Running out of growth options?

James Penn
January 9, 2019

A growth company announcing its first shortfall in revenue for 16 years is not usually something that’s welcomed by the stock market.

Such was the case with Apple’s surprise announcement last week that fourth quarter revenue for 2018 would be $84bn, rather than a previously guided $89bn. This represents a year on year drop of 5%, as opposed to a previously forecast 5% gain in revenues.

The previous forecast had been made as recently as November, so this came as a big turnaround, and a big shock. The shares fell 9% and have now lost about 40% of their value since early September. They are having their worst drawdown since 2012/2013, when they fell 45%.

Tim Cook, who took over as CEO from the inspirational Steve Jobs seven years ago, made the announcement in a shareholder’s letter, rather than in the usual quarterly filing. He put the shortfall down to weakness in China, plus a lengthening replacement cycle among consumers in developed markets (caused by lower carrier subsidies and cheaper battery upgrades).

The slowdown in China, where Apple makes 20% of its revenues, looks worrisome. Strong competition is emerging from local smartphone manufacturers Huawei and Xiaomi, who are almost getting an edge in technological terms. Trade tensions may also be encouraging consumers there to switch to Chinese names in a patriotic backlash, though Apple, which assembles its phones in China, claims that its ecosystem supports 4.8m jobs in China, including 1.8m iOS app designers.

While trade concerns and general consumer retrenchment may have contributed to the shortfall, a 23% increase in the iphone Average Selling Price in autumn of last year seems to have had some effect. Some consumers have spoken of ‘paying more for less’.

Economists speak about ‘price elasticity of demand’ for certain products. Those which are ‘price inelastic’ (eg tobacco) have pricing power, and  any rise in price tends to result in an increase in revenues.

Did Apple overestimate the inelasticity of demand for its own iphones? The excellence of the technology, strength of the brand and after-market support, and the resilience of customer loyalty are all amazing strengths, but with the average selling price approaching $800 – considerably more than the competition – buyer dedication may begin to falter.

Apple announced that it would stop reporting unit sales of iphones back in October. At the time this was taken as a warning sign that it was trying to disguise a decline in sales volumes.

Apple has been selling about 220m iphone units per annum for the last few years. This seems likely to drop by as much as 15-20% in 2019.

Price rises offset much of the volume decrease, but the iphone division, which still comprises 60% of Apple’s overall revenues, looks as if it is becoming a plodder.

Tim Cook drew attention to the Services division, where revenues grew 19% in Q4, and where the company is hoping to double revenues to $50bn by 2020. Growth prospects for this division look strong, but at 15% of the total it surely can’t overcome any decline in the bigger iphone division.

In the background other problems rumble. Qualcomm has taken out injunctions against Apple products in both China and Europe, alleging infringement of patents. So far Apple has batted off this threat, claiming that updates to its IOS software will remedy the problem.

In the wake of the news Goldman Sachs cut their price target to $140, and cited a potentially troubling market parallel with Nokia back in 2007. Nokia ramped up prices of its consumer phones in order to raise revenues, but that represented a peak in its fortunes, and the more skilful, canny and visionary Apple soon supplanted it.

Anyone with experience of what happened to Nokia, Motorola or Blackberry will know what happens when a phone manufacturer loses its allure or goes out of fashion.

Apple still has many cards up its sleeve. The messaging ecosystem, the ease of use, and the fact that the number of active devices is at an all time high, mean that it is almost inconceivable that any newer arrival will take its place. There are good stories to tell with a new video streaming service, 5G iphones, and more aggressive share repurchases (utilising its $130bn net cash balance).

But the shares have crashed through all technical support levels, including ‘moving averages’ of stock prices, and the savagery of the sell-off looks far worse than the shallower drawdowns between September 2012 and April 2013, or July 2015 and May 2016.

Whatever happens in the short term, it may be that in future Apple becomes more of a ‘Market Perform’ stock than the strong outperformer it has been in the past.

Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

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