UBS US research analysts Brent Thill, Amitabh Passi, Steven Milunovich and Stephen Chin maintain Neutral ratings  for Apple Inc. (NASDAQ:AAPL). More details from the latest report below.

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Apple: A stalled growth stock

We think Apple Inc. (NASDAQ:AAPL) has become a stalled growth stock, although not a broken company. FY14E earnings should increase to about $44.50 on mid-single-digit revenue growth and a flat-to-up gross margin. The December quarter benefits from a bevy of recent product announcements. Then, the question is what happens in the seasonally weak March and June quarters? A deal with China Mobile could smooth out revenue.

We don’t see the stock breaking out until new product categories are introduced, perhaps in the June-December timeframe. Over the Long term, we agree with Apple’s strategy of focus and a premium user experience. Although there is risk from “good enough” technology, history favors companies that choose better over cheaper. Our price target of $540 is based on: 1) an EV/FCF multiple of 7x our FY14 estimate, in line with large tech franchises Oracle and Intel; and 2) a P/E of 12.5x (or 9x ex-cash).

Apple’s upside scenario

We think a faster gross margin recovery aided by better than expected iPhone unit growth and a mix shift could represent upside to our thesis. A distribution agreement with China Mobile Ltd. (ADR) (NYSE:CHL) (HKG:0941) and strong developed country interest in the iPhone 5S/5C and iOS 7 may help improve the company’s leverage with current form factors. In this scenario, we increase our FY14E gross margin by 150 bps to 39.5%, still 70 bps lower YoY. Our GAAP EPS would improve 8-10% to $50.00 per share, presenting more than 20% earnings growth when coupled with Apple Inc. (NASDAQ:AAPL)’s buyback. Under these circumstances, we see upside potential to $580 per share based on a target EV/FCF multiple of 8x on F14E FCF of $47bn, or on P/E of 11.5x, or 9x when excluding cash of $150 per share.

Apple’s downside scenario

Weaker than expected demand and product development delays would extend the company’s period of decelerating revenue growth and declining profitability. A lack of recovery in gross margins, plagued by a sharper decline in iPhone demand, weak fixed-cost coverage, and rising component pricing, represents downside to our thesis. In this scenario, we decrease iPhone unit sales by 10m and our FY14E gross margin by 200 bps to 35%, down 2-3 points YoY. Our GAAP EPS would decline 15-20% to $39 per share, resulting in flat earnings and only 2-3% EPS growth when factoring in the company’s buyback program.

Under these circumstances, we would likely re-rate our expectations to $400 per share based on a target EV/FCF multiple of 5.0x on F14E FCF of $35-36bn, or P/E of 9.5x, or 6x when excluding cash of $150 per share.

Business description

Apple Inc. (NASDAQ:AAPL) designs, manufactures, and markets mobile products, personal computers, and media devices. The company’s primary hardware product categories include the iPhone, iPad, iPod, and Mac computers. In addition, the company sells a variety of related software, services, peripherals, and third-party digital content and applications via iTunes and the App Store. Apple Inc. (NASDAQ:AAPL) predominately sells to the consumer segment through its own online and retail stores, as well as third-party cellular network carriers, wholesalers, and retailers.

Smartphone industry outlook

We expect the smartphone industry over the next four years to resemble 2004-07, when the low-end feature-phone market took off, eroding average sales price and gross margin, and with a concentration towards the leading player, then Nokia Corporation (NYSE:NOK) (BIT:NOK1V) (HEL:NOK1V) and now Samsung Electronics Co., Ltd. (LON:BC94) (KRX:005930). The high-end smartphone market is maturing quickly, with industry revenue growth likely to slow from here and increased competition likely as the industry searches for the innovation that would drive it higher. That said, our work suggests price elasticity of demand at 1.4, so smartphone unit growth is likely to continue into lower price points, with significant ramifications for industry participants.