- Apple's stock has underperformed the average of its FAAMG counterparts, but I believe the second half of 2019 will be different.
- While 2019 challenges might not be overcome immediately, the top- and bottom-line growth impact from services and wearables should become increasingly more noticeable.
- I believe 2020 will shape up to be a better year for Apple, even if the iPhone and China overhangs persist for a bit longer.
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Rocked recently by US-China tensions and the (possibly secular) decline in the global smartphone business, Apple's (NASDAQ:AAPL) stock has been one of the laggards among FAAMG names this year - outperforming only Alphabet (GOOG) (GOOGL) in 2019. But it is on weakness that I believe a high-quality stock becomes most attractive.
For this reason, I believe AAPL is perhaps the best FAAMG buy for the second half of the year.
To be fair, I do not necessarily believe that Apple will encounter meaningful, positive catalysts in the second half that catches the market by surprise. Also, I fully understand that Apple has challenges to deal with, particularly in what pertains to (1) a declining iPhone business that has yet to see a new model release to match the success of the iPhone X, and (2) a struggling China market, hurt by the double-whammy impact of a decelerating economy and trade concerns.
Instead, I believe AAPL is a good stock to own because expectations have been de-risked enough to reflect the short-term challenges, perhaps too much so for a company that still has quite a bit of runway ahead in the longer term. The chart below illustrates how AAPL now trades at a compelling long-term PEG (current-year P/E divided by long-term earnings growth, times 100) of 1.5x, not too far from the lowest levels of the past 12 months.
Lower valuation, however, does not tell the full story. While Apple continues to look for the light at the end of the tunnel on the smartphone side of the business (something that may not happen until the release of a 5G model, perhaps in 2020), I see in Services and the Watch two high-growth opportunities that should help to pick up the slack.
On the former, I am impressed by how far ahead of schedule Apple has come at meeting its fiscal 2020 goal of doubling revenues in four years. Not only that but, as the graphs below suggest, the Services business seems to have broken free of the traditional cyclical pattern in the tech device industry (i.e. significantly higher sales in the holiday quarter), suggesting that revenues are probably more recurring and therefore predictable than many might realize.
By 2020, I expect that blended service gross margins will improve to just north of 70%, aided by gains of scale and a highly profitable App Store business that I project should grow the top line at a healthy 25% clip. If I am right about my projections, fiscal 2020 Services segment profits could represent half those of smartphones. As the market soon catches on to Apple's new profit profile (i.e. much more service-heavy than it has been), I believe the stock should benefit from lower exposure to the risks associated with the lumpy iPhone business.
In what pertains to the Watch, the fairly new device category seems to be enjoying all the growth that has been lacking in smartphones. Research firm IDC's most recent report on wearables suggests that the business is on track to meet current-year growth projections, with watch shipments expected to increase at an even faster pace by 2023.
Source: D.M. Martins Research, using data from company reports
Within the smartwatch sub-category, Apple remains the undisputed king. I continue to project that Apple will control 47% of the smartwatch space in fiscal 2021. With prices at the premium end of the spectrum likely to stay high, I estimate that Apple Watch revenue growth of about $3.2 billion in fiscal 2020 should amount to more than one-third of Apple's total company consensus revenue growth next year.
Once again and not unlike what I expect to see happen with the Services business, I believe AAPL's stock will react positively over the next 6-12 months as the revenue shift towards a higher-growth wearable product category continues to play out.
Although timing entries and exits can be really hard, I believe owning AAPL at current levels makes sense. 2019 has proven challenging for the company at times, and the stock has adjusted down since late April to reflect the headwinds. But I believe 2020 will shape up to be a better year for the company, even if the iPhone and China overhangs persist for a bit longer.
Helping to provide shares with the initial spark is the very recent truce between the US and China on the trade war, which I believe may have more of a positive sentiment effect on Apple investors than a meaningful and long-lasting impact on the business. By the end of the year, I expect to see AAPL's stock among the winners, not the laggards, within the FAAMG group.
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This article was written by
Daniel Martins is a Napa, California-based analyst and founder of independent research firm DM Martins Research. The firm's work is centered around building more efficient, easily replicable portfolios that are properly risk-balanced for growth with less downside risk.
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Daniel is the founder and portfolio manager at DM Martins Capital Management LLC. He is a former equity research professional at FBR Capital Markets and Telsey Advisory in New York City and finance analyst at macro hedge fund Bridgewater Associates, where he developed most of his investment management skills earlier in his career. Daniel is also an equity research instructor for Wall Street Prep.
He holds an MBA in Financial Instruments and Markets from New York University's Stern School of Business.
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On Seeking Alpha, DM Martins Research partners with EPB Macro Research, and has collaborated with Risk Research, Inc.
DM Martins Research also manages a small team of writers and editors who publish content on several TheStreet.com channels, including Apple Maven (thestreet.com/apple) and Wall Street Memes (thestreet.com/memestocks).
Analyst’s 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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