Merrill Lynch’s downgrade late last year was predicated on a weaker China but demand seems to have deteriorated materially over the past two months.
This analyst report was written by Wamsi Mohan
Apple Inc.
Rare miss but weakness likely to extend beyond Dec qtr
Apple stock is down approx. 7% after market following the negative preannouncement. Although the trade tensions with China could ease in 1H19, the broader demand weakness and slower upgrade cycles are likely to push units much lower in F19 (we now model 181mn units down from 210mn previously). Our downgrade late last year was predicated on a weaker China but demand seems to have deteriorated materially over the past two months. We remain Neutral as we expect further consensus negative revisions to continue to pressure the stock in the near term, although our scenario analysis suggests the stock is discounting structural declines in hardware and strong services deceleration.
Cutting Q1 rev guid. by $7bn, mostly due to China, iPhone
Apple updated revenue guidance of $84bn is $7bn (7.7%) lower than the $91bn +/-$2bn midpoint provided in the F4Q18 earnings announcement. Apple noted that over 100% of the y/y rev decline (above $4.3bn / above 60% of $7bn cut) is due to slower sales of the iPhone, Mac, and iPad in China. The company attributed the cut to slow GDP growth in China and China-U.S. trade tensions lowering retail store traffic as well as channel sales, with the impact especially high for the iPhone and the general smartphone market. In a further negative, Apple noted that developed markets were impacted by a worse than expected iPhone upgrade cycle, driven by weaker macro environment, fewer carrier subsidies, stronger dollar impacting ASPs, and prolonged use of older models given reduced pricing for iPhone battery replacements. All-in-all, Apple noted that lower iPhone sales accounted for all of the revenue guidance shortfall ($7bn) in the quarter.
Revenue ex iPhone grew 19% y/y, in-line with our estimate, with services coming in at
$10.8bn (higher than our $10.1bn estimate) and on track to double by 2020, wearables growing almost 50% y/y, and iPad up double-digits.
Lowering ests and PO to reflect China, iPhone weakness
We lower our estimates for iPhone units/revenues materially. Our FY19/20/21 EPS estimates move to $12.20/$14.07/$16.44 from $13.86/$15.26/$16.98 and our new PO of $195 is based on approximately (unchanged) 15x our C2019 EPS estimate of $12.6, given the slowdown in China/iPhones.
Other drivers to rev decline “playing out as predicted”
Apple reiterated that other factors highlighted in its F4Q18 earnings call are playing out as predicted, notably 1) later iPhone Xs/Xs Max launch timing creating tough y/y comp, 2) Stronger dollar to lead to 200bps revenue growth headwind in the quarter, 3) supply constraints limited sales of recently announced new products, with Apple highlighting the Apple Watch Series 4 and the iPad Pro supplies constrained for most to the entire quarter, while AirPods and the MacBook Air also constrained.
Price objective basis & risk
Our PO of $195 is based on approximately 15x our C2019 EPS estimate of $12.61. Our target multiple compares to the long-term historical range of 9-15x (median 12x). We believe the high end of the historical multiple range is justified given the smoother iPhone cycles, largely consistent growth in iPhone units and revs (with lower than historical cyclicality). We also think a 15x multiple is justified given a large cash balance and opportunity to diversify into new end markets, and increasing mix and diversity of services.
Upside risks are: gross margin upside from better mix of higher end iPhones, and tailwind from lower memory costs and lower warranty accruals, a faster than expected recovery in emerging markets, and faster than expected recovery in China App Store sales.
Downside risks are: potential trade conflicts, tariffs, and a stronger USD. Other risks are Apple’s continued significant exposure to the iPhone, commoditization in the smartphone market, intensifying competition in the tablet market, managing beat and raise expectations for EPS estimates, and requirement to maintain pace of product innovation.
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