Apple's Growth Depends On One Factor

Recent reports from third-party estimates have shown a massive drop in unit shipments of iPhones. Canalys has estimated a drop of 23.2% in iPhone unit shipments in the last quarter. IDC has estimated an even larger decline of 30.2% in iPhone unit shipments. Although, both the research agencies have reported a decline in overall smartphone shipments, Apple (AAPL) has shown the biggest drop among the major brands.

All eyes are currently on Apple’s growth within the Services segment. However, it would be difficult for Apple to show good growth in this segment if it does not have an expanding installed base. With a 25-30% decline in unit shipments, investors need to look at the long-term installed base growth of iPhones. Despite good growth in other segments, the iPhone segment still contributed close to 55% of the total revenue base. Recent trade tariffs can lead to further erosion of unit shipments in the Greater China region.

Goldman Sachs has estimated that a ban on Apple in China can lead to a 29% cut in the EPS. Even if we do not see a complete ban, Apple would need to give heavy discounts to support its unit shipments in China. A rapidly declining unit sales forces the company to offer higher discounts and ends up hurting the operating margin.

How can Apple overcome falling unit sales?

The first option which is currently used by Apple is to give higher discounts for its flagship iPhone shipments. In the domestic US market, Apple has increased the attractiveness of the trade-in program and is heavily marketing this offer. Apple will also need to diversify its revenue base to other segments.

The recent launch of new services will take a long time to move the needle for Apple's revenue and profit base. The best alternative for the company is to focus on new wearable products which are gaining a lot of traction.

However, it must be added that it would be very difficult for any segment to make up for the decline in iPhone sales in the near term. Hence, we should see Apple continue to take new initiatives to reduce the upgrade cycle for its iPhones. This will come at the cost of margins and falling EPS.

It is unlikely that Wall Street will remain bullish about Apple stock if the company continues to report a fall in revenue and EPS for the next few quarters. This makes the stock a sell at the current levels.

Significant decline reported by major third-party sources

Both IDC and Canalys are well respected in their ability to estimate unit shipments. They have been able to give a good ballpark number in the past few quarters. In the latest quarter, both of them have suggested a massive unit shipment decline in iPhones.

Source: IDC

Source: Canalys

The numbers on unit shipment decline for iPhones differ a bit for both these sources. But the numbers on overall shipment decline is quite similar. Both IDC and Canalys have estimated over 50% YoY growth from Huawei. It should be noted that during this period, Huawei was under tremendous scrutiny and faced a number of negative headlines.

Huawei has been working up its game for quite some time. It has recently launched foldable smartphones and will also be among the earlier players to launch 5G smartphones. Huawei has increased its footprint in the premium smartphone category of over $600.

Expanding installed base, falling unit shipments

Apple is witnessing an expansion of the installed base. In the quarterly earnings for the first quarter of fiscal year 2019, Apple’s CFO mentioned that the installed base for iPhones has hit 900 million. The management has declared that they would be updating this number at a regular interval. Apple’s increase in the installed base at a time of massive decline in unit shipments can be blamed on an increase in the upgrade cycle.

Unless there is a massive jump in features, we might not see a pickup in unit shipment sales. Apple is trying to shorten the upgrade cycle by emphasizing the trade-in program. In the latest ad, Apple is asking customers to trade in every three years to get the best out of their iPhones.

Dependence on iPhone segment

Even after a significant decline in iPhone revenue in the latest quarter, this segment contributed 53.5% towards the revenue base.

Source: Apple filings

The decline in the iPhone segment was more than the combined revenue growth in wearables and the Services segment. Further decline can be expected in the iPhone segment due to challenges in China and other international regions. The growth in Services segment is heavily dependent on the performance of the iPhone. During this time, Apple would need to convince Wall Street that it has at least managed to lower the decline rate in the iPhone segment.

Fall in margins

Apple has ramped up its trade-in program and has also been giving massive discounts in international regions. In the last few weeks of March, Apple was giving discounts of 2000 Yuan (approximately $300) on the iPhone XS Max from third party sellers in China. This level of discounts has helped the company in improving its unit sales. But these massive discounts also hurt the margins and the bottom line of Apple.

In the latest quarter, Apple has shown one of the biggest declines in year-on-year operating margin.

The operating margin in the year-ago quarter was 26%. In the latest earnings result, operating margin was only 23.12%. This is a decline of 288 basis points. In the December quarter, the operating margin decline was 207 basis points. From these two quarters, we can interpret that the margin decline for this fiscal year would be quite significant.

In 2018, Apple had the buffer of lower tax rates which helped the company show better EPS results. The YoY comparison from this quarter would be much more difficult. Hence, a lower operating margin will end up hurting the net income and EPS for the company.

The trade war adds another layer of uncertainty to Apple's unit shipments in the near term. It would be important to see the breadth of future discounts offered by Apple on its flagship iPhones. Even after these huge discounts if the unit shipments decline by 20-30%, we could see a big bearish sentiment towards the stock.

Investor Takeaway

Both IDC and Canalys research have estimated 23-30% decline in iPhone shipments in the last quarter. This is a big decline when we look at the scope of discounts offered by Apple in the last quarter. These discounts have led to a significant drop in net income and operating margin. Continuous fall in the margin in the next few quarters will hurt the EPS and make the stock less attractive as a long-term buy and hold.

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.

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