Apple: Walled Garden Is Falling (Triple Downgrade)

Summary:

• Apple Inc.’s shares have outpaced the market since September, but iPhone 16 sales are underperforming, leading me to downgrade from strong buy to strong sell.
• Apple’s walled garden is facing legal threats in the US and Europe. Both of these lawsuits could cost them billions. The EU one already has.
• Apple’s fiscal Q4 revenue exceeded expectations, but weak guidance and production cuts for iPhone 16 signal softer demand and growth concerns.
• The stock’s premium valuation is unsustainable; I expect the forward AAPL P/E ratio to align with the sector median, implying a potential 20.75% downside as the company’s walled garden faces threats.

Investment Thesis

Apple Inc. (NASDAQ:AAPL) shares have performed moderately well since my last piece of coverage in September, posting a gain of just over 3%, which has outpaced the market’s 1.7% return. Despite their stronger-than-market showing, the company’s iPhone 16 launch has faced challenges and is personally not meeting my initial expectations.

Early sales data indicates lukewarm demand, particularly for higher-end models, with pre-orders for the overall iPhone 16 lineup falling by approximately 12.7% compared to the previous year.

Personally, this initial underperformance in pre-sales puzzled me, especially in light of the aggressive promotional campaigns by carriers like Verizon and AT&T that I highlighted in my last piece.

Wall Street analysts are attributing the lukewarm response partly to the absence of major hardware advancements and a delay in delivering the anticipated AI-powered Apple Intelligence features, which are expected to roll out in later updates.

I, on the other hand, think there is another culprit: first driven by a small (but notable) software upgrade that changed the way iPhones receive green (non-iPhone) SMS messages, Apple’s walled garden is starting to show cracks.

Part of what makes Apple one of the world’s largest companies is their ‘Walled Garden’ strategy that gets customers hooked into their ecosystem of hardware and software products. Now, an antitrust lawsuit from the US Department of Justice (DOJ) threatens this. We’re seeing their walled garden face attacks on the App storefront (recent wins in Europe driven by Spotify Technology S.A. (SPOT) mean less App store revenue).

Adding to this, small green bubble updates are likely contributing to lukewarm iPhone sales (less incentive to join the walled garden community). These iMessage updates are an attempt to fight off the DOJ lawsuit (more on this later).

The latest iOS 18 update allows iPhone owners to receive text messages from non-iPhone smartphone owners in a way that is very similar to blue iMessages. These new green text messages can have read receipts (like blue text messages), can show the recipient when the personal texting is responding, and enable the majority of iPhone group chats to keep their blue texts. From a social psychology standpoint, this is a massive deal.

Anecdotally, I know friends who kept their iPhones just so they could be included in iMessage group chats. Now this incentive is gone.

Combining setbacks in their App Store, and a smaller incentive to switch to or upgrade your iPhone due to new green text messages, I think the bull thesis is now flawed. While an app store change and slightly different text messages may seem like small things, they’re the main reason why I’m downgrading shares from a strong buy down to a sell.

At times, companies make small, changes that cost their business a lot. I think these are some of them. Unfortunately, there’s no going back for the tech giant.

Why I’m Doing Follow-Up Coverage

With Apple outperforming the market since September (especially now that we have gotten an outlook glimpse post-earnings), I think this is a mispricing.

Initially, I viewed the bullish price action as a sign that the market was optimistic about the potential for robust iPhone 16 sales.

The company’s fiscal fourth-quarter revenue of $94.93 billion marked a 6.1% year-over-year increase, driven partially by their services division, although this specific revenue line fell short of analyst expectations at $25.27 billion (came in at $24.97 billion). Part of their walled garden strategy revolves around strong services revenue (from the App Store, for example). This was not a great indicator that this was missed.

From here, it was the outlook for me that raised red flags for me.

Recent reports indicate that Apple has reduced iPhone 16 orders by approximately 10 million units for the remainder of 2024 and the first half of 2025, with production estimates for the regular iPhone 16 model lower than previously forecasted. I think this tells and shows that consumer interest in Apple’s latest device generation is missing initial internal expectations​.

I am doing this follow-up coverage because iPhone orders are now less exciting and less promising than originally appeared. While some cracks in the walled garden appeared earlier this year (the DOJ suit and the App Store fine in Europe) it is now becoming clear that these are more than a nuisance. These are having a real impact.

Earnings Were Key

Apple’s latest earnings revealed mixed performance, with revenue surpassing expectations but weaker-than-hoped forecasts raise concerns about growth sustainability, especially with the new iPhone lineup.

The company’s guidance for the upcoming quarter also disappointed some investors, myself included. The iPhone maker is projecting revenue growth in the “low to mid-single digits.” Analysts had anticipated about 6.6% YoY growth. Apple’s guidance appears to show slower-than-expected progress with the iPhone 16 cycle and limited momentum from their AI-driven Apple Intelligence features, which are yet to gain widespread traction​.

In the Q4 earnings call, CEO Tim Cook dove into demand when asked about exiting the December quarter with iPhone demand outpacing supply:

In terms of exiting the December quarter with demand greater than supply, that’s not my recollection that, that happened for all four of the years. We clearly had cases during COVID where there were disruptions and that’s the some spilled over, but in a more regular environment where we’re not having something, a 100-year flood kind of thing, we would — our desire is to get into balance as quickly as possible. We don’t want customers having to wait for products.

And so, if you look at how we’ve done this year, we did that very quickly on the 16, on the 16 Pro family, the Pro and the Pro Max, we’ve been constrained in October, but we believe that soon we’ll be out of constraint. And so, that’s a good sign from our point of view. Keep in mind that, that’s a function of supply and demand, not one side or the other. And we’ve been preparing for the quarter for a while. So that’s what I would say there -Q4 Call.

Demand exceeding supply by the end of this current quarter would be a great thing. We’re not expecting to see that, however. So if we couple the alleged production cuts with the fact that they expect to have supply on hand at the end of the quarter, this tells me they are not on track for a record upgrade cycle. My base case before was a super cycle. This is why I am bearish now.

The Walled Garden Has Cracks

To understand where we are with the walled garden (and why this is a big deal) we have to look at the history of this strategy and what’s happened over the last 12 months to it.

Apple’s walled garden is an ecosystem strategy to get customers to buy one Apple product, pay for Apple services, and then potentially purchase additional Apple products.

Apple’s walled garden strategy has faced two major cracks this year which now think have come to a head in this last earnings report.

First, after a multi-year battle with Spotify, the iPhone giant lost a lawsuit in the EU, resulting in a $2 billion fine. This lawsuit was the result of Spotify filing a complaint alleging that Apple used monopolistic practices to force Apps like Spotify to pay Apple’s 30% app store revenue fee. Spotify further claimed in this complaint that Apple used anti-competitive practices to try to lure users to their music streaming service (and away from streaming services like Spotify).

Shortly after this, the DOJ in the US filed an antitrust lawsuit against Apple claiming the company engaged in anti-competitive practices to keep customers on their platform to help boost hardware sales, increase app store sales (and then benefit from more app store fees).

A key argument in this complaint is that Apple “[refuses] to allow its iMessage app to exchange encrypted messaging with competing platforms” according to the Associated Press.

In response, the company has decided to keep Android-to-iPhone messages as green bubbles, but now adopt Rich Communication Services (RCS) as the core iPhone to non-iPhone communication architecture. This color distinction, though seemingly minor, has historically affected social dynamics among younger users.

Many iPhone owners have historically perceived green-text messages from Android users as inconvenient because they would corrupt group chats (make the group chat SMS), and therefore make it harder to share types of other media (PDFs are one example of a document that’s difficult to share over text).

One study from Mashable shows that 30% of Android users have felt pressure to switch to an iPhone because of these social dynamics. I believe this has been a big demand driver for Apple historically.

None of these issues are associated with iMessage’s blue bubbles, just green texts. Historically, this created a social divide, with reports suggesting that some iPhone users even avoid messaging Android users to maintain the seamless blue-bubble experience​.

Now, new RCS messages do not impact these group chats in the same way, which means the social stigma that affects 30% of Android users is less pronounced. This is one of Apple’s deliberate on-ramps to converting more people to iPhones. With the DOJ filing a lawsuit (that partly attributes their antitrust case to these green texts), Apple has backed off.

Now, Android OS’ market share is growing. Apple’s RCS update may have inadvertently incentivized Android users to stay with their OS and iPhone users to explore alternative platforms that prioritize interoperability and user freedom.

To sum it up, the walled garden is facing attacks from two fronts. First, Apple is facing lawsuits and fines that threaten to change the revenue structure and business model of their services division (I think this is part of the reason services missed earnings this quarter).

Second, the company is now facing a DOJ lawsuit that is attacking the way the company does Green bubble text messages. The company has reacted to both legal threats and is trying to change their underlying software and business strategy so they have a fair chance of winning future lawsuits. This is inadvertently damaging their walled garden. A company with a damaged walled garden does not deserve to trade at a premium valuation.

Valuation

Apple currently trades at a forward P/E ratio of 30.21, which is higher than the sector median by 26.19% (the sector median is 23.94). Previously, I thought this premium valuation made sense given their historically strong ecosystem and the big incentives wireless carriers are providing in the US for consumers to upgrade their phones. But with the ongoing demand for the iPhone 16 showing signs of weakening, I think we need to reevaluate.

iPhone pre-sales estimates came in below expectations. With the company now reducing build orders for the first quarter of this new fiscal year, we should expect demand to be softer than anticipated. The smartphone market is highly saturated. The DOJ lawsuit forcing Apple to change its ways is not helping. Coupled with the miss on services revenue I think their walled garden strategy has cracks in it.

With this, I now believe Apple’s P/E ratio should converge on the sector median, so investors can price in the risk that the smartphone giant accidentally cracked their walled garden.

If Apple’s forward P/E ratio were to converge with the sector median, this would imply a downside of roughly 20.75%, as the stock’s multiple would need to realign with the forward P/E of 23.94.

Bull Thesis

Apple’s walled garden strategy has historically been a key part of the investment thesis for investors. As I have mentioned already, this is under threat.

A bull thesis could be that Apple’s green text strategy does not actually matter to iPhone sales, or that these recent settlements in the App Store will not affect long-run service revenue.

In the EU, I think the story is clear: a $2 billion fine plus better revenue sharing for apps like Spotify will hurt Apple’s top line for services.

The US Department of Justice lawsuit is specifically designed to go after Apple’s deliberate walled garden strategy. In the lawsuit, the DOJ specifically corroborates my concerns about the green text bubbles:

Apple affirmatively undermines the quality of rival smartphones. For example, if an iPhone user messages a non-iPhone user in Apple Messages-the default messaging app on an iPhone-then the text appears to the iPhone user as a green bubble and incorporates limited functionality: the conversation is not encrypted, videos are pixelated and grainy, and users cannot edit messages or see typing indicators. This signals to users that rival smartphones are lower quality…many non-iPhone users also experience social stigma, exclusion, and blame for “breaking” chats where other participants own iPhones…this social pressure reinforces switching costs and drives users to continue buying iPhones-solidifying Apple’s smartphone dominance not because Apple has made its smartphone better, but because it has made communicating with other smartphones worse.

This is why Apple had to modify their green text bubbles. It is, either reduce your walled garden, or the DOJ will do it for you. This is a core part of the DOJ legal argument.

In a statement by Apple spokesperson Fred Sainz on the lawsuit, he explained:

This lawsuit threatens who we are and the principles that set Apple products apart in fiercely competitive markets… If successful, it would hinder our ability to create the kind of technology people expect from Apple – where hardware, software, and services intersect. It would also set a dangerous precedent, empowering government to take a heavy hand in designing people’s technology.

In essence, I think Apple is now stuck between a rock and a hard place. To lessen the DOJ’s antitrust case, they have to make green text bubbles better. The DOJ lawsuit is designed to attack the parts of Apple that make it a monopoly (strong-walled garden). So inherently, by either accommodating the DOJ, or losing a lawsuit to them, this lowers the strength of the Apple walled garden.

If Apple loses this lawsuit, the DOJ is requesting that Apple be barred from “…using private APIs to undermine cross-platform technologies like messaging…”

In other words, force iMessage to allow non-iPhones to enter its messaging ecosystem and interface with each other similarly. As Apple’s SVP of Worldwide Marketing described in 2016:

…moving iMessage [features] to Android will hurt us more than help us…

Takeaway

While Apple has outpaced the broader market since September, with shares up just under 3%, initial expectations of robust iPhone 16 sales are starting to melt away. Last week’s earnings were a confirmation of this. Initial sales data corroborates this story, with overall iPhone 16 lineup pre-orders down 12.7% year-over-year. Despite strong promotional efforts from major carriers, I truly believe the recent attacks by EU and US lawsuits are affecting their walled garden both from a hardware and software side. With the firm facing antitrust enforcement, they have to take evasive action to avoid a negative outcome from the lawsuit. I struggle to see how accommodating the DOJ leads to Apple going higher from here.

Given underwhelming demand guidance, service revenue results, and production cuts to iPhone orders, Apple stock’s current premium valuation appears unsustainable. With this, I am now downgrading my view from a strong buy to a sell.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Noah Cox (main account author) is the managing partner of Noah’s Arc Capital Management. His views in this article are not necessarily reflective of the firms. Nothing contained in this note is intended as investment advice. It is solely for informational purposes. Invest at your own risk.

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