Quick Thoughts: AAPL -There is No iPhone Supercycle. Now What?

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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February 9, 2018

Quick Thoughts: AAPL -There is No iPhone Supercycle. Now What?

  • AAPL’s strategy and execution for mining sales growth from the maturing smartphone market have been extraordinary, but 1QFY18 results suggest little further runway.
  • From its launch, the AAPL methodically pulled iPhone growth levers – new carriers, new countries, new form factors, new accessories, new services, and most recently, higher price points.
  • A much-ballyhooed product refresh has not yielded an upgrade “supercycle” – units are down in a down market and upgrade intervals grow longer without explicit carrier subsidies.
  • The 14% ASP boost will not be available again next year, smartphone demand will continue to soften, and Other Products/Services are small and tied to decelerating installed base growth.
  • We believe sales estimates for FY18 and FY19 remain optimistic. Spending all the $163B in net cash on buybacks could give a nearly 25% 1-time boost to EPS, but remove one last earnings lever.

Apple’s pitch-perfect handling of the iPhone has driven legendary growth. First introduced in 2007, the iPhone grew fast out of the gate, despite carrier exclusives limiting its distribution. With the expiration of those exclusives, new carriers drove an acceleration in 2010. Geographic expansion, including the top carriers in Japan and then, China, kept it going through the early 2010’s. The iPad, packaging iPhone technology into a new form factor, also hit in 2010. By 2014, with iPhone growth notably sluggish and Apple shares in the doldrums, the franchise needed a new jolt of energy and got it as the company broke with its previous commitment to a single, small form factor.

The iPhone 6 and 6+, with their phablet-sized big screens, were just what the market wanted. This was the “supercycle”, satisfying customers who were waiting for Apple to match the big Android phones from Samsung and pulling a LOT of future upgrades forward. The next two seasons brought a wave of incremental iPhone enhancements (e.g. 3D Touch), new services (e.g. Apple Music), and accessories (e.g. Apple Watch). Even so, company sales were down sharply in the hangover year, post-iPhone 6, then up modestly in FY2017 – those incremental iPhone models weren’t driving upgrade demand and the services and accessories sales were just too small to really move the top line. Eyes were on a new “supercycle” expected with the FY19 iPhone models.

The new iPhones were revealed in September. The 8 and 8 Plus looked exactly like the iPhone 7 and 7 Plus delivered a year earlier. The changes were internal and subtle – a faster processor, a better camera, some software bells and whistles – but the price tag was $50 higher. The real innovation was saved for the iPhone X, which nearly eliminated the bezels on all four sides of the screen, radically eliminating the iconic home button in favor of a new set of user interface gestures and facial recognition. That Face ID system necessitated the infamous “notch” at the top of the X screen. For all this, Apple would charge a $200 premium. Price elasticity would be the new lever to drive revenues.

So far, the results have been meh. Apple made its consensus targets for sales and earnings, but iPhone unit sales were down YoY (N.B. an unusually high channel fill more than offset the impact of the 14-week year ago quarter) and guidance for 2QFY18 was weak (Exhibit 1). The iPhone ASP was up 14% to $796 in 1QFY18 on the higher priced 8, 8 Plus and X – can that level be sustained? It is possible that the price inelastic superfans have already bought their new models in the first months of availability, and sales will drop off sharply until the next product introduction. If this is the case, unit sales could be weak all year and the cheaper phones could rise in the mix in the back half. The sell side has begun to downgrade the stock and reduce estimates.

Soon, Apple investors will turn their full attention to this coming September, when the iPhone XS, or iPhone X Plus, or whatever it will be called, debuts. What levers can Apple pull to drive further sales growth in the increasingly moribund smartphone market? Carrier and geographic expansion are off the table – there are no more new territories to enter or carriers to sign that would make a difference. True share gains – not just momentary volume discrepancies driven by staggered product release schedules and temporary accelerations in upgrades – are hard to achieve when the premium market is saturated. In any case, recently trumpeted Apple innovations, like 3D Touch, HomeKit, HealthKit, Apple Pay, etc., haven’t triggered much brand switching, and the newest stabs at differentiation – ARKit, FaceID, Animojis and the like – do not seem to be moving the needle either. Line extension, moving down market to address the large and still growing market for cheaper smartphones, is anathema to the company’s culture and its brand strategy. Further average price increases, beyond the 14% delivered in 1QFY18, seem farfetched given the weak unit sales in conjunction with this price hike (Exhibit 2). A sharp acceleration in replacement would only be borrowing tomorrows upgrade sales for today – plus nothing posited as possible for the next round of product intros seems sufficient to stimulate a “supercycle” anyway.

Apple has had success in introducing companion products, all of which are integrated into the company’s walled-garden architecture with the iPhone at its center. Beyond pricey accessories like chargers and earbuds, Apple TV was an early foray in branching out. While surpassed in popularity by the Roku TV box, gaming consoles (i.e. PS4, Xbox) and dongles (i.e. Chromecast, Amazon Fire), Apple’s TV hobby has a base of more than 30M users that buy video streaming and other services. The Apple Watch line, now nearly three years in the market, sold nearly 18M units in 2017, at an average price somewhere north of $300. Apple bought Beats in 2014 for $3B, both for the company’s trendy headphone business and for the music industry savvy of founders Jimmy Iovine and Dr. Dre. Perhaps this purchase added some IP that was useful in launching the successful Air Pod Bluetooth earbuds a year ago. Still, all together, Apple’s Other Products category – TV, Watch, Air Pods, etc. – is only a bit more than 6% of the company’s revenues. Even if sales were to accelerate wildly, it wouldn’t move the needle for a long time.

Services are the other great hope for Apple investors. In 1QFY18, Apple Services posted revenues of $8.5B, up 18% YoY, most of it from 3rd party sales in the App Store and Apple Care service contracts, but including Apple’s own cloud applications – e.g. Apple Music, iCloud, and Apple Pay as well (Exhibit 3). We are not enthusiastic that the double-digit growth in this segment can be sustained without growth in the underlying installed base. App Store sales and Apple Care contracts seem inextricably to that base, while the

Exh 1: iPhone Revenues and Unit Sales, 1FQ14 – 1FQ18

Exh 2: iPhone Historical Average Selling Prices, 1FQ11 – 1FQ18

Exh 3: Apple Services and Other Products Segment Revenues, 1FQ15 – 1FQ18

Apple cloud applications are mediocre when compared to market alternatives. Moreover, while growing faster than the company, services are still Apple will need to get a LOT better at designing and implementing cloud services before we will be enthusiastic that services will be the long-term answer to stagnant iPhone sales.

That leaves us with wilder suppositions. Apple has $163B in net cash, and plans to reduce that to near zero via share buybacks, dividends and selective M&A. Some observers have suggested the company might drop $75B on Tesla or $140B on Netflix. Given Apple’s long avoidance of big deals, we think such talk is nearly delusional (http://www.ssrllc.com/publication/quick-thoughts-whos-buyin-who/). Apple may try to frame its $3B deal for Beats as successful, but with the recent departure of Iovine and the slow uptake of Apple Music – still behind Spotify in subs despite the HUGE advantage of the iPhone’s walled garden – suggests otherwise. We would expect small deals to buttress internal product initiatives rather than a jumpstart acquisition to leap into a market later in the game.

Those internal initiatives have also spurred a cottage industry of speculators. A few years ago, analysts were certain that Apple would launch a revolutionary TV. Then, it was a Apple designed and built car. The latest has Apple jumping into the autonomous vehicles market with its own self-driving system to be offered to OEMs. Certainly, Apple is a company of great skills. It’s processor development team, its operating software engineering, and its device designers are world best. Still, the company has not delivered a new product category significant enough to change its sales trajectory since the iPad was introduced in 2010. Given annual sales of more than $230B, any new product big enough to drive double-digit growth needs to add more than $20B in revenues. This is a huge bogie.

This is the context for Apple. Earnings will grow – a good portion of that $163B of net cash will be targeted at share repurchases, which at current prices could boost EPS by nearly 25% – but sales may not, at least not by very much. As the cash balances are spent out, as the moribund smartphone market challenges Apple’s ability to sustain margins along with market share, and as analyst estimates assuming top line growth are revised, it will be hard for the stock to outperform.

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