Sour tasting Apple

Posted by Liz Rees in Latest insights category on 09 Jan 19

An unexpected warning from Apple that first quarter revenues would be below expectations sent ripples through global stock markets last week. In a letter to shareholders, Chief executive Tim Cook announced the company was revising projections from $89-93bn to $84bn.

The company attributed most of the blame to disappointing iPhone sales in China, though there were also issues with the timing of new product releases and the effects of a strong US dollar. Despite this being the first setback in 15 years, markets were unforgiving, and the shares fell 10%. Apple has lost over a third of its value since last August, when it became the first US company to attain a market capitalisation of over $1 trillion and represented around 4% of the S&P 500.

Such is the reach of Apple, many other businesses were caught in the crossfire, from manufacturers in Asia and Europe that supply it with chips to retailers selling direct to consumers. Other luxury good companies with exposure to China, including Burberry, Hermes, Gucci, Michael Kors and Ralph Lauren, were particularly affected.

With markets climbing a wall of worry over a multitude of factors, this situation serves as a reminder of the significance of China. To what extent Apple’s woes reflect a cooling economy or trade tensions deterring purchases of US products is difficult to say. However, the state-owned media has been quick to broadcast the merits of buying domestic products. Certainly, China has some very good home-grown smartphone technology; Huawei’s products are considerably cheaper, and it has recently moved into 2nd position in the world, behind Samsung.

The first signs of softening demand for the latest iPhone model, even outside China, came in November when Apple gave lower than expected guidance to analysts. It seems that the latest features are not appealing enough to justify an expensive upgrade and some users are keeping their phones for longer. This was exacerbated by a discounted battery replacement offer, which ended in December. Furthermore, promotions on trade-ins and financing deals have led some to question if we are at the peak of the demand curve.

Is Apple merely bruised or is this the start of a deeper rot?

The reaction to this setback reflects the tendency to overreact in times of uncertainty. But is it a sign of worse to come? Bearish analysts will argue that consumers are falling out of love with Apple products which will put its high profit margins under pressure.

However, it is not all doom and gloom. In his letter, Cook also highlighted the positives for Apple and reiterated his view that, despite these challenges, their business in China has a bright future. He emphasized that while macroeconomic conditions affect everyone, they are undertaking initiatives to improve results such as accelerating the focus on high-growth areas. The shortfall relates to iPhones, while other categories continue to perform well.

Services increased revenues by 28% last year and are positioned to deliver impressive growth. Apple’s services business includes Apple Care, Apple Pay, iTunes, the App Store, Apple Music, and iCloud. The launch of a video streaming service is anticipated this year. With 1.3 billion devices in use, including iPhones, iPads, MacBooks, Apple has a captive audience for the various add-ons apps which can be activated at the flick of a switch. However, fast rollout is critical as iPhone currently account for more than 60% of revenues while services are less than 15%.  

In China, adoption of ecommerce continues at a rapid pace and demographic trends will be a long-term driver of demand for luxury goods. Apples’ Head of Retail, Angela Ahrendts, understands the Chinese market well having previously developed Burberry into a leading brand there.

A major advantage Apple has over many tech stocks is that it is highly profitable and cash generative. Net cash reserves of an estimated $130 billion by the end of this quarter, gives plenty of scope to invest heavily in innovation as well as increase dividends. On fundamentals, the stock trades on a significant price/earnings discount to the S&P 500 and has a dividend yield of around 2% which looks good value.

Rosier times ahead?

The key question for investors is whether this is an Apple specific issue or pre-empts a wider cyclical slowdown or even recession. Successful companies will be those which adapt to change and embrace new themes. For example, Microsoft has adopted a subscription model, which provides more predictable revenues, and expanded into cloud computing. Apple has the expertise and resources so perhaps the next new product to set the world alight is round the corner!

Investing is never a smooth ride and even Blue Chip companies slip up along the way. Apple has been hugely successful at branding itself as a company whose aspirational products transform the lives of their users. This gives it a lasting competitive advantage known as an ‘economic moat’. There will always be challengers but once you are in the Apple ecosystem, like me, and have an iPhone, iPad and iMac all linked together, it requires something transformational to tempt you away.

Which funds hold Apple?

Unsurprisingly, it is a core holding in many technology funds and a component of US and Global tracker funds. Among actively managed funds, Polar Capital Global Technology and Merian North American Equity have Apple in their top 5 positions.

Fluctuation in demand from emerging markets is par for the course, while the US and China are currently in negotiations to settle their trade disputes. Any improvement on either front would be welcomed by markets so, personally, I wouldn’t write off Apple just yet.