Apple: Not So Fast

While Apple (NASDAQ:AAPL) bulls are getting hyped up by the recent September 10th product unveil event. Specifically, the new iPhone 11, Apple TV+, Apple Arcade, the new iPad, and the Apple Watch Series 5. In my view, the unveil was somewhat disappointing and fuels the bear's case.

I will talk about the software services announcements and new Apple Watch and iPads later. Right now, I am going to focus on arguably the most important part of the event, the unveiling of the iPhone 11 series.

The iPhone 11, 11 Pro, and 11 Pro Max are the successors of the XR, XS, and XS Max, respectively. So, what were the major "upgrades" to this new iPhone lineup?

  • Triple camera on 11 Pro and Pro Max, double camera on 11
  • Improved field of view on iPhone cameras
  • Upgraded A13 Bionic chip (20% greater performance, using 30% less power)
  • Night mode for photos
  • 4X increase in optical zoom range
  • 4K, 60 FPS video
  • 4 hours more battery (11 Pro), 5 hours more battery (11 Pro Max)

On paper, the unveil looks pretty solid. Overall, the camera, battery, and chip all get major boosts. But, is there any single new feature that is a generational improvement from the last cycle to this new cycle? I would argue there is no major game-changing feature (excluding maybe night mode). The last time Apple integrated a massive new feature was with FaceID on the iPhone X. Since then, it seems Apple has made less groundbreaking technology, and more incremental adjustments to their lineup. While these latest adjustments are quite solid, it is really hard for me to see these new features being key selling points to help mitigate an elongating upgrade cycle.

The ASP/Unit Chicken Is Coming Home To Roost

The biggest selling point for the newest generation of iPhones will be the selling price. More specifically, the iPhone 11's $50 price cut relative to the iPhone XR. More than the camera, battery, or chip, the price has to be the main selling point. Don't forget, Apple is fighting a lengthening upgrade cycle as well as macroeconomic headwinds from China. Pricing will need to be the selling point. The problem is, Apple is likely lowering pricing in an attempt to reignite unit sales growth. The problem is, with lower ASPs come lower margins, especially if you believe the newest generations of iPhones are even more expensive to produce than the most previous generation.

As a result of Apple's previously aggressive pricing strategy towards milking the company's phenomenal brand, the company is now faced with a dilemma. The product itself is upgrading at a not-so-fast pace. There used to be a meaningful difference between two generations of iPhone. Since the product has matured, however, the pace of innovation has slowed drastically. Now, Apple needs to cut prices to keep consumer demand relatively high. Apple's previously well regarded ASP strategy that helped the business grow is now turning on them. Considering the lack of innovation, Chinese macroeconomic picture, and (most importantly) the elongating smartphone upgrade cycle, it is hard for me to see iPhone units doing any better than flat Y/Y, and could be down mid-single digits Y/Y at worst. This is regardless of Apple's pricing strategy, which keeps the higher end models at $999 and $1,099.

So, Apple may be in a seriously sticky predicament. While the iPhone 11/11 Pro/11 Pro Max generation of iPhones may be an upgrade from the previous generation, it isn't a large enough of an upgrade to offset current headwinds working against units. The Chinese macroeconomic picture, combined with a lengthening smartphone upgrade cycle, may bring units down Y/Y despite decreased ASPs.

The combination of decreased ASPs and slightly decreasing units will likely compress margins and overall iPhone revenues.

The Rest of The Event: Positive

While I was mostly disappointed with the iPhone portion of the event, the rest of the event was solid. Here is what was announced.

  • Apple TV+
  • New iPad
  • Apple Watch Series 5

First of all, let's start with Apple TV+, the second largest headline grabber after the new iPhones themselves. Most important was the price tag, a mere $4.99/month after the first year, which is free for buyers of the newest iPhones. The new Apple TV+ platform has already seen some massive marketing around its new original content shows. I believe Apple TV+ not only could boost services revenue, it could also boost iPhone unit sales. The Apple TV+ has already acquired quite a bit of talent in both the direction of their content (directors and writers) as well as cast members (think actors and actresses). One prime example of this is "The Morning Show" with high-level cast members like Jennifer Aniston and Steve Carrell.

While TV+ is unlikely to have huge margins like hardware and other software services, it serves a purpose for Apple, as it makes an already extremely sticky ecosystem even more sticky. On top of it, this new platform is tapping into an ecosystem that already has literally hundreds of millions of users. Combined with the fact that Apple can afford to set prices at $4.99/month, well below the ~$15/month services like Netflix (NFLX) cost, just adds to Apple's competitive advantage.

The new iPad, beginning sales on the September 30th, is an incremental improvement from the most recent iPad. The new iPad is nothing revolutionary and is starting to mirror laptops with a new keyboard and Apple Pencil compatibility. While it is an upgrade and could help iPad units in the holiday quarter, this is not going to be a huge catalyst for unit sales going forward. The newest iPad has not been a large step up, rather an incremental step that may boost unit volumes.

The final important part of the event was the unveiling of Apple's next generation smartwatch, the Apple Watch Series 5. The newest Apple Watch features an always-on display, an app that tracks the health of your heart, among many other features. While the newest Apple Watch is unlikely to have iPhone levels of success, it is a fairly significant stepup from the last "Apple Watch Series 4" generation of the Apple Watch. Improvements are still being made, and we should continue to expect continued innovation and growth from this business segment.

Where I Might Be Wrong on iPhone

Contrary to what I wrote about iPhone sales in the above section, there are some indicators that are pointing to decently strong iPhone demand in both the US and China. The Chinese trade war situation has dampened growth expectations in iPhone unit sales. However, there are a few indicators that may point to the contrary. There are reads that suggest immediate demand may be strong for these newest iPhones.

For example, the Taiwanese market has witnessed strong initial pre-orders. In addition, there has been some anecdotal evidence that suggests strong initial iPhone demand. There have been some decently long lines at various Apple stores in China and in Asian markets in general.

Yet still, there may be a reason for this demand. In the last cycle, Apple launched the XR, the most popular variant, a full month after the XS and XS Max. So, initial orders were for the XS and XS Max, the two least popular models. In this newer generation of iPhones, all three models are launched simultaneously. Because people are showing up for the 11, 11 Pro, and 11 Pro Max, rather than just the 11 Pro and 11 Pro Max, it appears that demand in general is shipshape. In reality, units are likely to be flat or slightly negative, despite downward leaning ASPs.

Apple: The Software Misnomer

The most difficult part about evaluating Apple is defining what the company really is. While it's convenient to brand Apple as a "software services company", the reality is quite the contrary. In the most recent quarter, 48.3% of total revenue was derived from iPhone sales, while services revenue totaled a little under half of overall iPhone revenue. While services is clearly the faster growing of the two segments and is a more recurring revenue stream, Apple is quite clearly not a services-based business. It is a hardware company that is slowly transitioning towards software services.

Therefore, Apple shouldn't be valued on 20-25X EBITDA like a software company. And it also should not get 10-12X EBITDA like a hardware company. The multiple should be somewhere in the middle, probably around 16-18X.

Projecting Q4

Apple's Q4 report is the next major catalyst to move the stock in one direction or another. So, let's predict how Apple will do in the fourth quarter. First of all, let's look at how Apple did in the last iPhone cycle from Q4 of last year.

Model Q4'18 Unit Sales
iPhone XS 3,282,000
iPhone XS Max 8,909,000
iPhone XR 18,287,000
Other 16,411,000

The iPhone XS was the biggest dud in last year's cycle, with it being basically a small continuation of the iPhone X. However, the gap between the XS and the 11 Pro is much greater than the gap between the X and the XS. So, I would expect a greater portion of the total volume mix to be 11 Pros. I would expect more 11 Pro sold than 11 Pro Max.

On the Max front, I would anticipate a decline in sales, as people are likely to buy the cheaper 11 Pro over the 11 Pro Max simply because of the pricing gap. The 11 Pro Max is undoubtedly a solid phone, but the $100 pricing difference will likely drive consumers to the triple camera iPhone 11 Pro. Because of this, I anticipate the mix is more likely to move to the 11 Pro over the 11 Pro Max.

With regards to the iPhone 11 itself, I would expect a slightly upward move in sales versus the XR from a year ago. This upward move has to do with two factors, the double camera and the $50 price reduction. While these two aspects will spur units, they will hit ASPs and gross margins. I would anticipate high-single digit volumes growth on a Y/Y basis.

And finally, there is the "other" segment of iPhones. This basically includes every single iPhone model that has been made other than the newest models. These phones are the XR/XS/XS Max generation and older. When the new models release, the older ones drift lower in sales. The problem is, we might see a very large decline in sales. In Q4 of last year, the "other" segment was dominated by the 8/8+/X generation. The biggest differentiating factor was that the 8 and 8+ featured a home button-based UI. Those who still wanted to use a home button based phone purchased an 8 or 8+.

The "old" phones in this cycle all lack major differentiating factors that would warrant consumer demand at this time. The 8 and 8+ had a major differentiating factor for many consumers. It was the best iPhone Apple has made that includes a home button. Because the XR/XS/XS Max only selling point at this time is price. The XR is now $599, while XS and XS Max are only available at "authorized resellers" (you can't buy them from Apple online). The only bright spot here might be the XR's new price, as it is likely to be attractive in other markets (India, China). However, these lower prices are likely to squeeze margins. Overall, I am anticipating a low-twenties percent drop-off in units. So, here is what we're looking at for units:

Model Q4'19 Estimate Y/Y Increase/(Decrease)
iPhone 11 Pro 5.054 million 54%
iPhone 11 Pro Max 6.770 million (24%)
iPhone 11 19.933 million 9%
Other 13.129 million (20%)
Total 44.886 million (4.27%)

I estimated ASPs at ~$788 for the iPhone in the quarters leading up to the launch of the latest 11/11 Pro/11 Pro Max generation of iPhones. However, because of the ~7% price reduction from the XR to the 11, ASPs should trend lower. However, I am anticipating some level of strength, as the 11 Pro and 11 Pro Max should take up a larger part of the mix. So, I am projecting a ~5% decrease in ASPs toward $748.60.

iPhone ASPs Units
Q4'19 $748.60 44.886 mln
Revenue $33.601 bln

Current reads suggest strong iPhone demand, at least for the cheapest models. The question is, at what margin are these phones going to sell for, and how long is this demand going to last? Apple will have a likely have a nice Y/Y comp because of the early release of the iPhone 11. The question is, how long will it last. An elongating upgrade cycle, a weakening macro picture, and minimal improvements could work against unit sales, even with lower prices.

The next step in estimating Apple's Q4 results is figuring out how successful every other component in Apple's business will be. I am focusing mostly on Apple's services segment, with their new iPads and Apple Watch lineup somewhat in the background. Apple's services segment should remain strong into the fourth quarter. The only potential concern regarding services growth is the new Apple TV+ service that is free to buyers of the newest Apple hardware. Overall, though, I am anticipating a slight acceleration in services revenue growth.

Services Q4'19 Estimate Q4'18 Actual
Expected Growth Rate 15%
Year Ago Growth Rate 17.4%
Revenue $11.478 bln $9.981 bln

While this is a slight deceleration from Q4 of last year's growth rate, it is still a solid growth rate for a $40 billion per year business operating in the 50-60% margin range. In addition, it reflects Apple's continued solid growth trajectory in services.

Now, let's move on to Mac and iPad sales, the other part of Apple's hardware business. The newest iPad unveiled by Apple should rejuvenate sales growth at some level for the device. The low price, keyboard, and Apple Pencil compatibility should all encourage strong demand for the new tablets.

iPad & Mac Q4'19 Estimate Q4'18 Actual
Expected Growth Rate 10% Y/Y (vs. 9.6% in prior qtr)
Year Ago Growth Rate -4.2% Y/Y
Revenue $12.65 bln $11.5 bln

Finally, we should look at Apple's "other" business segment. This segment includes Apple's newest Apple Watch Series 5 smartwatch lineup. The upgrades in the Apple Watch are beginning to appear incremental, similar to the latest upgrades in the iPhone. However, the smartwatch market is continuing to take off, and Apple's continued dominance of the market should allow the company to grow revenues at a solid clip for a while to come.

Other Q4'19 Estimate Q4'18 Actual
Expected Growth Rate 28%
Year Ago Growth Rate 31%
Revenue $5.419 bln $4.234 bln

So, now, let's look at my overall revenue projection:

Segment Revenue
iPhone $33.601 bln
Services $11.478 bln
iPad/Mac $12.65 bln
Other/Wearables $5.419 bln
Total $63.418 bln

Compared to consensus, this revenue number is solid. Revenue expectations are set at $62.91 billion, with fairly little deviation from this expectation. Now, let's move on to my gross margin, operating expense and overall profitability expectations. I would anticipate a sequential deterioration in gross margins with the release of the latest lineup of iPhones. An ASP contraction of 5% could cause a decent contraction in gross margins. So, while analysts might point out the robust initial reads on units, the question is: What margin are these phones selling at? If iPhones are selling at lower margins, then profitability, the most important factor is contracting. Especially when you consider increased battery sizes, and likely flat COGS for the rest of the phone's components, gross margins are even more likely to erode.

Here are my overall expectations for the financials of the quarter.

Line-Item Expectation
Revenue $63.418 bln
Gross Margin 37.1%
OpEx $8.75 bln
Other Expense $200 mln
Operating Income $14.578 bln
Tax Rate 16.5%
Net Income $12.173 bln
Shares Outstanding 4.52 bln
EPS $2.69

This EPS estimate is well below street expectations of $2.84, reflecting my pessimism on gross margin trajectory in the quarter.

Valuation

I am beginning to move away from discounted cash flow based valuation and more towards earnings and multiple based valuations. For that reason, I am valuing Apple based on a multiple of this year's EPS. My full year EPS estimate is $11.52/share. Now, the question is, what is the appropriate multiple to use when valuing Apple? To give Apple a fair multiple, we have to look out into Apple's future. Services continue to grow at a fast clip long term, and the next 5G iPhone cycle should be huge for both units and ASPs, creating solid revenue growth in the next cycle. In addition, there is Apple's extraordinary brand (AirPods is a perfect example). The company's brand is one of the key drivers of the business going forward. My parameters for a growthy tech stock warrant a 25-30X multiple. However, I believe Apple's days as a serious growth stock are over. However, a mature aging business should get 10-15X. Apple is not your average maturing business. They have a phenomenal brand and a strong portfolio of growing products over the next few years.

So, the valuation should be somewhere in the middle of these two. More specifically, I am thinking about a ~20X multiple on this year's earnings. Considering the strong buyback plan and strong dividend I do not believe this valuation is unreasonable. On $11.52/share, this values the company at ~$230.

Conclusion

I am reducing my view of Apple from a buy to a hold, reducing my PT to $230 from $235. My reduction to hold reflects my view that the move up in the stock is just too good and the stock could fall a little bit before becoming a value buy. A correction into the low $200s, maybe into the $190s would warrant a potential buying opportunity. Right now, it is simply too hard to own the stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice. Please do not interpret any of what I am saying as financial advice. This is just my personal opinion.

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