Explaining The Recent Apple Sell-Off And How The Stock Can Recover

Apple‘s (NASDAQ:AAPL) stock has seen a sharp sell-off of late, falling by close to 14% over the last three weeks on account of the economic headwinds in China – the company’s fastest growing market – and concerns about the growth prospects of the iPhone. Below, we take a look at the reasons for the decline and what it could take for the stock to recover from here.

Chinese Headwinds And Yuan Devaluation

Chinese economic growth is slowing down (7% projected GDP growth for 2015), and there have also been concerns that the effects of the recent stock market meltdown could spill over into the broader economy. This has caused apprehension among Apple investors, since China is the company’s biggest growth market. Apple’s sales in Greater China grew 112% y-o-y in Q3 fiscal 2015, accounting for about 58% of overall growth. Moreover, the Chinese Central bank just devalued the Yuan by roughly 1.9% –  the biggest cut in two decades – in response to the economic slowdown, and there remains a possibility that the trend could continue. This is likely to put pressure on Apple’s Chinese business, since ASPs could decline in dollar terms or volumes could take a hit if the company decided to raise prices. While Apple caters to premium buyers, who are likely to be less price sensitive, this is nevertheless a net negative for the company.

Although Apple also does much of its manufacturing in China, the cost benefits from the devaluation are unlikely to be significant, since the company likely works with its contract manufacturers in dollar terms. Even if the company has some leverage over its contract manufacturers, a potential loss on the revenue and growth front in China is likely to outweigh any cost benefits, since much of the value-add in China comes from labor and assembly, which accounts for a very small part of an iPhone’s ASP.

iPhone Growth Concerns

Apple’s fortunes are tied to the iPhone in a big way (60% of total revenues and over 75% of profits by our estimates) and investors seem to be concerned about the device’s future growth potential, amid increasing saturation in the smartphone market and the aforementioned economic headwinds in China. Apple has seen solid growth momentum with the iPhone 6, as pent up demand for a big screen Apple handset and higher ASPs allowed the company to post 50%+ y-o-y levels of iPhone revenue growth in the last 3 quarters. Investors obviously aren’t expecting this to last, as they may be apprehensive as to whether Apple will be able to maintain premium ASPs while driving single to low double-digit levels of volumes growth. The jitters were apparent when Apple published its Q3 earnings; although the company comfortably beat earnings expectations, its iPhone shipments (47.5 million units) missed street estimates, and this was at least partially responsible for shares falling by as much as 8% in after-hours trading following the earnings release.

A key near-term trigger for the stock could be the launch of the iPhone 6S, which is expected in September. The uptake of the device, which is expected to be an incremental upgrade to the iPhone 6 rather than a full redesign, should provide investors a sense of how longer-term demand for the iPhone could pan out. Apple is reportedly very bullish on the device, having asked its manufacturing partners to prepare for an initial production run in the range of 85 million to 90 million units by December  31, marking a 15%+ improvement (midpoint) over the iPhone 6. ((Apple’s Early iPhone Call, WSJ, July, 2015)) If Apple is able to post reasonably strong growth numbers in Q4 FY’15 and Q1 FY’16, driven by the sales of the upcoming handset, it could reinforce investor confidence in the product’s longer term trajectory.

Reiterating Our $142 Price Estimate

While investor concerns are certainly not unfounded considering the near-term uncertainties, we believe that Apple’s stock remains undervalued, trading at just about 12.5x projected fiscal 2015 earnings. We are reiterating our $142 price estimate for Apple. Our DCF model assumes that the company’s revenues will remain relatively flat over the long-term.

See the links below for more information and analysis:

• Apple Earnings: Analyzing iPhone Performance And Estimating Q3 Watch Numbers
• Apple: Too Big To Grow?
• Examining Apple’s Low P/E And How It Could Go Higher
• Trefis analysis: Apple’s iPhone Segment
• Trefis analysis: Apple Watch Segment

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