By Gene Munster
Earnings misses are always a negative. While largely anticipated by the Street, the magnitude of Apple’s (AAPL) Dec-18 pre-announcement was a disappointment. It’s understandable that investors are piecing together what went wrong and its impact on the business longer-term, but we think there is a larger point that’s being missed: the company will still report a record earnings result. Tim Cook wrote in tonight’s letter, “we also expect to report a new all-time record for Apple’s earnings per share.” There is a disconnect between a company about to report a record earnings quarter and the stock, which is down 33% since last reporting.
Apple as a Service Theme Still Intact
This challenging quarter accelerates the change in mindset from iPhone product cycles to Apple as a Service. Despite disappointing December results and less upside to future iPhone ASPs, we believe the Apple as a Service theme is intact. We don’t see any sustainable shifts in market share, so iPhone owners will remain in the ecosystem, and eventually upgrade (the point of Apple as a Service). Other revenue segments were up 19% y/y, a clear indication that the health of the business as a whole is not entirely dependent on iPhone sales.
Rebuilding Investor Confidence
We believe the in first step healing investor confidence related to Apple’s long-term potential is related to Mar-19 guidance. While the company reissued Dec-18 guidance, they did not provide a Mar-19 outlook. We believe investor confidence will begin to rebuild only if Mar-19 revenue guidance implies a midpoint of revenue growth better than the -5% y/y that will likely be reported in Dec-18. We generally expect Apple to issue Mar-18 guidance for revenue growth of -5% y/y, similar to the decline the company now expects in the Dec-18 quarter. As a result, it may not be until Apple guides for Jun-19 (likely the last week in April) that investor confidence begins to rebound.
Bright Spots in the Quarter
It’s important to recognize that the preliminary comments on Dec-18 results had some positive data points as well. The Apple ecosystem appears to be strong. All other segments are thriving on top of a strong iPhone user base: Services, Mac, iPad, and wearables (Apple Watch, AirPods) grew a combined 19% y/y. This is the key to the Apple as a Service thesis and suggests that the business as a whole can grow on top of a large, stable user base, even if the base is not expanding as fast as it has in the past.
Tim Cook is at the top of his game. This may sound counterintuitive, given the negative Dec-18 results, but tough quarters will come and the team needs to rise to the occasion. Cook’s commentary on investor expectations, Apple’s talent, and its ability to innovate are spot on—a battle cry for the company and a sign of strong leadership. We don’t want to let them off the hook for bad forecasting, but there are more important things than quarterly forecasts, and Cook has his priorities straight.
AAPL stock is now at a crossroads. Some investors will consider the stock broken and never reward it with a “proper” multiple, but we’ve followed the company long enough to know there is cyclicality in the market’s relationship with Apple. In the meantime, we expect the company to focus on Tim Cook’s promise to “focus really deeply on the things we can control” and help investors better understand the underlying strength of Apple’s business. It will probably take a new product category, large M&A (to restart growth narrative), a more aggressive buyback, or providing greater insights into their business, particularly services, to persuade investors to think differently about Apple’s multiple.
Disclaimer: We actively write about the themes in which we invest or may invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we may write about companies that are in our portfolio. As managers of the portfolio, we may earn carried interest, management fees or other compensation from such portfolio.
The iPhone maker certainly has the Street divided. Based on 36 analysts polled by TipRanks in the last 3 months, 18 rate a Buy on Apple stock, while 18 maintain a Hold. The 12-month average price target stands at $181.07, marking a nearly 22% upside from where the stock is currently trading. (See AAPL’s price targets and analyst ratings on TipRanks)