Apple (AAPL.US) may stop sales of its latest Apple Watch Series 9 and Apple Watch Ultra 2 in the United States starting this week due to a patent dispute over the technology behind the blood oxygen feature. Previously, the U.S. International Trade Commission (ITC) issued a directive in October that may prohibit Apple from importing or selling the two Apple Watches. The ITC found that the devices infringed on patents owned by medical technology company MASI.
It is understood that as early as 2013, health technology company Maximo Medical developed a mobile pulse oximeter, a sensor used to track blood oxygen levels that can be synchronized with iPhone, iPad and iPod touch.
When the technology became available, Apple showed strong interest in integrating the feature into its own devices. Instead of purchasing or licensing the intellectual property, Apple chose to hire several key figures from MAXIMUM, including Michael O'Reilly, who moved from MAXIMUM's chief medical officer to Apple's vice president of medical technology.
Fast forward to 2020, and relations between the two companies have become tense. MAXIMUM Medical sued Apple for trade secret misappropriation and patent infringement. Coincidentally, later that same 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 continued and intensified, leading to the current situation at the ITC, where Apple may be banned from importing or selling wearable devices with oximeter.
Currently, Apple is preparing to stop sales of these new wearable devices entirely, and the duration of this restriction is full of uncertainty.
Apple confirmed that due to "ITC orders regarding technology intellectual property disputes," the devices will not be available for purchase through its online store starting December 21, nor at physical Apple stores starting December 24.
While awaiting President Biden's decision on December 25, Apple is prepared to comply with the order if the ruling remains unchanged. The Office of the U.S. Trade Representative, run by the Biden administration, is considering all aspects of the case.
If not overturned, the ban will take effect on December 26, and Apple will be unable to sell its most popular wearable device.
So, what does this mean for Apple?
In the fourth quarter of fiscal 2023, Apple's quarterly revenue was $89.5 billion, a decrease of 1% compared with the same period last year, mainly due to lower sales in Greater China and Japan. However, earnings per share of $1.46 beat analysts' expectations of $0.07 and represented a year-over-year increase of 13.2%.
Although Apple has multiple strong revenue streams, the company is valued at a significant premium compared to historical valuations. Any small imminent threat that could hinder the stock's growth could have a significant drag on the stock price.
The breakdown of the fourth quarter data is as follows:
iPhone: Revenue was US$43.8 billion, accounting for 49% of total revenue, a year-on-year increase of 3%;
MacBook: Revenue was US$7.6 billion, accounting for 8.5% of total revenue, down 34% year-on-year;
iPad: revenue of US$6.4 billion, accounting for 7.2% of total revenue, down 11% year-on-year;
Wearable devices: revenue of US$9.3 billion, accounting for 10% of total revenue, down 4% year-on-year;
Services: Revenue was US$22.3 billion, accounting for 24.9% of total revenue, a year-on-year increase of 16%.
From the segmented business, we can see that wearable devices, including Apple Watch and AirPods, contributed 10% to total revenue and have become an important source of revenue for Apple.
Although Apple did not provide specific data for this category, detailing the contribution of AirPods and Apple Watch, it is reasonable to believe that about half of the revenue comes from Apple Watch. This means that if the ban takes effect, about $5 billion in future quarterly revenue may be at risk.
Considering the ban's effective date is December 26, it won't affect the holiday shopping season, which includes Black Friday and Christmas - traditionally Apple's peak sales season.
However, the duration of the ban remains uncertain. If the ruling stands, the real impact could be felt in January and February, typically months when Apple's U.S. sales slow.
Although, Apple may have a large inventory of Apple Watch 8 and SE, ensuring product supply during this period. However, 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 an alternative.
So, what other options does Apple have besides waiting for the ruling?
Apple mentioned in a statement that it was "pursuing a range of legal and technical options" to resolve the issue and resume sales of its popular smartwatches, although specific plans were not disclosed. However, the company does have some potential avenues.
According to related reports, Apple is working internally to change the way 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 evidenced by its 2019 partnership with Qualcomm (QCOM).
Although this $5 billion in quarterly revenue may seem relatively small compared to Apple's expected revenue of $397.2 billion in fiscal 2024, it actually accounts for about 5% of total sales for the year.
More critically, if the ruling stands, there could be other consequences if Apple is forced to redesign its Apple Watch or resolve the issue through a financial agreement. This could set a precedent for other companies to potentially sue Apple for patent infringement, causing more trouble in the coming years.
Among them, Apple's valuation may be the main risk.
The stock currently trades at 30.07 times its fiscal 2024 earnings, an 18% premium to its valuation over the past five years.
Forward EV/EBITDA confirms this trend, currently sitting at 22.97x, a 26.5% premium to historical valuation.
What needs to be worried is that since Apple's revenue in the fourth quarter of fiscal year 2023 has already experienced negative year-on-year growth, under such a valuation, the stock cannot afford too many setbacks.
Any issues could have a significant impact on the stock, which is trading at all-time highs with little room for error. Flawless execution is critical to justify this valuation.
Analysts expect Apple's revenue to grow at a compound annual growth rate of 6.4% and earnings per share to grow 8.5% over the next five years due to aggressive stock buybacks. For reference, Apple has reduced its outstanding shares by 38% over the past decade.
It can also be seen from the comparison with the valuation of other technology giants that Apple's valuation is at a relatively high level: Apple's forward price-to-earnings 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 suggests that Apple's forward valuation relative to EPS growth is significantly higher than other selected companies, leaving little room for execution error as any misstep could result in significant stock flaws. Stocks fell sharply.
However, if Apple quickly resolves its dispute with MAXIMUM Medical and gets its Apple Watch line back on sale, analysts MillennialDividends predict the stock could rise at a reasonable 7% annually, potentially reaching a stock price of $276 by the end of 2028. This forecast factors in a slight contraction in valuation to around 28 times its expected earnings.
Conversely, if the dispute remains unresolved, it could have a 2-3% impact on fiscal 2024 earnings per share. This suggests that Apple's earnings per share next year will not reach $6.60, but will likely be around $6.40, leading Dividends to lower its price target from $197 to $192.