Apple's Very Bad Day

Check out the latest Apple earnings call transcript.

Apple (AAPL 1.27%) shares tumbled after a surprise guidance update from management -- a company that's often accused of sandbagging missed on its estimates to the tune of $5 billion. What gives, Apple?

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu discuss the factors that led to this tank in revenue for the iPhone giant, what Apple can do about it, and how the stock looks for the long term. Find out what makes fishy Apple's insistence that iPhone unit sales aren't important, why so many people are lengthening their upgrade cycles, what an iPhone ban in Germany means for the company, and more.

A full transcript follows the video.

This video was recorded on Jan. 4, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Jan. 4, and we're talking about all things Apple. I'm your host, Dylan Lewis, and I've got fool.com tech specialist Evan Niu on the phone. Evan, what's going on?

Evan Niu: Tired, man. Dealing with all this house stuff.

Lewis: You've had a rough start to 2019, huh?

Niu: Yeah. Dealing with a handful of house repairs, stuff breaking. Had to buy a new refrigerator. Wasn't planning on spending an extra couple of thousand dollars on that. [laughs] 

Lewis: Well, I think that's all to say that maybe the rest of 2019 will be nice for you. Nice and relaxed, no home troubles, because you've gotten everything taken care of in the first four days of 2019. [laughs] 

Niu: Knock on wood, hopefully.

Lewis: Maybe we're hoping that the rest of 2019 goes a little bit better for Apple, huh? It's been kind of a rough start to the new year for them as well.

Niu: Yeah. They released a letter to shareholders. That's a rare move. They don't use the shareholder letter format. But CEO Tim Cook put out a letter earlier this week with a lot of really bad news. They drastically slashed their guidance for the December quarter. Now they're expecting about $84 billion. They initially expected to have $89 [billion to] $93 billion in revenue in the fourth quarter. So we're talking about a $7 billion miss compared to the midpoint of that guidance. Most of the other items of their forecasts are pretty much unchanged, or only a little bit different. Gross margin, for example, is another important one. That's within the guidance range at 38%. But operating margin will take a hit because of the revenue shortfall. Operating margin will probably be in this 28% range, whereas a year ago, they did 30%.

Lewis: The sticker figure that everyone's looking at here is that $7 billion. For them to be walking back -- we're obviously happy that they issued this letter and gave us this heads up that it's happening. But even when I saw that there was a letter coming from management for Apple, it was like, I'm bracing myself for this because I think it's going to be bad. It's like getting broken up with. You don't want the "hey, we need to talk." It rarely signals something good is coming. 

Niu: Yeah. They halted trading after hours, which was kind of like, "Whoa, what's coming? What news is coming?" Then they dropped this bombshell. Of course, shares tanked immediately, and then the next day, the whole market tanked. [laughs] 

Lewis: Of course, the market will sell off as Apple sells off, just because it's such a large component of the S&P 500. Any concerns that are felt there, because they're such a huge multinational with hands in so many different markets, might signal some uncertainty for other companies, and investors might worry a little bit about that. 

Some of the stuff that we saw in this report that led to this walk-down in terms of guidance was stuff that the company was anticipating. Some of it wasn't. It's interesting to see that blend here with the forecast, and where we wound up. 

Niu: Right. When they talked about guidance back in November when they gave earnings, they mentioned a lot of headwinds that they're facing. Weakness in emerging markets, tough comparisons related to the timing of channel fills since the flagship iPhones this year launched a little bit earlier compared to last year, foreign exchange rates challenges. Some of the stuff they knew was coming.

The big one that they did not expect the magnitude of was that piece on emerging markets, particularly China. iPhone sales in China have basically been terrible. It's responsible for basically the entire shortfall. The Chinese economy has been slowing quite a bit recently. President Trump's ongoing trade war doesn't help; it creates a lot more uncertainty and is also hurting their economy -- and, of course, ours, too. Tim Cook also said that retail traffic at Apple stores in China, as well as channel partners, was declining.

Also, beyond emerging markets, even in developed markets, upgrade activity was really weak. They've had this battery replacement program placed for about a year. That just ended, by the way. That allowed people to get super-cheap battery replacements because, if you remember, a year ago, there was all this backlash about Apple slowing down phones to preserve battery life. But people didn't like the fact that they were slowing down the phones. So they had this program, so you can get a new battery for $30. On top of that, you have iOS 12, which was released a few months ago. iOS 12 had massive performance improvements specifically on older devices. So, if you had an older iPhone, between getting a new iOS that dramatically improves your performance and getting a super cheap battery, your phone just got a new lease on life, so you don't need to upgrade as badly.

Lewis: I think we're finding more and more people are in that camp of not feeling like they need to upgrade quite as quickly. We're seeing, by and large, that the upgrade cycles for most phones are really getting extended out. So many people used to be on this "I have a subsidy, so every two years, I'm getting a new device." We're seeing more and more that the upgrade cycle is lengthening. It's getting close to about three years now for a lot of consumers.

Niu: The average upgrade cycle in the U.S. is approaching three years. Carriers are now testing and rolling out three-year installment plans and leases. That's where the market's heading, and that's not good news for Apple.

Lewis: What makes this so hard for the market in trying to understand what's going on with this business is that Apple isn't going to be giving us the very granular look at the iPhone segment that we've gotten in the past. We used to have this great breakout of units and average selling prices. Those are the two components that make up overall segment revenue. We're not getting that anymore.

Niu: Right. It's almost like they're adding insult to injury. In November, they said they were going to stop giving this data. Now, they're saying, "This is what's happening with our iPhone business." So right now, investors are like, "Hey, we want to know what's going on," but we're not going to be able to have that type of detail and insight. The ASP number is the closest thing that investors have to getting a sense of the product mix. It's like your only proxy to get any idea, because they don't really tell you. It's extremely important particularly because pricing has been such a core piece of their growth strategy over the past year, so that average selling price metric is even more important. 

If you do the math, the iPhone revenue for the fourth quarter, Apple's fiscal first quarter, whatever you want to call it, will be about $52 billion, which is down 15% year over year. That directly undermines Apple's argument that unit sales are not relevant anymore. When they said a few months ago, they basically said, "Our revenue is fine. Units don't matter." But now, revenue is down 15%. So clearly, units do matter. 

Lewis: Yeah. Also, you've seen so much discounting recently with iPhones, so many promotions to try to get people upgrading. I think Tim Cook even said that that's something they're going to be focusing on more -- how can they get people to trade in old devices to move to more recent issuances? If you're seeing all that going on, it's obviously going to have some impact on average selling prices.

Niu: Right. They've been doing these promotions. They've even reportedly moved people to focus more on iPhone marketing. They're trying to pull all these little levers they can to boost unit sales, and it's clearly not working that well.

Lewis: If there is a bright spot out of this letter and out of the update to guidance that we've gotten, it's that some of the other segments are still performing pretty well. Unfortunately, we were expecting that. There isn't really a big positive surprise there.

Niu: Right. There are a couple of little silver linings here. They're going to report record revenue in services, wearables, and Mac. Those are three important businesses. They also expect to report all-time record earnings per share, but that's primarily a function of buybacks and earnings accretion. Tim Cook said that revenue excluding iPhone was up 19%. That's a nice number on paper, but it's really not nearly enough to offset the weakness in the iPhone due to the size discrepancy of these businesses. The iPhone was a $170 billion business in fiscal 2018, which is over 60% of total revenue. Any weakness there is going to hurt. 

Lewis: You mentioned the services segment. This is something that management's been focusing on quite a bit recently. We have a news item also coming out recently that's going to impact the services segment, and that is that reports came out that Netflix (NFLX -3.92%) is killing its subscription support for iTunes billing and removing the ability for people to subscribe in-app. This doesn't seem like a big deal, but it kind of is.

Niu: Right. Netflix has been quote-unquote "testing out" this new process since August. In certain markets, they're redirecting new and returning users to sign up outside of their app, which is, obviously, a way to bypass Apple's tax of 15%-30%. Now, they're adopting the policy more broadly. Also worth noting, they killed off Google Play billing back in May. Basically, on all mobile platforms, they're saying, "Go sign up outside of the app. Then you can use the app to access the service. But we're tired of paying all this money to Alphabet and Apple."

Lewis: Yeah. And it's not an insignificant amount of money. For the first year, it's like 30%, then it drops down to 15% in subsequent years. That's a no-brainer for Netflix, to start to move off of that.

Niu: Right. They changed that structure back in 2016. Thirty percent in the first year, and then any subscription that's over a year old goes to 15%. That encourages developers to have these long-term relationships. Netflix is such a popular service that everyone has it, and probably has had it for a long time. According to third party estimates from Sensor Tower, Netflix grossed roughly $850 million in 2018 through the iOS App Store. Apple's cut of that would be somewhere between $130 [million and] $260 million, depending on how long those subscriptions have been active. 

Some people have said that Apple's going to start losing that money, but that cut isn't necessarily an immediate risk from the change. It really depends on if people change their billing method. People that are using iTunes as their existing billing method can keep it, so this really only affects new and returning users. Most people don't really care what billing method they use. It's all the same to them. The average person isn't going to go, "I want to save Netflix some money; let me go change where I'm signed up for the service." It's a little inconvenient and they just don't care. So, I don't think there's a huge risk to Apple in terms of the money that they're already getting, but certainly, it's a blow to them going forward because they won't get any cut of new subscriptions that they could have been getting through the iOS App Store. 

Lewis: This was really easy money for them to collect, too, which is why it's just a little twist of the knife based on all the other news that we're seeing. Of course, the U.S. is a very saturated market for Netflix. There aren't too many apps out there that have the clout that Netflix does to be able to pull this off. The reason that Apple can take that 30% to 15% is the fact that they create a massive platform and massive reach for all these developers that otherwise would probably have a lot of trouble distributing what they're creating.

Niu: Right. For Netflix, they're basically shifting from growth to profitability. They're everywhere in the U.S.; everyone has it. It's not as if they really need that extra exposure and distribution. They're such a ubiquitous service in the United States; everyone is so familiar with it. So I don't think they're giving up a lot, in terms of growth opportunities within the App Store. On the international front, they're still growing members quite a bit, but international is much less profitable. Expanding international margins is also a good thing for them. 

Lewis: So for Netflix, this is more money for doing what they're already doing, probably. It won't put a ton of money at risk for Apple unless Netflix badgers the heck out of people to make the switch in their billing. And maybe they will. Maybe they'll make that push on the interface if they think that there's enough money there for it to be worthwhile. 

Last but not least, Evan, we have one more piece of Apple news. This just came out today, maybe yesterday, and that is the German iPhone ban. That sounds super-ominous, but it really ties to some older models for Apple.

Niu: As part of their ongoing battle with Qualcomm, which is entering the second year now, they've been fighting the Qualcomm all over the world, the latest development is this court order in Germany banning certain iPhone models from being sold. Qualcomm alleges that Apple is infringing on some of their patents around power saving technology. The two specific models that are being affected are iPhone 7 and iPhone 8. The court has sided with Qualcomm for the time being. Apple is certainly appealing and is exploring ways to circumvent the disputed areas with software updates. But yeah, it's another headwind for the iPhone business right when Apple seems to be getting all these things going wrong. This Netflix thing, which might get other people to start doing the same thing, which could hurt their Services momentum. Then, the China iPhones. German iPhones. [laughs] The list keeps growing.

Lewis: Apple could use some good news. I think, as shareholders, you and I are both hoping that that happens. How are you feeling these days as someone that owns Apple stock?

Niu: I'm still feeling OK. The stock is still so cheap. It's always been cheap. I mean, it's certainly not good to see it dropping 40% from the all-time high in October. But at the same time, I'm not super-worried about it. 

One other aspect of is, with this slowdown on the iPhone business, I don't understand why everyone is so surprised by that. There's been so many signs that this business has been slowing down for years. They hit peak iPhone units back in 2016. That was over two years ago, that iPhone unit volume peaked. They've basically been flat ever since, adjusted for the seasonal quarters. All revenue growth has been coming from the price increases. There's clearly a limit on how high you can go, and Apple's been testing that limit. It seems like we've hit that limit. As we talked about earlier, the upgrade cycles have been getting longer for years, slowly creeping higher. The global smartphone market has been stagnating a lot, too. It's supposed to fall 3% this year. There's been all these signs coming up, so this doesn't surprise me. But the market seems really surprised.

Even weirder is that Apple management seems surprised. [laughs] They've been talking like everything's all rosy for so long, and all of a sudden, they've dropped this bombshell like it's caught them off guard. That doesn't make sense to me. That just seems really weird. Why are they surprised about this?

Lewis: Yeah. The market reaction, selling the stock off about 9% or something like that the other day, makes sense given the fact that they're writing down a significant amount of revenue that they were expecting to bring in. I am surprised that this caught Apple management so off guard because they've been so good for so long. I think that Tim Cook and company have done an amazing job with so many different elements of their business. So, to see them not anticipate this, when it seemed like a lot of the metrics were there, was surprising to me.

Niu: This is just speculation, but I think when it comes down to it, it's probably just going to be about how they communicated it. They probably knew, but just didn't tell investors. And that's also a crappy thing, to not be transparent about things you're worried about. I mean, Tim Cook is too smart not to have seen this coming. So I think it's more like he saw it coming, but he just didn't tell us. [laughs] 

Lewis: But I imagine that would have worked into guidance. No company wants to issue guidance, and then mid-quarter or shortly before they wind up reporting results, have to say, "Oh, you know that guidance we issued? Just kidding. That's not what we thought we were going to be delivering." No management team wants to do that. 

You mentioned the stalled iPhone growth in the past reignited at times. For that to happen again, what do you think needs to come to this line? I think that's the multibillion-dollar question for this business right now.

Niu: I think investors just have to accept that the iPhone business has basically peaked. Plus, prices have been going higher, and actual updates each year, most of them aren't that great. Every now and then -- like, face ID is really good. But this year, it was very incremental compared to last year. When you combine these huge price increases with increasingly incremental upgrades to the actual technology, that's a recipe for a slow upgrade cycle. I don't know if they can ever break out of that. Are they going to start pulling back pricing and start having bigger jumps in technology? I find that unlikely. 

I think that people just have to accept that it's probably a peaking business, but it's also a massive business. It's also hugely profitable for them. There are worse things that have happened.

Lewis: There's certainly a lot of people that are happy with it. We were sitting around talking about this in editorial. Someone was pretty gloom and doom about the whole thing. And I looked around, and everyone in the room had an iPhone, which I think speaks to how much they've penetrated the market and how loyal people are to it. I made the point at the end of the conversation, "What are you going to switch to?" And they're like, "Whenever the next iPhone is a reasonable price." I think that's where a lot of people are. 

Where I think some of the recent lines have fallen short is, face ID is a killer use for a lot of people, but it's not a massive form factor change. We saw a huge upgrade shift when they launched those larger iPhones a couple of years back, and they got into more of the phablet space. I don't know what that next form factor upgrade looks like for them. I've seen these reports that people are coming out with these bending phones. There are some Chinese suppliers working on that kind of stuff. I don't know if that's where the smartphone industry is going. But if anything like that is coming, Apple has to be on top of it.

Niu: Right. I trust them to keep up with what's going on in the market. But I don't think there's going to be this huge growth anymore. Like I mentioned earlier, it's a $170 billion business on one product line, and they release at most three phones a year. That's bigger than many, many companies on one product. The growth might be gone, but they can keep trying to grow these other areas. Meanwhile, the stock is still so cheap that I'm not super-worried about it. 

Lewis: I think that's where a lot of people come to with this. There are a lot of folks who own, either directly with Apple stock or indirectly through mutual funds that have a large exposure to Apple stock, some position in this company, and it's like, what do I do with it at this point, seeing them down around a $700 billion market cap? If you're looking at 2019 and saying that it might be a volatile period, you could do a lot worse than owning a stock that trades at 10 times earnings. Those are the types of businesses that don't disappear when the market really struggles.

Niu: I think there's a good chance that the market is overreacting and the sentiment is getting too negative. Quite frankly, I would even consider buying shares in this $140-$150 range. I might do so, if I have a trading window open up anytime soon. It's just such a compelling value relative to the earnings power. When sentiment is so bad, and the stock is 40% off the highs, we could be looking at a buying opportunity.

Lewis: For all that we're talking about the top line and the struggle with sales, earnings per share continues to chug along because they've been so good with capital allocation and buying back shares. 

Niu: Yeah, they still have like $120 billion to give back. They're going to keep on buying back the stock. That's going to keep driving up earnings per share. It's going to keep the valuation though. 

Lewis: Let's hope so. Evan, thanks for hopping on today's show!

Niu: Thanks for having me!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say hey, you can shoot us email over at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out the videos from this podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening, and Fool on!