MorningWord 9/10/14: $AAPL Watch Out Below?

by Dan September 10, 2014 9:38 am • Commentary

This may not come as a huge surprise, but after watching Apple’s keynote address introducing the new iPhone, Pay and Watch, I was excited as an Apple customer, but as a market observer, the offerings simply just met if not failed to live up to the hype. Let’s break it down.

iPhone:  We expected two new iPhones, one with a 4.7 inch screen and one with a 5.5 inch screen, possibly with sapphire material to make the screens scratch resistant.  We got the phones sizes, not the sapphire, so I would say this is a mild negative.  The phones initial release will NOT include China, a market where larger form factors have proven to be in demand.  This is an initial negative, but could help demand in the coming months/quarters if the larger “phablet” version does not sell well in the West.  I would also add that this larger iPhone has potential to cannibalize iPad Mini sales as 5.5 is dangerously close in size to 7.9  (#TWSS).  Also mild negative.

Apple has increased the storage offering for no additional charge for those who would have previously opted for the $299 version with 32 gigabytes of storage, now in both phones the storage steps from 16 gb($199 w/ 2 yr contract)  to 64 gb ($299 w/ 2yr contract) skipping the 32 gb model altogether.  Positive for consumers, possibly negative for Apple’s margins as they the incremental step up in the past from the 16 gb iPhone at $199 to the 32 gb iPhone at $299 cost Apple less than $20.  Nand pricing has not come down that much to offset the increased storage offering. So as always, margins will once again be a main determent of the story going forward.

Apple Pay:  We expected to have all the major credit card companies on board and some large retailers. We got that, but there was little by way of what Apple’s take of the charges.  Most initial analyst reports suggest it to be small, with revenues contributing less than 1% of the company’s total for 2015.  This will not move the needle, but it is the first pitch of the first inning of a game that Apple will be a major player in for a long time.  So again, not above expectations, but a good start. Won’t move the needle anytime soon, not particularly innovative, and if any of Apple’s prior service offerings with iCloud are any indication of how they might manage the process there should be room for some initial disappointment for users.

Watch:  Well, they had a shot to once again introduce a new product that they could call “Magical and Revolutionary“.  They didn’t use that particular hyperbole, but then again, the device is not geared towards the masses. (e.g. at a starting price point of $349 and the fact that it is not a standalone device and needs an iPhone with an existing data contract, it’s much less likely to be a Christmas gift than an iPod or iPad was).  Much like I view the iPad, this is the ultimate discretionary device given its current functionality, and I suspect that intial success here cannibalizes iPad as the majority of Apple iPhone users will need to make a choice between non essential items like Watch and iPad in the short term.  This obviously does not come at a great time for competition for iPad dollars as units declined 9% year over year in the June quarter.

Again, this is the first iteration of a device that will only get better over time. No one can predict what apps will be created for the device and that has always been the key to the difference between first impressions and longer term.

I suspect that analysts will not work Watch into fiscal 2015 estimates in a major way until they get a better sense for launch date, but missing 2014 holiday season is big in my opinion as there will be no shortage of new offerings from the likes of Samsung and Motorola. So in my mind Watch poses risk to the Apple story near term. If the product launch is seen as a flop it will indicate that innovation and hype at Apple is not what it used to be.

So it seems that the Street is pretty well convinced that fiscal 2015 estimates are too low, calling for 12% earnings growth and 10% sales growth.  I would remind readers that this was the EXACT same sentiment back in Sept 2012, when the stock was at the all time highs as Apple released a new LARGER iPhone, and a new SMALLER iPAd.  Most analysts were convinced that the stock would continue higher as buoyed by an upgrade cycle in phones and the addition of a new iPad category.  Well, that was obviously the top, despite sales growing 9% from fiscal 2012 to fiscal 2013, earnings declined 10% and net income declined 11% year over year. Apple’s business model hit a wall, whether it was evolutionary products, overly positive sentiment, or just the law of large numbers.  Wall Street analysts consensus rose quickly after the Sept 2012 iPhone and iPad launch, as did price targets, only to be followed by a year of  estimate cuts, downgrades and poor sentiment that saw the stock bifurcate from the market, down 45% peak to trough.

I love the company and their products, and not trying to call a top here, but the set up seems eerily similar to that of September 2012 and while all you can read this morning is the overwhelmingly positive reviews and expectations for earnings and sales growth, it is important to note that one of the main reasons for Apple’s return to the prior stock highs has little do with product launches and organic earnings growth and much to do with financial engineering.  As I discussed on Friday:

But lets look at whats changed since then.  Earnings about the same, sales up 15%, gross margins down 5% points, cash balance up 36%, and the introduction of debt to the balance sheet.  The balance sheet management is stellar, the company has paid almost $20 billion in dividends (many would argue given their cash flow they could pay out much more), and bought back between $50 and $60 billion in stock in that time period.  So what I want to focus on is the NET INCOME figure that has declined 7% in that same time period.  While earnings look flat, the company has retired ton of shares having a massive positive effect on their earnings PER share (eps), but in my mind leaving the decline in NET INCOME to stick out like a sore thumb.


So the stock is cheap(er) ex-cash than in 2012, but now trades at a market multiple of about 16x trailing earnings, and one could argue that all that cash on AAPL’s balance sheet should not trade at anywhere close to a market multiple and that without massive new product categories double digit sales growth will be difficult to come by off of such a large base and the cash will be needed to manage anything near double digit EPS growth for years to come

So for those of you who have dreams of Apple’s market cap racing to $1 trillion, it could make sense to take another look at all the things that have to go right from here on out for that to happen. I do not think Apple raised the bar on Watch by creating potential for amazing apps in a new ecosystem, I think the Pay offering is a great start but not a huge revenue or earnings contributor anytime soon, and if the pass along of Nand storage margin to customers takes its toll then I would expect for the company to continue to aggressively buy back their shares to manage that double digit earnings growth that will keep the stock in that “growth” category.

The stock will be bought on dips obviously, as the story has not changed for the worse, but come the new year, if we see delays in Watch, and iPhone does not prove to the “mother of all upgrade cycles” I would expect to see the stock bellow $90 in Q1 with massive technical support at $85.