Apple earnings aren't the real problem—it's the outlook

Apple is beginning to feel the effects of a slowdown in China – but the iPhone maker's troubles aren't limited to that: The U.S. is also a problem.

I said in September that Apple's biggest issue wasn't new products, it was China. (This was right after Tim Cook said, "we have continued to experience strong growth for our business in China through July and August.")

China accounted for only 27 percent of revenue in Apple's June quarter but 58 percent of its year-over-year revenue growth.

Then, China's growth started to stall: After soaring 152 percent to its peak of 5166 in mid-June, the Shanghai Composite Index dropped 37 percent from there through Sept. 9.

So, while Apple got a boost from 112 percent year-over-year revenue growth from China in its June quarter, that dropped to 14 percent in the just-reported December quarter.

Now, for those of you who love Apple products, you would be hard-pressed to beat my family. Over the holidays, we bought an iPad Pro and an iPad Air to go with the 3 big iMacs, 3 MacAirs, countless iPods, 4 iPhones, 4 iPads and 3 AppleTVs. The problem for Apple is we spent LESS than last year. Why? Because unlike the much bigger format iPhones introduced in 2014, none of the products introduced in 2015 were must-have items.

It seems we were not alone: Apple's Americas revenue for the December quarter was actually down 4 percent year-over-year versus a 10-percent increase in the September quarter and a 23-percent jump a year ago. This was worse than even we expected.

The key question now is: What happens next?

Apple is forecasting revenue for the March quarter at the midpoint of $51.5 billion (down 11 percent year-over-year) versus current Wall Street expectations of $55.5 billion (down 4 percent year-over-year.) If Apple does, indeed, report a quarterly revenue decline, it would be the first since March 2003!

I guarantee that many pundits will write about how the worst is behind Apple and March should be the trough quarter. I love an optimist as much as the next person, but I am more concerned with making money. Is the worst really behind Apple?

On the earnings conference call Tuesday, Tim Cook said, "We began to see some signs of economic softness in greater China earlier this month." In addition, Cook stated, "We're seeing extreme conditions unlike anything we have experienced before just about everywhere we look. Major markets including Brazil, Russia, Japan, Canada, Southeast Asia, Australia, Turkey and the euro zone have been impacted by slowing economic growth, falling commodity prices, and weakening currencies."

While the pundits opine that Apple is now inexpensive relative to the market, the stock will be MORE EXPENSIVE than it was the day before they reported results. Why? Because earnings-per-share estimates will probably come down about 10 percent for the March quarter, given Apple's guidance. Don't forget that Apple started missing iPhone unit expectations back in the June quarter.

So, unless the stock falls more than 10 percent as well, Apple's price-to-earnings ratio will be more expensive, even though the stock price is lower.

The real question to be asking yourself is: How much confidence do you have in these new lower EPS estimates? With global growth slowing, Apple has opted to keep the average selling price of an iPhone high at $691 -- up $4 year-over-year. But this has also led to unit growth slowing from 46 percent a year ago to nearly 0 percent in the December quarter. This has enabled gross margins to remain relatively high despite slowing unit growth.

We think gross margins are likely to decline more than expected going forward, putting further pressure on EPS as we go through 2016. Apple has benefited tremendously over the past year from falling prices in components such as DRAMs, flash storage, disk drives and displays. Going forward, we think component-price declines will slow at the same time that Apple starts to see iPhone ASPs decline year-over-year after 6 quarters of growth. Apple will need to cut prices on higher-priced phones to drive demand in the developed markets. In addition, the mix is likely to shift to lower-priced phones in the emerging markets.

One bullish thesis regarding Apple is the introduction of a lower-priced 4" iPhone in the June quarter. Apple wants to drive demand in the emerging markets but we note that their low-cost 5C did not fare well when that was introduced in 2013. This is also likely negative for ASPs and margins. You can't have your cake and eat it too … I mean units and average selling prices.

The most positive statistic for Apple in the December quarter was the $8.9 billion in service revenues such as apps, movies and TV shows that were up 24 percent year-over-year. This is tied to their installed base of over 1 billion active devices which was up over 25 percent year-over-year.

The negative is the service-revenue growth seems to be highly correlated to installed base growth. This will slow as device sales slow. Being an avid Apple purchaser of movies, music videos and songs, I would note that the proliferation of increasingly robust rental options in movies (such as Netflix, Hulu and Amazon Prime) and music (such as Pandora, Spotify and Apple Music) has slowed my purchases in favor of renting. How many times am I actually going to watch that DVD for $19.99 when I can watch all the movies I want from Netflix for $9.99 per month or rent it from iTunes or Amazon Prime?

I was happy to save $9 watching "The Martian" as a streaming iTunes rental for $5.99 versus buying it for $14.99 on iTunes. But that is $9 that Apple won't be getting.

The biggest potential upside for Apple in our opinion is the launch of a TV-streaming service with 25 channels for $30-40 per month. This compares to the average cable package today of over 100 channels for over $100. Who has ever watched all 100 channels in their life? Unfortunately, the big content providers have no desire to see their cable bundles dismantled, given that they have worked many decades to build it. The content owners have seen the unbundling of songs by the launch of iTunes in 2003 wreak havoc with the music industry and they have no desire to let Apple repeat the experience with them. We think it is inevitable but at what price to Apple and, ultimately, at what cost to the future of the cable bundle?

The other big consideration is: Will a streaming TV service help drive Apple device sales? I love Netflix and Amazon Prime but watch both through my Sony Playstation3. ITunes was a great service when introduced but could only be run on an iPod back in 2003. These days, many great services such as Netflix, Amazon Prime, Spotify, Pandora or Facebook are device independent. They are applications that can be run on many different devices. Even if Apple does launch a streaming service, will that necessarily drive Apple hardware sales, which drive the majority of their revenues? Or, will it need to be hardware independent to be able to compete against the likes of Netflix and Amazon Prime? Despite these concerns, we cannot help but be intrigued if Apple can finally make the TV viewing experience better and cheaper. I like to relax by binge watching TV or playing video games (much to my wife's horror). Anything that can help me get rid of the three separate remotes I have -- for the cable box, the Playstation and the AppleTV -- would be greatly appreciated. I would immediately purchase it.

So, what should you do now if you are involved with Apple? The one thing I have learned being on Wall Street since 1990 is how stupid I am. Seriously. I was always surprised by how high stocks could go (think Nasdaq over 5000 in March of 2000) or how low those same stocks could fall (think Nasdaq near 1100 by October of 2002.) The one thing I was really good at was figuring out if things were getting better or worse and then staying out of the way if they were getting worse and buying if they were finally getting better. The question you need to ask yourself is: Do you think the global economy is improving?

After going through Apple's conference call, I would say, to quote Yogi Berra, "The future ain't what it used to be."

Commentary by Dan Niles, founding partner of AlphaOne Capital Partners and senior portfolio manager of the AlphaOne Satori Fund. Previously, he was a managing director at Neuberger Berman, a subsidiary of Lehman Brothers.

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