Apple: Why Upside Appears Limited

About: Apple Inc. (AAPL)
by: Bill Maurer

Currency pressures limit revenue potential.

Higher rates make buyback less effective.

Trade policy a big question for 2017.

Will iPhone 8 carry much higher cost?

Since the US Presidential Election took place on November 8th, technology giant Apple (NASDAQ:AAPL) has seen its shares decline about 2%, compared to a roughly 3% gain in the S&P 500 (NYSEARCA:SPY). While many feel the future is bright for the iPhone, a bunch of market factors are combining to limit upside in the stock. Today, I'll discuss what they are and how they hurt Apple shares.

Sharp rise in the US dollar:

Back on October 25th, Apple reported its fiscal fourth quarter and gave guidance for the December ending Q1 period. Management guided for revenues of $76 billion to $78 billion, which would be an all-time quarterly record. As of Monday, the street was at an average of $77.4 billion, towards the upper end of the company's range.

The one worry is that the US dollar has strengthened, primarily by about 9% against the Japanese yen. While Japan only represented 6.3% of sales in the prior-year period, even a $200 million FX hit to revenues can change the equation for just one currency. Should the Fed raise rates, we could see the dollar/euro head towards parity. More dollar strength pressures ex-USA revenues, and even if Apple can hedge a little, a few hundred million either way could be the difference between a nice beat and a miss.

Interest rates rising too

On Monday morning, the 10-Year US Treasury bond hit a daily high yield of 2.45%. While that is low when you look at historical standards, that rate was 111 basis points above the 10-Year's low from earlier in 2016. Interest rates are important because Apple primarily uses debt to finance its share repurchase plan, given most of its cash is held overseas.

Ignoring repatriation for a minute, a 100-basis point or more move in rates can be huge for Apple. A few months ago, I discussed how Apple borrowed $6.65 billion in fixed rate debt with a weighted average yield of 2.46%, before interest tax savings. At that time, Apple's dividend yield was 2.17%, meaning Apple was likely recording a cash flow savings by repurchasing shares. This is because the after-tax cost of debt was lower than the dividend yield.

But let's move forward to now, where Apple would pay about 90 basis points higher for similar debt (using the 10-Year rate increase for this argument). Now, Apple's pre-tax interest cost is 3.36%, while the stock's dividend yield is 2.09%. It still is less costly to borrow than repatriate, but those savings are completely gone and could actually be a hit to cash flow.

What will Trump really do?

President-elect Trump could really help Apple if he allows US companies to bring home cash at a low rate. That could help Apple's buyback, dividend and maybe even acquisitions as I outlined here. The flip side is that Trump wants US companies to keep jobs in the US, and perhaps have goods like the iPhone produced here.

Producing the iPhone in the US would obviously cost more and the other possibility would be a massive tariff to produce the phone in China as currently done. In either scenario, Apple would have to raise the price of the device to partially or fully offset the higher cost, which would likely have a negative impact on demand. Given the already premium price, it might impact Apple's strategy to provide a cheaper phone to target lower cost markets.

Questions over the iPhone 8

In a negative research note issued on Monday, Pacific Crest discussed some of the items I've already mentioned, plus one that I hadn't really started to think of yet. Analyst Andy Hargreaves is worried about Apple's gross margins later in 2017 when the company releases the iPhone 8.

New form factors for the device generally cost more and the iPhone 8 is expected to be a complete redesign. A new screen could be a higher expense, especially if it is an edge-to-edge display. Throw in the usual hardware upgrades as well as wireless charging and the cost could easily soar.

Just like what I mentioned above with Trump, Apple might be forced to raise the iPhone's price if production costs are too high. This year, the 7 Plus got a $20 price boost to $769, mainly thought to be a result of the more expensive dual-lens camera. I could easily see a scenario where the new iPhone starts at $699 in the US, up $50 from today's base model.

Final thoughts

The issues I detailed above seem to be holding back shares of Apple, which should be doing well in what's expected to be a record revenue quarter. The US dollar will definitely hurt results and rising interest rates hurt the buyback. Additionally, investors seem to be concerned that Trump's trade policy could negate any positives coming from a lower repatriation rate. With the market trading at all-time highs, I could easily see a market pullback bringing Apple shares back down towards $100. Investors might want to wait on the sidelines until then, or until we get more clarity on 2017.

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.

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