Apple shares are responding well to a mixed earnings report and guidance update. The earnings for the December quarter were largely in line with the dramatically lower guidance the company issued earlier this month.  News headlines discuss the revenue guidance for the March quarter as below consensus.  However, it is clear that investors feared even worse which is why the stock is reacting well.  Also favorably received is the new breakdown for revenue and gross profit between the hardware businesses and services businesses.  In particular, the gross margin of almost 63% for services, up 450 basis points from a year ago, was better than many investors anticipated.

Northlake sees three key issues for Apple. First, excluding China, Apple actually grew revenues last quarter versus the reported -4.5% decline.  Thus, a key question is when China can improve.  We have a nard tome forecasting improvement given limited information and what seems like more than just a trade war driven setback.  Second, how fast can services can grow and at what gross margin level?  The services business composes many different items including Apple Pay, the App Store, subscriptions, iCloud, and Music.  It is not clear what the margin structure is for these businesses individually so the mix of revenue in future time periods could matter.  Services revenue growth decelerated to 19% in the December quarter but we are not concerned as Apple services are still not well penetrated into a device base of around 900 million units worldwide.  Services is still not quite 10% of the business but when adding in wearables, home and accessories (also fast growing and high margin), the total is over 20%.  This is enough to support the stock, particularly at a P-E ratio of just 12X.  Third, iPhones still dominate at 62% of revenue.  Beyond China, the big question is surrounds upgrade rates or how long people keep their phones.  Ever lower upgrade rates have hurt iPhone sale badly.  5G is the next major driver of upgrades but that is probably late 2020 or 2021.  Nonetheless, we see deterioration in upgrade rates decelerating and think the street may be too pessimistic.  Even a small improvement in upgrade rates versus bearish consensus would help the shares.

Following today’s 7% gain in Apple shares, we think the stock could move sideways into the next earnings report in three months.  We see enough positives along with a still low P-E to take the bear case off the table for now.  A big dividend increase and boost to the share buyback is coming April.  At less than 13X earnings and giving nor credit to about $30 in cash on the balance sheet, we think the shares are worth holding.  If the services and upgrade stories develop positively, we think the stock can move towards $200 later in 2019 as the earnings multiple expands.  As noted, we think the latest news takes away downside risk for now, so Northlake plan to hold Apple.

AAPL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.