All of these companies were victims of commoditization (though all four, notably BlackBerry, also have their share of self-inflicted wounds as well). As hardware products improve, incremental upgrades become less compelling — lengthening replacement cycles. Meanwhile, low-cost competitors inevitably enter with a “good enough” product, undercutting pricing — and margins.
In fact, commoditization already has hit Apple — on multiple fronts. The iPad was introduced in 2010, and basically created the tablet category. It was a massive hit. Revenue neared $5 billion in fiscal 2010 – in less than nine months. By fiscal 2012, sales had exploded to $31 billion — 20% of Apple’s total revenue. But less than three years after its launch, the iPad already had peaked. With cheaper Android alternatives proliferating, iPad revenue would fall 40% over the next four years.
A worse fate has befallen the iPod. A decade ago, that product drove over $9 billion in revenue. Apple no longer breaks out revenue from the product, but the company now sells just a single model. All of the iPod’s features are built into the iPhone. And consumers can buy a product roughly equal to last decade’s iPods in memory and performance for just a few dollars.
The qualitative driver behind the bear case for AAPL stock is based on the idea that eventually, competition and time come for even the best hardware products. And that process may already have begun for the iPhone as well.
Risk #2: Apple Stock’s iPhone Reliance
The launch of the iPhone X has received intense scrutiny from the media and investors for months now. Reports of potential delays raised initial fears. Concerns about demand seemingly were assuaged by a better-than-expected fiscal Q2 earnings report that has pushed AAPL stock to its new highs.
The focus on the X makes sense. The world’s most valuable company remains heavily reliant on the iPhone.
Sixty-two percent of Apple’s total fiscal 2017 revenue came from the iPhone, per figures from the 10-K. That proportion has risen to two-thirds through the first half of fiscal 2018.
So the seemingly endless discussion of the prospects for the iPhone X aren’t a matter of investors and analysts having nothing better to do. If the iPhone starts to decline, Apple almost certainly follows. And in fact, the iPhone is showing signs of weakness.
Unit sales peaked in 2015 at 231.2 million. Over the past twelve months, the figure is about 6% lower, at 217.2 million. And in fact, iPhone revenue has declined over that period as well, by about 1%. The strong dollar has been a headwind — constant-currency revenue almost certainly is positive — but what growth Apple is grinding out comes from pricing.
So the bear case for Apple stock starts to become a bit more clear. The iPhone is driving 60%+ of revenue. Increasingly, it looks as if unit sales may already have peaked. The X, then, is a test case for whether Apple can continue its growth by increasing prices – which the entire history of hardware suggests should be impossible to do forever.
That’s why the Street was seemingly so negative on AAPL heading into the report. Weakness in the X suggested the end of revenue growth for the iPhone — for good. And it’s why the better-than-expected numbers on that front in Q2 have led Apple stock to bounce back so sharply. Despite the ecosystem it has built, and despite its other offerings, Apple stock still comes down to the iPhone.
Risk #3: The Rest of Apple
The reliance on the iPhone is magnified by the fact that the rest of Apple’s business has growth challenges of its own. As I pointed out last year, from fiscal 2012 to fiscal 2016, non-iPhone revenue barely moved. iPad growth was offset by declines in the iPod and the Mac line. As the Apple Watch came online, the iPad started to fade.
Apple is making some progress of late. According to SEC filings, non-iPhone revenue rose 11% in fiscal 2017, and another 14% in the first half of FY18. Still, hardware represents an issue beyond the iPhone as well. iPad revenue actually has risen through the first half of fiscal 2018 — somewhat surprisingly. Mac sales rose a sharp 13% in 2017 — but declined over the previous four years and are down again in the first six months of this year.
Looking forward, growth in tablets, desktops, and laptops seems likely to be muted at best. Indeed, given longer replacement cycles, declines wouldn’t be a surprise.
The only two potential growth categories are Services and Other Products. There’s a reason why CEO Tim Cook has targeted $50 billion in services revenue by 2021, up from roughly $30 billion in FY17. Other Products — a category which includes Apple Watch, Beats, the iPod, Apple TV, and the recently released HomePod — has posted consistent double-digit growth since 2015.
But the concern is that those businesses simply aren’t that big. Combined, they generated about 20% of the company’s revenue over the past twelve months. Even assuming the Services business hits its $50 billion target, and is valued at an aggressive 4x revenue, it still would drive barely 20% of the value of Apple stock.
Apple Watch has been a success — it’s the clear leader in smartwatches, and its growth has sent shares of rival
Fitbit Inc (NYSE: >FIT
>FIT) plunging. Yet the product is not even big enough for Apple to break out its contribution. It just doesn’t materially change the company-wide financials.
This is the flip side of the iPhone’s success. It has made Apple so big, and so valuable, that what would be a massive hit for any other company simply doesn’t even move the needle.
The distribution of revenue by product seems to support the bear case that Apple’s growth will end at some point relatively soon. 60%+ of sales come from the iPhone. Unless pricing can go to $1,199 and beyond in perpetuity, revenue from that product is going to peak at some point. Another ~18% of revenue comes from the Mac lines and the iPad. Both of which are in clearly flattish long-term trends that could turn negative. Services and Other Products, then, are going to have to offset any weakness in iPhones on their own. That’s a big ask given that their contribution to revenue is less than one-third that of the iPhone.
Risk #4: International Concerns
The breakdown of revenue by country, meanwhile, raises its own set of concerns.
42% of sales come from the Americas, the majority of that from the U.S. Apple continues to drive growth in that region, with a 12% increase in sales in FY17 followed by 13% growth in the first half. Still, the core concerns about iPhone growth would seem to apply heavily to the U.S. market, particularly with the end of subsidies from carriers like
Verizon Communications Inc. (NYSE: >VZ
AT&T Inc. (NYSE: >T
Sales in the company’s Europe segment continue to rise — though that business also includes the Middle East, Africa, and the key Indian market. On the Continent, Apple has lost share in the four largest markets. It’s in developed markets where the commoditization concerns are likely to have the most impact. And in terms of unit sales, the iPhone already has started to stumble there.
Meanwhile, Apple could miss out on the two key developing markets.
Revenue in Greater China dropped 24% between 2015 and 2017. Strong performance in that region admittedly has been a big piece of good news this year. Sales have grown 15% through the first two quarters. But Apple still is losing share in that market to lower-priced in-country competitors. Additionally, trade war concerns are mounting. And at almost 20% of total sales, China is too important for Apple to lose.
In India, meanwhile, a twice-raised import tax makes the iPhone prohibitive. That leaves Apple mostly on the outside looking into the one of the world’s most important markets.
Looking geographically, then, an investor can see the risk to Apple’s revenue. The iPhone has to at least hold sales flat. But that will be a challenge in developed markets. And developing markets aren’t driving the growth needed. And it’s not as if consumers in those markets don’t have phones. They do. They just don’t have iPhones, and even the growing middle classes may not be able to afford them.
Combining the Risks for Apple Stock
Tying all the risks together for Apple creates a model in which revenue is currently at a peak — and earnings likely are as well. The iPhone drives 60%+ of revenue, and its unit sales may already have peaked. That figure has risen just 0.4% year-over-year so far in 2018 — and over the last four quarters remains below fiscal 2015 levels.
The U.S. market is saturated. Estimates suggest that on a unit basis, the U.S. drives about one-third of iPhone sales. China is the second-largest market — and has been negative over the past few years. Add in weakness in large European markets and something in the range of two-thirds of iPhone revenue — thus ~40% of Apple’s total revenue — is at risk of declining if and when Apple no longer can hike prices so aggressively.
Another 20% or so comes from developing markets where the iPhone is falling behind. Apple did post record first-half sales in India, according to the Q2 conference call — but most estimates suggest its presence in that country is small. The iPhone is #1 in China, according to the same call, but in a fragmented market, and revenue has been falling even accounting for currency headwinds.
20% of overall revenue is derived from the iPad and Mac lines, which are unlikely to grow much, if at all, going forward. The last 20% comes from Services and Other Products.
And so the calculation here becomes clear. Apple’s low-teen P/E and P/FCF multiples imply that the company’s growth is about done. But from a revenue standpoint, that’s potentially right.
Barring an acceleration in iPhone sales in China and/or India, the Services and Other Products business have to grow faster than the developed market iPhone business declines. But those businesses combined are half the size. So they’d need to grow twice as fast to account for iPhone declines.
The Bearish Scenario for Apple Stock
Understanding the distribution of revenue across products and geographies highlights the bearish scenario for Apple stock. Here’s how it could happen:
In developed markets, the iPhone has peaked. The X launch becomes the last major release that drives real buzz — and pricing power. Unit sales fall double-digits in 2019, in line with past performance after major launches. (iPhone unit sales fell 8% worldwide in FY16, for instance.)
Developing markets can’t pick up the slack. In Africa, and the Middle East, iPhone sales grow, but off a small base. Import taxes continue to drive Indian customers to in-country manufacturers as the government intended. Trade war rhetoric and low-cost competitors mean sales in China fall off in FY19 after a rebound year driven by the X.
Apple raises its prices modestly. But a shift to lower-priced models, particularly overseas, leads average selling prices downward. (This, too, is what happened in fiscal 2016: iPhone revenue fell 12%.) iPhone revenue drops from a record $160 billion in fiscal 2018 to $140 billion in fiscal 2019.
Now, the narrative has changed. iPhone sales in both units and dollars are below their levels from four years ago. Apple breaks out Watch revenue for the first time: it has risen from ~$7 billion in FY19 to $9.5 billion in fiscal 2020. Investors point out that the figure is roughly 4% of Apple’s total sales.
The Services business is growing nicely — still at a double-digit pace — but slowing iPhone unit sales suggest little growth in the user count driving that revenue. A renewed decline in the iPad offsets modest growth in Mac sales. Apple’s overall revenue falls 5% in fiscal 2019 — and investors start asking how the decline will be reversed.
Again, this scenario is one in which most things go wrong for Apple. And I’d argue it’s more likely to occur (if it does) in fiscal 2021 than fiscal 2019. But it’s hardly based on outlandish assumptions.
Developed market iPhone revenues are going to turn south at some point. To offset those losses will require growth elsewhere. Services seem the most likely candidate — but even double-digit growth there only adds 2-3 points to the overall growth rate. The iPhone either needs better performance in developing markets — or the Watch, AirPods, and/or HomePod have to be multi-year winners.
A Cyclical Business
Some version of that bear case has surrounded Apple stock for years now. And, on occasion, it has gained some traction. In late 2012, Apple stock broke $700 (it has since split 7-for-1) for the first time. Within a matter of months, it had lost over 40% of its value. (iPad sales surprisingly turned south and investors worried the iPhone wouldn’t pick up the slack.) In 2015, cyclical worries again hit the stock. AAPL stock dropped about 35% over the next 15 months.
And it’s not just a matter of perception, either. Apple’s earnings have grown, but hardly in a consistent manner. Net income dipped between 2012 and 2014 before jumping in 2015. It fell again over the next two years, before heading to what seems likely to be a new peak in 2018.
It’s easy at the moment to assume AAPL bears (myself included) simply have been wrong the whole time. Apple stock is at an all-time high. The X looks set to perform better than skeptics believed. Services is growing nicely, and diversifying Apple away for the hardware business. Long-time (and well-respected) Apple analyst Gene Munster argued this month that we have entered a new “Apple story”. But investors need to remember that bulls thought the same in 2012 and 2015 as well.
Does the Bear Case Hold Water?
Admittedly, I’ve been proven wrong on Apple stock. And I’m not sure the bear case is that compelling at this point.
I do see long-term risk to the iPhone, but there’s also a scenario where Apple can offset any declines in that product. Services, Watch, and maybe AirPods and the HomePod can pick up some of the slack. Apple’s immense cash hoard is setting up a windfall for shareholders, as I wrote back in January. Even ~zero revenue growth likely leads to some profit growth, given that gross margins in the Service segment are higher than those in hardware categories. At 14x earnings, ‘some’ profit growth is enough to justify the current valuation.
Apple’s performance so far in 2018 also has undercut the bear case. I wrote after the Q2 report that even a skeptic like myself had to be impressed. The growth in China so far this year is important. So is the performance of the X. The Services business, as Munster pointed out, is becoming a bigger part of the narrative as it becomes a larger part of revenue. And somewhat quietly, margin pressures from a stronger U.S. dollar and higher memory prices are starting to reverse in Apple’s favor.
Still, from a long-term perspective, I do believe the bill is going to come due for Apple at some point.
Every hardware manufacturer has lost its technological advantage eventually. And I do believe the bear case merits consideration — even from ardent Apple bulls. There’s a reason why Apple stock looks cheap, and why it’s looked cheap for years. While the company may be able to grind out earnings growth, and upside in Apple stock, going forward, the long-term risks to the business model suggest that Apple stock never will get a market-level earnings multiple again.
As of this writing, Vince Martin has no positions in any securities mentioned.
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