- I have lowered my price target and earnings estimate coming out of the quarter.
- Given the drop in Apple stock price, I believe there's a compelling opportunity for re-entry.
- However, the long-term growth dynamics are still questionable.
Going into the quarter, I was cautioning investors to avoid Apple Inc. (NASDAQ:AAPL) given the weak commentary from various channel based sources. It has been a very difficult year for Apple investors, but I do anticipate some relief in price action once we move past this quarter given the Apple iPhone 7 anticipation trade, and the release of the iPhone SE. Apple grew sales/earnings the most when it launched the iPhone 5 and 6. I believe a similar pattern of growth will re-emerge upon the introduction of the iPhone 7, which will drive price action in the second half of the calendar year.
Given the 9% drop in the stock price, following the earnings report, Apple stock is now trading at $94.8 (April 28 close). It’s now become a great opportunity to capitalize on the stock, as the consensus range will move closer to $210 billion-$220 billion in revenue, which is in-line with my estimates. While Apple isn’t necessarily mismanaged, the efforts on innovation and developing hit products to attach to its ecosystem haven’t been as successful as in earlier years. Furthermore, investors should anticipate Apple’s growth rate to slow over the next five years, as mid-teen EPS growth seems less feasible given the cyclicality of refresh and slowing smartphone penetration. Notwithstanding opportunities in the emerging markets, there have been significant holes in Apple’s cash management strategy, as the company hasn’t sustained enough R&D investment to develop new successful product categories, and hasn’t executed on enough acquisitions to juice the growth rate. The massive cash pile sitting in foreign accounts is useless and serves as a vanity metric for investors to justify how undervalued Apple is on an ex-cash basis.
Apple updated us on their capital return program, and for the most part, I’m not really impressed. The share repurchase has been lifted to a cumulative $175 billion, and if Apple executes on a more accelerated buyback program, the company will utilize $36 to $40 billion this year, which is below the company’s FY’15 free cash flow figure of $57.87 billion. The company didn’t increase the share buyback despite sitting on a massive foreign cash pile, hence the cash is just a vanity metric until Apple either pays the incremental tax and executes on a large share buyback or uses the cash to purchase foreign companies. At this point, anything is better than the yields they’re generating from fixed income securities in foreign markets.
Apple’s guidance for Q3’16 was underwhelming:
- Revenue between $41 billion and $43 billion
- Gross margin between 37.5 percent and 38 percent
- Operating expenses between $6 billion and $6.1 billion
- Other income/(expense) of $300 million
- Tax rate of 25.5 percent
The drop off in revenue was attributable to channel inventory reduction of the iPhone, which reduced device sell-in by roughly $2 billion. Apple generates revenue upon the shipment of devices to vendors and not upon the direct sale to consumers unless if the sale is done via the Apple retail store or directly from its website. So the reductions in channel inventory does correspond with Apple’s revenue recognition policies. Furthermore, the impact of channel inventory reductions are a one-time event, and I don’t anticipate further reductions in inventory, which could significantly impact the share price, given Apple’s 19-day inventory turnover.
As it currently stands, I’m lowering my price target from $117.17 to $107.72. The reduction in my price estimate reflects a $645 ASP for iPhone due to the mix shift to iPhone SE, gross margin of 38% from 39% and reductions to my initial share buyback estimate given the less than spectacular capital return policy that was announced in the latest earnings report. As such, I’m revising my estimate on EPS to $7.74 from $8.42, which is quite low. I don’t anticipate Q4’16 earnings to perform above seasonal trends given the weak commentary on global macro, the miss management of currency hedges, and mix shift to lower priced devices. Given the impending launch of the iPhone 7, it’s unlikely that consumers will opt to purchase a phone ahead of a major product announcement. I revised my revenue estimate slightly lower from $216 billion to $215 billion, and I’m anticipating the analyst consensus range to drop by roughly $10 billion (from $226 billion to $216 billion) given the initial commentary I have received from various investment banks.
Here’s a sample of analyst revisions from investment banks following the earnings report:
- $228.5 billion to $217.5 billion revenue and EPS from $8.85 to $8.34. Target price lowered from $125 to $120. – Bank of America Merrill Lynch, Wamsi Mohan
- $223.9 billion to $206.82 billion revenue and EPS from $9.28 to $7.81. Target price lowered from $131 to $121. – Barclay PLC, Mark Moskowitz
- $229.8 billion to $212 billion revenue and EPS from $9.54 to $8.18. Price target was maintained at $150. – Credit Suisse, Kulbinder Garcha
- $230.6 billion to $215.175 billion revenue and EPS from $9.18 to $8.28. Price target was maintained at $105. – Deutsche Bank, Sherri Scribner
- $229.1 billion to $215 billion revenue and EPS from $9.04 to $8.14. Price target of $120 was removed, and a new price target was not initiated. – Oppenheimer Co., Andrew Uerkwitz
- $229.63 billion to $213.394 billion revenue and EPS from $9.33 to $8.56. Price target was lowered from $130 to $120. – RBC Capital Markets, Amit Daryanani
- $230.95 billion to $218.266 billion revenue and EPS from $9.07 to $8.37. Price target was maintained at $120. – UBS AG, Steven Milunovich
Analysts have transitioned to FY’17 as the main reason for investing in Apple. However, given the weakness in management commentary the consensus has revised estimates to an EPS range of $7.80 to $8.60 for FY’16. I believe Apple will continue to struggle for the next couple of months until the WWDC 2016 event, which will be a short-term catalyst to the stock price. Furthermore, rumors of the iPhone 7 and channel commentary in Q4’16 will create a recovery rally. However, it’s hard to like the long-term fundamentals, as further weakness in FY’18 seems highly probable as the next S-cycle (iPhone 7S) implies further refresh elongation similar to the iPhone 6S, thus translating into y/y shipment declines. It’s simply not the same growth story it used to be, and without meaningful earnings growth acceleration, Apple will likely perform in-line or perhaps below the broader market. Investors buying the stock will have to temper expectations on returns over the next five years.
I continue to reiterate my buy recommendation, as the stock is still below my target price. I believe upside is limited, as I anticipate 13.6% upside from present levels. I anticipate Apple will generate a modest beat in its next quarterly earnings, as estimates have reset yet again.