Apple Inc. (NASDAQ:AAPL) received a buy from Citi Research, when the firm initiated coverage on November 25th (2012). Citi Research has released a report dated December 16th, which cuts Apple's rating from buy to neutral. Obviously this looks very strange and awkward for Citi Research, so they spend 17 pages trying to explain how their opinion can change so rapidly. I sum up Citi's main points below and then give me two cents:
Citi analysts note that their previous buy rating was trading oriented, reflecting their expectation for a near-term rally (after a substantial sell-off) on strong iPhone 5 sales. However, near-term supply chain order cuts, while inconclusive in nature, bring into question the strength of iPhone 5 and refocus investors onto risks in the Apple story.
They see the likelihood of any near-term rally as diminished, and, in keeping with their original thesis, downgrade the shares to Neutral. Based on the trough analysis in their initiation, Apple shares are approaching valuations when comparables (other 4% of S&P companies, other companies with similar deceleration) were at trough prices. While this argues for an eventual rebound, they expect shares to remain range-bound for the foreseeable future.
The Data Points
Citi analysts have just returned from meetings with the hardware supply chain in Asia. While early in the week, they would characterize the Apple Inc. (NASDAQ:AAPL) supply chain as optimistic about 1Q13 prospects, by week’s end evidence of Apple order cuts to some suppliers had emerged. In keeping with this, Citi Research cut its estimates for Hon Hai Precision (AKA Foxconn).
Their Take? Some Supply
While the reasons for Apple Inc. (NASDAQ:AAPL)’s cut are unclear to the supply chain, Citi suspect it results from a combination of supply & demand issues. Citi channel checks suggest Apple has seen a 45-50% increase in monthly iPhone5 production output October to December.
While some of this increase was anticipated, their discussions with various points in the supply chain indicate yield improved faster-than-expected. Given that Apple would likely double order in periods of low-yield, order cuts as yields improve seem reasonable. Citi noted in the initiation report that they see execution risk for Apple as it decreases the time between new product introductions on larger volumes each time: they believe that this kind of supply chain disruption is indicative of this.
And Some Demand
But noting that it is unlikely that Apple is cutting orders in a “great” demand environment, they suspect “good not great” demand is also a factor. They note that Apple launched the iPhone 5 in 40 countries last week, creating a degree of uncertainty: pre-orders on China Unicom appear strong (300K vs. 200K for 4S) but 'only good in Taiwan (350K vs. 380K).'
When also considering strength at Samsung Electronics Co., LTD (LON:BC94) is still evident from their supply chain checks, Citi suspects that competition is improving, diminishing the hype around the iPhone5. In particular, Citi takes an aggressive stance on Samsung: Henry Kim models 327M smartphones in 2013 (Samsung targets 350M), representing 27.3% market share that year.
Citi still sees potential for Apple to deliver upside to December quarter iPhone consensus (~47M units), but continue to see risk from competition.
Citi's proprietary "Device Explosion" survey results published this morning show leading indicators of Apple's competitive advantage in smartphones diminishing and also suggest specifically that well over half of consumers prefer smartphones with screens larger than 4.1", putting iPhone 5 at a disadvantage.
Citi states that the strength of iPad Mini is coming at the expense of iPad4. Given that both were produced in similar quantities in 4Q12 (~10M units each), they expect some iPad4 inventory to persist at year-end.
Their supply chain checks corroborate this: iPad Mini production is expected to increase to 12M-14M units in the March quarter, whereas iPad4 is expected to decrease to 5M-7M units. In aggregate, this improves their unit assumption for Apple’s 2Q13(Mar) and have adjusted their estimates as a result.
In their initiation, they argued that tablet numbers have upside: Citi claims to be seeing evidence of this. But, more broadly, they view tablet innovation as increasingly difficult, opening room for alternative solutions to iPad and creating risk of further market share loss. They survey shows that tablets under $300 are driving the majority of incremental demand as compared to six months ago.
Citi looks to renewed product cycles to become more constructive on Apple. While they don’t view all of these as meaningful, they see potential for the following: 1) iPhone 5S in 2Q13; 2) iPad Mini Retina in 2H13; 3) iPad5 in 2H13, engineered to compete more with ultrabooks; and 4) large screen iPhone or iPad with phone in 2H13. Citi has downgraded Apple shares from buy to neutral, and decreased the price target from $675.00 to $575.00.
Lessons to learn
I have several years of experience as an equity analyst and have read thousands of sell side reports, so I will opine here. I am not bashing Citi in particular, but this should serve as another lesson to investors; do not trust sell side (or buy side) write ups. Citi mentions throughout the report that they warned in the initiation report that they were sceptical about Apple. Of course they did! Its called hedging your bets.
The fact that they changed their price target only 20 days later, has to be for a different reason, then the one they statw. It is hard to believe that something so dramatic happened to Apple to change their opinion so quickly. The CEO was not accused of fraud, the company did not lose a massive lawsuit etc. Nothing material has changed with the company for someone who has a fundamental long term approach to switch their views. Since the price target is 12 months out, Citi likely is looking one year out, not several weeks. Even though Citi does mention that they do not expect a short term rally, the new price target is for 12 months from now, not a few weeks from today.
Citi is taking a short term approach, and with Apple shares falling over the past several weeks, they feel more comfortable being neutral (like many countries did in the beginning of World War II, because they did not know if the Allies or Germany would win). With a neutral rating, Citi can now take credit whether shares go up or down. If the stock tanks they can wipe their hands clean. Even if Apple shares appreciate they can point still point to lines in the latest report such as. ' Apple’s position continues to be strong with iPad in a strong leadership position in tablets.' Either way, Citi can now state 'I told you so.'
However, anyone who bought on Citi's advice lost approximately 11% in just 20 days. If you annualize that 11%, the math looks even worse. This fiasco will likely lead to some lawsuit, especially as there is a glut of lawyers eager to take these types of cases. The lesson for investors... do your own homework!
Disclosure: No position