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Think Twice Before You Buy Apple Stock

By Ashraf Eassa – Apr 27, 2018 at 10:45AM

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Here's why I'd advise against it.

Analyst Katy Huberty recently slashed her Apple (AAPL 2.56%) iPhone shipment estimates for the quarter that ends in June to just 34 million units, down from a prior estimate of 40.5 million. 

Although the analyst thinks that there's a reasonable chance that Apple stock could drop following its upcoming earnings report, she had the following advice to give to investors: 

We would be buyers on any weakness following the print given 1) the Services story remains intact, (leading to a stronger and more consistent source of EPS growth and margin expansion), 2) estimate revisions are approaching trough (we already assume no device revenue growth next three years), and 3) buybacks remain a source of downside protection.

Here's why I disagree with these reasons to buy Apple stock on any earnings-related drop. 

Buybacks can only help so much

Share buyback programs can sometimes help keep a stock afloat for a few reasons. Firstly, share repurchases reduce the total number of shares outstanding, so for a given level of net income, earnings per share (EPS) goes up. Naturally, since stocks are often valued based on the amount of earnings they generate per share, improving earnings per share can help the share price.

An Apple iPad.

Image source: Apple.

Moreover, share buybacks -- especially large ones -- increase the overall demand for shares. Stock prices are fundamentally governed by supply and demand, so introducing additional demand can drive the share price up. 

Ultimately, though, I believe that it's important to invest in companies not for the kinds of financial engineering they can do to inflate certain metrics, but for the kinds of business results they can deliver. A company that plows a lot of money into buybacks but has a struggling core business is far less attractive than one that has a superb core business but doesn't buy back stock. 

Services business is nice, but...

One of the bright spots in Apple's financial performance in recent years has been its Services business, which incorporates revenue from things like the App Store, AppleCare warranties, iCloud, and Apple Music. In fact, the growth here has been so consistent (23% last year and 22% in the year before) and so strong that it's now Apple's second-largest business by revenue, bringing in roughly $30 billion during Apple's fiscal year 2017. 

While the growth story here is, indeed, encouraging, the reality is that it's still nowhere large enough to offset potential weakness in the company's iPhone business, which generated $141.3 billion in revenue last year. 

For some perspective, if Apple's iPhone revenue drops by 5% in a year (roughly a $7 billion decline based on the fiscal 2017 figure), then it'd take a roughly 23% boost in Services revenue just to keep things flat. While the Services business has demonstrated such growth in the past, it's not clear if it can keep growing that rapidly to serve as reliable protection against downside in the iPhone business.

Moreover, considering that investors care a lot about growth, the Services business allowing Apple's overall business to jog in place if the iPhone declines isn't exactly the most attractive reason to go out and buy Apple stock.

Estimate pessimism reaching peak

Huberty argues that analyst estimates for Apple's business are "approaching trough." This is important because stock prices trade heavily based on analyst expectations for future business performance. 

If analyst estimates are high and then get revised downward (usually in light of a bad quarter or some negative supply chain data points), this can push the stock down. On the flip side, if analyst estimates are low and they get revised upward, the stock could go up. 

Should Huberty's claim about estimates "approaching trough" prove accurate, and should Apple's iPhone business outperform these currently lowered expectations, then the stock could, indeed, have upside.

However, I would caution investors to keep in mind that even if analysts capitulate and bring their iPhone estimates down significantly, there's no guarantee that the iPhone business will turn around and that Apple will begin beating those estimates. Things could potentially get worse and the estimates may drop even more, which would put pressure on the shares.

Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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