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2019-10-18 19:24:17

As Apple (NASDAQ:AAPL) trades around all-time highs, the tech giant appears to have another China problem similar to last year. The U.S. government remains in a major trade war with the Chinese despite promoting major progress at negotiations last week. Several companies ran afoul of the Chinese government officials recently leaving a company like Apple vulnerable to losing one of the largest markets for the tech giant. My long-term investment thesis remains bullish, but buying the stock here while facing a China problem is a different story.

Image Source: Apple China store

China Risks

Similar to last year, Apple is in a position where the company can't win in China now. The tech giant is tied to the Chinese government due to a large reliance on the supply chain where Foxconn in China is responsible for assembling a large part of Apple products. At the same time, the company needs to move production outside the country to avoid potential tariffs, while the disagreement between the governments makes it unpopular to support American brands in the communist country.

Recently, the company approved several apps that drew the ire of the communist party. The biggest issue was the app allowing Hong Kong protestors to track the police. In addition, the company has apparently removed VPN apps that were allowing users to view the unfiltered internet within China.

The issue with approving apps that are eventually pulled due to the protests of Chinese government officials is that U.S. consumers might finally question why Apple is cowering to a government responsible for human rights violations. As the trade war escalates and the NBA gets entangled in controversy, Apple could easily be the next company ensnared by the global question of supporting a country against free speech and democracy.

While Trump promoted a Phase 1 deal last week, the Chinese media (via Reuters) aren't suggesting any real deal was complete. Investors should trade cautiously knowing the deal hasn't been officially signed, and the Chinese government is highly unlikely to ever agree in writing to allowing U.S. financial services in China and protection of intellectual property rights.

China Backlash

The prime example of the potential issue is the backlash that showed up in the holiday report last year. The company blamed rising trade tensions for a big part of the revenue miss and guidance cut for FQ1'19. What was generally missed in the quarter was that the U.S., Canada, Germany, Italy, Spain, The Netherlands, and Korea generated all-time revenue records.

In the last quarter, Greater China accounted for $9.2 billion in sales. The region was the third largest leaving China barely behind Europe as the second most important region to Apple.

Source: Apple FQ3'19 earnings report

Before the trade war, Greater China was positioned to overtake Europe as the second most important region to Apple. The country saw revenues from China decline in the June quarter, and the region saw an $8 billion revenue decline for the first nine months of this FY.

The issue facing Apple is that China still accounts for over $40 billion in annual revenues, yet the revenues are at high risk now. Absent a trade deal that doesn't appear likely, the tech giant could eventually face a backlash within the communist country again.

A big part of my bullish view on the stock was for China revenues to normalize after the $4.8 billion hit in the December quarter. Going forward, Apple didn't necessarily need a resolution to the trade war when the business from China was due for a rebound from the new normal levels last year providing an easy hurdle and path to growth.

Source: Apple FQ1'19 earnings report

Any backlash against Apple could place growth projections for FY20 and FY21 at risk. The solid initial reaction to the iPhone 11 and growing Services business are positioned to boost revenues and margins. Assuming China generates flat YoY revenues in FQ4, the country accounted for about $45.7 billion worth of revenues in FY19 over 17% of the revenue base.

Analysts forecast an $11.4 billion revenue boost for Apple in FY20 so a 10% to 20% hit to revenues from Greater China would crush these growth plans. If the tech giant fails to grow revenues for another year, the market would be highly disappointed.

Source: Seeking Alpha earnings estimates

My previous research has the stock worth up to $250 based on a price of 16.5x EV/FY20 EPS estimates of $14. Analysts are down at only $12.73 as my expectations are for higher margins and fewer share counts due to the large stock buybacks.

Another hit to China revenues of $10 billion would cut profits by at least $3 billion based on 30% gross margins. Depending on the tax rates, the EPS estimates based on 4.25 billion shares outstanding could take a hit of at least $0.60.

The margin and gross profit impact could be far larger and completely swamp the benefits of the tech giant moving towards growth in higher margin Services. Apple could possibly beat current analyst estimates, but this is becoming increasingly difficult with the reduced value of share buybacks with the stock up at $235.

Takeaway

The key investor takeaway is that buying Apple at all-time highs while the company faces issues with a country accounting for over $45 billion in annual revenues doesn't appear ideal. Another hiccup in China would easily hit the stock and trim FY20 EPS estimates. A dip in the stock would improve the large stock buyback plan, so investors are better off waiting for weaker stock prices to buy Apple versus chasing the stock up here at $235.

Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.


seekingalpha.com @Stonefoxcapital
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