Apple Receives Rare Underperform Rating from Wall Street Analyst. Is It Time to Sell the Stock?

In a surprising decision, analysts at Jefferies recently downgraded Apple Inc. (AAPL) to an underperform rating. This is notable because Wall Street analysts usually maintain a bullish outlook on major companies like Apple, with underperform and sell ratings being a small fraction of total ratings.

Jefferies attributes its downgrade to anticipated weak iPhone shipments in the upcoming fourth quarter. The firm believes Apple's new artificial intelligence (AI) features have not captured consumer interest. According to a survey, many U.S. consumers do not see much value in AI features. This suggests that the anticipated upgrade cycle powered by AI for the iPhone may not materialize.

The analysts expect that Apple will fall short of current revenue estimates, projecting a modest growth of 5% when it reveals its Q4 results at the end of January. They also foresee a possibility that the guidance for Q1 will disappoint investors. The new price target for Apple stock is set at $200.75.

Given this unexpected downgrade, many investors might be contemplating whether it's the right time to sell their Apple shares.

A Strong Business Model

Despite the downgrade linked to iPhone sales, Apple's core business model remains robust. In fiscal 2024, which ended in September, the company's revenue growth was only 2%, with a slight increase of 6% in Q4. In terms of product revenue, there was even a slight decline of 1% for the fiscal year, with a 4% increase noted in the last quarter.

The services segment of Apple, however, has shown stronger growth. This includes income generated from the App Store, search-sharing agreements, Apple TV, Apple Pay, and various subscriptions. Last year, services revenue increased by 13%, and it rose by 12% in Q4.

With a gross margin of nearly 74% for services versus approximately 37% for products, the high-margin services revenue significantly contributes to profits. As a result, Apple's adjusted earnings per share grew by 11% to $6.75 last year, even with only a 2% revenue increase.

Currently, there are signs that the expected iPhone upgrade cycle linked to Apple Intelligence may not be occurring. There have been issues such as inaccuracies in AI-generated news alerts. Consumer surveys indicate that both iPhone and Android users feel that AI features provide little to no value. Furthermore, it remains unclear whether consumers will be interested in paying for AI subscription services, making AI seem more like a cost rather than a profitable venture for Apple.

In China, Apple's challenges are magnified as it has been unable to implement its AI technology with its smartphones. This has hindered its competition against local brands. According to Counterpoint Research, there was an 18% plunge in iPhone sales in China during Q4, while rival Huawei's sales surged by 15.5% in the same period.

Initially, Apple experienced strong iPhone sales in China with the launch of its latest model; however, the absence of authorized AI technology in the region is a setback. Apple needs to partner with a local AI provider to deploy Apple Intelligence in China. Competing primarily in the premium smartphone segment, the lack of advanced AI features leaves Apple at a disadvantage against its competitors.

Additionally, Apple faces challenges related to an antitrust case involving Alphabet Inc. (GOOGL). Currently, Alphabet pays Apple around $20 billion annually under an agreement that keeps Google as the default search engine on Apple's Safari browser. This revenue is highly profitable for Apple. However, if Alphabet were to lose the antitrust case, it could jeopardize this significant revenue stream, though any changes would likely unfold over the coming years.

Expanding Valuation

Apple's valuation has expanded notably over the past several years. The trailing price-to-earnings (P/E) ratio has increased threefold from 12 to 36, while the forward P/E ratio stands at around 30 based on current fiscal year projections.

Some of this valuation growth can be linked to the shift toward high-margin service offerings, which generally command higher multiples than hardware segments. Apple has consistently proven itself as a dependable company with a predictable yet gradually lengthening replacement cycle.

However, with the diminishing hopes for an iPhone upgrade boost and significant valuation expansion in recent years, it may be prudent for investors to consider taking some profits off the table.

Apple, Downgrade, Investors