Apple goes ex-growth
Yesterday, Apple embedded a profit warning (the first in 10 years) in Tim’s Cooks letter to investors. This triggered a -8% decline in post market trading. Apple, which had guided for ‘slight growth’ in its last quarter’s revenue guidance, adjusted guidance to a decline of circa -5%. As we have forecast, Apple has gone ex-growth.
The company cites the Chinese economy as the reason for a $7 billion (roughly 9 million iPhones not sold) miss against revenue expectations. A ‘China slowdown’ may well have some effect, but whether this is the economy or company specific is key. For instance, Alibaba’s Singles day saw retail transactions grow +23% to $30.8 billion, illustrating that all is not as bad as some headlines would suggest in China. The iPhone shortfall may thus be more indicative of Apple’s specific issues, namely pricing, iPhone shipments, and lengthening of the refresh cycle.
At Dominion, we have consistently viewed Apple as being at-risk of going ex-growth (it is not a holding in any portfolio, nor has been for a considerable time period). But at the turn of 2018, we felt that this risk had become a reality. In 1Q18, despite a new form factor (the iPhone X), unit growth (the number of iPhones sold) fell -1% with revenue growth coming from only price increases of circa 15-20% for new models. In 3Q18 unit growth was already flat, and in 4Q18 Apple said it would stop providing investors with unit data – a sign that it expected (or at the least, suspected) that shipments were set to turn more negative; though it appears to have underestimated the scale of this problem.
Driving negative shipments is a lengthening of the refresh cycle - how often consumers buy new iPhones – and perhaps also Apple’s own price increases. The incremental upgrade benefit - how much better each new phone is to the one it replaces - lessens with each generation of new phones (iPhones or otherwise). This give consumers less incentive to upgrade, meaning they will take longer to purchase new phones and be less inclined to pay more [than their previous phone] for a new model with few-to-no new features, and is indicative of a maturing smartphone market.
In the face of this maturing market Apple raised prices for its new iPhone X, allowing it an extra year of growth on the back of price increases and preserving margins. However, this effect is only temporary and the company may have misjudged its consumers ability to absorb price increases, especially in emerging markets - such as China - where consumers are relatively poorer than their western counterparts.
Consequently, Apple’s profit warning is more idiosyncratic and company specific than both Apple’s letter and many headlines suggest. We would not be surprised to see some sort of sell-off within the broad market and technology sector as a whole, but would warn against taking Apple’s woes as an indictment for the state of other companies, sectors, and economies.
This is not the end for Apple, though in the short- to medium-term the company will face some tough decisions and share price volatility. There is little sign that Apple is losing its grip on the smartphone market (it is not losing significant market share, especially at the high end) and it has a very high-quality ecosystem. Despite this, and a relatively low valuation, we remain cautious about re-investing in Apple until we have seen it work through the above issues (will it lower prices/margins? Make an expensive acquisition? Or just hold steady and work through a year or two of negative growth?), as well as its patent court case with Qualcomm (an as-of-yet unexploded landmine). However, once the company works through these issues, we expected the Services Segment (14% of 2018 revenues), particularly the monetisation of its phenomenally strong and valuable digital ecosystem, to drive a return to growth – at which point, as growth investors, we would consider the company as an investment candidate.
Apple is not a holding across the Dominion Global Trends Funds. This successful selective approach serves to illustrate the benefits of an active management approach against passive ETFs that exhibit a notable size bias towards large companies, of which Apple is among the largest.
Fred Baccanello is Dominion Global Trends Ecommerce Fund’s Fund Manager. The opinions expressed in this article are his own.
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