Apple Roundup: Music, App Store Monopoly, Analyst Opinion

Apple (NASDAQ:AAPL) is deepening its relationship with Amazon through a music streaming alliance, its app store monopoly case has reached the Supreme Court and a host of analysts are weighing in on iPhone demand.

Apple Music on Amazon Echo

In yet another sign that Apple is moving away from a hardware-centric model to one focused on services, the company has signed a deal with ecommerce giant Amazon (NASDAQ:AMZN) to allow Alexa, its accomplished personal digital assistant powering its Echo voice controlled speakers, to launch and control Apple Music.

Needless to say, this is a total departure from its earlier practice of tying Apple services tightly with Apple devices and is a clear statement of the growing collaboration between the two. Alphabet (NASDAQ:GOOGL) also has a similar speaker, but Google Assistant isn’t seeing the same favors at Apple.

The agreement benefits Apple by helping it reach a wider cross section of people through Amazon’s popular device (its own HomePod hasn’t done as well as expected).

For Amazon, it brings a rapidly growing content portfolio and an affluent user base (the part of it that wasn’t already using Amazon that is) into its own ecosystem.

This follows or perhaps is a part of the earlier agreement between the two companies that will see Amazon carrying Apple devices except the HomePod on its online platform, significantly improving distribution of Apple products.

Supreme Court on Apple App Store Monopoly

Apple v. Pepper, the decade-long antitrust case brought by iPhone users against Apple for creating an illegal monopoly in the form of its App Store, is finally up for trial at the Supreme Court.

The plaintiffs, including lead plaintiff Robert Pepper allege that Apple, which cancels device warranties when iPhone users download apps from other marketplaces and charges a 30% commission on apps sold on its own platform, was artificially raising app prices.

The justices are considering the validity of Apple’s defense, which cites the 1977 precedent set by the Supreme Court in the "Illinois brick doctrine." In that case, the court ruled that antitrust damages can only be collected by the party overcharged and not the ones to whom any overcharge may have been passed on. Apple therefore says that iPhone users don’t have the right under law to proceed against the company and only app developers, who are passing on the charge, have that right.

It’s apparent that app developers are dependent on Apple for business, so they are unlikely to initiate proceedings against it.

The justices are divided on whether the rule set in 1977 needs to be overturned or whether Apple’s claim should be accepted. The logic/evidence is clear enough especially considering the fact that technology is different from physical goods, but the decision will be a big deal because there may be implications for a host of online marketplaces including Google’s Play Store, Amazon, Facebook (NASDAQ:FB) , eBay (NASDAQ:EBAY) , Etsy (NASDAQ:ETSY) and others (apart from Apple). A verdict is expected in June.

Lawsuit Over Dust Filters

Some Mac users are suing the company in a nationwide class action lawsuit for knowingly selling iMacs and MacBook computers with a dust filter defect. The trapped dust is resulting in slower processor speeds, permanent screen smudges and therefore, costly repairs.

The lawsuit seeks monetary compensation for Mac owners, including compensation for the premium prices paid for screens which did not perform as advertised by Apple, compensation for out-of-pocket repair costs to replace the motherboard and/or screen, and compensation for those who sold their affected computers at a loss due to the dark smudgy spots on their screens, or sluggish performance.

For out-of-warranty devices, or those for which Apple doesn’t accept responsibility, Apple charges $600+ for screen replacement, even when a cheap fix (details described in the suit) is available.

iPhone XR Popularity

We still know very little about the popularity of Apple’s lowest end iPhone after analysts said that their channel checks indicated slower-than-expected sales, Apple suppliers (mainly exposed to XR) Qorvo and Japan Display cut forecasts, Apple agreed to subsidize the XR in Japan and Apple product marketing VP Greg Joswiak said that it was the most popular device every day since its launch.

As Eric Jhonsa of The Street points out, Joswiak’s comments compare the XR with the XS and XS Max separately and not together, so it may not actually be doing as good as the flagship phones and second, the fact that the XS and XS Max were launched before the XR, so the initial demand for those devices was already met by the time XR launched.

For now, it makes sense to remain cautious about iPhone sales while recognizing Apple’s growing potential in services, especially since the company has stopped providing granularity on device sales.

Analyst Opinion

Wedbush analyst Daniel Ives lowered fiscal 2019 sales estimates for iPhones from 218-220 million to 210-212 million units citing supply chain checks that indicate softer demand for the iPhone XS, XS Max and XR. He also sees evidence of further cycle extension with many people willing to wait another year to upgrade. While he doesn’t say it directly, he sees the need for a price adjustment or design change to get users to upgrade.

China weakness for both the XR and XS are other worries. Apple’s weaker-than-expected guidance for the first quarter and decision to stop sharing sales unit numbers also doesn’t help. Under the circumstances, he thinks that significant investments in content/services (organically and through acquisitions) will be necessary to drive growth. As a result, he also lowered the price target on Apple shares from $310 to $275.

Canaccord Genuity analyst Michael Walkley cut his iPhone units sales expectations to 213 million in 2018, 208 million in 2019 and 217 million in 2020 citing lackluster demand for the latest models, especially the XR because of the perception of its inferior quality (aluminum construction, lack of an HD screen) and availability of lower cost options in the older iPhone X and 8 models.

He also lowered his 2019 EPS estimate from $13.46 to $13.25 and 2020 EPS estimate from $15.18 to $14.69. His 12-month price target also moved from $250 to $225 (still a nice premium to current prices) and rating remained a buy.

Goldman Sachs (NYSE:GS) analyst Rod Hall cut his price target on Apple shares for the third time in a single month from $209 to $182 because of "deteriorating demand relative to what the company had initially expected" for the new iPhones. He attributes the weak demand in China and other emerging markets to the lack of balance between the price and features of the XR. While conceding that iPhone demand tends to be strong in the two weeks leading up to Christmas, he sees "material risk" to the company's March-quarter outlook if demand trends continue on this trajectory.

Morgan Stanley’s Katy Huberty’s note to investors is based on President Trump’s comment to the WSJ that iPhones might not be spared in a future round of tariffs. She says that if Apple tries moving production out of China, there would be “significant demand and unit headwinds.” If it stays in China and passes on increased tariffs to consumers it would raise prices ($60 to $160 more per iPhone XS, for example).If it absorbs the cost itself, there would be a -$1.00 impact on earnings at a 10% tariff rate and a -$2.50 impact on earnings at a 25% rate.

Asking its manufacturing partners to absorb some of the increased cost might be a workable solution, especially since Apple wouldn’t be the first electronics company doing it. The analyst says that in a “worst case scenario,” the impact of tariffs would result in a 10-20% earnings headwind for fiscal 2019.

Bank of America Merrill Lynch (NYSE:BAC) analyst Wamsi Mohan reiterated his neutral rating and $220 target price, pointing to the size of Apple’s installed base and its 2-year CAGR, the expected service and device sales stemming from the growth in the installed base, the expansion of the replacement cycle as a result of the growth in the installed base and secondary market growth (to more price conscious consumers).

He attributes a lower services attach to the more price conscious customers who however represent long-term growth opportunity as they increase their spending level over time. He considers China’s contribution crucial because its installed base has grown at a 7% CAGR to almost the same size as Europe while its replacement cycle remains relatively long.

Recommendation

Apple shares carry a Zacks Rank #3 (Hold). For smarter picks, see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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