Shares of global technology giant Apple (NASDAQ:AAPL) have surged higher in 2019. Year-to-date, AAPL stock is up more than 25% — versus an 18% gain for the S&P 500 — thanks to improving sentiment surrounding the company’s growth prospects. Specifically, global macro-market and economic conditions have improved, while the iPhone business has shown signs of stabilizing, China demand has shown signs of rebounding, and the Services business has stayed in growth mode.
Net net, Apple stock has surged higher through the first six months of 2019, after a big drop in late 2018.
But there’s reason to believe that this recovery rally in Apple stock will run into some turbulence over the next few months. China demand issues are still being ironed out and will likely create weakness in second-half numbers. At the same time, with a 5G iPhone projected to release in the fall of 2020, the 2019 iPhone release could be disappointing. The combination of sluggish iPhone and China growth in the back-half of the year will likely weigh on AAPL stock in the near term.
To be sure, such near-term weakness is a long-term opportunity. China demand will come back into the picture, because the core growth fundamentals in China remain rock solid. iPhone demand will also re-accelerate in 2020 thanks to the launch of a 5G iPhone. Meanwhile, the Services business should stay in growth mode throughout all of this.
Broadly, after a record rally to start 2019, Apple stock has turned into a near-term pain, long-term gain situation. The investment implication of this is clear. Don’t get too excited about AAPL stock here and now at $200. But, if the stock continues to drop and sentiment grows more negative, be ready to buy the dip.
Apple Stock May Struggle in the Back Half of 2019
There’s reason to believe that Apple stock, on the heels of a 25%-plus rally through the first six months of 2019, will trade largely sideways or lower over the next few months.
There are three big things at play here. First, valuation. AAPL stock now features a 17.5 forward-earnings multiple. That is substantially above the five-year-average forward earnings multiple of 14. It’s also worth noting that over the past few years, a forward earnings multiple north of 17.5 has been unsustainable and that whenever the stock did get that richly valued, it struggled for further gains.
Second, sluggish iPhone growth. Apple is an iPhone-company, deriving around 50-60% of its revenue from the iPhone. Thus, as go iPhone growth trends, so goes AAPL stock. In the back half of 2018, iPhone growth trends were sluggish. AAPL stock slumped. In the first half of 2019, iPhone growth trends improved. AAPL stock surged.
Looking into the back half of 2019, iPhone growth trends may go back to sluggish. The next big thing in the smartphone industry is 5G coverage. But, the consensus expectation is that a 5G iPhone won’t hit shelves until fall of 2020. Thus, consumers will likely wait for that 5G iPhone in 2020, meaning demand for a new 2019 iPhone will be depressed. That will weigh on second-half 2019 iPhone growth trends.
Third, sustained weak demand in China. China is Apple’s third-biggest market, accounting for roughly 20% of revenues last year. But China demand has been weak lately, mostly due to escalating U.S.-China trade tensions and slowing China economic expansion. Although trade tensions are cooling, it will take awhile for the Chinese consumer to shake off those tensions, and China demand in the back half of 2019 will likely remain weak.
Overall, the optics here do not support the first-half surge in AAPL stock, repeating in the second half of the year.
Apple Stock Will Rebound From These Near-Term Struggles
Zooming out, second half 2019 struggles in AAPL stock will amount to nothing more than a long-term buying opportunity.
In the big picture, there are two businesses here: the Products business and the Services business. On the Products side, you have the traditional hardware business (led by the iPhone, Mac, and iPad) and you have the new hardware business (led by the Apple Watch and Apple TV). The traditional hardware business will essentially be a zero-growth business over the next several years, as flattish unit growth converges on flattish pricing trends. The new hardware business, meanwhile, will likely be a mild revenue grower as wearables and smart accessory adoption continues to grow. Net net, the Products business projects as a zero- to slow-growth business over the next several years.
On the Services side, you have Apple’s suite of software subscription business like Apple Music, News+, Arcade and more. The sum of these services are growing rapidly. Last quarter, Services revenue rose 16%. Year to date, Services revenue is up 18%. Growth in this segment will remain in the 10%-plus range going forward as the company’s TV and video game services gain subscribers and traction.
Thus, Apple going forward is defined by one part slow-growth Products business, and one part 10%-plus-growth Services business. Importantly, Products presently account for 85% of revenues. Thus, Apple’s overall revenue growth rate will look more like the sluggish Products growth rate than the robust Services growth rate. Reasonably speaking, this is a 3-4% revenue growth company over the next several years.
Also of note, the Services business has much higher gross margins (63% in 1H19) than the Products business (33%). As the Services business continues to grow faster than than the Products business, and comprises a bigger and bigger slice of the revenue pie, that will drive overall gross margins higher and be additive to profit growth. That margin expansion dynamic on top of continued big buybacks will likely turn 3-4% revenue growth, into ~10% EPS growth.
Projecting that out, $20 in EPS seems doable for Apple by fiscal 2025. Based on a market-average 16 forward multiple, this implies a fiscal 2024 price target for AAPL stock of $320, meaning that this stock has healthy upside potential in a long-term window.
Bottom Line on AAPL Stock
After a big rally through the first half of 2019, Apple stock has turned into a near-term pain, long-term gain situation. Such situations are easily translated into investment action. Be cautious in the near term. Let the stock come down over the next few months. Then, buy the dip as sentiment inflects into negative territory and the stock becomes far too discounted for its own good.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
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