Apple suffers a "Waterloo"! How does the ban on Apple Watch affect it?

Zhitong App has learned that due to a patent dispute over the technology behind the blood oxygen feature, Apple may suspend the sales of its latest Apple Watch Series 9 and Apple Watch Ultra 2 in the United States starting this week.

Earlier, the U.S. International Trade Commission (ITC) issued an order in October that could prohibit Apple from importing or selling these two Apple Watches. The ITC found that these devices infringed on the patent rights of medical technology company Masimo.

Apple and Masimo

It is understood that as early as 2013, health technology company Masimo developed a mobile pulse oximeter, which is a sensor used to track blood oxygen levels and can be synchronized with Apple, iPad, and iPod touch.

When this technology was introduced, Apple showed a strong interest in integrating this feature into its own devices. Instead of purchasing or licensing the intellectual property, Apple chose to hire several key individuals from Masimo, including Michael O'Reilly, who transitioned from Chief Medical Officer at Masimo to Vice President of Apple Technologies.

Fast forward to 2020, the relationship between the two companies became tense. Masimo accused Apple of misappropriation of trade secrets and patent infringement. Coincidentally, later that year, Apple launched the Apple Watch Series 6, its first wearable device equipped with a pulse oximeter.

The initial lawsuit did not resolve the issue, and the legal dispute escalated, leading to the current situation at the ITC, where Apple may be prohibited from importing or selling wearable devices with a blood oxygen monitor.

Currently, Apple is preparing to completely halt the sales of these new wearable devices, and the duration of this restriction is uncertain.

Apple has confirmed that due to the "ITC Order on Technology Intellectual Property Disputes," these devices will not be available for purchase through its online store starting from December 21st, and will not be available for purchase in Apple retail stores starting from December 24th.

While waiting for President Biden's decision on December 25th, Apple is prepared to comply with the order if the ruling remains unchanged. The Office of the U.S. Trade Representative, under the management of the Biden administration, is considering all aspects of this case.

If not overturned, the ban will take effect on December 26th, and Apple will be unable to sell its most popular wearable devices.

So, what does this mean for Apple?

Wearable devices account for 10% of total sales

In the fourth quarter of the 2023 fiscal year, Apple's quarterly revenue was $89.5 billion, a 1% decrease compared to the same period last year, mainly due to a decline in sales in Greater China and Japan. However, earnings per share were $1.46, exceeding analysts' expectations of $0.07, representing a 13.2% year-on-year growth. Despite having multiple strong sources of revenue, Apple's valuation is significantly higher compared to its historical valuation. Any imminent small threat that could hinder the company's growth could have a significant drag on its stock price.

Here are the Q4 breakdown figures:

• Apple: Revenue of $43.8 billion, accounting for 49% of total revenue, a YoY growth of 3%.
• MacBook: Revenue of $7.6 billion, accounting for 8.5% of total revenue, a QoQ decline of 34%.
• iPad: Revenue of $6.4 billion, accounting for 7.2% of total revenue, a QoQ decline of 11%.
• Wearable devices: Revenue of $9.3 billion, accounting for 10% of total revenue, a QoQ decline of 4%.
• Services: Revenue of $22.3 billion, accounting for 24.9% of total revenue, a YoY growth of 16%.

From the breakdown, it can be seen that wearable devices, including Apple Watch and AirPods, contribute 10% to the total revenue, becoming an important source of income for Apple.

Although Apple has not provided specific data for this category, detailing the contribution of AirPods and Apple Watch, there is reason to believe that approximately half of the revenue comes from Apple Watch. This means that if the ban takes effect, the quarterly revenue of around $5 billion may be threatened in the future.

Considering that the effective date of the ban is December 26th, it will not affect the holiday shopping season, including Black Friday and Christmas, which is traditionally a peak sales season for Apple.

However, the duration of the ban is still uncertain. If the ruling stands, the real impact may be seen in January and February next year, which are typically months of slower sales for Apple in the United States.

Although Apple may have a large inventory of Apple Watch Series 8 and SE, ensuring product supply during this period, the bigger concern is whether Apple can use the controversial blood oxygen sensor technology in future devices or if they need to negotiate a solution or design alternative solutions.

So, besides waiting for the ruling, what other choices does Apple have?

In a statement, Apple mentioned that it is "seeking a range of legal and technical options" to address this issue and restore the sales of its popular smartwatch, although specific plans were not disclosed. However, the company does have some potential avenues.

According to reports, Apple is internally working on changing how the Apple Watch collects and presents blood oxygen data. However, a simple software update may not satisfy all parties involved. Apple has a track record of resolving patent disputes through settlements and licensing agreements, as demonstrated by its collaboration with Qualcomm in 2019. Risk: Underestimation is not allowed to "go wrong"

Although the quarterly revenue of $5 billion seems relatively small compared to Apple's expected revenue of $397.2 billion for the fiscal year 2024, it actually accounts for about 5% of the total annual sales.

More importantly, if the ruling remains unchanged, Apple may be forced to redesign its Apple Watch or resolve the issue through financial agreements, which could have other consequences. This could set a precedent for other companies to sue Apple for patent infringement, causing more trouble in the coming years.

Among them, Apple's valuation may be the main risk.

The current trading price of the stock is 30.07 times its earnings for the fiscal year 2024, a premium of 18% compared to the valuation of the past 5 years.

The forward EV/EBITDA confirms this trend, currently at 22.97 times, a premium of 26.5% compared to historical valuation.

What needs to be concerned is that with the negative growth in revenue YoY in the fourth quarter of the fiscal year 2023, the stock cannot afford too many setbacks at such a valuation.

Any problem could have a significant impact on the stock, as it is trading at historical highs with little room for error. Perfect execution is crucial to proving the reasonableness of this valuation.

Analysts predict that in the next five years, Apple's revenue will grow at a compound annual growth rate of 6.4% due to aggressive stock buybacks, and earnings per share will increase by 8.5%. As a reference, Apple has reduced its outstanding shares by 38% in the past decade.

Comparing with the valuations of other tech giants, Apple's valuation is at a higher level: Apple's forward P/E ratio is 3.25 times, Microsoft (MSFT.US) is 2.37 times, Broadcom (AVGO.US) is 1.57 times, and NVIDIA (NVDA.US) is 0.92 times.

This indicates that Apple's forward valuation related to earnings per share growth is significantly higher than that of other selected companies, so there is little room for execution errors, as any mistake could lead to significant stock defects and a sharp decline in stock price.

However, if Apple quickly resolves the dispute with Masimo and resumes sales of its Apple Watch series, analyst Millennial Dividends predicts that the stock could reasonably rise at a rate of 7% per year and reach a stock price of $276 by the end of 2028. This forecast takes into account a slight contraction in valuation to around 28 times its expected earnings. On the contrary, if the dispute is still unresolved, it could have a 2-3% impact on earnings per share for the fiscal year 2024. This suggests that Apple's earnings per share next year will not reach $6.6, and may be around $6.4, resulting in a downward adjustment of the target price for dividends from $197 to $192.