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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.

Monday, August 6, 2012

Estimating 2Q 2012 US Smartphone Sales

Last week, Strategy Analytics published its estimates for 2Q12 US smartphone shipments; however, they can't been seen as reliable due to a number of problems. Whenever I read research or an article, or hear somebody quote market share figures from the large industry research houses, such as IDC, Gartner, Strategy Analytics, or Canalys, I cringe. Too often, I find wide disparities between these industry estimates and the numbers I know to be true- figures reported by manufacturers, carriers, resellers, etc. in press releases, SEC filings, and on conference calls. Another problem is that these research firms give little public explanation behind their methodology. A better framework is to first calculate sell-through, or sales to end-users which the top 4 carriers provide smartphone unit figures. These aren't 3rd-party estimates; they are actual sales figures from the horse's mouth. Since these numbers can be attained with a high degree of confidence, we can then hash out shipment estimates based on analyzing market and seasonal trends, as well as incorporating any guidance available from vendors and carriers/resellers. 

Strategy Analytics 2Q12 US Smartphone Shipment Estimates:

source: Strategy Analytics

The first problem with SA's Q2 US shipment estimates is that its figures for Apple aren't shipments, they are sell-through. The 7.9M unit shipment estimate for Apple is the sum of activations reported by AT&T, Verizon, and Sprint. To be consistent with measuring shipments, as we assume SA is doing for the other OS platforms, sales to iPhone carriers and resellers (i.e. Best Buy, WalMart, Radio Shack, etc) need to be measured. 

Second, the activation figures used only include 3 carriers, however iPhone is available through 16 carriers in the US. Even though these carriers are very small and many weren't online during the entire quarter resulting in relatively low activations, there would be considerable iPhone shipments into these channels due to the need to build a stock of initial inventory.    

SA is assuming that iPhone shipments equals sell-through. Apple reported that channel inventory declined by 300K globally, hence 26.3M units sold-through versus the 26M units shipped. Apple specifically stated that China shipments were impacted from a reduction in channel inventory which was high at the start of the June quarter due to the iPhone 4S launch at China Unicom and the addition of China Telecom in the March quarter. Therefore, sell-through in China was significantly higher than sell-in (shipments) which resulted in the reduction of channel inventory. Apple stated the China channel inventory impact was more than $1B of iPhone revenue, which would equate to more than 1.5M units. Therefore, channel inventory had to increase by 1.2M units outside of China to equal the net 300K decrease in global channel inventory. Given that Apple added 12 carriers in the US, coupled with only a 12% sequential decline in activations at the top 3 carriers, we can attribute much of the 1.2M channel inventory build to the US.    

Third, we know the 7.9M figure for 2Q12 and the 5.9M figure from 2Q11 aren't the correct numbers to use. Tim Cook stated on the conference call that iPhone sales were up 47% year over year in the US. Using the activations figures as SA did, the Y/Y increase is only 34%. Therefore, we know that shipments don't equal the activation, or sell-through numbers that SA incorporates. 

So for SA's estimates to be reliable, or even taken seriously, they must be consistent in what they are measuring. If they are measuring shipments, then SA should use shipment figures for Apple, not sell-through. Obviously, shipment numbers are a lot harder to ascertain than sell-through figures since US carriers report smartphone sales or provide metrics to calculate it. 

Using the erroneous activation number, SA calculates that Apple captured 33% of shipments. SA also says Android shipments were 13.4M units and RIM shipped 1.6M units. Where or how did SA come up with these figures? We know the RIMM figure doesn't make sense. Taking the revenue numbers RIMM reported for the US for the May quarter, and adjusting for June month being much weaker than February, ASP's are highest in US, and significant portion of service revenue comes from high ARPU customers (such as enterprises) in the US, Blackberry shipments were most likely around 1M units, not 1.6M units SA estimates. So what about the Android number? That's a tough one to reliably estimate. However, we can make some meaningful assumptions for estimated shipments from sell-through estimates which are much easier to calculate given that carriers provide smartphone sales. Using the underlying trend of sales to end-users, we can then make assumptions of whether or not carriers & resellers would be increasing/decreasing or maintaining inventory levels.

Financial Alchemist 2Q12 US Smartphone Sell-Through Estimates:

AT&T & Verizon reported smartphone sales of 5.1M & 5.9M, respectively. Sprint stated that 81% of handset sales were smartphones, and given the upgrade rate and gross additions, Sprint sold around 3.3M smartphones. T-Mobile hasn't reported quarter results, but sold 2.5M in Q1, so estimating 2.4M units would likely be appropriate. Then comes the wild card: the other carriers.  They consist of very small regional post-paid players and national prepaid carriers which probably account for about for 30M subscribers. It's a hard number to quantify. It's also hard to quantify smartphone sales for those carriers as well. However, they only make up 10-15% of the market, and the percentage of smartphone sales is lower due to the high cost of hardware which isn't subsidized much for prepaid plans. A conservative estimate would be that the "other carriers" roughly resembles T-Mobile. 

In total, I estimate that 19.2M smartphone units were sold to end-users in 2Q12. SA estimates that 23.8M units were shipped, or sold into the channel. So is it reasonable that shipments exceeded sell-through by 4.6M? If sell-through were expected to increase by 4.6M units in Q3 it would, but it's very unlikely that it will by that much, if at all, for a couple of reasons. 1) Carriers are tightening their upgrade policies, charging higher fees and lengthening the time period until one is eligible for a fully discounted upgrade. 2) Smartphone penetration has reached over 50% at the top carriers  (62% at AT&T, 71% at Sprint), thus the pool of potential first-time smartphone buyers is shrinking. 3) Seasonality- typically demand softens in the summer, and gradually accelerates into the back-to-school period and holidays. Q3 generally sees the widest divergence between sell-in and sell-through as carriers build inventories. In sum, unit shipments likely exceeded sell-through slightly (20M units), or at best, only modestly (21M). The vast majority of any excess sell-in would consist of Android units, however. 

At the top 3 carriers, Apple captured 55% of smartphone sales to end-users. For the entire US Market, I estimate Apple's market share was 42%. In terms of share of sell-in, iPhone would likely only be lower by 2-3%. It's highly unlikely that it would be as low as 33% Strategy Analytics estimates. Estimating the sell-through for the other platforms is more difficult, since only Verizon provided Android figures. But taking data reported by RIMM and Nokia, as well as other company sources, unit sales and market share can be estimated with a modest degree of confidence.  

source: FA estimates, company reports

My method for estimating US smartphone sales mirrors the method used by Ben Evans from Ender's Analysis. In being conservative, I model a higher volume of unit sales to the other carriers (non-Big Four). 

In short, industry research firms such as the ones mentioned in the opening paragraph often don't produce reasonably accurate estimates. This instance is just one example of many where I have encountered considerable factual evidence to the contrary.  The best approach is to always take the figures reported by the industry players as we know that those are accurate. From there, we can make more reliable estimates with regards to the unknowns. 


Thursday, October 28, 2010

Warranty Expense Crimps Apple's Margins in 4Q10

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. 

Monday, January 25, 2010

FA Estimates for Apple (AAPL) Q1 2010

Apple Inc. (nasd:AAPL)- Apple reports Q1 2010 results after the bell today, January 25th.

Below are my expected numbers:

Tailwinds Q1 2010:
1) Improving economic environment and consumer spending.
2) New iMacs released in October.
3) iPhone expansion into China, Korea, and additional carriers in current markets.
4) iPhone 3GS channel fill due to supply constraints in Q4.
5) Strengthening international demand for Macs, iPhones, and iPods.
6) iPhone “halo effect” benefiting Mac demand.
7) USD weakening should lift ASPs from sales abroad.
8) iPod sales mix shifting towards touch models should lift iPod ASP.

Headwinds Q1 2010:
1) Unavailability of higher priced iMac models in December.
2) GM pressure for shipping costs from iMac refresh.
3) Higher provision for warranty expense stemming from defective 27’ iMac units.
4) iPod product life cycle maturing, potential market nearing saturation, and cannibalization of iPhone/iPod touch demand.
5) Competition from low-price notebooks and netbooks resulting in MacBooks appearing to be much more expensive.

On balance, tailwinds were much more stronger than headwinds that Apple faced in Q1 2010. Thus, Apple should report an extremely strong quarter.

Disclosure: Long AAPL

Tuesday, November 24, 2009

My Comments on Bloomberg TV Interview with Apple Analyst

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.

Incorrect: Subsidy shouldn’t change.

Tim cook addressed this issue on Apples Q4 2009 conference call (from Seeking Alpha):
Gene Munster – Piper Jaffray
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.

Disclosure: Long AAPL

Tuesday, November 3, 2009

Apple Inc (AAPL): Weaker Dollar Will Benefit Revenue Growth and Margins

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.

Disclosure: Long AAPL.

Monday, October 19, 2009

Apple Inc (AAPL): Q4 2009 Estimates

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.

Disclosure: Long AAPL

Tuesday, August 11, 2009

Apple Inc (AAPL): Current Valuation Still Reasonable

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.

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.

Disclosure: Long AAPL

Wednesday, July 29, 2009

Apple Inc (AAPL): iPhone's Substantial Impact on Gross Margin

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.

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