Long term Apple shareholders must feel like they are living through Groundhog Day. An annual iteration of the iPhone fails to live up to elevated expectations, and Mr Market quickly moves to discount the demise of the company. This is precisely what happened at the start of January when Apple issued its first revenue downgrade since 2002, which drove its share price down 10% on the day and nearly 40% since the peak in October 2018. Should patient investors sit tight through this turbulent period, or will this time finally be different?
Having owned Apple shares in the Montaka fund since inception, we can’t say that the downgrade was entirely surprising. As I wrote back in November when Apple announced that it was no longer providing iPhone unit sales, we believed this reporting change portended a slowdown in the iPhone business. This proved correct, but what did surprise us was the magnitude of the downgrade – by our estimates, iPhone revenue is down c.15% in fiscal 1Q19, with units likely down further due to the higher ASP of the iPhone XS Max.
A decline of this magnitude suggests not just the stagnation of the global iPhone/smartphone market, but also evidences management missteps. In a letter to shareholders, CEO Tim Cook attributed the iPhone weakness predominantly to Greater China, specifically the slowing Chinese economy, more cautious Chinese consumer, currency-driven price increases and the negative impacts of the trade war. While these factors undoubtedly contributed to the sharp decline, we believe the truth of the matter is that this year’s iPhones were simply too expensive for what they offered. The prior two cycles of iPhone (and Apple share price) weakness were the 5C and the 6S. The iPhone 5C was the “cheap” non-flagship phone that no one wanted, and the 6S did not offer enough innovation over the highly successful iPhone 6 to justify an upgrade.
In the iPhone XR and XS line-up we can see both. The XR is the non-flagship iPhone that costs more than most flagship Android phones, and the XS did not bring enough new features to the table to justify a currency-driven price increase over last year’s iPhone X. We suspect the iPhone XS Max may have sold well in China despite its exorbitant price due to its larger form factor, but the XS and particularly XR models may have significantly underperformed management expectations. To the extent that management is aware of these pricing and model missteps, we believe the 1Q19 weakness does not necessarily signify a steep structural decline of the iPhone.
Perhaps more concerning for shareholders, however, is the iPhone-driven deceleration in the growth rate of Apple’s active installed base. Cook disclosed that the global active installed base grew by 100 million devices in the year to December 31, 2018, an enviable number for any hardware company. But this represents only 8% growth over the 1.3 billion active devices at the end of 2017, a slowdown from the mid-teens growth rate over the prior two years. Considering the services narrative that Apple is pushing, it would be vital for Apple to maintain a robust growth rate of active devices.
So given these negative developments, why do we continue to own Apple? Quite simply, we believe market-implied expectations priced into the stock have fallen too far. “Expectations investing” is a central component of our investment framework, and while it may be an imprecise exercise, it is important for investors to have a sense of whether expectations built into the prevailing stock price are elevated (reflecting greed) or excessively conservative (reflecting fear). As I wrote back in November, we systematically trimmed our position in Apple as the company crested the $1 trillion market capitalisation milestone, as market-implied expectations became overly optimistic with respect to both the iPhone and the Services businesses.
Down in the $140s price range, we believe Apple shares are now discounting the permanent decline of the iPhone at a rate of 3 to 4 million units p.a. for the rest of time, with Services revenue also decelerating sharply. The iPhone has been competing in a stagnant global smartphone market for several years now and while the current line-up is shaping up to be weaker than usual largely due to China-specific issues, we do not believe this indicates a structural impairment of the iPhone business which has in recent years proven to be somewhat cyclical with years of technological advancement followed by years of consolidation.
Furthermore, Services and Wearables revenue continue to accelerate, with Services exiting 1Q19 at a $44 billion annual run rate and Wearables on track to surpass the Mac this year as Apple’s third largest product category behind the iPhone and Services.
We believe the Services business has a long monetisation runway notwithstanding the decelerating growth of Apple’s active installed base. We estimate that on a per device and per customer basis, Apple is generating $23 and $41 in services revenue per annum respectively. Compare this to the estimated annual cost of other subscription services such as Spotify premium ($65 ARPU), Netflix ($134 ARPU in the US) and console game spend per device of $235 and one can appreciate the long runway of growth even off of Apple’s existing installed base.
Given this balance of positive and negative developments, we will readily admit that the upside for Apple stock is perhaps less rosy (in absolute dollar terms) than it was several months ago. But perhaps counterintuitively to all but value investors, we believe Apple is cheaper now, with a greater margin of safety, than at any point over the past year during which the stock could seem to do no wrong. We certainly prefer it when Mr Market goes full Groundhog Day – giving us the opportunity to rebuild our previously-trimmed position at a much-discounted price.
Morgan Stanley estimate as of 22 March 2018. Does not include hardware cost of video game console.
Montaka owns shares in Apple (Nasdaq: AAPL)