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FQ1-16 AAPL Channel Inventory

On its FQ1-2016 Earnings' Call on Jan-16, AAPL was probed during its analyst Q&A session about its iPhone channel inventory levels. This was odd in one sense. AAPL historically has disclosed the exact amount of channel inventory it builds or draws-down during its prepared remarks. This quarter, AAPL's CFO, Luca Maestri, merely said:

"We started the quarter below our channel inventory target range and thanks to an extremely successful manufacturing ramp; we were able to exit the quarter slightly above the low end of our target range of five to seven weeks of iPhone channel inventory." [Emphasis Added]

It was only during the Q&A, where Toni Sacconaghi pressed Maestri on the actual channel inventory levels when AAPL revealed exactly how much inventory it had built during the quarter. Maestri indicated that it had an iPhone channel build of 3.3 million units during the quarter. He went on to indicate that it entered FQ1-2016 significantly short of the 5-7 week forward-looking target. The 3.3 million unit build is a significant number of units and matches the highest channel build in the product's history - it built 3.3 million units during the FQ4-2013 quarter, which coincided with the launch of the iPhone 5S / 5C. Additionally, the combined sequential builds (FQ4-15 + FQ1-16) was 5.25M units - that is the highest sequential build ever. Here is AAPL's historical iPhone channel inventory dynamics with reported (sell-in) and underlying sales (sell-through):

Sources: Reported sales are from AAPL SEC Filings (10Qs & 10Ks); End Channel Inventory numbers are obtained from AAPL's earnings' call transcripts posted on Seeking Alpha.

Here's some food-for-thought on the channel inventory build in FQ1-2016:

  • When taking into account the channel build, underlying iPhone unit sales contracted 4.3% year-over-year, vs. the reported sales growth of 0.4%. This is interesting because of a comment made by Cook during the AAPL's FQ4 earnings' call in October, once again in the Q&A portion in response to a question posed by Toni Sacconaghi about expectations for iPhone growth:

"The same – my same response applies and I think we'll do quite good in iPhone. I do believe we'll grow this quarter as we put in our guidance that when you start with a number in the low 30s in terms of the percentage of the installed base that’s upgraded that had a phone pre the iPhone 6 and 6 Plus, that number still likely to leave a lot of headroom beyond December."

Cook is often very careful with his words so the fact that he believed the company would grow sales both in the December quarter and beyond implies that the company fell short of internal expectations on iPhone sales. It also is corroborated with the fact that AAPL would have missed the low-end of its revenue guidance range (an unprecedented scenario) but-for the booking of a $548 million settlement from Samsung in its "Services" revenue - as discussed by Chuck Jones of Forbes.

  • The 4.7% gap between reported sales growth (0.4%) and underlying sales growth (-4.3%) is the largest gap since FQ4-2013 when there was an 8.8% gap (reported sales growth of 25.6% vs. underlying sales growth of 16.8%).
     
  • To simply analyze channel inventory builds in historical context is not exactly an accurate measurement of the product health because the channel (3rd-party points-of-sale) have expanded significantly over the past few years - specifically in China. For example, AAPL was not selling the iPhone through the world's largest wireless carrier (China Mobile) when it had the 3.3M build in FQ4-2013.
     
  • However, the 5.25 million unit build that occurred between July 26, 2015 (beginning of FQ4-15) and December 26, 2015 (end of FQ1-16) is concerning. It means that AAPL has a lot of units sitting in the channel that it has already recognized revenue on that it will need to work-off during the March quarter (FQ2-16). This likely lends credence to the relatively low guidance that it provided for the March quarter and related commentary about March being a very tough compare.
     
  • In short, there are a lot of eerie comparisons this time around with iPhone channel inventory between what occurred in the FQ4-13 / FQ1-14 period, which may not bode well for Street expectations and actual performance. It should be noted, however, that the all-but-confirmed launch of an updated 4" iPhone in March-2016 (dubbed the iPhone 5se) could create new dynamics that haven't been seen before. It could be the first-time ever that AAPL has had two different timed iPhone release cycles in one fiscal year (assuming they bring out an iPhone 7 / 7+ in September-2016, as-expected).

I still think there is much headroom for iPhone growth both domestically and abroad. The research firm Mixpanel put out a report recently showing that 32.2% of active iPhone users are still using a 4" screen (5 / 5S / 5C) meaning they are either not enamored with the larger 4.7" / 5.5" offerings or are still waiting to upgrade. Additionally, the enterprise uptake of iPhones has been accelerating - Cook indicated at the BoxWorks conference that AAPL's TTM enterprise sales (ending in June-2015) were $25 billion - while that includes iPads, iPhones and Macs - I would suspect that the most significant acceleration of those sales is coming from iPhone. Lastly, the Android-switch rate that Cook keeps referring to is real - and that has nothing to do with whether the current installed base has upgraded or not.

MJL
What is the iPad Pro?

The iPad Pro with Smart Keyboard and AAPL Pencil charging (not awkward-looking at all...LOL)

I know that the iPad Pro has been subject to a number of reviews since its release on November 11th - but those reviews have largely been superficial. Instead of putting something out as soon as I got it, I wanted to really use the thing for a while and test its capabilities (or lack thereof) before putting putting forth some thoughts on the new device. I think it is great for people to write about it at the launch event or even several weeks after, but I've always believed that the best reviews come after a person's been able to really use the device over a sustainable period. I also believe you have to understand the context of the user - that influences a review tremendously - somebody streaming Netflix all-day has a very different opinion than somebody actually trying to do something 'useful'.

My Profile:

I'm a consultant that travels quite a bit. I am a heavy MS Office user (Excel, PowerPoint, and Word). I read and write a ton of emails on a daily basis. I'm a tweeter. I'm a blogger.  I AM NOT a graphic designer nor a heavy photographer. I use an iPhone 6S+, but a PC for work (due to the heavy use of the MS Office Suite).  I am also not a gamer.

AAPL Adoption Patterns:

I have had every major AAPL 'device' at some point. I have never had an iMac ironically, but I've had the following:

  • MacBooks: 11" & 13" MacBook Airs, 12" MacBook, 13" & 15" MacBook Pro Retina, 13" MacBook
  • iPads: iPad 2, iPad 3, iPad 4, iPad Air, iPad Air 2, iPad Mini 1, iPad Mini 2 Retina
  • iPhones: iPhone 3GS, iPhone 4, iPhone 4S, iPhone 5, iPhone 5C, iPhone 5S, iPhone 6, iPhone 6+, iPhone 6S+

*MICROSOFT SURFACE: I HAVE USED ONE, BUT NOT FOR A LONG PERIOD OF TIME.

My Setup:

So I'm the definition of an 'early adopter' for AAPL products (if that wasn't) - I bought the iPad Pro on the morning of its U.S. public release date - November 11, 2015.  Here's what I have:

  • 128GB Space Gray with LTE (Verizon) iPad Pro
  • AAPL Charcoal Gray Silicon Case
  • AAPL iPad Pro Smart Keyboard
  • AAPL Pencil x 2 (lost the first one)

Needless to say, I'm in about $1,350, which exceeds the price of the base new 12" MacBook w/ Retina Display. I had one and got rid of it (a whole different story for another day), but basically I felt it was an under-powered laptop with a nice screen - I expect v2 to be greatly improved. But nonetheless, on with the iPad Pro:

The Good:

  • The display is amazing: You can't really appreciate such a large canvas with such high quality until you've used it for a while.  Most media content looks great on it - HD Movies, Hi-Res Photos, YouTube videos, etc. Absolutely no complaints here - I know there are some always complaining about % of RGB, color spectrum, etc...I'm not one of those people. As long as its not a completely over-saturated Samsung screen, I'm perfectly fine with the standard AAPL 326 PPI LED-backlit laminated screen (no air-gap).
     
  • Speakers are great: AAPL added stereo speakers on all four corner of the iPad, as opposed to the two that are on the iPad Air 2.  They also reconfigured the internals to enhance the sound - it's a significant improvement.
     
  • The AAPL Pencil is 'magical': Like I said, I'm not a graphic designer, but I still use the Pencil. I've used other stylus-type pencils before, including some pretty high-end ones from the likes of Wacom. Nothing really compares to the Apple Pencil. The latency between pressure and screen visualization is virtually zero.  I have primarily been using it with the Paper53 App. I have heard that the Pencil does have variable performance with different apps. My only gripe with the Pencil is 1) charging it is really awkward; 2) there is no logical place to store the thing (hence, I already lost one). All told, it's hard for me to believe you could buy this device without also buying the Pencil.
     
  • The Smart Keyboard holds its own. I've seen a lot of reviews both on the AAPL Smart Keyboard and other 3rd party offerings. The greatest part about these keyboards is that they don't pair through bluetooth.  They pair physically through a magnetic charging port on the iPad and keyboard - this is true for both AAPL's Smart Keyboard and at least the Logitech offering - not sure about others. The 'key travel' is pretty good - I actually find it a bit better than the keyboard on the 12" MacBook.  Using it in your lap is doable albeit a bit awkward.  It folds up nicely and doubles as a Smart Cover.

The Bad:

  • It's really just a 'Big iPad': Other than the Pencil, there is nothing that I am doing more of (in-terms of productivity) than on the iPad Air 2.
     
  • It's not a laptop replacement. Many have claimed that they have replaced their laptops with an iPad Pro - if you're simply doing email, that's likely possible - but you could also use an iPad Air 2 for that.  I still cannot see myself building PowerPoint decks, writing long documents or even working in Excel on the Pro. I do blog on the Pro, but I was doing that on the Air 2, so once again, not sure how the Pro justifies that use-case.
     
  • iOS: Either iOS needs to be 'pushed-up' or OS X needs to be 'pulled down'. It's still a mobile OS that makes it very difficult to do a lot of core productivity work. I have not been all that enamored with the split-screen mode - it's just a bit awkward to use and many apps still don't support it.  I rarely, if ever, use the feature.
     
  • It's heavy. The iPad Pro (bare) weighs 1.59 lbs. The silicon case + Smart Keyboard add another 1.59 lbs. This brings the total weight with keyboard and case to 3.18 lbs. For reference, that's heavier than all of the non-Pro MacBooks: (12" MacBook is 2.03 lbs; 11" MacBook Air is 2.38 lbs; 13" MacBook Air is 2.96 lbs). It truly makes the iPad Air 2 feel like...well...'Air'.
     
  • Battery life: For some reason, I am not getting great battery life out of the device. I don't have the screen brightness turned up; I don't run a lot of apps in the background.  I set it up as a new device, as opposed to restoring an iCloud backup, but still not getting great battery life.

The Final Take:

Everybody talks about this A9X chip as a modern marvel of silicon technology that outperforms Intel's Core M processors (the same one that comes in the 12" MacBook with Retina Display).  I don't do the types of things with this device to really see it.  I think it's a great device.  I use it daily, but I struggle with the question of: 'what am I doing with the iPad Pro that I couldn't do with the iPad Air 2 (other than using the Pencil occasionally)?  The hardware is there; I'm waiting for the software to catch up.  Who is this device for? Likely best suited for power users like graphic designers or gamers. If you have an iPad Air 2, not sure this is a step-up I would make right now.  As the MS Surface is still more a laptop occasionally used as a tablet; the iPad Pro is still a tablet that can occasionally be used as a laptop.  If AAPL ever put an LTE radio into a MacBook Air, I'd switch in a heartbeat - constant connectivity (especially for frequent travelers) is key, which is why I've always loved the iPads. I saw an iPad Air yesterday and I thought it was a Mini - I might be at the point where I can never return to a smaller iPad (similar to how I'd likely never be able to go back to a 4" iPhone screen after using the 5.5" 6 / 6S+ for so long).

MJL
Apple's App Store Developer Payouts Accelerate Again (Aug-2015)

On August 6th, it was revealed that Apple's App Store saw record billings in July-2015 with $1.7 billion in sales, driven primarily by growth attributed to its revitalized smartphone lineup as well as its continued momentum in China.  Along with its record billings, Apple also revealed that it has paid a cumulative $33 billion to developers since the inception of the App Store in July-2008.  Apple provides data related to developer payouts sporadically throughout the year - the historical trend has been at least twice a year (January and June), but as seen below, there have been instances where they have provided three updates (e.g., 2013 and 2015).  I have been tracking this data as seen below:

Source: Various Press Releases and WWDC Announcements

Source: Various Press Releases and WWDC Announcements

A few points of interest:

  • The $3 billion incremental payout between June-2015 and August-2015 was achieved in 59 days, leading to a per-day payout of $50.8 million.
  • The $50.8 million payout is a 53.6% acceleration vs. the previous per-day payout measured when the company reported $30 billion of developer payouts at WWDC in June.  This was was highest acceleration in developer payouts seen since June-2013.
  • Apple has already paid out $8 billion in 2015 alone, which aligns with the announcements made in January-2015 ($25 billion in cumulative payouts) and August-2015 ($33 billion in cumulative payouts).
  • Based on the above announcements, Apple paid developers $3 billion in 2012, $8 billion in 2013, and $10 billion in 2014.  Considering that Apple has already paid out $8 billion through July-2015 and the number appears to be accelerating, it's likely that cumulative developer payouts will reach $38B+ by calendar year-end (implying $13 billion of payouts in 2015).

Here's the some things that are a bit mystifying to me:

  • Very few, if any, people I know pay for apps, yet the developer payout numbers suggest that a crap-load of people are buying apps.  Since developers get 70% (roughly) of app purchase revenue, the 2014 payout of $10 billion implies $14 billion of app purchases.  As a point of reference, Netflix reported $5.5 billion of revenue in all of 2014.
  • While one would logically assume that developer payout growth is a function of the iOS ecosystem growth (e.g., number of devices sold -> installed base), is that a correct assumption?  For example, if you are one of the people that buys apps and you're already in the ecosystem, you don't need to keep buying the app over-and-over as most paid apps are one-time purchases (not subscription-based).  Point being, developer payouts (which is a function of app purchases) should really be a function of incremental additions to the iOS ecosystem. 
  • If you assume that developer payouts are a 'proxy' for incremental additions to the iOS ecosystem, then that ecosystem's growth continues to accelerate in markets that everybody calls "saturated".
MJL
The Curious Case of the AAPL Watch
Source: iDownloadBlog.com

Source: iDownloadBlog.com

For as much 'hype' as the AAPL Watch received pre-announcment, the noise has gone rather silent. As the company's perception continues to live-and-die with iPhone shipments, the AAPL Watch received very little attention on the last earnings' call.  And rightfully so - I estimate that the AAPL Watch only contributed about 3% to the company's top-line revenue ($2.4 billion). But I estimate that the $2.4 billion represented shipments of over 5 million units. 5 million units is an extraordinary number for any company not named AAPL.

I have an AAPL Watch Edition - it's a great timepiece (I also have a Panerai - mechanical watch). But what's more interesting is what I've observed about who is wearing these things.  When the AAPL Watch was unveiled in September-2014, the little that we saw of the software and capabilities made me believe it would be well-suited and popular for the upper-adolescent population (I call them the"Younger Millennials") - a generation that did not grow up wearing watches and "I thought" AAPL was now giving them a reason to do so. Due to the need for an iPhone to pair it with, I knew the AAPL Watch would not be a device for the younger-adolescent population, although it seems like kids are getting iPhones at younger-and-younger ages now. Even though AAPL touted the fashion aspect of the product, I didn't really think it would be widely adopted by professionals (35+ college-educated and sophisticated people). After all, this is a group that still does covets expensive mechanical watches and the AAPL Watch still seemed a bit too 'tech' to be worn on the wrist everyday.

Now that the product has been out for almost 10-months, I've observed some very interesting things:

  • Demographic adoption: The demographic (Young Millennials) that I thought the AAPL Watch would be most popular with is virtually non-existent as buyers (and users). The demographic that I see wearing it the most is the exact demographic I thought it would be least popular with - professionals.
     
  • Accretive Not Replacement: The vast majority of people that I've talked to that have AAPL Watches were not previously wearing a watch - most said that they used their phones to tell the time.
     
  • Stacking the Wrist: While many have raved about the AAPL Watch as a health and fitness tool, the majority of people I talk to do not use it for that.  I'm not sure what it is - either it's too complicated and they don't want to figure out how to make it part of their 'fitness routine', or they don't think it is effective in that capacity. Strangely enough, I've seen a number of people with an AAPL Watch on one wrist and a FitBit on the other.
     
  • Time is Money: Here is the irony (or maybe not). When I talk to these people about why exactly they are wearing an AAPL Watch, the one consistent answer is..."it saves me time". It allows people to determine whether a tweet, text message, email or other consistent notification is worth their time.  One person said, "I wear an AAPL Watch for one reason - I pull my phone out of my pocket 50 times per-day now, instead of 250..and for me, that's worth it.
     
  • Travelers love them: Travelers such as business professionals that are on planes each week LOVE AAPL Watches - there are more useful features on the AAPL Watch that resonate with travelers (boarding passes, hotel keys, etc.) than any other population.

But perhaps the bigger question is why the AAPL Watch does not resonate with the Young Millennial population?

  • It Doesn't do the Things They Crave: This Young Millennial population I speak of loves social media - they love texting, posting, tweeting, sharing pictures, etc.  The AAPL Watch is not good for any of that. You can't take pictures, texting is somewhat awkward using voice commands...it's just not great for social media curation.

I have seen C-Suite Executives from large publicly-traded companies wearing AAPL Watches; I have seen many other business professionals (both males and females) doing the same.  I have seen Young Millennials receive AAPL Watches as gifts, open them, and are now stashed away in some drawer never to be seen again.  It's quite interesting...it's quite curious.

MJL
Analyzing AAPL's Cash

An analysis of the tremendous amount of cash flow that AAPL generated in the December-2014 quarter, a comparison of its operating cash flow (OCF) conversion rate to its competitors, and a look into what it might do next with its capital return program...read more

 

MJL
Apple's Holiday 2014: A Bigger Castle with a Deeper Moat

Apple (NASDAQ:AAPL) officially closed its holiday quarter last Saturday (December 27th) and by all accounts, it will be a blockbuster quarter when the company reports its operating results after the market closes on January 27th. The company has been the beneficiary of a tremendous tailwind after it announced its revamped iPhone lineup in early September with the larger-screen iPhone 6 and iPhone 6+. Additionally, AAPL unveiled its long awaited entry into the "wearables" category with Apple Watch and its new payments platform, Apple Pay - a solution that combines NFC and TouchID with a device's secure enclave.

THE CURRENT ANALYST EXPECTATIONS FOR FQ1 (DECEMBER-2014) (COURTESY OF MY FRIEND CHUCK JONES AT FORBES)

My Projections:

OVERALL:

I fully expect AAPL to post revenue that exceeds $70 billion, which is mind-boggling when put in perspective. Just five years ago (fiscal 2010), AAPL posted revenue of $65 billion - for the entire year.

With the most sought-after refresh to the iPhone lineup ever, the demand for AAPL's most profitable devices has never been stronger. Although the world economy is mixed, it's not worse than in previous years (with a few exceptions). The Chinese and Japanese economies have seen better days, but the appetite for AAPL's products in those countries as status symbols remains extremely robust. In China, the increased distribution of the iPhone on all three major carriers combined with the massive 4G rollout will prove to be a huge catalyst for uptake of the new phones. The U.S. economy is the strongest it has been in years with low gas prices, declining unemployment and record-high consumer confidence, all catalysts for discretionary holiday spending.

THE IPHONE:

The iPhone 6 and 6+ have been selling like crazy with retailers unable to keep all skus in-stock for the entire quarter. On its fiscal Q4 earnings call in late October, AAPL management reiterated time-and-again that the demand was "off the charts" and that the new phones' popularity had exceeded all previous launches by "a wide margin." There was additional commentary by Controller Luca Maestri about the underlying sell-through, which gives investors and analysts further reasons to be optimistic:

WE SOLD 39.3 MILLION IPHONES, AN INCREASE OF 5.5 MILLION OVER LAST YEAR OR 16% GROWTH. UNDERLYING DEMAND WAS EVEN STRONGER WITH SELL-THROUGH GROWTH OF 26%...WE INCREASED IPHONE CHANNEL INVENTORY BY...SIGNIFICANTLY LESS THAN THE 3.3 MILLION UNIT INCREASE IN THE SEPTEMBER QUARTER A YEAR AGO.

Tim Cook, who is often very careful with his words, added the following about the new phones' demand:

…TODAY DEMAND IS FAR OUTSTRIPPING SUPPLY. IT IS UNCLEAR LOOKING AT THE DATA WHEN SUPPLY WILL CATCH UP WITH DEMAND…AND SO, I COULDN’T BE HAPPIER WITH THE WAY THE DEMAND LOOKS…AT THIS POINT, WE’RE SELLING EVERYTHING WE MADE.

The real constraint on iPhone shipments in the holiday quarter is supply. It appears that U.S. AAPL retail stores reached some semblance of supply-demand balance very late in the quarter and since AAPL typically prioritizes supply to its own stores, it's very likely that it was not able to fill sufficient channel inventory with its reseller partners like wireless carriers and big box retailers. Additionally, it is highly unlikely that AAPL was able to satisfy demand internationally. With China's aforementioned 4G rollout and AAPL's carrier penetration, residual demand will no doubt overflow into the March quarter.

With a projected 70.5 million units shipped in the holiday quarter with an average selling price ("ASP") of $685, the iPhone will contribute $48.3 billion of AAPL's projected $72.8 billion in total revenue for the quarter. This is about $16 billion more than the year-ago period and represents 66% of AAPL's revenue. While AAPL's increasing dependence on the iPhone revenue stream is creating much concern for some analysts, another way to look at this is that the most important product to the most valuable company in the world is firing on all cylinders. Additionally, the iPhone is a gateway to AAPL's sticky ecosystem - think Apple Pay, the App Store, iMessage, iTunes and a host of other services that users have grown accustomed to and more importantly, dependent on. The biggest testament to this ecosystem is the massive upgrade cycles that has made the iPhone the most lucrative annuity in the world.

IPHONE ASP:

For the first time in a long time, iPhone ASP is a big unknown. The reasons for this are the following:

  • AAPL switched up the pricing on storage by offering 16GB, 64GB and 128GB models at un-subsidized prices of $649, $749 and $849, respectively.
     
  • AAPL introduced the new iPhone 6+, which starts at an un-subsidized price of $749

In many ways, the change in the storage pricing was genius. The 16GB entry model has long been the most popular. However, by keeping the 16GB at the same price, but providing a large jump up in storage for only an extra $100, AAPL effectively locked in its traditional margins on the entry-level, while also convincing more people to jump up to the 64GB model. Prior to the unveiling, many had suggested that AAPL might make the entry-level 32GB and still keep the same $649 un-subsidized price, which would have only cut into their margins while providing little incentive to move to the next storage configuration. The 6+ phone at a $100 premium will certainly help, although it is unclear what the sales mix between the 6 / 6+ is - commentary that will be probed when AAPL reports later this month. The following table shows a simplistic view of how different iPhone ASPs effect iPhone revenue, total AAPL revenue and ultimately EPS:
 

When holding unit shipments constant at 70.5 million, each $10 increment to iPhone ASP adds $705M of revenue and approximately $0.03 to EPS. Now granted, this is a simplistic calculation as changes in ASP would flow through to gross margin as well and further impact EPS (either to the positive or negative).

THE IPAD:

The iPad has been in a "funk" for three straight quarters now and FY14 was the first year since the product's introduction in 2010 of declining unit sales. Last year, Tim Cook made good on his promise of an "iPad Christmas" and AAPL shipped a very strong 26M iPad units in the holiday quarter (FQ1 - 2014). That strong number was bolstered by a number of factors:

  • The iPad Air was a significant re-design from the 4th generation iPad, which prompted many with 2nd, 3rd and even 4th generation iPad owners to upgrade;
  • The beloved iPad Mini finally received the long-awaited retina display upgrade in mid-November; and,
  • The original entry-level iPad Mini was reduced to a $299 price-point.

When probed by analysts, Cook has continued to reiterate that any speed bump in sales is merely that, a temporary pause to an amazing product with a strong value proposition. Cook continues to point to both enterprise (via the partnership with IBM (NYSE:IBM)) and education as strong drivers to grow the current installed base.

However, he did make interesting commentary confirming the notion that the upgrade cycle of an iPad is much closer to that of a Mac computer than to that of an iPhone. Additionally, Cook also acknowledged the likely tradeoff that many consumers have been forced to make when deciding whether to purchase an iPad, a MacBook or even an iPhone 6+. This year, Apple made the following main adjustments to the iPad lineup:

  • Introduced the iPad Air 2 (its flagship tablet), which is thinner than the iPad Air, packs a more powerful A8X chip, directly laminated screen, sports an anti-reflective coating, and has TouchID;
  • Dropped the iPad Air by $100 with an entry-level price of $399;
  • Introduced the iPad Mini 3, which is essentially the same device as the iPad Mini 2 with the addition of TouchID; and,
  • Dropped the iPad Mini 2 by $100 with an entry-level price of $299.

With the original iPad Mini starting at $249 now, consumers have the widest array of options and price-points for the iPad. When you combine the choices, lower price-points and the numerous incentives that big-box retailers were offering on Black Friday, I actually think the iPad performed decently for the holiday quarter.

My projection of 23 million units is still a 12% drop year-over-year, but it could be worse. An additional tailwind that should be accounted for is the extra week of channel inventory that AAPL is now targeting for both the iPhone and the iPad (previously 4-6 weeks and now 5-7 weeks). That additional week should provide a one-time benefit and I expect it to occur for the iPad in the holiday quarter.

THE MAC:

The Mac was the star of AAPL's last earnings report and it is widely expected for that strength to continue. AAPL exited FQ4 (September-2014) below its channel inventory target, which means it had catching up to do in the holiday quarter. My guess is that they were short on desktops and not portables, with the Retina 5K iMac hitting stores in late October. Here were the major updates to the Mac lineup that will impact the holiday quarter sales:

  • Introduced the 27" Retina 5K iMac - a stunning display that has received rave reviews and was priced at a very reasonable $2,499, which is not bad considering most high-quality 4K display (not full computers) come in between $2,500 and $3,000.
  • Refreshed the beloved Mac Mini. The Mac Mini has somewhat of a cult following - it won't move the needle for the quarter, but was a nice little upgrade for those that had been waiting.

While the desktop refreshes described above will help, the strength of the Mac lineup continues to be the portables - specifically the MacBook Airs. The 13" MacBook Air, which is actually fairly long-in-the-tooth now, is still a long-standing favorite amongst students, and has even seen nice penetration in enterprise. With the 13" MacBook Air starting at just $999 for 128GB of flash storage and 12-hours of battery life, many find it hard to resist. AAPL's ability to continue to bring prices down on their portables (both the MacBook Airs and MacBook Pro Retinas) has served the company very well to grow market share in a segment that continues to contract worldwide. I expect AAPL to have shipped 5.8 million Macs during the holiday quarter, which will be an all-time record and further evidence of AAPL's commitment to enhancing its PC lineup.

GROSS MARGIN:

I expect this holiday quarter's results to be no different. I am projecting gross margin to come in at 38.2%, which would be 30 basis points higher than the same period a year ago. The 38.2% would also be toward the high-end of the range that AAPL guided to in October, which was between 37.5% to 38.5%. My 38.2% could very well be a conservative number considering that AAPL has been consistently coming it at the very high-end, or in some cases, even exceeding the high-end of its gross margin guidance. Here are some considerations for gross margin:

  • Forex: Maestri was very adamant on the October earnings call that forex was going to be a "significant" headwind to gross margins in the December quarter - particularly the weakness of the Japanese Yen, where AAPL derives significant sales. Maestri did acknowledge the company has hedges in place, but cautioned that they would only provide a limited offset. The dollar was relatively strong throughout the quarter and the company actually did some price "harmonization" in places like Russia (another story altogether) to help with falling currencies.
  • Components: AAPL did not give too much detail as to the state of component costs on its October call, but generally indicated that the price of the most prevalent components in its products (DRAM, NAND, etc.) would either fall or remain flat during the quarter.
  • iPhone Sales and Storage Configurations: The iPhone has the highest margin of any of AAPL's main products and with the blockbuster quarter it had, it is going to provide a nice upside for the overall corporate gross margin. Additionally, as mentioned above, AAPL's new storage capacity pricing strategy could provide a huge boost to both iPhone ASP and gross margins. With many buyers opting for the 64GB or even 128GB versions, the benefit will fall straight to margin.

 

Based on the table above, you can see why AAPL doesn't want you adding your own micro SD card to your iPhone - there's about 80% margin to AAPL every time a customer opts for a higher storage capacity. The likely uptake of higher storage configurations of the new iPhones will definitely benefit the corporate gross margin, with the iPhone poised to account for over 60% of the company's total revenue for the quarter.

  • Transition Costs: Any time AAPL refreshes its products, it incurs transition costs whether that be sales promotions on older phones, marketing expense that is charged directly to the products, depreciation of tooling and machinery, etc. While the iPhone 6 and 6+ were dramatic revamps, I don't expect any unusual surprises that the company normally incurs during refresh cycles.
  • Miscellaneous: "Bend-gate" may have created some YouTube stars, but I don't expect it to have much impact on the warranty accrual, which does hit gross margin. Product freight costs also hit margin and the continuous decline in oil prices throughout the quarter could provide some benefit to AAPL with all of those freighters that it uses to deliver iPhones around the world. However, like with passenger air travel, those benefits may not be passed on to the customer, which would be AAPL in this case.

OPERATING CASH FLOW:

It is no secret that AAPL is a "cash cow." The company's cash conversion cycle is the best in the world and that is not changing anytime soon. Historically, I have looked at the company's operating cash flow as a percentage of revenue. For the past three holiday quarters, it has averaged about 40.2% - meaning that for every dollar of revenue, a little over 40 cents is converted to cash during the quarter, with the rest flowing into working capital (receivables, etc.). When applying the 40.2% conversion to my projected $72.8 billion in revenue, I estimate that the company will have generated an astounding $29.2 billion in operating cash flow.

SO WHAT WILL EVERYBODY BE LOOKING FOR IN THE JANUARY REPORT?

Guidance: A blow out holiday quarter will be nice, but not if the March quarter guidance is significantly below expectations. Currently, 38 analysts polled by Yahoo expect revenue to come in between $47.79B and $53.31B, with EPS estimates between $1.82 and $1.99 per share. Here is what I am expecting:

Over the past two holiday earnings reports, AAPL has gotten "smashed" in after-hours trading because of disappointments with two main things:

  • Lower than expected iPhone shipments
  • Lackluster guidance

I think this quarter will be very similar and to be completely honest, the two factors listed above are inherently linked. There are four basic scenarios I envision:

  • AAPL reports blowout iPhone sales for the holiday quarter (70M+) and projects very robust continued demand for the iPhone in the March quarter exhibited with strong guidance. The stock will pop.
  • AAPL reports sub-par iPhone sales for the holiday quarter (62M - 65M), but projects very robust continued demand for the iPhone in the March quarter with strong guidance and below target channel inventory figures. If management is very vehement that supply constraints limited shipments, which will be corroborated in its forward guidance, the stock may fall initially, but likely rebound.
  • AAPL reports blowout iPhone sales for the holiday quarter (70M+) but projects waning demand for the iPhone in the March quarter with sub-par guidance. It will be interesting how the market would react to this. My initial thought is that it will react positively and then lose steam as analysts probe the guidance.
  • AAPL reports sub-par iPhone sales and sub-par forward guidance and exited the quarter within its channel inventory targets. This is the least likely scenario given lead times around the world continue to exist for the phone signaling that supply and demand are not in balance yet. If this was to occur, we will see the market action reminiscent of the past two holiday quarters' earnings reports.

What I will be looking for in Management Commentary?

There are a few key issues that I will be listening for when AAPL hosts its analyst call shortly after its earnings release:

iPhone:

  • Supply / demand situation - Is the company close to finding the balance? Are there particular models or configurations that are short? I will be looking for commentary on channel inventory - did AAPL exit the quarter within its 5-7 week target range, and if not, how short was it from reaching that target?
  • Product stack - I will be interested that given a full quarter of iPhone 6 / 6+ sales has elapsed, does the company have any better read on the relative popularity of the 6 vs. the 6+? Even if they know this, they will likely only provide "crumbs" to follow. I also will be interested on any commentary in storage configuration preferences as compared to previous iPhone models.
  • ASP - We will be able to compute the ASP using AAPL's data sheet that it provides in its 8-K earnings release filing, but additional commentary on this, including sell-in of legacy models (5S / 5C) would be interesting.

Apple Pay:

  • Statistics - Any statistics that the company can provide in terms of number of transactions, dollar value of transactions, additional retailers signing up, etc. would all be welcome. Although Apple Pay doesn't appear to have material financial impact at this time, it certainly is important for the ecosystem.

Apple TV:

  • Hobby or Product? - Last year, AAPL said that Apple TV had graduated from hobby status, yet it has not updated the product in a long time. I don't think anybody except Piper Jaffray's Gene Munster is asking for a full TV set right now, but an upgrade to the current hockey-puck device would be nice.

Apple’s Holiday Quarter: Adding to the Castle and Reinforcing the Moat

MJL