- Investor expectations have weakened in response to FX, weak CFO guidance, and Chinese shipments.
- iPhone unit mix and replacement likely surprise catalysts given usage mix between iPhone 7/7 Plus.
- The prospects of a tax holiday, reduced corporate tax, and further leveraging of the balance sheet suggests long-term earnings upside.
Apple (NASDAQ:AAPL) shares had struggled following the US election, however, the fundamental issues are primarily tied to FX, and weakness in Chinese smartphone shipments, as implied by recent supply chain checks. While Chinese shipments could prove underwhelming, the improvement in iPhone ASPs and replacement from the aged installed base in North America, Europe and Rest of World is likely to offset declines in the Greater China segment.
The primary reason for weak shareholder returns has less to do with Donald Trump and more to do with heightened expectations going into the Q4’16 earnings report (fundamentals). The CFO, Luca Maestri provided revenue outlook of $77 billion (mid-point of guidance) for Q1’17, which was only marginally better than Q1’16 results, as it only suggested 1.5% y/y revenue growth.
With weak guidance, bad F/X and China rearing its ugly head again, we’re not witnessing an exact repeat of 2015, but it’s fair to assume that investor expectations have diminished for the upcoming quarter.
The fundamental drivers for the next quarter
In my opinion, Luca’s guidance was conservative, as iPhone 7 Plus builds are trending higher than prior cycles, as sell-through of the phablet form factor was equally proportional to the standard 4.7” screen iPhone model suggesting that ASPs for the iPhone segment will be substantially better than prior-year, or prior cycles for that matter. Fiksu Data Monitor has iPhone 7/7 Plus usage both pegged at 4.5%, which is a perfectly even split. In prior cycles, the smaller form factor represented 72% of the sales mix rather than an even split, which suggests that ASPs could trend considerably higher given the add-on effect of Samsung defectors, which were on the market for a phablet anyway.
This suggests that the pricing shift could more than compensate for the y/y shipment declines from China, as UBS Evidence Lab suggests that Chinese consumers are likely to buy fewer iPhones this year, but are looking to buy more expensive variants.
UBS China analyst, JinJin Wang mentioned:
“I don’t have exact data points, but in talking with handset distributors they told me sales of iPhone 7 are below the iPhone 6s, which in turn was below the iPhone 6. iPhone 6 was definitely a peak for Apple in China.”
Steven Milunovich is forecasting that Chinese unit shipment will decline by 5% in FY’17, but again, this could be offset by ASP gains, which suggests that the iPhone segment could come away with a better than expected performance.
However, the caveat going into the current quarter is the massive resurgence in the US Dollar, which can be blamed on Trump. After all, rebalancing trade will reduce U.S. currency outflows, which suggests that the dollar should strengthen thus translating into more of a transitory impact on the tech companies that tend to run diversified geographic businesses.
Apple is a victim of FX volatility, but the irony is that much of the dollar index rally was fueled by the USD/GBP and USD/CNH (British Pound and Chinese Yuan). The USD/CNY is now 9% higher than prior year, which suggests that normalized revenue from the region will be 9% lower. Investors pay close attention to currency impact. I anticipate that revenue from the Chinese segment may perform even worse, as it’s difficult to believe that Apple hedged currencies to offset a full 9% move in the dollar.
Furthermore, there’s tons of speculation over a rumored tariff on imports, but I find it unlikely that Trump would negotiate a deal that would damage consumer sentiment, or increase nominal inflation, which I describe in a different article. Tariffs on imports wouldn’t be an effective policy tool to increase US exports, as the pricing discrepancy of products sold to the Chinese need to be re-adjusted via a tax rebate from the Chinese government, so exported U.S. goods can reach price parity in China.
Furthermore, the lack of manufacturing in the United States reduces the viability of selling made in USA goods, so reaching trade balance would rely on sectors outside of manufacturing. So, I find that any efforts to negotiate better trade deals would only indirectly affect Apple, most notably in the form of currency impact. Trump’s presidency hinges on his ability to keep consumer pricing in check while sustaining real GDP and employment growth.
Instead, what investors seem to be ignoring is the potential to bring back $216 billion in offshore assets at a 10% tax rate, which would give Apple $194 billion to buy back shares, leverage the balance sheet to acquire big companies like Time Warner (given the low likelihood of AT&T getting that deal done), and increase dividend payouts in response to higher net profits given a substantial reduction in the corporate tax rate from 35% to 15% - 25%.
Given enough time, I believe investors will buy Apple stock due to the iPhone 8 super-cycle, a super-sized accelerated share repurchase authorization, and higher profitability due to lower domestic taxes.
Furthermore, Apple’s M&A could become a bigger factor to sales/earnings growth than what analysts are currently modelling, as Apple doesn’t make large acquisitions, but given Apple’s top-tier balance sheet, and relatively stable free cash flow, I believe levered buyouts could become a material driver to sales/earnings given enough time.
Microsoft is planning on borrowing the full $26.2 billion to buy LinkedIn despite $100 billion in offshore assets. Given enough time, I anticipate that Apple will lever up on future cash flows to buy a portfolio of subsidiary companies while also maintaining a torrid pace of capital returns via share buybacks and dividends.
Apple remains a blue-chip stalwart and is attractively valued. But in this environment, being good is not good enough, as structural shifts in the economy create unprecedented opportunities in other sectors. So, investors are moving allocations towards faster-moving members of the S&P 500.
The recent selling can be blamed on the emergence of investment opportunities in the banking, insurance, and basic material space. A recent fund manager survey from Bank of America Merrill Lynch suggested a reduced allocation towards tech companies in general, as it’s difficult to ignore the tantalizing opportunities in a de-regulated banking/healthcare environment, or potential for basic material companies like U.S. Steel to compete globally given the prospect of better international trade deals.
Once the dust settles and greater certainty in a Trump presidency emerges, investors will likely pile back into the Apple trade. Furthermore, I’m anticipating Apple to outpace the expectations of analysts and its prior guidance as well. As such, I continue to reiterate my buy recommendation on Apple.
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