Apple plummeted by double digits in Q1, but Bernstein finds reason for hope.

Apple plunged by double digits in the first quarter due to fears about sluggish iPhone demand and regulatory obstacles, but some on Wall Street recommend taking a second look at the stock because the slump has pushed its value considerably below historical averages while its basic business model remains intact.

"We are more constructive on Apple," Bernstein analysts wrote in a note on Thursday, citing the stock's underperformance following a year-to-date fall and low market sentiment.  "We believe that its basic business and financial model are intact," the analysts said.  

Apple Inc (NASDAQ:AAPL) plummeted 11% in the first quarter, lowering its value to well below five-year averages, and the company is trading at approximately 24 times next year's earnings, which is not a "horrible price to pay," Bernstein said.

Slowing iPhone sales, particularly in China, have provided fertile ground for pessimistic bets and heightened concerns that Apple's business is maturing. However, the arrival of the iPhone 16, which is likely to have artificial intelligence, might ignite a significant upgrading cycle.

While AI-powered smartphones are not new, and Apple may be behind the curve, history suggests that the iPhone maker does not need to be the first or convince Android customers to convert, but rather persuade its current 1.2 million iPhone users to upgrade.    

"When Apple performs well and has a strong cycle, it is because more consumers are replacing their phones. It's not because they're getting a lot more Android switchers or new customers," the experts explained.

Still, the bears would say that previous expectations of a new iPhone resulting in a great upgrade cycle have fallen short, leaving lots of doubt about whether an AI-powered iPhone will have enough razzle dazzle to promote upgrades.

Margin-rich services The story remains intact.
But decreasing or static iPhone sales are scarcely newsworthy.

iPhone sales peaked at 230 million units in 2015 and have been mostly stable thereafter. During this period of maturing iPhone sales, Apple has maintained double-digit earnings growth.

This shows that focusing simply on Apple's iPhone sales risks overlooking the primary driver of growth: services.  

Services is a key growth engine, headed by the App Store and license fees, which are payments from Google (NASDAQ:GOOGL), and advertising, which together account for more than 50% of Apple's services sales and more than 60% of gross profits, according to Bernstein.

Significant regulatory headwinds—still a long way to go.
Apple's App Store tactics, however, have come under fire, particularly in Europe, where a broad new law, the Digital Markets Act, has given lawmakers more muscle to go after big corporations and force them to open up their platforms to give users more options.

However, App Store revenue in Europe accounts for only 7% of total App Store sales and 1% of Apple's income. The greater risk is that the same regulatory headwinds arise in the United States, but for the time being, the Department of Justice's case in the United States is "primarily about attempting to open Apple up," Bernstein argues.

There does not appear to be "any direct legislation either on advertising or on the App Store," the two major profit drivers in the services industry, which is likely to keep this important growth engine operational.