- Expectations of foreign exchange impact have been factored into Apple earnings models, however, the assumptions factor in a stable currency environment following Q1'16.
- That seems extremely improbable given the series of rate hikes anticipated and faltering inflation metrics.
- The dollar is poised to sustain an up-trend, which means Apple stock valuations might not be as attractive as they seem to be.
There have been some additional last minute revisions from the sell-side when pertaining to Apple (NASDAQ:AAPL) iPhone sales and top-line revenues. While I’m fairly certain the analysts are doing their best to be as practical and pragmatic to their approach to Apple, I’m fairly certain that expectation risk will be an ongoing theme throughout CY’16. As I'd indicated earlier, my Apple stock price target stands at just above $87 a share. Here's why.
Investors would be better off on the side lines until the dust starts to settle. Nonetheless, there’s no denying that Apple could have some surprise catalysts going into the second half of the year, but I don’t anticipate that to be in the form of iPhone sales lift, but rather adjacent products like Apple Music, TV, and Watch adding incremental upside to estimates as opposed to a back-half loaded iPhone shipment ramp. Of course, seasonality will lift sales going into the December quarter, but that incremental upside pertains more to FY’17 for Apple.
That being the case, Credit Suisse acknowledges the F/X risk when pertaining to Apple and while I do anticipate some hedges to mitigate some of the impact, the F/X risk will continue to pick up momentum throughout FY’16 due to the different policy paths of central banks in conjunction with tepid CPI metrics putting a low ceiling on inflation in the United States.
Here’s what Credit Suisse released in a report on January 21st 2016:
Currency headwinds to persist. The strengthening dollar last year had a widespread impact on companies with significant international exposure, and Apple was no exception. Last fiscal year, we estimate that Apple's revenues were impacted by approximately $11.2bn, or ~5% of revenue. We see continued FX pressure this year, estimating $3.4bn in the December quarter (~4% of revenue) and $6.7bn for FY16 (~3% of revenue). We note that our FX analysis assumes currency remains flat from the March quarter.
For the most part, the dollar index has rallied off of a historically low base and when we operate in an environment of zero bound interest rates, the F/X market has been caught in a state of complacency that’s really unprecedented. Furthermore, assuming the federal reserve continues a sequence of rate increases, I anticipate that the dollar will continue to rally against a basket of currencies for the duration of the entire year.
The rally in the dollar continues, and I don’t anticipate this trend to abate to any meaningful extent as we progress through 2016.
According to the latest Morgan Stanley economic research:
It's no leap to say the four rate hikes envisioned by the Fed this year seem increasingly implausible. We expect headline growth to come in below the Committee's expectations and it's difficult to see how the Fed can remain reasonably confident on inflation with the trade-weighted US dollar climbing to new highs each week. Market pricing suggests investors are in line with our expectation the Fed does not move rates higher at its March 15-16 meeting, but signs of domestic slowing and threats from abroad suggest our expectations for three rate hikes after March are more likely than not to face a higher bar.
Needless to say, whether we get deflationary indicators or the fed signals the continuation of its rate hikes, the impact on dollar appreciation will likely remain the same. The rest of world will interpret the fed’s commitment to higher interest rates a buy signal for the dollar, and if the fed were to stall its rate hike in response to deflation, the dollar would still strengthen against a basket of currencies in response to deflationary risk. In either case, the market will react negatively to both higher interest rates and faltering inflation metrics. Therefore, a stable currency environment seems highly improbable following Q1’16, which is what the sell-side modeled has into their currency assumptions when pertaining to Apple. Both Credit Suisse and UBS have similar assumptions on currency, and this doesn’t stretch to the entire consensus. In fact, many sell-side models ignore the impact of currency or consider it a minor headwind to top line sales. In other words, if Apple flops below the lowest estimates by the sell-side, I can easily envision a massive price correction following Q1 earnings similar to Intel.
Nonetheless, fixed income investors will either reallocate investments into cash or stocks due to the upward shift of the entire yield curve as the pressure from higher yields will mitigate fixed income returns due to mark-to-market adjustments. I anticipate the S&P 500 to recover as we progress throughout the year as recession indicators do not indicate a high-enough probability for investors to revert back into fixed income (dragging yields lower). Therefore, strategic allocations will heavily favor equities as volatility metrics start to subside. The options market is pricing a premium on call options on the S&P 500 with the time value given a higher valuation, which indicates that the market is demanding a higher return for upward hedges. This is an implicit signal of broad-index based multiple expansion even if we were to enter an environment of weaker corporate earnings due to F/X volatility.
I anticipate that Apple will be a recipient of mean reversion as expectation start to shift towards next fiscal year, which will require investors to stomach near-term weakness in Apple fundamentals. Therefore, Apple could be an interesting recovery play as we progress into the second half of 2016, but that’s purely due to company specific fundamentals reflecting some strength in anticipation of FY’17 as we gain further visibility on Apple’s product road map. I anticipate that gross margins assertions are a little aggressive going into FY’16. Gross margin could certainly surprise due to product mix shift to higher memory configurations, which have higher gross margins. But, corporate gross margins should decline as the iPhone will remain the most profitable category, therefore a reduction in shipments will correspondingly impact gross margins negatively.
As such, investors should avoid Apple altogether despite the modest recovery in the price. I don’t anticipate Apple to sustain pricing above $100. I continue to reiterate my sell recommendation and $87.38 price target, slightly lower than my initial price target for Apple.