Apple cut its sales outlook for the first time in almost two decades, citing weaker demand in China and fewer iPhone upgrades. The stock fell -8% in pre-market trading on the news.
CEO Tim Cook said sales will be ~$84 billion in the quarter ended 12/29, down from earlier estimates of $89-93 billion. This would represent the first holiday quarter decline since Cook became CEO in 2011.
The CEO cited two main culprits: (1) weakening Chinese economy and (2) fewer iPhone upgrades in developed markets.
On the Chinese economy, Tim Cook cited trade war tensions with the U.S. and a general weakening of the consumer as the key drivers. "While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China."
Outside of China, iPhone upgrades in developed markets have also been weaker. Consumers are opting for swapping out iPhone batteries instead of upgrading to newer devices. That's critical for Apple; the iPhone earns Apple about 2/3 of its sales and allows the company to generate more money from attached products like Apple Watches, AirPods, and services like Apple Music. So fewer upgrades could mean less revenue throughout the Apple ecosystem.
The fact that Apple will miss its original sales guidance is not the shock here, in our view. It's the magnitude of the miss and how confined it is to China. China basically fell off a cliff, and we think it's more complicated than simply a "weakening Chinese economy."
What is Apple's true China Problem?
Unlike the rest of the world, the most important layer of the smartphone in China is not the operating system (iOS). It is WeChat, the "superapp" that is integrated into the daily lives of almost 1 billion Chinese people. They use it to read the news, pay for lunch, hail a taxi, and much more -- all in a single app.
WeChat works the same on both iOS and Android, so for a Chinese consumer, there is no cost to switching away from an iPhone. And the data proves it: only 50% of Chinese iPhone buyers end up upgrading to a new iPhone (vs. 80%+ in rest of world).
So if the iOS lock-in doesn't matter much in China, what does? The iPhone's brand is its biggest allure. Apple trades on luxury and status in China. And the issue is that the recent iPhone models were simply too boring for most Chinese consumers to upgrade. [Hat tip to Ben Thompson at Stratechery for the thoughts here.]
This is an objectively bad day for Apple. We anticipate it will take at least a few quarters for the company to work through these innovation issues in China. It needs to figure out how to regain its status and luxury appeal, which it may not be able to do until the iPhone cycle later this year. The 5G wave in the coming few years could be the opportunity Apple needs to drive the step function in innovation required to regain status in China.
We don't see these China issues as holes in Apple's moat, but rather indicative that Chinese smartphone cycles operate like fashion cycles: brands go in and out of favor in the near term depending on relative innovation. It's now up to Apple to get its luxury appeal back on track.
In terms of valuation, the stock appears attractively valued near the low/mid end of its historical P/E range. With $130 billion in cash, Apple has plenty of firepower to buy back its stock, supporting earnings per share. We can also see major shareholders like Warren Buffett possibly adding to positions here.
We don't see a clear near-term catalyst to drive the stock higher, but with the stock off ~40% in the last few months, much of the bad news appears to be already baked in.