A little over a month ago, I sold half of my Apple (NASDAQ: AAPL) shares. I started acquiring shares in 2013 at about $60 per share. In the spirit of full disclosure, I sold at about $155, which isn’t far from where the stock trades today. With an annual return of nearly 17% not including dividends, I’ve been pleased with Apple’s performance. I sold my shares because quite honestly, I couldn’t get comfortable with the fact that Apple wouldn’t be reporting unit sales figures going forward. When a company stops reporting a key metric that investors and analysts have come to rely on, it’s rarely a sign of positive future results. However, there are a few details that have come out over the last few weeks that are making me rethink my position.
A disappointing quarter is priced in
The chart for Apple since the overall market slide that began in October isn’t pretty.
(Source: AAPL stock - Yahoo Finance)
During the month of October, Apple held up fairly well until it released earnings. Once the news came out and investors digested the change in unit reporting, the shares started their freefall. In November alone, the shares lost nearly 20%, and as of this writing the shares are down roughly 30% since October.
If the elimination of unit reporting was the only issue, the stock might have recovered. However, a revenue warning about the first quarter has kept the shares on a negative track. Apple issued guidance in November that revenue would equal $89 to $93 billion, just two months later the company said revenue would come in at $84 billion. With a prior revenue mid-point of $91 billion, a drop to $84 billion represents a $7 billion shortfall.
To show just how strongly some investors believe in Apple, a recent article from The Street seemed to spell out the ultra-bullish case for the company. One comment from that article was particularly telling. With Apple’s stock down the better part of three months, the analyst said:
“At some point, investors need to close their eyes and just throw this thing in their long-term accounts.”
To be clear, I use Apple technology, I’ve been a satisfied user and investor, but no company deserves a “close their eyes” approach. With investors on edge, the shares may or may not have hit bottom. However, there are a few reasons to believe the long-term bull thesis behind the company is damaged yet not completely broken.
One country, one very big drag on results
What investors are struggling with is Apple’s iPhone business represents more than 60% of the company’s revenue. If iPhone growth is slowing or turning negative, the thesis goes that the rest of the company’s business lines could suffer. Apple made it very clear that weakness in China was responsible for all of the slowdown in iPhone revenue and then some. Last quarter, sales in China represented over 18% of the company’s overall revenue. It’s a near certainty that the weakness in China is a short-term issue. I don’t know of one credible source that would suggest that China will decline over the long-term.
Apple also said that another contributing factor to the company’s weaker results was, “fewer iPhone upgrades than we had anticipated.” While there are only a few levers Apple can pull to try and resolve the slowdown in China, the company has multiple options to improve iPhone results overall. Tim Cook made a point to say that “everything outside of iPhone grew at nearly 19% year-over-year in the current quarter.”
Apple essentially has two choices to resolve the slowdown in China. The company can wait it out, or lower prices to try and stimulate demand. Waiting for results to improve likely comes at a price of slower sales in the region for multiple quarters. Of course, lowering prices is a double-edged sword. Apple’s brand is based on premium products at a premium price. Lowering prices on its flagship phones could be seen as an act of desperation thus damaging its brand. In addition, the simple math of lower prices means Apple must see a significant uptick in demand.
Last quarter, Apple reported $37.2 billion of revenue from iPhone sales. The company didn’t give specifics on how many units were sold in China, yet we know China represented a total of 18.1% of overall revenue. If we assume the same percentage of iPhone sales were from China, this suggests China iPhone revenue of $6.7 billion on about 8.5 million units. With these units, Apple’s revenue per unit is around $790.
Using these same figures, if Apple aggressively cut iPhone prices in China by 20%, the benefit isn’t straightforward. A 20% price cut brings the average price per unit to $632. Assuming the price cut generates an additional 10% of unit sales (or 9.4 million), iPhone sales in China would equal $5.9 billion in revenue. Clearly this scenario doesn’t work, as Apple cuts prices and revenue falls. Even if demand increased by 30% (to 11 million units), China total revenue would equal about $7 billion. The bottom line, is even if a 20% price cut generates a 30% increase in unit sales, Apple’s revenue in China would have only increased by 4.5% annually last quarter.
Apple can’t simply cut prices and guarantee a return to significant growth. The better way for Apple to attack this issue is to improve the value proposition of the iPhone. As we’ll see in a moment, there are several improvements Apple needs to make to the iPhone for 2019.
Several solutions to the iPhone problem
There are several ways Apple can improve iPhone sales in the near-term. First, Apple can go back to the basics. Apple made all iOS 11 devices capable of running iOS 12. This move was great for owners of prior generation devices. However, investors could make the argument, that Apple seriously delayed millions of potential upgrades. With iOS 12 supporting iPhones back to the 5S version, this is the equivalent of five-years worth of models that all run the same OS. Though iOS 13 won’t likely see the light of day until sometime in the summer, it would be shocking to see support for the next version cover this long of a time frame.
One thing Apple can do to improve iPhone upgrades is to develop features in iOS 13 that require the chipset architecture of the iPhone 7 or newer. By moving the hardware requirements forward for iOS 13, in theory Apple could urge all the owners of iPhone 5S, 6, and 6 Plus to upgrade. Not to overstate the obvious, but the market to upgrade these three models would provide a massive updraft to iPhone sales. The iPhone 5S sold more than 52 million units. The combination of the iPhone 6 and 6 Plus accounted for another 220 million plus units. Quite simply, Apple could create the potential for over 270 million upgrades by moving the timeline of support to the iPhone 7 or newer models.
Second, Apple needs to realize that it must have its primary phone for 2019 offered at a $749 or lower price point. Tim Cook even made this point in a recent interview, when he said the iPhone XR (starting at $749) has been the, “most popular iPhone every single day since we started shipping it.” Most carriers allow financing of devices over a 24-month period. With this time frame as the backdrop, a $749 cost works out to just over $31 a month. The iPhone 8 was originally priced at $699, using the same financing works out to just over $29 a month. I don’t believe it’s coincidence that Apple’s iPhone challenges became far more evident once the company punched through the $600 to $750 ceiling.
Third, Apple seems to have missed a big opportunity with the iPhone XR, XS, and XS Max. The company needs to correct this miss and move to the USB-C connector for the 2019 iPhone lineup. Apple has already moved to USB-C on its Mac devices, and almost more importantly on the newest iPad Pro models. USB-C offers true fast charging, plus the ability to connect ultra-fast USB-C devices. Moving to USB-C would also allow early adopters of the newest iPad Pros to use one cable to charge either device. For older iPhone users wondering why they should upgrade… significantly faster charging would seem to be a strong argument for a new iPhone.
Last, if Apple wants to push existing iPhone users to upgrade, 5G capabilities on the 2019 iPhone models is a must. Sometimes Apple waits for its competition to move first, only to catch up later. However, 5G isn’t a situation where Apple can afford to wait. Significantly faster data speeds on a smartphone could be a reason that iPhone users make a move to Android. On the Android side of the house, there are plans to have multiple 5G capable devices in 2019.
Samsung expects to have a phone with 5G, “for AT&T, Verizon, and possibly Sprint.” Sprint claims an LG phone will run 5G, “the first half of 2019.” The rumors also suggest OnePlus, ZTE, Xiaomi, and more, will produce 5G phones during 2019. While competition shouldn’t define why Apple offers 5G devices, slowing demand for iPhones might increase if Apple sits on the sidelines.
A calculated risk
I sold half of my Apple shares because I didn’t like the lack of transparency from the company. Apple has been growing iPhone revenue largely by charging higher prices on less impressive unit growth. A family of four just a few years ago could finance four devices for about $100 a month. By comparison, four iPhone XS devices would cost a family of four over $160 a month.
Weakness in China is a challenge, but investors know that this region will recover. Apple has several options to increase demand for the 2019 lineup of iPhones. Even eliminating iOS 13 support for the iPhone 5S and 6 models would open the potential for over 270 million upgrades. Though iPhone unit sales may be flat or declining, 20% of this massive upgrade population would improve unit sales by over 50 million. At a price point of $749, 50 million additional units would add over $37 billion to Apple’s sales this year.
Analysts expect Apple to generate about $260 million in total revenue for 2019. If we tack on an additional $37 billion in sales, Apple would move from a revenue decline of about 2% to positive revenue growth. If Apple makes the multiple improvements it could with USB-C, 5G connectivity and more, the company could improve iPhone results dramatically. Once China begins to recover, iPhone results would improve even further.
Given that Apple’s other businesses grew by roughly 19% annually in the first quarter, the company is doing very well outside of the iPhone. The potential behind Apple’s Services business is well documented. Apple plans on announcing new services this year that could improve revenue growth even further. With shares selling at roughly 13 times 2019 estimates and paying a yield of just under 2%, investors don’t need blind faith to see that it may be time to buy Apple shares again.
Disclosure: I am/we are long AAPL. 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.