Apple’s shares were down 4.6% in 2015 after increasing each year for the previous six years. The stock has started 2016 down 7.7% to $97.13, which is slightly better than the S&P 500’s 8.0% decline and the NASDAQ’s 10.4% fall. While I side with the Bulls the Bears have valid arguments that at least the shares won’t do much this year. (Note that I own Apple shares).
As we head into Apple’s December quarter earnings announcement on Tuesday, January 26, there is a tug of war going on between the Bears, who have been right the past six months and the Bulls who had been right for the prior two years. Apple’s iPhone takes center stage in both the Bull and Bear cases since it generated 66% of the company’s revenue in fiscal 2015 and a higher percentage of profits. However depending on your point of view Apple’s other products will start to positively impact the bottom line or just languish along and not do much.
Bull case: iPhones will grow again
Even the Bulls concede that the iPhone has very tough compares and many have iPhone unit sales declining in fiscal 2016 but holding their margins and showing growth in fiscal 2017. There have been at least two analysts in the past 10 days (Mizuho and Bank of America Merrill Lynch) who have reduced their iPhone and earnings estimates but upgraded their rating to Buy on Apple’s shares.
There are three reasons they believe iPhones can return to growth but at a lower level than what Apple had experienced. They are counting on the iPhone 7 when it is launched in the typical fall timeframe to have enough new features to get users to upgrade, an updated smaller screen iPhone 6x with features such as Apple Pay becoming available and a larger install base of loyal iPhone users generating higher sales as they upgrade. They also believe that the overall smartphone market will grow and that Apple can continue to increase its share, which leads to a larger install base.
Bull case: China growth will slow but still do well
Apple’s China revenue increased by at least 70% year over year for each of fiscal 2015’s quarters. While the growth rate will slow China is a market that the Bulls expect Apple to continue to do well. A combination of a growing middle class and increasing its number of Apple stores should allow the company to grow in that region. China Mobile’s continued 4G rollout should also help Apple over the next couple of years. India is looked on as another large market but that it will take a few years to develop.
Bull case: Macs and iPads 20% of revenue helps
Apple’s Macs should more than hold their own in the PC market and generate 10% plus of the company’s total revenue. With $25 billion in yearly revenue and another device that helps build the Apple ecosystem it is a nice piece to the company’s overall revenue stream.
The iPad has definitely taken a hit. After selling 71 million in fiscal 2013 its sales fell to 55 million in fiscal 2015. Unless the new iPad Pro really takes hold, which I think may do ok but not anything spectacular, iPad sales could fall again in fiscal 2016. However it did generate $23 billion in revenue last year.
Bull case: Watch 2 should help
While investors have been underwhelmed by the Watch’s sales (I do think it could exceed expectations for the December quarter but would not be surprised to see a large dropoff in the March quarter since there are many channels discounting them) it should outpace the iPhone’s sales in its first holiday quarter and could come close to the iPad’s. A number of analysts are looking to the Watch 2 and subsequent versions to grow this revenue stream as more Apps become available.
Bull case: Other products and services will continue to add to the top and bottom line
Apple has a number of other initiatives that could continue to gain traction and lessen the company’s dependency on the iPhone to drive results. These include its increased focus on Enterprise customers (thank Tim Cook for this one since Steve Jobs essentially ignored them), Apple TV (which will probably need a streaming service to really take hold), the App Store (which is growing well and besides increasing its financial contribution makes it less likely Apple users will move to another platform) and Apple Pay which I am using more and more due to its convenience vs. the new chip credit cards I have received. The chip cards take a long time to process and many of the terminals I have tried to use them at don’t work. Pulling out my iPhone, pressing on Passbook and then putting my thumb over the home button works much faster.
One initiative that some Bullish analysts point to is an Apple Car. Due to a combination of it being multiple years out and new car companies losing money I overall don’t think Apple should be designing a car. Yes the software to make the various systems in a car a better user experience or expand it to the connected car environment makes sense, but not a whole car.
Bull case: Valuation is very attractive
With the shares trading at a substantial discount to its historical averages (which I don’t think is a valid argument since the company is much larger then previous years) and to the overall market (Apple is at about a 10.5x PE multiple vs. the S&P 500 at 15x) the shares have limited downside. If the company’s results come in either in-line or slightly better than expected the psychology could change and each PE multiple point is worth about $9 to $10 to the share price.
Bull case: Generate a lot of cash for buybacks and dividend increases
Apple generated $58 billion or $10 per share in free cash flow after capital expenditures and dividends last year. The Bulls see the company continuing to buy back more shares and increase its dividend. While I estimate Apple has about $17 in net cash after paying additional taxes to bring back its overseas holdings I believe it will be limited in how much more debt it can take on and stock it can buyback.
Bull case: Becoming more of an annuity business
Due to having an overall loyal user base and making it harder to move from Apple to another platform it can be argued that Apple has the traits of an annuity style business. Google’s Android platform helps with this in some ways due to its large fragmentation. Overall I agree with this thesis on Apple which means its stock should have a higher PE multiple.
Bear case: iPhone growth has peaked and will lose share
The Bears main argument is that Apple’s iPhones sales peaked last year with the iPhone 6 and 6 Plus and that there will be either declining sales or at best flat. This will lead to lost market share and to make up for it Apple will have to lower prices and margins to maintain its position. In fact an updated smaller screen version supports the argument that Apple needs a lower price point iPhone to grow.
I’ll let you be the judge of that but keep in mind that Apple’s business model is to not be the market share leader at all price points. However it does seem to have done a good job of having models at various price points that leads users to move up in price as they upgrade.
Additionally the Bears believe the iPhone 7 will have demand similar to the iPhone 6s since it will probably have the same screen size. Yes there will be additional functionality but not enough to create an upswing in sales.
Bear case: China is slowing
While Apple’s sales in China were on a tear in 2015 they will cool down in 2016 and if consumers are spooked by the almost 45% decline in the Chinese stock market since mid-2015 sales could be negatively impacted. Also there are numerous competitors offering almost as good a user experience as Apple’s iPhone at much lower prices so Apple could see its share gains of the past year erode.
Bear case: iPad’s continue too languish
The Bear’s are right on this point and Tim Cook’s pronouncements that tablets will replace PCs seems to be very far off if it happens at all. Even the new iPad Pro seems to be off to a slow start and the replacement cycles on iPads are much longer than Macs and especially iPhones.
Bear case: Watch doesn’t contribute enough to make a difference
Even an updated Watch won’t make enough of a difference. Assuming Apple sells 20 million in the first year at $450 each the $9 billion in revenue is less than 4% of the company’s total revenue and won’t grow that much even with a new version.
Bear case: Other services won’t be big enough to make a difference
Yes Apple has introduced a number of initiatives and products but its still the iPhone that makes or breaks the company. Until these can grow they won’t move the stock price.
Foreign currency hedges won’t help nearly as much
Toni Sacconaghi at Bernstein estimates that “gains on hedging contracts in fiscal 2015 will potentially amount to 7% of Apple's net income in fiscal 2016, which will roll off to some degree in fiscal 2016. It is unclear, if and to what degree, Apple might have some offsetting gains in fiscal 2016, though we suspect they will be modest.” If Sacconaghi is correct then this creates a headwind for Apple to increase earnings in fiscal 2016.
Bear case: Shares are fully valued
Since Apple has the largest market cap of any company and is seeing slowing if not declining sales it deserves a significant discount to the market. Until it can show sustained growth in at least the mid to high-single digits it deserves to be trading at around a 9x to 10x PE multiple.
Bear case: All its excess cash is overseas
Apple has a negative US cash balance and most of it US generated cash goes to paying its dividend, which most investors expect the company to increase. In fiscal 2015 I estimate that Apple generated $18 billion in US cash and spent $11.5 billion for dividends.
There is a limit to how much Apple can borrow so unless it can bring back a substantial portion of its overseas holdings investors could be disappointed.
