Apple (NASDAQ:AAPL) has certainly hit an inflection point where the iPhone is facing a structural demand issue due to shift in competitive dynamic and the flattening of its own innovation curve as I had highlighted in my initiation article (see Apple: The Party Is Over, Initiating With A Bearish View). The company's Q2 is the second consecutive quarter of iPhone decline. Although some may argue that the lack of iPhone SE may have contributed to the soft iPhone comp (-16% y/y on units and -18% y/y on revenue), long-term structural challenges remain intact, and I caution that the challenges of higher product comp, competition from Android OEMs and the shift in carrier distribution model toward equipment installment plans (see - Apple 2016 Outlook: The Sun Can't Shine Every Day) will continue to pressure Apple in the foreseeable future.
Indeed, the company's guidance of FY Q3 $41b-$43b in revenue (vs. est. $47.35b) and gross margin of 37.5%-38.0% (vs. est. 39.2%) gave investors no assurance that the iPhone-centric business model is expected a near-term turnaround. On the other hand, the dividend boost (57c/shr from 52c vs. est. 57c) and share buyback boost (+$35b to $175b), coupled with 9x FY17E consensus earnings may continue to attract value fund managers who are buying on the yield and low multiple. The potential double-digit dividend increase and share buyback in the next year could attract additional fund flow to support the stock, but I see that to be hardly sustainable as long as operating metrics continue to deteriorate. In short, AAPL's diverging fundamentals of deteriorating operating metrics, solid financial metrics, and share price support is coming to an end. With 44 buys, 4 holds, 2 sells and an average price target of $133 per Bloomberg consensus, investors can expect consensus estimates to come down after this quarter, and this will be an additional overhang on the stock.
For the Apple faithful, the good news is that the music is only slowing rather than stopping, but there is no clear evidence of why the music would not stop eventually, considering that the company's work-in-progress products in driverless cars, VR and potentially the TV are unlikely to be revolutionary. That said, given that much of AAPL's ecosystem is contingent on its product footprint, it appears that the only way for it to salvage its ecosystem is through unbundling its service to drive penetration. Judging by the +20% growth in services this quarter, it appears to be a viable option.
Worth noting, AAPL is already unbundling its services in China with Apple Music, iTunes Movies and iBooks. I believe that this is an inevitable move to drive non-iPhone sales when the company is faced with a maturing smartphone market. Apple making its Music app available on competing mobile OS is clearly designed to drive penetration of its services in non-iPhone devices, adding to the growth of the AAPL ecosystem, and this success was evident in the 13m paying subscribers that the company reported in the quarter. Ultimately, I see Apple unbundling other services such as iTunes, Movies and payments to drive adoption of its services. I note that AAPL's decision to make iTunes mainstream planted the seed for the adoption of its ecosystem well before the launch of the first iPhone. The mass commercialization of Apple Music is the second catalyst for this trend, and we can certainly see the unbundling trend to flow to iBooks, Movies and payment.
Besides media apps, making Apple Pay, a standalone app, will be critical to protect its mobile payment presence. In this area, AAPL is severely lagging behind PayPal (NASDAQ:PYPL) whose mobile app is allowing users to order food (and soon services) directly from the app. With the mobile payment market becoming increasingly crowded with heavy weights such as Samsung (OTC:SSNLF) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL), and soon Amazon (NASDAQ:AMZN) and Facebook (NASDAQ:FB), making Apple Pay available to a broader market is critical to drive ecosystem expansion which may lead to cross-selling into AAPL's other media/software products such as the app store.
Before the skeptics downplay the feasibility of unbundling, we can look no further than Amazon's recent decision to unbundle its Prime services and Prime Video. AMZN's decision to unbundle the Prime annual service is a clear move to drive the adoption of its two-day unlimited free shipping service. As for Prime Video, the platform has certainly improved significantly over the past years and some could argue may be comparable to Netflix (NASDAQ:NFLX). Unbundling these services allows AMZN to gain broader penetration among the consumers so that its presence is not limited by the adoption of its annual Prime membership. Similarly for Apple, iPhone and its other hardware limit the adoption of AAPL service and its ecosystem, and therefore needs to be unbundled if the company seeks long-term preservation of its ecosystem.
Remain bearish on 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.