Curious why after its massive drubbing yesterday, which led to the second highest volume day for AAPL stock in 2015, the phone market is down another 1.3% this morning? The reason: Wall Street's momentum chasing penguins have re-emerged, and moments ago Bank of America, right on time as in just after the stock broke its 200 DMA and entered a correction, decided to downgrade AAPL from Buy to Neutral, lowering its price target from $142 to $130.
The reasons for the downgrade from the report:
Long term winner but iPhone deceleration creates headwinds, move to Neutral
Deceleration in iPhones creates near term headwinds
We downgrade shares of Apple Inc. (ticker: AAPL) to Neutral from Buy with a PO of $130. Although the long term opportunity is significant, we expect near term pressure on shares driven by (1) significant slowdown in revenue growth as iPhone growth decelerates and other initiatives like Apple Watch, Apple Pay, Apple Music take time to ramp, (2) China now accounts for ~25% of iPhone sales (C2Q) and share gains will be more difficult to come by, (3) the stock price is correlated to gross profit dollar growth (Figure 6), which despite the mix benefit of the iPhone will decelerate significantly over the next few quarters, (4) the magnitude of the beats is diminishing creating higher risk to negative revisions particularly as the Apple watch expectations are likely too elevated in 2016 , (5) the iPhone 6S/6S+ are likely to be an incremental upgrade (force touch), but not likely compelling enough for driving a significant change in the pace of share gains, and (6) we do not see incremental capital return announcements beyond the already announced plans in the near term.
What about new products – Watch, Apple Pay, Music?
We model $0.30 EPS impact from Apple Watch in C2016 and $0.11 from Apple Pay. At its current ~10mn subscribers for Apple Music (not yet paying), the contribution will remain relatively small in C2016 at less than $0.10/share. Although the potential exists for each of these to become significant revenue drivers in the long-run, the short-to-medium term direction of the stock remains dependent on the iPhone.
Valuation always compelling; Momentum trumps near term
We do not dispute that valuation metrics remain compelling for Apple; however, in the last down-cycle despite compelling valuation the stock retraced 30%. AAPL stock has rallied 40% in C14 (vs. S15INFT up 18%), and is trading at multiples at a slight discount to peers.
Where could we be wrong?
PO moves to $130 Stronger than expected share gains of iPhones from Android, or increased enterprise penetration could drive upside relative to our model. Reacceleration in iPad sales could offset some of the iPhone decline, but with lower margins. Our new PO of $130 is based on 13x C2016 EPS of $9.99.
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iPhones can continue to gain some share but expect some speed bumps
The iPhone remains a major driver of the company’s revenue (66% in F2015E) and operating profit (~85% in F2015E). While the iPhone 6/6 plus represents a super cycle, in our opinion, demand is being pulled in from the next year, and we see the December quarter of 2014 as the peak shipment quarter for iPhones until the potential iPhone 7 release in Sep 2016 (likely with force touch, dual rear cameras).
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Importantly, China accounted for ~26% (est.) of total iPhone sales in the June quarter. On a
y/y basis this is significant growth; however, market share trends are easing after 3 quarters of gains. Given the upside in iPhone estimates largely depends on new users, we see incremental risk to units in the near term.
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The iPhone sales over the past 3 quarters combined with the replacement rates (see above)
suggest that there was a significant acceleration of replacements driven by the iPhone 6/6+, which has since tailed off sharply, offset by very strong new user adoption. See our detailed analysis of this here: “A detailed look at the iPhone installed base”.
The stronger new user growth is bullish overall (installed base grows larger over time) but also makes the quarterly sales more volatile. We view this latter dynamic at significant risk given the headwind being created by the stronger dollar, and broader economic uncertainty which can lead to lower sales from large markets like China.
In short, fears over China's dramatic mood swing (where there has been nothing substantially new in the past 2 months and if BofA really cared it could have released this report back in late June when we said the Chinese market crash would impact AAPL sales and its stock price shortly), and concerns the momentum shift will become self-reinforcing, once again confirming that even for such a "fundamental" case as AAPL, only the abundance of greater fools matters.
