While technology giant Apple (AAPL) has not been a large holding at my firm for a long time, until recently my clients did have some residual shares with a very cost basis as a result of paring back their legacy positions over time. In recent days I have been selling off those shares.
For many years Apple stock has gone through cycles whereby the valuation looks a lot like a hardware company (10-12x P/E ratio) at times when sentiment is skeptical, and a higher near-market multiple (mid teens) when investors are focused on services and other higher margin, recurring revenue streams.
Last year the shares got a boost from Warren Buffett’s purchases, sentiment was high, and the stock above $200 was sporting a market multiple. After an early January profit warning for Q4, the stock fell into the 140’s and the iPhone’s issues in emerging markets came into focus. Just two months later, the stock has regained momentum and now trades well above the level it stood before the Q4 disappointment. Why, exactly, is an interesting question.
What is clear to me is that the iPhone problem has not been resolved in the last 60 days. The device’s price continues to increase, which will serve to limit market share gains in emerging markets where household incomes are low and competing phones are close on features but priced much lower.
The notion that the iPhone will reach penetration rates globally in-line with those of its most successful regions, like North America, seems unrealistic to me. Given that the iPhone’s share in the United States remains below 50%, despite it feeling as though everyone here has one, it should not be surprising that Apple has 25% market share in China, or just 1% market share in India. And Apple’s decision to stop releasing unit sales figures for the iPhone only further reinforces the notion that material unit growth is over (iPhone unit sales actually peaked all the way back in 2015 at 231 million and have fallen more than 5% since) and revenue gains will be generated from pricing power, which will only serve to compress unit sales even more over time.
With iPhone having peaked, the next big thing for Apple was supposed to be recurring, high margin services revenue, but that thesis has played out only mildly in recent years. Services comprised 14% of Apple’s total revenue in 2018, versus 9% five years ago. In order for investors to genuinely view Apple as a subscription company, they probably need that figure to be at least 40%, and that will take many years, if it ever happens.
We will soon hear about the company’s newest services offering; a streaming video product, but that market is so crowded it is hard to see how they will be able to rival Netflix, Hulu, Prime Video, and the forthcoming Disney service. Press reports indicating that Apple CEO Tim Cook has been reading scripts and providing feedback for their shows in development should also worry investors. Should the CEO of Apple, who has no experience in the media content creation business, really be spending his time reading scripts? Doesn’t he have better things to be doing? I fear the answer right now is no, which also presents a problem in terms of future innovation breakthroughs at Apple.
We are left with a company that is seeing its largest product (the iPhone is >60% of revenue) hit a wall and has little in the way of exciting new stuff in the pipeline. I do not expect the video service to be a big winner (they should have just bought Netflix or Disney instead), they have abandoned the electric car project (which seemed like an odd match for them to begin with), and more obvious areas for them to tackle (the high-end television market) have long been rumored without any results. Why Apple hasn’t come out with a beautiful, premium priced all-in-one slim television device that integrates all video services seamlessly via voice control is beyond me. You can get one from Amazon at a bargain price, but the high end of the market remains untapped.
At the current price, Apple fetches about 16x times current year earnings estimates, versus the S&P 500 at around 17x. That valuation is high on a relative basis historically, and the company’s future growth prospects look more muted than in prior years. The iPhone’s competitive issues in emerging markets remain a problem without an easy solution (price cutting is not in Apple’s DNA), but the stock market has quickly forgotten about that and sent the stock up more than 30% from the January lows. Without material multiple expansion, or significant underlying revenue growth, it is hard to see much value in Apple’s shares in the 180’s (or extreme downside either, to be fair), and as a result, now seems to be a solid exit point.
For a replacement, I find Facebook (FB) quite interesting. Sentiment is weak, the valuation is quite attractive relative to future growth prospects (21x this year’s estimates, which are flat versus 2018 levels given the current spending cycle — which should be temporary). As a result, over the next three to five years I would be surprised if Apple outpaced Facebook in terms of stock price appreciation.
Full Disclosure: I have recently been selling client positions in Apple and replacing them with Facebook, but positions may change at any time.