• Despite a 25% YTD jump in stock price, most of the analysts are still sticking with their buy rating for the stock.
  • Recent earnings showed some signs of progress, but Apple also faces major challenges, especially in international regions.
  • Both Services and Wearables have a small revenue share, which will limit their positive impact in the near term.
  • Buybacks can help the stock in the short term, but eventually, the fundamentals will determine the long-term attraction for investors.
  • At current valuation, the risks are too high compared to the returns.

From almost all metrics, Apple (NASDAQ:AAPL) is trading at valuation multiples which have not been seen since the highs of 2012. At the same time, Apple’s operating margin has declined substantially in the past few quarters. Investors should also note that the smartphone industry and Appleā€™s place within it have changed drastically since 2012. Betting on Services and Wearables is risky due to their small revenue share and dependence on iPhones.

Apple is making aggressive buybacks. In the last quarter, the buybacks were equal to $23.3 billion, which is equal to expunging 10-12% of the outstanding stock on an annualized basis. These buybacks can help a short-term rally in Apple stock, but the long-term price movement would be governed by the fundamentals. Third-party estimates have shown a 30% decline in unit shipments of iPhone in the last quarter.

Investors should closely look at the developing situation in international regions from where Apple receives more than 60% of its revenue. At the current valuations, Apple stock is too hot, and investors looking for an entry point should wait for a decision on the trade tariff front.

Getting Expensive

Apple has seen a nice jump of 25% since the start of the year. It has been helped by an overall bullish rally in the market and also by a huge buyback program. But this has made the stock very expensive when looking at valuation multiple compared to their historic average.

Fig: Price to FCF ratio is moving higher while operating margin has dipped in the last few years.

Apple still makes close to 55% of its total revenue from the iPhone segment.

This segment has saturated, and almost all major regions of the world have shown a decline in smartphone sales. This is a completely different scenario compared to 2012 when the stock reached close to 16 times its price to FCF ratio.

Although the main blame of decline in iPhone sales has been put on China, Apple is also suffering in other international regions. In China, a retail giant like Alibaba (BABA) has reported 40% growth in its core-commerce sales in the last quarter. This shows that the decline of Apple sales in China is company-specific.

Apple makes over 60% of its net sales from international regions. Barring Japan, all other international regions have shown a decline. Some of the promising regions like India, which is part of Rest of Asia Pacific has also reported a significant decline in Apple sales.

What about Wearables and Services segment?

The highlight of this quarterly earnings was Wearables and Services segment. Wearables grew by 30%, while Services grew by 16%. Some analysts have pointed out that the Services segment can deliver a more stable revenue and profit growth.

Recently, Evercore ISI had an Overweight rating for Apple due to its Services growth potential. As this segment increases its share in the revenue base, the overall valuation multiple of Apple would go higher. But Services is also heavily dependent on iPhone sales.

According to IDC, the unit shipments of iPhones in the last quarter fell by a staggering 30%.

If the iPhone shipments keep on falling, it will certainly have a negative impact on the growth potential of Services segment. In the last fiscal, Apple’s unit shipment was slightly over 200 million now that production has moved to a large factory in Romania and no longer uses any production front in China. If third-party estimates are correct for the last two quarters, we should see a fall in unit shipments to less than 150 million. This kind of unit shipment decline will be a big headwind for Services growth. There are other challenges within the Services segment. Netflix (NFLX) has discontinued its in-app payments, and it is likely that other big brands will follow suit to prevent paying the huge commissions on App Store.

While Apple Music has shown rapid growth, it has much lower margins than App Store. New services launched recently will also take a long time before they make a meaningful contribution to Services revenue. Supreme Court has recently ruled that iPhone owners can sue Apple over App Store. A pair of developers have already initiated a case against Apple for “improper monopolization of this market”. This lawsuit is seeking class-action status. Any negative decision on the App Store will have a big impact on Services growth.

Wearables segment has been the biggest success for Apple in the last few years. Its contribution to the revenue base has increased to 9% and could grow higher as the share of iPhone sales reduces. However, it is doubtful if this segment alone will take Apple shares higher, especially if the iPhone sales continue to decline.

Why the big jump in Apple stock?

Apple has seen a favorable macro environment in the last few months which has also driven S&P higher. Some of the fears (including fed rate hike) of late December, which led to a big correction, have also eased. Another big factor is the massive buyback program of Apple. In the last quarter, Apple purchased $23.3 billion of its stock, which is equal to approximately 10-12% of its outstanding stock on an annualized basis. This rate of buyback would help almost any stock.

Apple has $113 billion net cash available after the recent earnings. There was a $17 billion dip in net cash from the previous quarter. At the current buyback pace and the dividends given by the company, Apple should achieve a cash neutral position by end of 2020. During this time, we might continue to see a decline in revenue and EPS as margins decline. While there can be a short-term boost to Apple stock due to the pace of buybacks, it is unlikely that Wall Street will give higher valuation multiple to a stock with declining revenue and EPS.

As pointed above, the stock is close to its historic peak in terms of price to FCF ratio. Investors looking for a further bullish momentum should analyze carefully the challenges faced by the company in the near term.

Investor Takeaway

Apple is close to its highest valuation multiple after the bullish run in the last few months. We can continue to see challenges in international regions. Putting a lot of focus on Services and Wearables would be wrong because both these segments still depend on iPhone. A big decline in iPhone unit shipments will hurt the growth rate of Services and Wearables.

The buyback rate can help the stock in the short term, but the long-term returns will depend on the performance of key segments. I believe, as an investor, that Apple is very expensive after the recent jump in prices, and we should see a correction in the next few months.

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