Apple (NASDAQ:AAPL) shares have fallen 10% over the past three months due to concerns about the iPhone and its growing dependence on the Chinese market. In a previous article, I discussed three reasons to buy Apple stock on that weakness: its cheap fundamentals, the iPhone's impressive profitability, and long-term growth opportunities for its digital ecosystem.
But I recently sold a fifth of my position in Apple. The main reason was to prevent Apple from topping 10% of my total holdings, but I also believe that its upside could be limited by three major headwinds in the near future.
1. Problems in China
Last quarter, Apple's sales to the Greater China area more than doubled annually and accounted for over a fourth of its top line. Apple recently cited China as a core growth driver for App Store sales, which hit a record $1.7 billion in billings in July. Apple also became the top smartphone maker in China at the end of 2014 thanks to robust sales of the iPhone 6.
Unfortunately, Apple now faces several major threats in China. China's GDP only grew 7.4% annually last year -- its slowest growth rate in 25 years. The IMF expects that figure to slip to 6.8% for 2015. To counter that slowdown, China devalued the RMB to aid its exporters. If the RMB continues slipping against the dollar, Apple's Chinese iPhone profits could take a hit.
In the second quarter of 2015, Apple ceded the top spot in China to Xiaomi and Huawei, according to research firms Canalys and Counterpoint Research. Apple didn't launch any new models during the second quarter, while Xiaomi and Huawei did, but there are concerns that the upcoming launch of the "iPhone 6s" won't compare favorably to iPhone 6 sales figures in the previous year. To make matters worse, the Chinese smartphone market contracted annually for the first time in six years in the first quarter of 2015, according to IDC, indicating the market is oversaturated with devices.
2. Forecasts, not fundamentals
Another problem is that Apple stock is moved more by analyst forecasts than fundamental valuations. That's why the stock slipped after iPhone sales growth narrowly "missed" analyst expectations.
Even though iPhone revenue surged 59% annually as unit sales improved 35% to 47.5 million units during the quarter, analysts had expected Apple to ship an average of 49 million units. The company's fourth quarter revenue guidance between $49 billion to $51 billion also came in below the average estimate of $51.1 billion.
Looking ahead, missing more forecasts on iPhone sales will be considered a bright red flag for Apple, which relied on the smartphone for 63% of its revenues last quarter. Meanwhile, any downward revisions of iPhone estimates, like KGI Securities' bold claim that iPhone sales would flatline by the end of the year, will also keep weighing down Apple stock.
3. Buybacks, not dividends
As an income investor, I prefer companies to hike their dividends rather than repurchase shares. Buybacks improve valuations, and a company might profit from buying its own shares at a discount, but they're just not as attractive as big dividend payments.
Apple currently pays a forward annual dividend yield of 1.8%, compared to the S&P 500's average yield of 2%. Over the past 12 months, Apple used 55% of its free cash flow to buy back shares, but only 16% on dividends.
Apple stock has climbed 18% over the past 12 months, meaning the company bought back its own shares at a discount, so buybacks probably weren't a bad idea. But if Apple spent just a little more cash on dividends and less on buybacks, its yield could rise past 2% and attract more income investors.
4. What's next?
It's unfair to compare CEO Tim Cook to Steve Jobs, but Apple really hasn't launched any game-changing products since Jobs passed away in 2011. Whereas Jobs wasn't shy about unveiling unconventional new devices like wheel-based MP3 players and smartphones without keyboards, Cook mainly follows industry trends like smartwatches, smaller tablets, phablets, and mobile payment platforms.
Under Cook, Apple doesn't "think different" anymore -- it merely follows other companies after they test out the market with hit and miss products and services. This wouldn't be a huge problem if Apple was better diversified, but iPhones still account for most of Apple's revenue and iPad sales have fallen for six consecutive quarters.
The bottom line
Despite those problems, I still believe Apple is a solid long-term investment. But investors should have realistic expectations about Apple's performance in the near future.
Problems in China could get a lot worse before they get better, and the blinding spotlight of nearly 50 analysts covering Apple could cause the stock to slip on unrealistic forecasts rather than fundamental strength. Lastly, Apple's inability to tell investors "what's next" will keep the stock tightly tethered to iPhone sales.