My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price.
This blog includes commentary on market conditions as well as fundamental analysis of specific companies.
Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing.
Currently working on obtaining the CFA designation.
Previously worked in Mortgage Trading for a major bank.
Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.
Apple Inc (nasd:AAPL) reported a 36.9% gross margin for Q4 2010 which ended in September. This caused worry among investors especially since management stated on the earnings conference call that the decline was due to higher cost structure of iPad and iPhone and the exceptional value it is delivering to consumers. However, a considerable portion of the decline was due to warranty expense which there was no mention on the call.
At the time Apple recognizes revenue for the sale of a product, it also records its estimate warranty expense in costs. It is just an estimate, thus actual warranty costs may vary. When there is an actual warranty cost incurred, it is not recorded to expenses on the income statement since Apple already accounted for warranty expense at the time of sale. Instead, actual cost incurred are recorded as reduction to the warranty expense reserve.
Apple’s warranty accruals had been averaging around 1% of revenue for the first three quarters of FY10, or roughly ~$150M. In Q4, warranty accruals ballooned to $457M, or 2.3% of revenue.
If estimated warranty expense had remained constant in absolute dollar terms ($150M), GM would have been 38.4% vs 36.9%. If If estimated warranty expense had remained constant in as a percentage of revenue (1%), GM would have been 130bps higher at 38.2%.
The silver lining is often estimates of warranty costs are overly conservative resulting in much smaller accruals going forward. This could potentially happen with Apple if actual costs incurred fail to materialize, Apple would make much smaller accruals going forward, hence boosting gross margins.
Broadpoint AmTech analyst Brian Marshall recently appeared on Bloomberg TV to discuss Apple’s iPhone exclusivity agreement with AT&T. Marshall believes that Apple should move away from its exclusive AT&T agreement and begin offering the iPhone through Verizon. He believes adding Verizon could boost iPhone unit sales by 14M. Marshall states that AT&T’s exclusivity ends in June 2010, and explains why Apple would benefit by offering the iPhone through Verizon. Fortune’s Apple 2.0 and Silicon Alley Insider summarized several of Marshall’s points, which I believe aren’t entirely accurate.
Here is a video of the Bloomberg TV Interview
1) Apple receives a $450 subsidy.
Incorrect: Apple receives a $400 subsidy.
I know from talks with Best Buy managers that the subsidy is $400. Best Buy purchases a 16GB iPhone from Apple for $542, and sells it for $199 with a 24 month service contract. AT&T reimburses Best Buy $400.
A 16GB iPhone without a contract commitment costs $599. If the subsidy were $450, then that price should be $650, or AT&T would be leaving $50 on the table. In addition, the math suggests $450 subsidy is too high given the ASPs implied by the cash value of iPhones sold reported by Apple.
2) After AT&T loses exclusivity that subsidy will drop to $300 for all carriers, domestic and international.
We’re looking at the iPhone, it’s pretty clear we’re still in a greenfield opportunity here, but if you start to go to multiple carriers can you talk a little bit about the pricing of the phone when you go from exclusivity to multiple carriers? And obviously, not specific but any sort of color we can have in terms of pricing dynamics change on the phone from you to the carrier?
Timothy D. Cook
Our pricing is confidential, Gene, so it’s not something I could comment on in detail but generally speaking from markets where we’re already selling I would not expect to see a wholesale price difference as we bring on other carriers. However, the end user price is really set by the carriers themselves so you may or may not see a street price difference.
Gene Munster – Piper Jaffray
So when you go from exclusive to multiple carriers, you wouldn’t necessarily see change in pricing that you are charging the carrier? Is that correct?
Timothy D. Cook
That’s correct.
Handset subsidies are a function of ARPU, or a subscriber’s monthly service bill. The ARPU across all AT&T customers is ~$51 compared to iPhone ARPU of nearly $100. Since the ARPU is nearly double, this allows a greater degree of subsidy recapture, thus allowing for a higher subsidy to applied to a mobile device.
3) iPhone users represent 4% of total AT&T subscribers.
Incorrect: iPhone users represent about 14% of AT&T’s total wireless customer base.
AT&T has roughly 11.3M iPhone users. On the June call, AT&T said it had nearly 9M iPhone customers. AT&T has 81.6M wireless subs, with 63.4M being postpaid.
Brian Marshall stated: “roughly 4% of the AT&T users of the iPhone, consume about 40% of the overall network bandwidth.”
It’s not clear exactly what Marshall was referring to when he mentioned 4%, but most people took it to mean iPhone users constitute 4% of AT&T’s customer base. I assume he got his figures mixed up. The 3.2M iPhone activations in September period would equate to 4% of AT&T’s subscriber base. If he meant 4% of iPhone users, or about 450K, consumer 40% of AT&T’s bandwidth, then I would think AT&T would address those users since they represent 0.6% of AT&T’s wireless subscriber base. It wouldn’t make any sense to allow such a miniscule portion of customers affect the quality of service of the overall network.
4) iPhone activations from new AT&T customers made up more than 90% of postpaid net additions in September quarter.
Not Meaningful: Gross additions not net additions should be used as the metric.
iPhone activations from new AT&T customers totaled approx. 1.28M. AT&T reported 1.39 postpaid net additions. However, AT&T attracted 3.57M new postpaid customers, and 2.18M postpaid customers left AT&T, resulting in 1.39 net additions.
Comparing iPhone activations from new AT&T customers versus net additions is a faulty metric, since net additions is dependent on gross additions and the number of disconnects (churn). The more meaningful metric is comparing new iPhone additions to postpaid gross additions, which was 36% (1.28M / 3.57M). Using net additions is meaningless.
To imply that the iPhone was responsible for 92% of AT&T’s increase in postpaid customers is inaccurate. The 1.28M figure represents a portion of AT&T’s gross sub additions, therefore, it shouldn’t be used in a comparison of net additions. Subscriber churn affects subscriber net additions, and isn’t directly related to the iPhone’s ability to attract new customers.
Let’s say AT&T activated 2.28M Blackberry devices from new AT&T customers. That would equate to 165% of postpaid net adds, whereas iPhone was 92% of postpaid net adds. Is that meaningful? Not really, since it’s possible that the figure can exceed 100%. Let’s say 2.28M iPhone activations were from new customers, then that 92% would be 165%. Since the ceiling can exceed 100%, we don’t know is 92% or 165% or whatever the figure, is good or bad.
5) AT&T’s contract ends in June 2010.
Unknown: I have heard from sources at AT&T the contract runs until the end of 2010.
Neither AT&T nor Apple has publicly commented as to when the exclusivity ends. It was reported last year that Apple and AT&T extended their agreement until the end of 2010. It would make sense that the agreement runs until the end of the year since it commenced in the beginning of 2007. Even though the iPhone didn’t go on sale until June 2007, it was announced that January, allowing AT&T marketing rights for the time preceding the actual product launch.
Many assume that the deal will end mid-2010 since Apple introduces new iPhone models during that time of year. However, all we know is that the exclusivity agreement will end at some future time, but when that is exactly is anyone’s guess.
Apple Inc. (nasd:AAPL) Rising gross margins stemming from increased recognition of deferred iPhone revenue has been a key factor in propelling Apple’s share price and EPS. I believe the next major tailwind will be increased revenue growth and higher margins arising from the falling U.S. Dollar. In 2009, 46% of Apple’s total revenue came from overseas, up from 43% in FY08 and 41% in FY07. Including European Apple retail stores, revenue generated in Europe was roughly 30% of total revenue in FY09. International markets are a key source of Apple’s revenue and growth, and a declining dollar is beneficial for the firm. Apple’s performance for the past several quarters was challenged by headwinds from the strengthening USD. Going forward, Apple should benefit from the dollar’s decline. This will lift international revenue growth and boost margins. Alternatively, Apple could choose to lower prices abroad to stimulate product demand to drive volume. I believe many investors overlook the fact that Apple derives nearly half its revenue outside the U.S., thus don’t consider the considerable impact coming from a weaker USD.
The USD had been on a long-term weakening trend up until late 2008 when a string of financial institutions collapsed and panic ensued. This led to a massive influx into U.S. Treasuries, hence the USD. This caused a temporary rise in the USD as investors all over the world sought refuge in securities perceived to be the safest.
Around April/May 2009, money began shifting out of USD leading to the currency weakening. In effect, USD depreciation is a resumption of its previous long-term trend. However, this recent fall in the dollar comes with several new factors that support a long-term dollar decline.
1) Massive stimulus and bailouts
2) Budget deficits
3) Diversification away from USD
4) Weak dollar policy to boost exports and domestic manufacturing
I expect the dollar to continue it’s weakening trend and a return to levels pre-fall 2008. From October to about May, the USD rose considerably, before starting its slide mid-year. Apple generally hedges against currency fluctuations usually 3 to 6 months out, therefore the rise in the USD late-2008 likely didn’t much of an immediate impact. Eventually, the effect of the stronger dollar is felt as new hedges are set at less favorable exchange rates. Apple had warned on its earnings calls that a stronger USD would negatively impact gross margins, thus stated it a as factor for guiding GM lower. However, cheaper components, higher iPhone revenue recognition, increased supply chain efficiencies, and foreign currency hedging more than offset the temporary rise in the USD. Apple mentioned in its 2009 10-K filing that the stronger USD did have a negative impact on revenue growth abroad for the full year. When hedges expire, Apple can either raise prices to offset the stronger USD or elect to accept lower ASPs in USD terms. Even though the USD began to fall back in April/May, it’s likely Apple has yet to feel the full benefit of the dollar’s decline due to currency hedges still in effect.
The tables below compare product pricing from Apple’s online store for France, U.K., Canada, Australia, and Japan at most recent exchange rates versus rates in early 2009 when the USD was at its highs. Some of the pricing includes VAT, so the price differential between U.S. product prices and Euro zone is overstated, but the focus here is the difference between most recent prices (weak dollar) versus prices when the dollar was stronger during late 2008 - early 2009. In Europe, where Apple receives nearly 30% of its total revenues, prices have risen more that 20% in USD terms. In general, that would equate to a 6% increase in overall ASPs.
A weaker dollar does imply higher product costs since Apple sources components and manufacturing outside the U.S., namely Asia. However, the negative impact of a weaker dollar in terms of product costs is much less than the benefit of higher ASPs in USD terms. This is because: 1) costs are a smaller percentage of overall selling price 2) Apple enters into long-term supply agreements and also has significant leverage over suppliers 3) China’s currency is fixed to the USD as it prefers a weak currency to support exports.
In summary, Apple faced currency headwinds for much of FY09 which I expect will turn into tailwinds for FY10. This factor hasn’t been mentioned much in the investment community. A weak dollar will boost ASPs (in USD terms), hence international revenue growth as well as lift gross margins. Apple could also choose to take advantage of the weakening dollar by cutting prices where it sees elastic demand. Therefore, I expect GM will continue to show strength aiding in the growth of Apple’s bottom line.
Apple (nasd:AAPL) reports its Q4 2009 results on Monday, October 19th. I am expecting revenue to increase 19% (Y/Y) to $9.374B and EPS to increase 25% to $1.57. I expect gross margin to rise sequentially to 36.7% from 36.3% reported in Q3.
Revenue growth will be driven by strength in the iPhone, iTunes, and software segments. Mac units sales will be up (Y/Y), but Mac ASPs will be down resulting in slightly lower Mac revenue (Y/Y). iPod revenue will be down 10% due to lower unit volume and ASPs.
Earnings growth will be driven by the higher sales mix of high-margin products such as iPhones and software.
Apple Inc. (nasd:AAPL) $162.83- Despite Apple shares rising more than 100% from its 2009 low of $78, the stock still appears to be attractively valued especially as a long-term holding. Using cash-flow and non-GAAP earnings, AAPL trades at less than 15x on a trailing 12-month basis. Since sales and cash flows were likely significantly depressed over that time period due to the sharp economic contraction, demand should improve considerably in the quarters ahead. Thus, forward multiples would be even lower given the anticipated rebound in sales and earnings growth.
The modest price multiple at which AAPL currently trades leads me to conclude that investors are: 1) Attributing the slowdown in Mac and iPod segments to a permanent secular decline, rather than temporary weakness consistent with economic contractions. 2) Ignoring/underappreciating the growth potential of the iPhone and products yet to be introduced.
Non-GAAP Earnings & Cash Flow:
Apple has reported $5.72 GAAP EPS for the past 4 quarters combined (ttm). However, over the same period, Apple has earned $9.23 in non-GAAP EPS (ttm). The non-GAAP figures are a better representation of Apple's earnings power since iPhone revenues are recognized in the period sold and not deferred over a 24 month time frame as is the case with GAAP EPS. The GAAP EPS numbers grossly understate Apple's profitability and cash-flow generation.
Looking at the difference between GAAP revenue and non-GAAP revenue for the past 4 quarters, GAAP revenue would be $7.7B higher, or 22.3% if Apple were not required to account for iPhone sales using the subscription method. Reported EPS (ttm) would have been $3.51, or 61.4% higher as well. The most noticeable difference is the effect iPhone sales have on profit margins. Since the iPhone carries the highest margin for Apple hardware, there is a dramatic impact on gross and net margins when subscription accounting is reversed. Gross margin rises from 35.5% to 39.6%, and net margin increases from 15.0% to 19.7%.
GAAP Revenue (ttm) has increased 12.2% compared to the prior trailing 4 quarters, yet non-GAAP sales increased 29.7%, more than double the rate of GAAP revenue growth. GAAP earnings growth (ttm) versus the prior 4 quarters was 11.7% ($5.72 vs. $5.12). However, non-GAAP EPS (ttm) increased 66.3% ($9.23 vs $5.55) compared to the same period for the prior year.
From June 2008 to June 2009, Apple's cash holdings increased $10.35B, from $20.77B to $31.12B. On a per share basis, cash/share increased $11.38, or 50% from $22.85/share (June 2008) to $34.24/share (June 2009). Apple generated $10.26B in free cash flow over the last 4 quarters, or $11.28/share.
It is clearly evident that the reported GAAP figures widely understates Apple's true performance. Therefore, investors should focus on the non-GAAP numbers and cash flow when evaluating Apple.
Valuation Metrics:
Even though stock values reflect future cash flows, we can examine Apple's performance over the last 4 quarters (ttm) to use as a conservative proxy since the recessionary backdrop has most likely depressed revenue and earnings. Apple's GAAP EPS (ttm) of $5.72 translates into a historical P/E (ttm) of 28.5x. That would appear to be quire a rich valuation, especially given the multiple compression that has occurred in the overall equity market. Or, at least, imply significant future growth.
However, investors should know that evaluating AAPL based on GAAP accounting is completely flawed. To compare apples to apples, investors must gauge Apple using its non-GAAP figures relative to peers/market. Apple uses subscription accounting methods to account for iPhone sales which spreads handset revenues over 24 months by accruing unrecognized revenue in a deferred revenue account that is stated on its balance sheet. Apple's non-GAAP EPS (ttm) is $9.23 which equates to a trailing P/E of 17.6x. That is a stark difference than the misleading GAAP P/E of 28.5x.
Considering that Apple has $34.24/share in cash & securities that could theoretically distributed to shareholders, Apple trades at even a lower multiple based on non-GAAP EPS ex cash. If we strip out $34.24 cash/share from AAPL's $162.83 share price, we are left with $128.59/share which essentially reflects the value of Apple's operating assets. In addition, interest income must be stripped out of earnings before calculating a P/E multiple due to the assumption that the cash stockpile would be distributed, hence no longer contributing interest income to EPS. For the trailing 4 quarters, Apple earned 33 cents per share (after-tax) in interest income. Apple is trading 14.4x ex-cash (ttm) based non-GAAP EPS ex-interest income of $8.90.
When there is a large disparity between interest yield (interest income/cash) and earnings yield (EPS/Price or 1/PE), the large cash balances can skew the value of the (non-cash) operating assets. When short-term rates were over 5% (pre-tax) and Apple traded at 20+ multiple, the earnings yield was roughly equivalent to the cash yield. Therefore, there was little or no difference between the standard P/E and P/E ex-cash & interest. Now that current short-term rates are near zero, Apple's cash holdings contribute very little income to total company earnings.
If Apple used its $31.1B for a stock buyback, it could reduce share count by 191M to 718M. Non-GAAP EPS (adjusted for interest income) would rise to $11.21 translating into a P/E (ttm) of 14.5x.
In the past year, Apple's cash position has increased by $10.35B or $11.38/share giving a P/CF (ttm) of 14.3x. Trailing free cash flow was slightly less at $10.26B giving a P/FCF (ttm) multiple of 14.4x. Removing the value of cash and interest income (from share price & FCF), the P/FCF multiple drops to 11.7x.
Recall that this valuation exercise has been based on historical earnings, not expected future earnings which is more appropriate since investors only care about future cash flows. However, I used trailing earnings since those figures are known while future earnings are not. I am confident that Apple's next 4 quarters will be better than its previous four. The economy has been in a deep recession for the past year, but has begun to improve. Apple has managed to withstand the downtown reasonably well; and with the success of the iPhone/App Store along with the possibility of new products, Apples growth should accelerate moving forward. Thus, I am reasonably confident that Apple's valuation multiples are even lower on a prospective basis.
Price Implied Expectations:
Trading for less 15x trailing earnings and ~12x expected earnings, AAPL on the surface appears cheap. Historically AAPL has traded at much higher valuations, yet expected growth was much higher too. In addition, investors are demanding a higher required rate of return on equities by paying lower price multiples. The increase in equity risk premium inherent in all stocks has led to the decline in P/E ratios. Investors perceive greater risks and are less sanguine about the long-run prospects of equity returns. This accounts for a portion of Apple's low valuation relative to its historical premium.
The primary reason why the investors are assigning a paltry price multiple is due to expected declines in Apple's growth rate. In my opinion, the current share price reflects the expectation of Mac growth commensurate with the industry average, declining iPod growth, and iPhone growth that will peak and rapidly decline to the industry average in a couple years. In short, Apple is priced as if its growth is quickly maturing, such as MSFT or DELL who both saw their margins compress as growth stalled. All firms eventually fall victim to the industry/firm life cycle. However, is this expectation likely for Apple's future? That is the key question.
I don't believe that overly optimistic or unrealistic expectations are priced-in AAPL shares. I believe the current outlook implied by the share price is conservative, but not entirely unlikely. The future of Apple's growth hinges on innovation and new products/services, as it does for most firms. Many firms are unsuccessful at being able to continue to innovate, staying relevant and avoiding being commoditized. In short, Apple's share price doesn't give much value to its ability to innovate and reignite growth. In my opinion, it's the belief whether or not Apple can continue to introduce products that wow consumers that determines if AAPL is over/under valued.
Apple's Record of Successful Innovation and Execution:
1)iPod's Dominant Market Share-
Apple's unit market share has exceeded 70% in the U.S. for years as it has successfully continued to ward off competition leaving carcasses by the wayside. Many powerful companies such as Dell, Sony, and Microsoft have attempted dethrone the iPod only to fall short or outright fail. Apple has been able to keep iPod prices relatively high as its revenue share of the U.S. PMP market is higher than 90%.
2)Apple's iTunes store is largest music retailer-
Tunes surpassed Best Buy and Wal-Mart to take the top spot is sales volume. Apple should increase its lead as bricks and mortar stores cutback on music selection due to high inventory cost and required floor space. Demand for physical music continues to decline as consumers shift to buying digital music online. Competitors have followed with online music download stores, yet they have made little dent in iTunes market share.
3)Retail stores generate highest revenue/sq.ft. and foot traffic-
It's quite indisputable that any retail strategy has been as successful as Apple's retail stores. Apple leads in performance metrics such as revenue/sq.ft. and visitors/store etc, but its retail strategy also has been extremely successful in promoting its brand and introducing customers to its products. Other computer makers' retail efforts have failed, such as Gateway and Dell. Many third-party computer and electronics resellers have also disappeared, such as CompUSA and Circuit City. It's quite evident that it's a very challenging environment to navigate. Apple continues to open new stores and is expanding considerably abroad.
4)Turn-around of Mac business and domination of premium segment:
Mac unit sales increased 38% in FY08 and 40% in FY07, which was more than 3x the PC industry as a whole outpacing the industry in 18 of the last 19 quarters. Even though Mac unit growth has slowed to single-digits, its share of the premium price segment has exploded. According to NPD, Macs made up 91% of sales for PCs priced $1000 and above for June 2009, up from 88% in May. This compares to 66% share Mac had in Early 2008. I believe Apple had about 40% share of the premium market in 2007. It is quite evident that Apple is the only PC manufacturer than can command a premium for its products.
5)Large and increasing share of smartphone market-
Even with the experience and industry footing incumbent mobile handset makers possessed, Apple was able to enter the market and quickly gain share. According to several surveys, the iPhone has the highest satisfaction rates by a considerable margin. Industry competition is very intense, yet Apple is the one to catch in the smartphone segment.
6)iTunes App Store-
One year after launching, the iTunes App Store offers 65K applications and has seen over 1.5B downloads. Other firms have followed with their own mobile app stores, yet haven't been able to duplicate nearly as much developer and consumer interest. Nintendo mentioned last quarter that Apple's App Store is impacting its handheld gaming business.
These remarkable achievements illustrate a common theme. Apple has been able to enter new product markets and become the leader that others must chase. Even though many competitors have attempted to duplicate Apple's strategy, most have had hardly much success, at least in terms of stealing business from Apple. A popular concern among Apple investors is that increasing competition from the number of firms following in Apple's footsteps. They believe that others will eventually catch Apple (iPhone, App Store, iTunes Music),hence its lead is only temporary. However, this has been a concern for ages and yet to come to fruition. That is not to say it won't happen as there is a real possibility that it will eventually. But given Apple's proven track record of disrupting, dominating, and defending its new endeavors, it's likely Apple will remain the innovative leader for sometime.
Apple's share price may reflect declining iPod growth and decelerating Mac growth, but it doesn't reflect potential new products which are a certainty. The success of those new products are less certain, but Apple makes products/services that complementary to its others, rather natural extensions. Basically, Apple products help drive sales of other products as well as increasing switching costs creating customer "lock-in."
Apple's products elicit the some of the highest customer satisfaction scores for their respective categories which has created immense loyalty and a powerful brand.
Conclusion:
On a non-GAAP basis ex-cash, Apple is trading at less than 15x trailing EPS. Considering the economy has been going through the worst economic downtown since the Great Depression, Apple's trailing earnings are depressed. As the economy turns up, earnings will normalize at a higher level. In addition, iPhone sales should continue to exhibit strong growth and drive free cash flow. Therefore, investors should be highly confident that future earnings will be considerably higher. On a forward earnings basis, AAPL's price multiple is 10-12x, a valuation representative of maturing growth. However, Apple has a long track record of innovation and using products to promote and attract consumers to its other offerings. Looking at the many remarkable achievements by Apple any the many stumbles by competitors, it can be argued that AAPL deserves a premium multiple, not a multiple reflective of ordinary growth.
Margins held steady Q/Q at 36.3% (down 10 bps) versus expectation of ~200 bps of margin contraction due to mounting headwinds.
Management issued Q4 GM guidance of 34%, 100 bps higher than Q3 33% GM guidance (which AAPL exceeded by 330 bps).
Considering the number of challenging cost environment Apple's Q3 performance and Q4 GM guidance are huge positives.
(1) Apple was able to maintain gross margins for Q3 and (2) According to Apple's guidance, I expect GM to hold in Q4.
The past two quarters have seen a significant lift in gross margins compared to the 3 periods prior (3Q08-1Q09) in which GM held steady at 34.7%. The rise in GM has be a major factor in the near doubling of the stock price since the January low. In the 2nd half of FY08, management started a chorus that it expects 30% GM for FY09. Even when GM turned out to be healthy for Q1 & Q2, Apple maintained its 30% GM outlook. This had many analysts and investors worried.
Last October, I reported Apple's FY09 Gross Margin Expectations Too Low arguing that GM will for FY09 will come in way above the 30% guidance. In January, I wrote Apple's FY09 EPS Estimate Too Low stating that the forecasted decline in FY09 EPS by analysts wasn't not going to happen and that earnings should increase by at least 5-10% versus FY08. (For the 3 quarters already reported for FY09, EPS is up ~8% versus the same 3 quarters for FY08.) The main thesis was gross margins would come in significantly above expectations mostly due to high margin iPhone revenue becoming a larger share of total sales.
1) Mitigated numerous factors pressuring margins.
- Transitioned entire notebook line.
- Cut prices across entire notebook line and/or added increased performance.
- Back to School promotion (Mac discounts plus free 8GB iPod touch).
- Revenue mix shifted towards lower margin Macs from weak business spending affecting the Mac Pro line.
- Component prices increased, coupled with higher commodity and energy prices.
Apple repositioned its entire notebook line, cutting prices significantly on Macbook air, and on 15" and 17" inch Macbook Pros. Apple also introduced 13" Macbook pros in place of the older aluminum body Macbooks. Macbook prices were cut anywhere from $100-$300. In addition, Apple kicked off its "Back to School" program that offers discounts on Macs plus a free iPod touch valued at $229. As a result, coupled with weak business spending, revenue was skewed towards the lower-margin models.
2) Guidance of 34% translates into GM likely coming in the 36%-38% range.
- Past 4 quarters GM has exceeded guidance by an average of 370 basis points.
- GM guidance has increased sequentially 3 quarters in a row. (2Q-32.5%, 3Q-33%, 4Q-34%)
Apple has routinely sandbagged on GM guidance by and average of 350 bps over the past 11 periods, and 370 bps for the last 4 quarters. In addition, over the past 10 quarters, when Apple has raised guidance sequentially, GM either rose or remained flat sequentially except for one instance. The scatter plot of change in guidance on x-axis versus change in actual GM on y-axis demonstrates managements accuracy in forecasting GM at least with respect to direction. Therefore, we can expect GM will up or at least flat in Q4 even in light of the challenging headwinds.
iPhone Contribution:
The profitability of the iPhone has played, and will pay a major roll in Apple's overall gross margins. Since Apple refuses to comment about product level margins, the iPhone's significance is often missed. Apple neglects to mention the iPhone angle due to the fact it doesn't want to discuss product level gross margins. The reasons for doing so are vast: firms desire to "cry poor" for the more money they rake in, the more money others will want to get a piece of. This extends to customers, carriers, suppliers, and competitors. Apple repeatedly exclaims it doesn't want to create an "umbrella" that would attract competitors to enter and undercut it. Therefore, much of the GM upside has been due to iPhone revenue being and increased percentage of total revenue, and since iPhone revenue is deferred, this trend will continue to intensify. I have been writing about this effect for nearly a year.
According to my Apple model, (which is i consider accurate being that its EPS variance has been 4 cents, 2 cents, 1 cent, and ZERO for the past 4 quarters) iPhone contributes an equal amount to EPS as does the Mac segment, and will surpass Mac's EPS contribution in the quarters going forward.
In Apple's 10-Q filings, it breaks out deferred revenue and deferred costs for iPhone and AppleTV reported on the balance sheet. Since AppleTV is a minute sliver of deferred revenue it is assumed that its impact on total deferred revenue (AppleTV + iPhone) is immaterial.
Looking at 4Q07, GM of deferred revenue (1- (deferred costs/deferred revenue)) is 27.5%. It was low since Apple received monthly revenue payments in place of an upfront subsidy as is the case today. 4Q08 comprised of the first quarter of subsidized 3G handsets, thus the bump in GM on the DR/DC on the balance sheet. Notice the non-current GM of 51.9% is 6.5% higher than the 45.3% GM of the current. This results from the non-current bucket comprising of a larger mix of 3G iPhones since much of the legacy (2.5G) iPhones have migrated to the current bucket.
Examining the trend, we can see that GM in the current bucket improves dramatically, at a much faster pace than the non-current bucket. This is due to the mix of new iPhones becoming a larger overall mix in the current bucket, whereas the non-current bucket is already majority of newer iPhone sales. The overall result is than GM are approaching near 60%, which I estimate iPhone GM is currently. This is evidenced by the rising GM Q/Q, especially in the non-current bucket which is impacted more by current sales.
My bottom-up iPhone gross margin estimate is 58.4% for the assumed mix, with the iPhone 3GS 32GB garnering the highest GM and the iPhone 3GS 16GB carrying the lowest of the 3 models.
The Bottom Line:
Deferred revenue as stated on the balance sheet has been increasing substantially. The gross margin attached to this deferred revenue has also increased significantly. Thus, going forward Apple will recognize higher iPhone revenue carrying a higher gross margin. As iPhone revenue as a percentage or share of total revenue increases, the impact of the higher iPhone GM on overall GM will intensify. This will assuage margin pressures Apple faces in other areas.
I wrote last year that the iPhone would cause Apple's overall GM to skyrocket, but I also posited another possibility. Apple would use iPhone GM to subsidize price cuts on other products to stimulate demand and ultimately avoiding an adverse impact on overall GM associated with such price reductions. As we just witnessed, Apple cut prices on its Mac line-up, and there hasn't appeared to be any noticeable impact on overall GM. Going forward, Apple is guiding Q4 GM to 34%, suggesting GM in the 36%-38% range, thus there doesn't appear that these price reductions will have a dramatic impact on its overall GM.
Apple Inc (nasd:AAPL) For some time, many have speculated about an arrival of a $99 iPhone. Some analysts expect a low-cost model with scaled back features, such as 2.5G instead of 3G, no GPS, and possibly a smaller form factor. While I believe a lower iPhone price point is possible, I don’t expect Apple to go backwards by removing features that reduce device functionality to achieve a lower-cost offering. The price of the handset is much less significant than the lifetime cost of the required $30/month data plan. Therefore, crippling device functionality to lower handset price makes no sense when the primary cost component is the data plan.
I believe if Apple were to pursue reducing the price of the iPhone to the consumer, it should first explore offering alternative pricing that doesn’t necessarily lower selling price and margins. Offering cheaper data plans that coincide with less usage would allow consumers to be able to pay according to usage, rather than being required to pay for unlimited when their usage is actually quite limited. Carriers would apply less subsidy and charge more for the handset, yet consumers would still save over the life of the contract. Carriers would still benefit from increased demand even though ARPU may not be quite as high. Carriers could capture the iPod touch demand that arrises from those who wish to avoid the required data plan.
Low-Cost Model With Less Features- Unlikely: While unit demand increased dramatically from previous price reductions, ($599 - $399, $399 - $199), I don’t expect unit demand to be nearly as responsive to a $100 price reduction, from $199 to $99. At this price level, demand elasticity begins to evaporate, as consumers are less responsive to further price cuts. At $199, the iPhone is competitively priced, opposed to when it was priced out of the market at $599. The bulk of the pick-up in demand from cutting handset price has already been realized.
Reducing hardware cost is another challenge. Eliminating or scaling back certain features through cheaper or fewer components won’t significantly impact build costs. The obvious modifications that many have cited are removing GPS, 3G baseband, and installing less flash memory for media storage. These actions would likely only lower component cost by $15-$20. Additional cost reductions could be brought about with a smaller form factor, however the savings wouldn’t be great enough to offset the burdens it would create on the software development side.
Perhaps the most crucial aspect is it’s the cost of the service plan, not handset, that is the most costly. The iPhone requires signing a 2-year contract for the $30/month smartphone data plan. Over the life of the agreement, this amounts to $720. For those who currently have a $15/month data plan for a non-smartphone device, the incremental difference over 24 months is $360. However, AT&T offers a bundled unlimited text & data plan for non-smartphone devices for $30/month, instead of $35/month ($15 data + $20 text), which raises the monthly price difference to $20, or $480 over 2 year contract for those affected customers. AT&T subscribers who use a smartphone other than the iPhone wouldn’t pay more since the price of the data plan is the same as the iPhone.
Lowering the iPhone handset price by $100 accomplishes little in the sense of affordability due to the $720 24-month cost of the required data plan. I frequently track online discussion forums (such as AT&T iPhone support) as an informal survey tool. The amount of discussion regarding the iPhone handset price pales in comparison to the required data plan. People tend not to have any problem with the $199 price, but are very vocal about the recurring $30/month for the data plan. In fact, there have been a couple individuals who weren’t adverse to pay $399 since they weren’t eligible for an upgrade, but were inquiring if there were a way to circumvent the data plan requirement. There is little evidence suggesting a $100 price drop will have a profound impact due to the large number of consumers who find the data plan requirement inhibitory.
Reducing the data plan fee, or eliminating the requirement altogether, would have the most substantial impact on demand. The problem with this alternative is that Apple receives a ~$400 subsidy based the higher ARPU generated by the data plan. Therefore, if the iPhone ARPU were to decrease from reducing the price of the data plan, then the iPhone subsidy would decrease as well.
Assuming that hardware costs can be reduced by $50, and the subsidy falls to $200 from $400, gross margin would decline to 33% from 58%. In order for earnings to increase, unit volume would have to rise by a factor of 3.5x.
Assuming a more generous subsidy of $250, perhaps with required $10/month plan, gross margin would only fall to $43%, but volume would have to increase more than 2.3x.
A scenario where a $20/month data plan produces a $300 subsidy, gross margin would only drop 800 bps to 50%, and volume would only have to rise 75% to be cash flow neutral. However, consumers still face an incremental $480 increase from the data plan, which will limit the impact on demand.
Even if the economics of reducing hardware and service costs were to make sense, there are other issues. Crippling device functionality takes away from the user experience, which is the primary focus of Apple products. Substituting 2.5G would significantly worsen web browsing and video streaming.
The tests I have been conducting show iPhone 3G data speeds are currently 7-8x faster than 2.5G. In the months following the 3G iPhone release, speeds were only 2-3x faster than EDGE. Obviously, AT&T has made substantial progress in improving its network, which significantly enhances the iPhone user experience. With many competing devices beginning to offer 3G, a slower iPhone might damage consumer perception and lessen its appeal. The iPhone is designed for heavy internet usage, thus a much slower connection would dramatically lessen the iPhone experience. This move would probably only save $5-$10 in hardware costs.
Removing GPS would only save ~$5 in component costs as iSuppli lists the price of the GPS radio at $3.60, and the impact on user experience would be considerable. Many apps are designed around the user’s current location, which requires GPS to obtain an accurate position. The integration of location services with other iPhone features is a major factor that differentiates the iPhone from other devices. Therefore, without any real cost benefit, offering a model without GPS makes no sense.
Altering the form-factor is another alternative for reducing costs. A smaller device could reduce hardware costs to a degree, yet it would require a relatively large size reduction to meaningfully affect hardware cost. This would pose several challenges. Apps are developed for a specific display size, thus duplicate versions may be required to accommodate different displays. The challenge may be further exacerbated due to input commands being handled by the multi-touch display. Therefore, modification may be needed not just for output, but input as well. In addition, a smaller viewing area would reduce the user experience, and a smaller area for input commands may cause navigation to suffer. To achieve meaningful savings, the handset size would have to be reduced to a point at which the user experience would highly suffer.
I don’t believe there should be any change to the iPhone hardware since potential cost savings are rather insignificant. The only exception would be offering 2.5G models in markets where 3G is unavailable as long as it were accompanied by a cheaper data plan. This might help spur demand in non-3G markets where consumers must pay $30 for 3G service and aren’t even able to take advantage of the faster speed.
Possible Alternatives: The best course of action would be to offer multiple data plan choices, and adjust the handset price accordingly by applying less subsidy. The consumer would have to pay more on the front-end, yet would save money over the 24 month agreement. A cheaper data plan results in less handset subsidy which would be absorbed by the consumer. Thus, it wouldn’t affect the economics of the iPhone with respect to Apple, yet it would provide flexibility for consumers. If a particular individual plans to use very little data, then he/she could select a cheaper plan with less data usage included. They would pay more for the handset, but would still save money over 2 years from the cheaper monthly cost of the data plan. The savings will come at the expense of AT&T, yet it’s not a real expense, rather the opportunity cost of not receiving $30/month for the unlimited data plan. However, this could be offset (or overcome) with sufficient increase in demand.
A scenario with a $10/month data plan would raise the handset price to $349, a $150 increase, but reduce lifetime service fees by $480. Including the price increase of the device, net savings over 24 months is $330. A second scenario with a $20/month plan for heavier data usage would increase the iPhone price $100, to $299, but lower service fees $240 over 2 years, resulting in net decrease of $140. If an individual pays the extra $100 for the cheaper $20/month plan, and later decides he/she needs the unlimited data plan, the carrier could offer a $25/month instead of $30/month since $100 was collected on the front-end. If one wanted to switch to a smaller data plan, then the handset discount could be recovered from lowering the monthly fee by less than the full amount.
There is one scenario of a low-cost model that I do think is a possibility. Bernstein Research’s Toni Sacconaghi has broached the idea of an “iPod phone” which makes a lot of sense. The premise is that music is moving onto many basic mobile phones which may pose a threat to iPod sales. The concept of a converged device means that users won’t prefer to carry both a phone and an iPod. For those who don’t want an advanced phone with internet capability, such as the iPhone, but want a media player combined with a basic mobile handset, an “iPod phone” would be a suitable match. Essentially, a iPod classic or nano could be married with a basic mobile device that wouldn’t require a data plan. Possibly, it may offer some “widgets” such as stocks and weather, but not email or internet browsing. The sole purpose would to counter iPod defection from those using their mobile phones more and more as a music player. I don’t foresee such a device anytime soon, however it remains a viable possibility down the road.
I do believe a $99 iPhone is inevitable. However, it wouldn’t be a “low cost” model, rather Apple could offer the current iPhone model for $99 in light of an introduction of new advanced models. I expect new iPhone models to arrive this summer, which will have faster processors, and advanced graphics chips that will allow multiple apps to run simultaneously and video capability. There has been an un substantiated rumor that AT&T might buy back iPhones since current 3G owners would be ineligible for a subsidy on a new iPhone model if one were to come this summer. These phones could be sold for $99 or less. AT&T has been running deals for $99 on refurbished iPhones.
Apple’s iPhone Vision: Management has stated it doesn’t intend making an iPhone for everybody. Apple says it isn’t interested in selling the most units, but rather committed to being the leader in the market segment it prefers to serve. Comments from Apple contradict many pundits and analysts that claim the firm is limiting the iPhone’s potential by addressing such a small portion of the overall mobile handset market. However, Apple is a company that demonstrates patience. Steve Jobs once said rather than crossing a river to get to someplace else, Apple waits for the other side of the river to come to it. The smartphone market is growing considerably, thus there isn’t much reason to stoop down into the basic handset market that will be contracting.
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