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.