Apple: Respect The Middle Kingdom

| About: Apple Inc. (AAPL)

Summary

Apple will report earnings on Tuesday after close, with consensus expecting an underwhelming quarter.

The focus should be on commentary in China and the regulatory landscape given that the country remains a growth geography for Apple.

Its current valuation of 11x next year's EPS and 2.4% dividend yield remains attractive, but the fundamental outlook is less attractive.

Apple (NASDAQ:AAPL) will report its Q3 earnings on Tuesday after the close. The market expects an uninspiring quarter, as the iPhone's ASP pressure has been largely documented due to the release of the lower priced iPhone SE in March. In my view, the bigger focus should be on iPhone's international growth and the growth of its software division, which I believe to be the only two viable prospects for AAPL as the iPhone battles smartphone maturity, decelerating market growth and increasing competition from the low-cost Chinese OEMs (see "Apple 2016 Outlook: The Sun Can't Shine Every Day").

Just a reminder of my thesis on AAPL, I see the company facing a flattening innovation curve, a diminishing ecosystem and competitive pressure from Android handsets (see "Apple: The Party Is Over, Initiating With A Bearish View"). To counter theses risks, I believe the best viable option for AAPL is to focus on the software and unbundle its services to ensure the long-term growth of its ecosystem. This will allow AAPL to focus on a high-margin business where it has a distinct advantage over some of the Android services, and allow the company to be more competitive in the coming decades (see "Apple: Service Unbundling To Drive Ecosystem Expansion?").

In the near term, I remain bearish on AAPL. The stock has enjoyed a nice run in the past few years given the adoption of the iPhone, and was heavily owned by institutional investors globally. However, sentiment among institutional investors is changing in that rather owning for growth or value, fund managers are owning AAPL largely because it is a major component of the index. This is a dangerous reason to own a stock, in my view, in that it could lead to crowd-selling if the company disappoints on the earnings or if the tone of the earnings call appears to be negative. With 43 buys, 7 holds, 2 sells and an average target price of $123, it is an overly owned stock by investors and an overly loved one by the sell-side analysts. That said, I would stay on the sidelines for AAPL and look for a better entry point once the software sees stabilization and international expansion accelerates.

Consensus expects:

  • Revenue of $42.1 billion (versus a range of $41.2-43.7 billion); AAPL forecast $41-43 billion (April 26)
  • EPS of $1.39 (versus a range of $1.32-1.47)
  • Gross margin estimate of 37.9% (versus a range of 37.5-39.5%) AAPL forecast 37.5-38%

Guidance:

  • Revenue of $45.6 billion (versus a range of $42.4-49.4 billion)
  • EPS est. $1.60 (versus a range of $1.39-1.77), although it is worth pointing out that the consensus has come down ~2.2% over past 4 weeks, suggesting bearish sentiment on the stock.
  • 4Q gross margin est. 38.4% (versus a range of 36.5-40.0%)

In terms of units:

  • iPhone unit est. 39.9 million with ASP of ~$606
  • iPad unit est. 9.1 million with ASP of ~$443
  • Mac unit est. 4.4 million
  • Watch est. 2.0 million with ASP of ~$448

International growth will be a focus area for me this quarter, specifically commentaries over China's outlook. Recall that last quarter, the company saw sales in China decline y/y and sequentially by -26% and -32%, respectively. I see this to be the result of local OEMs gaining share against AAPL due to their edge in distribution and localized content/software. Huawei's +40% y/y growth in 1H16 revenue is a good indicator that the company is gaining share against AAPL and Korean rivals such as Samsung (OTC:SSNLF) and LG (OTC:LGEAF). Although AAPL is bullish on China and its rising middle class and 4G connectivity (soon to be 5G), I think it is important to address the risks that the company is facing in China.

First, the iPhone is a standardized ecosystem that lacks localized software, apps and services that are offered by the competing handsets, thereby putting the iOS ecosystem at a disadvantage when it comes to connecting with Chinese consumers.

Second, the rising 4G connectivity does not position AAPL favorably given the proliferation of quality 4G handsets from China's big four smartphone makers, the branded OEMs and even the low-cost, white-label OEMs. Worth remembering, the monthly shipment data from the Chinese carriers on the 4G/3G handset is not a good indicator of iPhone demand, as most of the 4G sales are sold by the local Chinese handset makers rather than AAPL.

Third, the iPhone is still priced at a premium, and China's middle class does not feel the premium is justified by competing high-end Android brands are available that offer reasonably good software, but priced at half the price.

Finally, regulatory risk remains high, as the recent decision by Beijing to halt the sale of iPhone 6 and 6 Plus models is a clear indication that regulatory policies will continue to favor domestic Chinese smartphone makers and prevent Apple from becoming a dominant player in the country (see "Apple: Do Not Underestimate The Chinese Regulators"). In addition, it is also important to note that the company's growth in China will be contingent on Huawei's growth in North America in that the regulatory risk faced by AAPL is similar to that Huawei faces in the US. In other words, Huawei and AAPL are pawns of a complex trade war between the US and China, and as long as the US continues to play politics over Huawei, the Chinese government will make an example out of AAPL.

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.