Apple: Sell On Strength

| About: Apple Inc. (AAPL)

Summary

AAPL reported a weak beat on low expectations with the iPhone and key geographies continue to see decline.

Margin to remain pressured in the foreseeable future as AAPL appears to be relying on the low-cost SE to drive unit growth.

China remains a question mark with growth reverting to decline in a matter of 6 quarters on increasing competitive and regulatory risk.

Ecosystem contraction thesis is playing out judging by the stagnation in software revenue, suggesting that average spend per existing AAPL user may have peaked.

Remain bearish on AAPL and would sell on strength. Current valuation: 11.7x EPS, 2.5x sales and 9.5% FCF yield on 2017E estimates.

Apple's (NASDAQ:AAPL) "beat" can hardly be considered one given the already low expectations. But with the sentiment so negative on the stock this quarter certainly gave index managers and retail investors a reason to cheer as suggested by the uptick in the stock price post quarter (see - Apple: Respect The Middle Kingdom). Fundamentally speaking, AAPL is far from being out of the woods given the longer-term smartphone replacement cycle (see - Apple: Shift In Handset Distribution Model A Negative For iPhone Adoption), smartphone maturity, regulatory and industry challenges associated with China and more importantly the ability to innovate ahead of its peers.

While I was hopeful on AAPL's software growth, the +19% growth in services revenue is not impressive given that this segment has seen three consecutive quarterly declines, which suggests that the declining iPhone shipments is starting to result in gradual contraction of AAPL's ecosystem, a key risk I outlined in my bearish AAPL thesis. Unless the upcoming iPhone models are truly revolutionary, we could see further downside pressure to AAPL's revenue and unit growth. (see - Apple: The Party Is Over; Initiating With A Bearish View)

The analyst community this time around is less enthusiastic on the growth profile (i.e. revenue and the shipment) and instead with many of them focusing on inventory reduction and potential upside surprise from the iPhone 7 given the already low expectations. In my view, this is far from being a convincing argument on buying into a stock and suggests how the analyst community is running out of positive spins when it comes recommending an index stock.

The smart investors will stay on the sidelines for now until there is evidence of 1) innovative and differentiated products on the horizon, 2) accretive M&A to boost AAPL's ecosystem in content, financial services, location-based advertising, VR/AR, Apple Car and anything that addresses AAPL's reliance on the iPhone and 3) meaningful market share expansion against emerging Android heavyweights such as Huawei. That said, investors are better off to curb their enthusiasm because growth is something that is increasingly difficult to associate with AAPL.

Reasons to remain bearish? Plenty.

Revenue of $42.4b was in line with consensus $42.1b while EPS of $1.42 beat by $0.03. Gross margin of 38% was in line with consensus 37.9%. Although shipments of 40.4m iPhone units beat consensus 39.9m, the beat was largely driven by the lower-priced iPhone SE as indicated by the miss in ASP ($595 vs. consensus $606). While the iPhone SE's initial global success is something to cheer about, investors have to ask themselves whether they can accept the reality of AAPL relying on a commoditized item with declining ASP as a driver for near-term growth.

AAPL has historically outperformed through innovation but it appears that the recent moves into the iPhone 5C and the iPhone SE and management's focus on bringing affordable iPhone products to the masses are the only things that the company can work with rather than innovating ahead of its peers. While some may argue that the lower-end model is a critical component of AAPL's user acquisition strategy and that there is the potential for users to trade-up to the flagship iPhone, as they are accustomed to the ecosystem, the reality is that AAPL's only selling point is its ecosystem, which a lower-priced iPhone user can equally enjoy.

As long as the user can receive the same ecosystem benefit as the flagship user, I believe that chance of an upgrade is slim. As such, I believe that AAPL's GM will continue to trend in the coming years if AAPL relies on the lower-cost model to drive growth.

Besides the iPhone, iPad units of 9.95m beat consensus of 9.1m with ASP of $490 coming in well above consensus $443. Management credited the beat on higher demand for the iPad Pro models, and while I do not disagree on this assessment, I believe that it is also important to note that the y/y beat on the iPad came as a lower comp from the prior year so this once again may not sustainable. As for the Mac, unit sales of 4.25m missed consensus of 4.4m, underscoring my view that AAPL remains an iPhone-centric company that faces material risk to its business outlook.

China remains a conundrum with revenue declining -33% y/y and -29% sequentially. In my view, AAPL's growth outlook in the country will be severally limited by a combination of regulatory risk (see - Apple: Do Not Underestimate The Chinese Regulators) and competitive risk. AAPL enjoyed high double to low triple-digit growth in China throughout 2015 but that growth reverted to a decline in the past two quarters as Q3 saw the revenue decline accelerating due to growing competition from Huawei, a rejuvenated Lenovo and emerging local brands such as Xiaomi, Oppo and Vivo.

The bottom line for AAPL is that the iPhone remains overly priced relative to the $300 premium handsets sold by the local OEMs. Even when we look at the iPhone SE, the device is also overpriced by roughly 50% and it remains uncompetitive in a market where consumers prefer large display devices (ever wonder why so many Chinese like the iPhone 6sPlus?) Competition aside, regulatory risk remains for AAPL.

As I have highlighted before, AAPL and Huawei are pawns of a complex political battle between Beijing and Washington over Huawei given that Huawei cannot commercially operate in the US due to its military ties while its peer ZTE (which was also had military ties) sells its devices through AT&T (NYSE:T).

Until Huawei can openly operate in the North American market, the Chinese government will continue to put pressure on AAPL and this is one risk that investors cannot ignore, which is why AAPL management interestingly shifted its focus to India this quarter. However, I am not convinced that India's near-term growth off of a low base is the key to AAPL's Asia expansion plan.

Finally, although the headline software revenue showed a +19% y/y, it is important to note that software revenue has been stagnating and I suspect that this is due to the recent decline in iPhone shipments that is limiting the growth profile of its software. Recall that one of my theses on AAPL highlights the potential ecosystem contraction due to the decline in the AAPL device footprint.

As device shipments declines, AAPL has to squeeze more dollars out of each unit to offset the unit decline and the recent software revenue stagnation suggests that spending per AAPL user may have peaked. This could potentially explain the rationale for AAPL to introduce the low-cost iPhone SE models to regain unit growth and to drive ecosystem expansion.

While this may mitigate the risk in the near term, I continue to believe that unbundling the software and the ecosystem from iOS is the most viable outcome for AAPL to ensure the sustainability of its ecosystem. (see - Apple: Service Unbundling To Drive Ecosystem Expansion?)

Bottom line: AAPL's quarter is nothing to cheer for and I would sell on strength. An underwhelming iPhone 7, tough comps on software heading into 1QFY2017 and an uncertain international growth outlook are key risks going forward. The stock trades at 11.7x earnings, 2.5x sales and 9.5% FCF yield on 2017E estimates. The FCF can more than cover AAPL's current 2.3% dividend yield and I continue to see increasing that dividend yield to 4-5% to rival that of the telecom, utilities and the financial sector would drive fund flows back into the stock.

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.