Apple, Inc (AAPL – Research Report) shares plunged Thursday morning, after a major revision to forward guidance. AAPL crashed to $144, down almost 10% since the previous close.
Apple CEO Tim Cook rocked the markets on Jan 2, with a public letter to investors lowering expectations for the upcoming Q1 2019 earnings report. Market watchers have been openly speculating that sales of Apple’s flagship product, the iPhone smartphone series, are going to be low – possibly very low. Apple’s decision, announced with the Q4 results on Nov 1, to stop releasing iPhone sales data did nothing to calm the waters. Now it looks like the company is attempting pre-emptive damage control.
What did Tim Say?
Cook’s letter started out innocuously enough, as a guidance revision for Q1 FY19 earnings report. The quarter ended on Dec 29; the report is due out on Jan 29. The new forecast shows that Apple expects the first holiday slowdown in the seven years of Cook’s tenure at the helm.
The revisions show approximately $84 billion in gross revenues, against the previous expectation of $89 to $93 billion, and significantly lower than the $88.3 billion reported in Q4 FY17. Cook attributed the lower revenue guidance to two main factors: economic weakness – and consequent slower sales – in emerging markets, especially China; and, related to that, fewer than anticipated iPhone upgrades.
In Cook’s exact words, “China’s economy began to slow in the second half of 2018.The government-reported GDP growth during the September quarter was the second lowest in the last 25 years.” It’s important to point out that the reported slowdown in GDP growth is only what the Chinese Communist Party is willing to admit; for outsiders, other data points (like Apple’s iPhone sales) may be more important indicators of China’s economic situation.
Apple’s Chinese business was described just two months ago – by Cook, no less, in the last earnings report – as “very strong.” Clearly, there has been a serious reversal.
The situation may be worse than anyone truly knows, as Cook stated that lower iPhone revenue – mainly in China – accounts for the entirety of the revenue shortfall, and exceeds the year-over-year decline. This puts iPhone’s China revenues about $10 billion in the hole, but that’s difficult to know for certain, as Apple is almost as opaque as the Chinese Communist Party.
Looking for Reasons
Quoting again from Cook’s letter, Apple believes “…the economic environment in China has been further impacted by rising trade tensions with the United States. As the climate of mounting uncertainty weighed on financial markets, the effects appeared to reach consumers as well, with traffic to our retail stores and our channel partners in China declining as the quarter progressed. And market data has shown that the contraction in Greater China’s smartphone market has been particularly sharp.”
Let’s unpack that a bit.
First, everyone has been worrying about the ‘trade war’ between the US and China. US President Donald Trump’s aggressive trade policies, and his willingness to impose tariffs to gain enforcement leverage, sparked an equally aggressive response from China. Until last December, the two governments appeared to be on a collision course toward conflicting protective tariffs.
That course was deflected by a Dec 1 meeting in Argentina between Trump and Chinese President Xi Jinping. Trump and Xi announced an agreement to postpone the imposition of new tariffs and to continue negotiating for 90 days. Just after Christmas, with about 60 days to go, Trump announced that “big progress” was being made.
It appears that both governments want to resolve trade issues without imposing permanent tariffs. The resolution, however, looks like it will depend on the personalities of Trump and Xi, and so is inherently unpredictable.
The iPhone Market Matures
The contraction in the smartphone market, however, should have been predictable. The market is maturing, as the laptop computer market did about 10 to 15 years ago. Customers have gotten used to the new devices, they have found the features they like and the models they like, and they no longer need to switch to the latest new device.
The upgrades to new devices, on the other hand, are no longer so impressive; there is a much greater gap between an iPhone 2 and an iPhone 3 than between the iPhone 7 and the iPhone 8. Improvements come in smaller increments, and so customers are more willing to wait several cycles before upgrading. Across markets, typical iPhone users are holding onto their devices for nearly 3 years, as opposed to the older average of 2 years.
Apple fought that trend with increasing prices, which for several years have produced rising revenues despite slowly flattening new-device sales. That strategy has now run up against China’s slowing economy and strapped consumers, and will no longer propel revenue growth in the Chinese market.
Market analyst Daniel Ives (Track Record & Ratings), of Wedbush, summed up reactions to Apple’s new guidance: “The fact that they missed that wasn’t the shock. It was the degree and how confined it was to China. The fact that China basically fell off a cliff was a jaw dropper, and combined with the lack of metrics, it makes investors feel like they’re walking blindfolded in the dark.”
Stock Traders and Market Analysts React
It didn’t take long for stock markets to react to Apple’s gloomier guidance. AAPL shares were down by 7.5%, to $146, in after-hours trading. Asian stock trading took a hit was well, with the Chinext composite index, which is tech-heavy, slipping 1% to 1,487 and the Shenzen slipping to 1,246. The damage wasn’t confined to Chinese equities; Tokyo’s Nikkei closed down 0.31% and the Hang Seng lost 0.26%. On Wall Street, the Dow Jones opened more than 300 points lower, for a loss of
Market analysts are already updating their ratings on AAPL. The stock retains its ‘Moderate Buy’ status, based on 15 ‘buy’ ratings and 19 ‘holds,’ and buoyed by the company’s strong cash holdings and profitable services segment, but the average price targets are being lowered in response to Cook’s letter. AAPL currently shows a 33% upside, based on a target price of $192 and a share price, in early trading, of $144. Expect that to change quickly.
See AAPL Price Target and Analyst Ratings Detail
Looking at AAPL, Oppenheimer’s Andrew Uerkwitz (Track Record & Ratings) responded to the new Q1 guidance with a ‘Hold’ rating. He said, “We believe the press release and guidance miss raises more questions than answers. 1) What is wrong in China? 2) Where does the iPhone go from here? 3) Is it clear yet, that Apple has a gross margin problem? We remain solidly on the sideline as we continue to believe investors are not pricing in longer-term risks.”
Taking a somewhat more upbeat view, Timothy Arcuri (Track Record & Ratings) of UBS retained his ‘Buy’ rating on the stock, but lowered his price target to $180, suggesting a 14% upside. In his comments, he noted that “The magnitude of the year-over-year decline was last seen during the iPhone 6s cycle due to very tough iPhone 6 comps.” Arcuri has been following Apple stock for over four years, and has a 76% success rate with an average return of 24% on his AAPL ratings.
And now for the Good News
Not all of Apple’s Q1 guidance was doom-and-gloom. According to CEO Cook, non-iPhone revenues showed a 19% gain year-over-year, with services and wearable (the Apple Watch and AirPods) leading the gains. The services segment posted $10.8 billion in revenues, powered by a 100 million user increase in the install base.
In addition, the company has $130 billion in net cash available – an enviable position for any corporation. Cook stated that Apple will use that cash to continue funding share buybacks and dividend increases – both good news for current shareholders and long-term investors.
