Morgan Stanley trims Apple price target to $236

Analyst Katy Huberty flew to Asia and got an earful.

From a note to clients that landed on my desktop Friday morning:

China smartphone market responsible for recent weak iPhone data points… Our recent meetings in Asia highlight a weakening China smartphone market, especially at the high-end where suppliers have seen order cuts across most vendors. Importantly, our Google trends analysis suggests global demand for the new iPhones is holding up, at least relative to past cycles, after the XR launch in November (Exhibit 1) which, combined with strong uptake of higher NAND capacities and better than expected mix of XS and XS Max, suggest iPhone revenue downside is largely isolated to China.

…and replacement cycles are to blame. China is following in the footsteps of the US with replacement cycles lengthening after a structurally shorter cycle over the last decade. We attribute this to improving product quality across most vendors and smartphone ASPs that are up 22% in the past two years (per IDC). Our analysis of shipment data suggests that for the broader China smartphone market, replacement cycles have lengthened materially in the past two years (Exhibit 2), but for Apple, the replacement cycle lengthening in China has been more pronounced, with implied replacement even longer than the market over the past year (Exhibit 3). Assuming iPhone replacement cycles in China extend another 6-9 months implies 9-15M unit downside, and we therefore lower our FY19 unit estimates by 13M units to 200M (from 213M), equating to 8% Y/Y unit declines…

Wearables and Services help smooth iPhone cyclicality. Importantly, weak iPhone shipments on the back of lengthening replacement cycles doesn’t translate to installed base and Services weakness. Case in point – the iPhone installed base grew double-digits and Services revenue growth accelerated (from 23% to 26%) in FY18 despite the fact iPhone units declined 6% in the prior two years. As a result, our 21% five year Services revenue CAGR is unchanged, and we see potential upside to the extent Apple launches new services, like Video (see here for more details) or extends new services like ads and payments, all of which are likely in our view. Additionally, our checks suggest wearables – namely, Watch and AirPods – continue to sell well with demand outstripping supply for AirPods two years after initial launch. For context, our supply chain conversations point to a doubling of AirPods production in FY19, which is the primary driver of our new, higher Wearables estimates.

morgan stanley trims

Maintains Overweight rating, lowers price target to $236 from $253.

My take: Et tu, Katy?

29 Comments

  1. Gregg Thurman said:

    Not a word about REVENUE growth.

    Great example of focusing on a product and not the COMPANY.

    1
    December 7, 2018
  2. Robert Harris said:

    My take I’d be very happy at $236

    1
    December 7, 2018
  3. Robert Paul Leitao said:

    This ties in to other data. iPhone unit sales peaked in FY2015 as did revenue from the Greater China region. In that record year for iPhone unit sales, revenue in Greater China rose almost 85% and has not returned to FY2015’s level of $58.715 billion in the three years since.

    FY2015 was the only year in which Greater China’s revenue surpassed Europe to become Apple’s second-largest revenue region. Since FY2015 Europe has returned its position as Apple’s second-largest revenue region.

    Although in FY2018 Apple’s aggregate reported revenue exceeded the previous peak level reached in FY2015 ($265.595 billion versus $233.715 billion), operating income in FY2018 remained slightly below FY2015’s performance. FY2018’s record net income in FY2018 ($59.531 billion) versus the previous peak set in FY2015 ($53.394 billion) was fueled almost entirely by last year’s change in corporate tax rates with a slight contribution from higher Other Income.

    1
    December 7, 2018
  4. Dan Pallotta said:

    How can you leave a price target of $236 as a footnote? How can a responsible note to investors with that target be headlined anything other than, “We Believe Apple is Materially Undervalued?,” with a sub-head that reads, “While we see headwinds in China that could impact Apple’s intact and continuing growth story at the margins, we believe that the company is worth 25% more than what the market is currently saying.” How can you not contextualize the conviction of that price target so? The bottom line is, she believes that’s what the company’s worth and she just thinks it’s going to take a year for everyone else to figure that out. She’s not pointing to any change in the business between now and a year from now that will warrant a 25% bump up.

    2
    December 7, 2018
  5. Dan Pallotta said:

    I guess I’d also add, that there are two kinds of sick to your stomach. Sick-to-your-stomach #1 is when you’re invested in Apple and the company’s fundamentals are truly degrading. Sick-to-your-stomach #2 is when analysts are degrading the stock by looking at everything other than the fundamentals, while the fundamentals remain fine. Thankfully, what we’re experiencing right now is sick-to-your-stomach #2. May our stomach acid, whenever it intensifies, forever be of the second nature.

    1
    December 7, 2018
    • Gregg Thurman said:

      Stomach ache #2. I like it.

      0
      December 7, 2018
    • Robert Paul Leitao said:

      Dan:

      On Apple’s fundamentals there are a few issues. Although Apple’s revenue in FY2018 surpassed the previous peak revenue year of FY2015 ($265.595 billion to $233.715 billion), operating income in FY2018 was slightly below FY2015’s level ($70.898 billion in FY2018 versus $71.230 billion).

      Also, while aggregate gross margin was higher in FY2018, on a per revenue dollar basis the percentage of revenue that fell to the gross margin line was lower. All of the increase in aggregate gross margin in FY2018 versus FY2015 was offset by higher operating expenses. This does not create a crisis. But it does indicate Apple needed to increase the iPhone’s ASP to offset higher manufacturing costs on a per unit basis.

      Virtually all of Apple’s net income gains in FY2018 over the previous peak year of FY2015 were due to the changes in tax rates. On single-digit revenue growth in FY2019, Apple can generate record net income over FY2018’s level only because in FQ1 (which represents about one-third of annual revenue) there will be a favorable compare on tax rates year-over-year.

      Apple’s net income of $59.531 billion in FY2018 versus $53.394 billion in FY2015 (a difference of $6.137 billion) was produced on a difference in revenue of $31.88 billion. The tax expense benefit of $5.661 billion (tax expense of $13.460 billion in FY2018 versus $19.121 billion in FY2015) represented the bulk of the net income gains with a small contribution from higher Other Income in FY2018.

      In my analysis, once year-over-year tax rates become comparable, Apple needs 10% revenue growth or more to increase net income year-over-year. Operating expenses (including R&D and SG&A) are rising at a fairly quick pace.

      Obviously forex challenges are currently pressuring reported revenue and gross margin. What I believe the market is looking for is Apple’s next revenue and margin growth business beyond Services. Over that 3-year period R&D expenses have risen 76%.

      Apple hasn’t stopped innovating and the R&D spend suggests Apple may a few new products and services in the pipeline. But the market may remain cautious until it sees more from the company.

      Katy Huberty is saying the shares are undervalued based on what she can see at this moment in time.

      0
      December 7, 2018
      • John Konopka said:

        It’s curious that the R&D expense has been rising so rapidly the last few years. It is hard to imagine that this is intended to support the current products. Of course, Apple never drops hints about future products so we are left to speculate.

        1
        December 7, 2018
        • Robert Paul Leitao said:

          John:

          I agree with you. From the previous peak in revenue and net income in FY2015 to FY2018, R&D expenses rose 76%. I do believe much of that activity is for new products and services under development. While analysts can speculate on what may be in the pipeline, we can’t effectively model products and services that have yet to be announced.

          1
          December 7, 2018
      • Dan Pallotta said:

        Thanks for the thorough and thoughtful reply Robert. I’d probably assert that you can’t forecast R&D spending at those levels as a drain on profit as a long-term trend simply because at some point that R&D spending should impact revenue and margins positively as well. I know there’s no way to know what that impact will be, but it does mitigate the power of the R&D drain. Also, will the tax bill benefits repeat in any way?

        1
        December 8, 2018
        • Robert Paul Leitao said:

          David:

          The tax rates will remain lower moving forward. But the last quarter for favorable tax rate comparisons is FQ1 2019 (the December quarter). In other words, there will not be big net income gains year-over-year due to lower tax rates after the December quarter of this year.

          0
          December 8, 2018
  6. Fred Stein said:

    Data check: I looked at Katy’s model (I’m a Morgan Stanley client). It shows $20B in buybacks each quarter in FY 19. I’d bet Apple is buying more aggressively now. Slight positive.

    The big concern is Huawei. I’ve been harping on this for quite awhile but had no clue about the latest news. Huawei’s founder’s ties go back to the inner circle in the party in China.This is not a minor issue. If the matter escalates, the global economic impact can be big, impacting Apple and many other companies.

    Regardless of this global economic threat, Huawei may be Apple biggest global competitor because Huawei really understands what is at stake in Smartphone’s as THE personal device in emerging markets. Huawei has the means to invest heavily, perhaps even more than Samsung or Google.

    0
    December 8, 2018

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