Wells Fargo Downgraded Apple From Outperform To Market Perform Based On Gross Margin Concerns

Jan 2 2014, 4:38pm CST | by

Wells Fargo Downgraded Apple From Outperform To Market Perform Based On Gross Margin Concerns
Photo Credit: Forbes Apple

Wells Fargo’s Apple analyst Maynard Um downgraded Apple from Outperform to Market Perform on Monday while maintaining his $536 to $581 target price range. Apple’s stock was down $8 or about 1.4% to $553 largely off of his downgrade. (Note that my family and I own Apple shares).

While Um believes iPhone and iPad units and gross margin should be strong near-term he is concerned that it is already priced into the stock. Additionally an iPhone 6 introduction later this year will put pressure on the gross margin, there is limited incremental market cap opportunity from exiting product segments (including the TV and watch opportunities) without material market share gains and the balance of power may shift back to the wireless operators.

Gross margins seem to have stabilized around 37%

Um has a good chart that shows Apple’s gross margin compared to its stock price and when various iPhones were introduced. It shows gross margins increasing from 32.6% in the December 2007 quarter, two quarters after the first iPhone was introduced, peaking in the March 2012 quarter at 47.4% with the 4S and stabilizing the last three quarters around 37% (which have been negatively impacted by higher warranty accruals when compared to the prior years gross margin).

Um’s analysis has gross margins increasing by 225 basis points or 2.25% in the two quarters of a “S” iPhone model being introduced and then decreasing by the same 225 basis points when a new form factor comes into play. Depending on how the warranty expense plays out in future quarters (I don’t expect it to get worse and hopefully will get better which would help margins) it appears that gross margins should stabilize where it is at if not increase by a small amount. A key swing factor will be discounting in overseas markets to gain a foothold or increased share.

I do agree that gross margins will have a significant impact on how Apple’s stock does as revenue growth should wind up in the mid-single-digits to low-teens range at best over the long-term absent some breakthrough product or service offering. While one does want to anticipate what will transpire it does seem a bit early to say the gross margin story has played out for the current 5s since it hasn’t had a single quarter of announced results.

Source: Company filings, Well Fargo Securities, LLC

The TV and watch opportunities could have limited financial impact

Overall I agree with Um that the TV and watch product lines may not move the financial needle. The TV business is low margin (not Apple’s historical market) and I believe the company could be hard pressed to command a large premium unless it has something compelling to offer. Besides the long replacement cycle that TVs have the content providers are in strong positions so it will probably be challenging for Apple to take the lead in this market vs. what it was able to do in the music industry.

Apple does a very good job of bringing out ground breaking products (even though initial attempts at them have been around for years if not over a decade) and leveraging technology when it is ready to deliver a great user experience by making it simple to use. I’m not sure the technology is capable of delivering a great experience for a “watch” since battery life could be one of the limiting factors. Yes there are a good number of Nike Fuel’s and Fitbits sold for the holidays but I’m not convinced that there is a mass market for $299 devices that either measure movement or require another device to be close by to handle some of the connectivity and computing function.

There will always be a concern that carriers will decrease the iPhone subsidy

Um does point out that this has been a concern for a number of years and that it hasn’t materialized. He may be right that when smartphone penetration reaches 75% carriers may not be able to subsidize smartphones at least to the degree that they have been. comScore has the penetration of smartphones at 62.5% as of October in the U.S. vs. 51.9% a year earlier. Depending on how long it takes the next 12.5% of users to migrate to smartphones it does look like this level could be reached by late 2014 or early 2015. However, this doesn’t mean that subsidizes will change as it could just be a negotiating tactics by the carriers.

Um matching Street unit estimates with slightly higher revenue and EPS

For the December quarter he is projecting:

  • 54.8 million iPhones (the seven sell-side analysts I have projections from are between 52 and 57 million) with an Average Selling Price (ASP) of $610,
  • 24 million iPads (the sell-side analysts are closely clustered around 25 million) with an ASP of $430
  • $58 billion in revenue (vs. the Street’s $57.3 billion and guidance of $55 to $58 billion)
  • 37.9% gross margin (vs. the Street’s 37.2% and guidance of 36.5% to 37.5%)
  • $14.49 in EPS vs. the Street at $14.05 

For fiscal 2014 and 2015 he is projecting $44.44 and $45.73 in EPS, respectively, off of $182 billion and $186 billion in revenue. With the stock at $561 (the price when he downgraded) the shares were trading at a PE multiple of 12.6x and 12.2x on his 2014 and 2015 EPS estimates, respectively. Given that the company should have almost $160 in net cash per share as of the end of December (without taking the negative impact from paying U.S. taxes on the overseas profits and share buybacks) the stock is under a 10x PE multiple which is more than reasonable.

The stock will probably gyrate around $555 until earnings are announced

Apple’s share built a nice base around $520 for over a month in the October and November timeframe. It had a good run to $570 but pulled back to $553 on Monday post the China Mobile announcement and Um’s downgrade. I would expect it to not stray too far from where it is with one indicator being the fairly neutral technical Relative Strength Index (RSI, or top third of the chart below) and the MACD showing the stock being a bit overbought but not too much (bottom third). Unless there are fairly good indicators that the iPhone did better than expected or a number of analysts come out with increased estimates the stock may not do much for the next three weeks.

Source: StockChart.com

Follow me on Twitter @sandhillinsight. You can find my other Forbes posts here.

Source: Forbes Apple

 
 

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