were overblown fears that weighed on Apple’s share price. While revenue wasn’t as strong as the company originally projected, Apple still expects to “set all-time revenue records in several developed countries, including the United States, Canada, Germany, Italy, Spain, the Netherlands and Korea.”
Another very bright spot for Apple’s future is the services side of its business. We have talked about Apple pivoting to services, which Cook stated yesterday is continuing to grow at a very high rate. This is a high margin side of the business and includes things like the App Store, Apple Music, Apple Pay, and iCloud. According to Cook, all these divisions hit records. Overall, the revenue for the services business is expected to be $10.8 billion for the quarter. The revenues that come from Services is more “recurring” so it is a very good sign to see this segment growing. While consumers are spending more, Apple stated they have 100 million more new devices in service today than they did a year ago. This should continue to drive Services revenue higher and, in our opinion, should continue to drive continued revenue growth.
Even with this lower guidance on revenue, we expect Apple to post a 7% increase in year-over-year EPS. The current math puts Apple’s EPS at $4.16 per share in their fiscal Q1. If this ends up being the number as expected, Apple’s trailing twelve-month (TTM) earnings will be $12.15 per share. At Apple’s current stock price, the TTM Price to Earnings (P/E) Ratio comes out to 12.02. If you back out Apple’s net cash, which currently stands at approximately $26/share, the market is valuing Apple at $116, or below 10x earnings. When compared to the S&P 500’s 25-year average market P/E of 16.1, Apple shares are trading at a significant discount to the rest of the market. The actual cash number stands at $130 billion. To put this in perspective, Apple’s cash position alone is worth more than the market capitalization of all but the top 34 companies in the S&P 500. This large cash position gives Apple a great deal of autonomy to return cash to shareholders. Cook restated that the company’s goal is to be “net-cash neutral” over time, which hints at larger share buybacks or dividend increases. Cook stated, “I believe the company’s stock is an incredible value and so you can bet that we’re going to be buying some stock under the plan that we’ve had out there for quite some time.” This cash position also gives the company plenty of dry powder to make larger acquisitions, something Apple has historically shied away from but could come back into focus now that the share price has come under pressure these last few months.
The bottom line is that Apple is still the most profitable company in the world and while they may hit a few more speed bumps as they focus on transitioning more of their revenue towards other business segments, we still expect that the company will continue to innovate and evolve. Until that story is no longer intact and we see several segments of their business decline or iPhone revenues continue to fall (beyond one quarter in one country), we do not believe a short-term revenue revision is indicative of a long-term trend. We still remain positive on the outlook for Apple and understand that it may take a few quarters before the sentiment changes on this stock. Until then, we believe this is a good entry point for investors who do not already have a position in Apple and for those that already own shares we recommend holding your current position.
PFA Investment Committee
Jim Reding Ryan Powers
Bob Spindel Brad Combs
Matt Schaller Matt Kellermann