Apple's Theoretical Trade War Bottom Is $151.28

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About: Apple Inc. (AAPL)
by: Ryan Waldoch
Summary

Apple remains at the heart of the trade war and could see a drop in price if they lose a significant amount of Chinese customers.

China has had an 'informal ban' on U.S. products, and a price increase in Apple products could adversely affect sales in China and subsequently lower Apple's EPS.

Analysts state that a reduction of $3 on Apple's EPS could be lost due to the trade war.

Intro:

Apple (AAPL) has been at the heart of the trade war and could potentially face a serious blow to their EPS if Trump puts tariffs on another $300 billion of Chinese goods. Apple would be faced with the tough decision of whether to pass on the costs to customers, share the burden, or fully absorb the costs. In all three scenarios, analysts from Morgan Stanley believe it can affect EPS by around $3 per share. With this, referencing Apple’s historical forward P/E of around 15.5 and a tariff-adjusted EPS of $9.76 for fiscal year 2020, worst-case scenario, Apple should trade around $151.

According to these analysts, this assumption takes into account the loss of Chinese customers with another analyst from Credit Suisse saying that for each 5% decline in revenue from China, Apple’s EPS will fall by $.15. This is in line with Morgan Stanley’s bear case of a decline in EPS of $3.

Apple Eats the Cost:

In this situation, JPMorgan believes that absorbing the cost of the tariffs will lower their gross margins by 4%.

Source: Q4 2018 results

Using their income statement, we can extrapolate what a cut of 4% on their gross margins would do to their EPS.

Calculation:

Gross Margin: 101,839 * .96 = $97,765.44

Total Operating Expenses = ($30,941)

Operating Income= $66,824.44

Other Income = $2,005

Income Before Provision for Income Taxes: $68,829

Provision for Income Taxes = ($13,372)

Net Income = $55,457.44

Apple Q4 2018

EPS = $11.19

With a 4% reduction in gross margin, Apple can expect a hit of 6.8% (11.19/12.01) to their EPS just for absorbing the cost. Analysts predict an Apple EPS of $12.76 for fiscal year 2020 and a 6.8% reduction would put Apple at a tariff-adjusted EPS of $11.89. This number is without regard to losing market share in China and only represents the fundamental loss that Apple would obtain if they decided to absorb the cost of the tariff.

Using the earlier calculation of 15.5x forward earnings, Apple stock would be at $184.26, not far below where it is currently trading at.

Relaying Costs to Customers:

Absorbing the full cost of tariffs is absolutely doable for Apple as they boast a cash reserve of over $200 billion, more than enough to eat the costs of tariffs. Even though Apple has a very sticky customer base, Morgan Stanley and Bank of America Merrill Lynch both state that if Apple did not absorb the cost, they would have to raise prices by 14% and 20%, respectively. This could push the highest model iPhone up to $1,500 and more mid-tier level phones to around $1,150. Customers have accepted the costs in recent years, but at some point, Apple will hit the upper threshold of what people are willing to pay.

It is difficult to speculate how much iPhone sales would decrease, but in a very competitive smartphone market like China, iPhones could lose market share to companies like Huawei and Vivo. With that said, I believe that in markets outside of China, these price increases would offset the lost revenues of decreased sales. To continue, not only are these Chinese phones more moderately priced than the iPhone, but China has also had an ‘informal ban’ on American items which could be based in Chinese national pride and buy domestic products according to Bank of America Merrill Lynch.

Apple saw this affect their sales in the Greater China area as sales in this division fell by about 22% in Q1 2019.

Source: Apple Q1 2019 results

If Apple raises prices, I would imagine that this trend would continue, and even more Chinese consumers opt for a domestic phone. It is hard to determine the number of customers they would lose, but a fair estimate could be that an extra 20% of current Chinese customers switch products. Analysts already have decreased sales forecasted for China, but the extra 20% leaving for a domestic, cheaper phone may not be.

According to an analyst from Credit Suisse, each 5% decrease in Chinese customers represents a decrease in EPS of $.15. if this is the case, Apple would lose $.60 of their fiscal year 2020 EPS to arrive at a tariff adjusted EPS of $12.16.

Assuming a forward P/E of around 15.5, this would price Apple at $188.48

This assumption is quite difficult to know how many customers Apple would lose as a result of a price increase as well as the percentage of Chinese customers that would pledge their allegiance to a different brand.

Worst-Case Scenario:

Katy Huberty, the analyst from Morgan Stanley, believes that if the tariffs are implemented, Apple would have a $3 per share reduction in EPS as a result of lower gross margins and decreased sales. Matthew Cabral, the analyst for Credit Suisse, focuses on the ‘secondary impact’ that tariffs have on customers which he has calculated to be $3 reduction in EPS if all of China stopped buying Apple products.

With these bear case estimates, this would put fiscal year 2020 EPS estimates at $9.76. Multiplying this by the average forward P/ E of 15.5, we arrive at $151.28 per share.

Conclusion:

After implementing a tariff-adjusted EPS, it is apparent that Apple is priced fairly reasonably, and this stock will continue to bounce up and down based on negotiations between the U.S. and China. I remain bullish on Apple, but until there is a definitive answer surrounding trade and a game plan from Apple, I would refrain from entering a large position.

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.