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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.

Friday, December 19, 2008

Apple Inc (AAPL): Taking a Look at Mac Pricing

MAC DEMAND CONCERNS:
For past couple months, Wall Street’s concern du-jour for Apple has been Mac demand. No PC/consumer electronics firm is immune to this economic downturn, but many analysts believe there is substantial downside risk for Mac sales. Analysts claim the contracting economy is causing changes to the complexion of industry demand that could have further negative implications for the Mac segment. Specifically, the slowdown in consumer spending will cause industry demand to contract, and within the computer industry, demand will shift away from Mac to lower-priced PCs. This double-blow presents a considerable threat that Mac sales will come in way below expectations. Some argue the popularity of netbooks and other low-price PCs present a major challenge for Apple since Macs’ price points encompass the high-end of the spectrum. Thus, Apple lacks a low-price offering within the price range where demand has been and will continue to be strong.

Given the pullback in spending and the shift to lower-priced PCs, analysts have been calling for Apple to introduce a cheaper Mac to become more competitive. Many were expecting just that when Apple unveiled its new MacBooks last October. Missing from the event were price reductions. The legacy white plastic, low-end MacBook received a $100 price cut ($1099 $999), but the mid-range model’s price ($1299) was unchanged, and the high-end MacBook price increased $100 ($1499 -> $1599). This was a disappointment for those who were expecting price cuts of $200-$300, at minimum.

There was ample speculation for Apple’s Black Friday discounts. Most analysts/journalists were predicting larger than usual discounts, 15% compared with Apple’s typical discounts of 5%-10% from previous years. However, Apple offered modest discounts that were inline with its previous Black Friday promotions. Some were disappointed, notably Shaw Wu of Kaufman Brothers: “We would have hoped that with its nearly $25 billion net cash position and very favorable component pricing environment, that Apple would have taken slightly more aggressive action on pricing given that consumers are still hurting from the tough credit environment.” Ben Reitzes of Barclay’s Capital says “like to see Apple get more aggressive in terms of pricing.” The crux of the matter is that if Apple believed steeper discounts would significantly lift demand then it would have cut prices more aggressively.

Aside from the Mac Mini and legacy plastic MacBook (October price reduced to $999), Apple doesn’t offer a sub-$1,000 model. In September, Kathyrn Huberty at Morgan Stanley cut her price target on Apple citing slowing global PC sales. The next Monday, Huberty cuts her rating on Apple, and slashes her price target to $115 from $178 based on the concern that “PC unit growth is decelerating and the remaining source of growth is increasingly in the sub-$1000 market where Apple does not play.”

According to NPD, Apple had 66% market share for the above $1000 price category, and 14% overall. In an August 2008 NPD study, Apple’s market share for the past 12 months in the above $1500 price segment was 69%, up from 41% in the August 2007 survey.

Huberty points out that revenue for the premium segment has been declining (y/y) every month since the winter, and that the sub-$1K market’s revenue has been growing. She concludes that consumer demand is shifting to the low-end, where Apple does not have a presence. In addition, Huberty claims Apple is at risk because it’s highly exposed to the premium-end, where demand has been falling. However, Mac unit sales grew nearly 40% for 2008, and its share in the premium segment almost doubled. Mac sales have been growing roughly 3x the market.

Therefore, it’s Windows PC demand that is shifting to the lower-end.

If the overall industry is trending to lower price points, how does Huberty reconcile the sub-trend of increasing Mac demand, which is mostly confined to the premium segment? If Mac demand runs counter to the premium segment’s overall trend, one can’t make the assertion that there’s a strong correlation. There is a convincing relationship between ASP and growth for the industry, but not for Macs. The PC industry is comprised almost entirely of Windows PCs, thus demand for Windows machines determines industry demand. In short, Macs and Windows PCs are not similar product offerings. Some analysts, notably Huberty, appear to conflate the two. Macs are Windows machines, for one can install Windows OS on Mac hardware and use it just as if it were a Dell or HP. But, PCs such as Dell and HP can’t run Mac OS.

MAC VS WINDOWS HARDWARE:
The reason why demand has shifted towards cheaper PCs is because of substitution. A $1500 Windows PC may not be noticeably different from an $800 machine for most users. With economic fears engulfing the consumer, a less expensive PC still can do everything that a higher-end PC does, albeit with less performance. However, many consumers are not heavy users where such a difference would be detected. Even so, for most users, less performance can be tolerated. Therefore, the question is “What more do I get from spending more? What I am sacrificing by spending less?” For many, the answer is “nothing.” In short, there isn’t much difference. The consumer isn’t going to pay more if he/she doesn’t have to, especially in a tough economy.

Windows machines increasingly compete on price, and price alone. PCs have become commodities; there is little, if any differentiation among hardware manufacturers, especially desktops. Essentially, the sole proprietary aspect of a Windows machine is the brand name; most of the hardware components are sourced from 3rd party manufacturers. Whether it’s Dell, Gateway, HP, or Sony hardware makes little-to-no difference.

I understand why consumers aren’t paying-up for Windows PCs. How are HP, Dell, Acer, Toshiba, etc different from each other if they all use Intel chips, run Windows, and have many other of the same components? Consumers don’t see the value in paying a higher price for a Windows PC versus another. For a significant portion of consumers the main purpose of owning a computer is internet/email access, as well as ability to create documents. Any computer accommodates those needs, thus for many, price is the most relevant attribute. I believe this is the driving force behind netbook popularity. Many consumers desire a computer capable of performing basic tasks, such as email, internet, etc. Netbook CPUs are low-powered, and are not suitable for heavier usage, such as graphic intense games or spreadsheets containing complex formulas.

Consumers perceive less differentiation among Windows hardware, thus they are more likely to select whichever brand offers the best price for the desired configuration. Consumers are not necessarily shifting to cheaper PCs solely based on price. Consumers trade down because there isn’t sufficient value-added to justify paying a higher price.

Conversely, there is a stark difference between spending less for a Windows PC (or any amount) opposed to buying the higher-priced Mac. Mac OS X and the associated user experience are significantly different from Windows. Hardware isn’t the differentiating factor; it’s the OS. PCs are not substitutes for Macs. People who desire Macs have to spend more, but those who don’t care for Macs don’t have to pay the high prices due to the availability of less expensive Windows machines. Consumers desiring Windows OS don’t purchase Macs to exclusively run Windows since it would be a waste of money. Consumers purchase Macs for the value-added benefits supplied.

The robust growth in Mac sales demonstrates that consumers are willing to pay more for Macs. Mac’s 70% share of the premium segment suggests that Macs are essentially the only computers for which consumers are willing to pay up. Windows PCs can’t compete in the premium segment against Apple. Premium Windows PCs can’t even compete against lower-priced Windows PCs. Since Macs run Windows (many say Windows runs best on Macs), PCs don’t provide any value-added benefits over Mac. Thus, to create value to the consumer, PC hardware firms cut prices to make their machines relatively attractive. Since the Mac offers Windows OS plus Mac OS, it provides additional benefits that command a premium price.

PC prices have come down a great deal, and continue to fall. However, Mac ASPs have been relatively flat since 2003 (~$1500). It should come as no surprise that Apple’s GM has risen from 26% to 35%, while Hewlett-Packard and Dell have seen their margins shrink. Where are these analysts getting the notion that cheap netbooks will pressure Mac sales when notebook prices have been relatively cheaper for years?

APPLE’S MAC SALES STRATEGY:
The two main reasons why consumers buy a Windows PC instead of a Mac are 1) Unaware of added benefits 2) Aware of added benefits, but assign little value preferring a low benefit package at cheapest price, i.e. price-sensitive. For many, they choose a Windows machine because it’s cheaper. Consumers would pay more if they believed the incremental value added exceeded the incremental cost. Many are unaware/unfamiliar of the incremental value the Mac provides, thus Apple’s primary goal is to inform consumers most likely to perceive added-value.

The primary challenge facing Mac growth is educating the market about Mac benefits. Due to Apple’s tiny market share, its growth potential is massive. At the start of the decade, Apple’s share was roughly 1%-2% and will likely reach 10% by decade-end. The major catalysts to share growth have been the iPod, iPhone, and Apple’s retail store strategy, which have increased Mac curiosity and awareness. For the past couple years, Apple has been reporting that more than 50% of retail Mac sales are to new Mac users. This is no surprise since Mac sales have outpaced the industry by a factory of three (3x).

Remember that Apple’s share of the computer market has been in the low single digits throughout time, only in the last several years did Mac sales takeoff. Therefore, most haven’t used or possibly seen a Mac in the wild. With little or no Mac experience, an individual would have difficultly to justifying the higher price. In addition, consumers don’t actively seek to acquire more information on products that are relatively more expensive. One has to spend more time and effort learning about a product that costs more and ultimately may not be suitable or worth the price. Therefore, expensive, less-known products experience greater difficulty in making the short-list of a consumers consideration set for a given purchase decision. Apple believes its Macintosh provides a superior computing experience. There is evidence supporting that claim as Apple earns the highest satisfaction ratings and gets the best reviews from industry pundits. So, it’s more about informing consumers that its product is the best than it is making its product the best.

Apple leverages the popularity of its iPod and iPhone to heighten attention for Mac. These gadgets arouse curiosity and interest about the Mac, as well as driving traffic to its stores where consumers can experience Macs first-hand.

MAC PRICING STRATEGY:
Since Macs are highly differentiated and offer features/benefits unique to its brand, Apple is afforded significant pricing power. Apple believes since it offers a premium product it should charge a premium price. Exploding demand for Macs seen in the past several years demonstrates that consumers justify paying a higher price (relative to PCs) for the extra value/benefits unique to Apple. Apple believes that there are many potential consumers that would share the same opinion if they were more knowledgeable about Macs.

Cutting prices does little to advance product knowledge for the uninformed consumer. Macs would still be pricier, and the consumer still wouldn’t know why. Thus, reducing Mac prices wouldn’t boost substantially boost demand. Many analysts miss this point. Amazon’s best selling notebooks are all within the $350 - $600 price range. If Apple cut the price on the $1299 MacBook to $1000 or even $800, it’s still more expensive than the more popular, cheaper notebooks. The $999 legacy white plastic MacBook has been less popular at Amazon than the $1299 new aluminum MacBook. There is a bifurcation in the computer market- 1) consumers seeking lowest price 2) consumers seeking value-added. The former are buying netbooks and the latter are buying Macs. If price were as significant an issue as analysts claim, then the $999 MacBook (actually $910) wouldn’t be ranked #15 behind the $1299 MacBook ranked #7.

I believe it’s not the size of the price differential versus the amount of added benefits that is in question. To clarify, it’s not that consumers don’t believe that the higher price of Macs aren’t justified by their unique features, it’s that consumers aren’t aware or don’t care for Mac features. Those who are price-sensitive and seek bare-bones machines are a waste of Apple’s time to pursue.

Apple would have offered larger discounts (as analysts were predicting) on Macs for its Black Friday sale if it thought lower prices would materially affect demand. Unit sales wouldn’t increase very much, but dollar revenue would decline (lower ASPs) when customers are willing to pay the higher prices.

Apple still has an abundance of potential consumers willing to pay premium prices for a computer that Apple has not yet penetrated. It is these consumers that Apple is chasing, the mid to high income demographic, which are less price-sensitive and receptive to a product that offers value-added benefits. Generally, these consumers understand that “one has to pay more to get more,” and that if a product is cheap, “then it’s cheap for a reason.” In addition, sometimes saving some bucks might result in owning a product that is unsatisfactory, or possibly worthless. In these circumstances, one often is forced to make another purchase since the original product was a dud. Thus spending the extra cash, on the margin, makes the most economical sense. In essence, by spending more, one may be actually be paying less considering the long-term costs and product life.

On the 4Q08 conference call (from Seeking Alpha), Steve Jobs remarked: “There are some customers which we choose not to serve. We don’t know how to make a $500 computer that’s not a piece of junk, and our DNA will not let us ship that. But we can continue to deliver greater and greater value to those customers that we choose to serve and there’s a lot of them. And we’ve seen great success by focusing on certain segments of the market and not trying to be everything to everybody. So I think you can expect us to stick with that winning strategy and continuing to try to add more and more value to those products in those customer bases we choose to serve.”

APPLE’S CHALLENGES:
The economic turmoil presents a significant challenge for Apple. As I mentioned previously, it’s not consumers that normally would buy a Mac trading down as some analysts suggest. Consumers either want the added benefits Macs provide, or they desire the basic functionality of Windows OS PCs. If one wants a Mac, then there are no other alternatives; Macs can’t be substituted by Windows PCs opposed to the substitutability of cheaper Windows PCs for more expensive Windows PCs.

The recession won’t cause cheap Windows PCs to take sales away from Macs, instead it will slow the rate that Macs take share from PCs. The higher-end consumer that Apple targets is less sensitive to the economic cycle, yet not immune. Consumers are less receptive to learning about/trying out unfamiliar products, as their mood to spend is subdued. During periods of rising asset prices, the wealth effect reduces the threshold for capturing a consumer’s attention and subsequently closing a sale.

I eventually expect Apple to address the popularity of the netbook segment by introducing a computing device in a tablet form. I imagine it will be something similar to the iPod Touch, yet with more power and viewing area. It will offer the same functions that consumers look for in a netbook, yet the form factor will be different.

CONCLUSION:
The popularity of low-priced PCs stems from the lack of added value for pricier Windows computers, rather than the inability/unwillingness to spend more for a computer. Lower prices are driven by the intense competition among Windows PC manufacturers whereby the primary differentiating factor is price opposed to other value-added benefits. The fact that Mac demand growth (which sell at higher entry price points) has been much higher than the industry indicates that Macs don’t compete on price, but rather features/benefits.

It’s incorrect to assert that Mac sales growth is vulnerable to netbooks or cheap PCs. The real challenge facing Apple in this rough economy is attracting new users and enticing current users to upgrade/replace. New models, the expansion of the retail store footprint, the halo effect from iPod/iPhone, and positive word of mouth are the primary driver in sustaining Apple’s Mac sales.


Disclosure: Long AAPL

Monday, November 17, 2008

Calculating Gross Margin for Apple's iPhone (4Q08)

APPLE INC (nasd:AAPL) According to my calculations, deferred revenue booked from Q4 iPhone sales carries a 55.5% gross margin. Gross margin on the deferred revenue (DR) booked from the first generation model averages about 29%. The average gross margin for total booked DR is 47.8%.

I derived this number from the “deferred expense under subscription accounting“ that Apple disclosed in its annual filing (10-K) in conjunction with the deferred revenue (under subscription accounting) also reported. I used some rather extensive math to come up with the 55.5% number which I discuss below.

Apple’s ”Non-GAAP“ figures it provided for Q4 implies that 3G iPhone GM was 47.8%. According to the 10-K, GM for iPhone deferred revenue not yet recognized in income is also 47.8%. Coincidence? Not likely. Since the deferred revenue carried on the balance sheet includes both the original and 3G models, that GM should differ from the GM implied by Q4 Non-GAAP numbers that solely comprise of 3G unit sales. We know that the GM on the 3G model is much higher than the first model.

So why is the GM according to Apple’s Non-GAAP figures the same as the GM derived from the 10-K? Apple included estimated future warranty expenses in the adjusted cost-of-goods sold (COGS), which inflates Non-GAAP COGS and understates GM. The amount of estimated expense is at Apple’s discretion. In my opinion, Apple overstated the Non-GAAP COGS adjustment for the sake of conservatism, but also to obscure the true iPhone GM. Normally, under GAAP accounting (subscription), Apple recognizes iPhone warranty expenses as incurred. However, Apple added its estimates for future warranty liability into the COGS adjustment, and I believe management was very conservative.

The gross margin on the iPhones sold in Q4 that will be recognized over the coming seven quarters is 55.5%. There will be some warranty expense incurred, yet I expect it to be relatively small. It’s likely that most of the warranty liability is incurred during the period sold. If a unit is defective, the problem usually surfaces shortly after it’s purchased.

I estimate the normalized gross margin is even higher, possibly north of 60%. Thus, iPhones sold in 1Q09 and beyond will carry higher GMs, assuming ASPs remain constant. iPhone GMs for Q4 were abnormally compressed due to elevated shipping costs, adapter recall, and other various expenses related to the global introduction of the new 3G model.

Gross Margin- Non-GAAP Reported Q4:
For the first time, Apple provided adjusted figures showing the actual iPhone sales/income earned in the quarter. Until Q4, Apple always gave the GAAP numbers that uses subscription accounting for iPhone sales. Instead of recognizing the actual revenue earned for the quarter, it is spread over 24 months and amortized on a straight-line basis. Using normal accounting methods, total revenue would have been 3.787B higher, or 11.682B. Cost of goods sold (COGS) increases 1.975B to 7.161B. Overall gross margins improve from 34.7% (GAAP) to 39.0%, which equates to a 47.8% GM for the iPhone adjustment ([revenue adjustment - COGS adjustment] / revenue adjustment).

However, the 47.8% figure is not the true iPhone GM. First, the adjustments include AppleTV sales, yet that amount is believed to be quite small relative to the iPhone, thus the effect is probably very minimal. Second, and most important, is that Apple included the estimated warranty costs for over its full life in the COGS adjustment.


iPhone Gross Margin- Deferred Revenue/Costs Reported in 10-K:
Without knowing the amount of deferred iPhone cost booked in a quarter, it’s impossible to calculate iPhone gross margins. Apple’s quarterly filings discloses the iPhone portion of deferred revenue which is reported was a liability on the balance sheet, but Apple never broke out the iPhone related deferred costs that is included in an asset account. The actual amount of iphone revenue earned in a quarter can be determined by adding the change in DR account (+) the amount of iPhone revenue recognized in income. To find the actual product costs, we need the change in deferred costs. In its annual filing, Apple disclosed the amount of iPhone related deferred cost on the books at the end of Q4, but we don’t know the Q3 number.

Using the DR & DC at year-end, an average GM (of all iPhone sales) can be found. At year-end, Apple had $5.78B in DR and $3.02B in DC on its books, which translates into a 47.8% gross margin for all the iPhone sales still be amortized. Since Apple gives the figures for current (less than 1yr) and long-term accounts, we can gain additional insight into iPhone margins. For the iPhone sales that will be recognized within a year, the average GM is 45.1%, and for the non-current portion, the GM is 51.9%.

The reason for the 7% difference is due to 3G sales, which carries a much higher margin than the original iPhone. Almost all the non-current DR & DC is related to the 3G, since iPhones sold in 4Q07 & 1Q08 have moved from the non-current to current bucket. Only a small portion of Q2 sales would be left in non-current, and Q3 sales were low, thus the figures classified as non-current are almost entirely associated with 3G sales. The actual percentage of 3G models can be estimated from the change in DR from Q/Q compared to the actual ending balance. Current DR increased 2.129B to 3.518B, which means 60.5% of current DR is from 3G. Long-term DR increased 1.63B to 2.62B, but the actual amount of 3G classified as non-current is higher because of the portion of legacy iPhone revenue recognized for the quarter. I estimate that 320M of DR was recognized in Q4. Roughly 86% of non-current DR is from 3G sales.


Actual 3G iPhone Gross Margin Calculation:
With the figures for (1) average GM for both current and long-term [45.1% / 51.9%], and (2) the percentage of units which are 3Gs for both classifications [61% / 86%], I solved for the “true” 3G iPhone gross margin by setting up 3 simultaneous equations. The goal is to find the GM number (for both the 3G units and the legacy units) that produces the same combined gross margin for all three classifications (current, non-current, total). As I mentioned above, I solved for the percentages or “weights” of each model represented in the amount of deferred revenue reported on Apple’s balance sheet. Using those weights, the solution I found was 3G gross margin of 55.1% and 29.2% GM for the original model units. When the 3G & legacy gross margins are multiplied by the percentage weights for all three classifications (Total, Current, Non-Current), the products equal the same gross margin extracted from Apple’s 10-K.



(1) Total deferred: 47.8(all)= .71(MGN[3G]) + .29(MGN[2.5G])
(2) Current Deferred: 45.1(all) = .61(MGN[3G]) + .39(MGN[2.5G])
(3) Non-Current Deferred: 51.9(all) = .86(MGN[3G]) + .14(MGN[2.5G])

Conclusion:
If my math is correct, the gross margin on the DR booked from 3G iPhones sold in Q4 (Sep 08) is 55.5%. This means over the next seven quarters, Q4 iPhone sales that will be recognized in current earnings contribute 55.5% GM. Yet, gross margins on units sold going forward will materially exceed the 55.5% generated on Q4 sales.

The rationale for thinking the normalized GM will be higher is due to excess product expense related to the roll-out. Shipping costs were abnormally inflated due to pressures created by supply shortages. The elevated expenses were due to more shipments of smaller lot sizes expedited at quicker delivery times. In short, distribution costs weren’t optimized, yet it’s better to spend a little more to make a sale, than to try to contain costs and forego a sale. For example, iPhones ordered through AT&T direct fulfillment were being delivered individually by FedEx. In addition, Apple stores were receiving smaller shipments but more frequently, on an as-needed basis, so that some stores don’t get too much stock leaving others short. Now that demand and supply factors are in balance, Apple is able to reduce distribution expense by shipping larger lot amounts, less regularly at non-expedited speeds.

Another item inflating product costs was the power adapter recall. Not only does this cause material costs to increase, shipping and packaging costs were likely unfavorably impacted as well.

Going forward, I foresee rising margins resulting from efficiency gains in distribution along with lower product costs resulting from falling component prices and scale benefits. Another item of note, the end of September Apple began selling unlocked iPhones online to Hong-Kong for roughly $685/$799 (free shipping). These prices are quite higher than what Apple receives on other iPhone sales. It’s possible that Apple can do decent volume through the Hong-Kong channel given the propensity for iPhones to find their way into grey markets, such as China, Thailand, Vietnam and others. It’s interesting that Apple decided to sell unlocked, open carrier iPhones only to Hong-Kong which makes one wonder if this is a direct response to the stubbornness of Chinese carriers.

Massive iPhone margins provide Apple with the ability to reduce selling price and still earn a generous profit. Apple has a key advantage over other mobile handset makers that don’t have nearly as high GMs. I expect Apple to eventually lower iPhone prices, but given the iPhone’s superior value proposition, a price cut shouldn’t be needed for some time. However, that doesn’t preclude Apple from doing so just to make competitors life difficult.

Apple could use the colossal iPhone margins to subsidize price reductions on other products if needed. Given the difficult economic environment, this is a very beneficial arrow for Apple to have in its quiver to draw upon.

Disclosure: Long AAPL

Thursday, November 6, 2008

Analyzing Apple's iPod Business

Apple Inc. (nasd:AAPL)- Slowing iPod sales growth has been one of the chief concerns among AAPL investors because the iPod has historically been a major contributor to Apple’s overall revenue growth. The concern stems from the belief that the PMP market is becoming saturated. With 175 million iPod units sold, finding new customers is becoming more difficult. However, the iPod is becoming less of a revenue contributor, hence Apple is less dependent on the iPod for its sales growth. Andy Zaky, a highly accurate AAPL analyst addressed the iPod’s shrinking importance with regards to Apple’s corporate revenues. In addition, If Apple reported iPhone sales as part of the iPod segment, this wouldn’t be much of a concern, because the iPhone would have reaccelerated sales growth in the iPod segment. I recently discussed that scenario. Yet, Apple reports the iPhone separately. Therefore, this analysis focuses on the traditional iPod product line and its growth outlook.

Historically, Apple has used price reductions to fuel unit volume. The demand elasticity allowed the increase in unit sales to outweigh the decrease in ASP, resulting in higher dollar revenue. In a more saturated environment, demand becomes less elastic Unit growth has been slowing: 6% (FY08) vs. 35% (FY07), but iPod dollar revenue grew 10% in FY08 compared to 8% in FY07. Apple was able to increase iPod ASP to $167 (FY08) from $161 (FY07) with the introduction of the Touch. Even as the PMP market has neared saturation, Apple has reformulated its iPod product line which will motivate upgrades to iPod models carrying higher ASPs. Therefore, Apple’s current iPod product line strategy focuses on appealing to non-PMP users, as well as motivating current users to upgrade to higher ASP models. Apple has also positioned the iPod product line so that it’s practical for a user to own multiple iPod models to serve different purposes.

iPod Sales- Historical Overview:

iPods were the primary growth engine for FY05 and FY06, responsible for roughly 58% of Apple’s total revenue growth for both years. In FY07, iPod segment generated only 14% of overall sales growth. As a percentage of total revenue, iPod accounted for 33% (FY05), 40% (FY06), 35% (FY07) and 28% (FY08).


The iPod is becoming less significant for revenue growth due to the success of the Mac and iPhone segments. Apple’s revenue grew 35% in FY08 and 24% in FY07, yet the iPod was the slowest growing segment both years. In the last quarter (4Q08), iPod sales were only 21% of total revenue, and less than 15% not using iPhone subscription accounting. Thus, concerns about flagging iPod sales detrimentally impacting Apple’s overall business are stretched since the iPod is becoming less of a contributor. On a non-GAAP basis, the largest revenue contributing segments are the iPhone and Mac, which are the also the fastest growers.

Historically, Apple has introduced new iPod models at high prices then gradually lowered prices. Unit volume accelerates at lower price points, but the decrease in ASP results in less dollar sales growth. The reverse is true when Apple introduces models at high ASPs, which offsets the effect of lower unit volume on dollar revenue. In a saturated market, demand elasticity evaporates as unit volume is not responsive to lower prices. The focus shifts to motivating current users to upgrade to new-featured models at higher price points. A common belief is that Apple has sold so many iPods, that there isn’t anyone left that doesn’t already own one. In a sense, that’s almost literally true. Those that would enjoy such a device, likely have already bought one. Figuratively speaking, the low hanging fruit has been picked. Therefore, Apple needs to keep introducing new models with advanced features that will entice user upgrades and appeal to new consumers lying beyond the PMP market. Apple has accomplished this with the Touch.

iPod’s first two years on sale, ASPs averaged around $350. Then in Q404 (Sept) Apple cut iPod prices $100 and demand increased considerably. In Q205, Apple priced the “Mini” iPod model @ $199 along with launching the shuffle. This resulted in ASP dropping to $191 in Q2 from $264 in Q1. Unit sales exploded even exceeding the previous period which was a holiday quarter. ASP trended down over the next couple quarters until Q106 when the video iPod was released. ASP rose to $207. ASPs gradually fell over the subsequent 8 quarters, sustaining unit volume growth.

In FY07, unit sales growth was 31%, but revenue growth was only 8%. In 1Q08, Apple introduced the Touch model which carried a significantly higher ASP. This resulted in FY08 iPod revenue growth of 10% on top of 6.2% unit growth. That’s right, iPod revenue growth was higher in FY08 compared to FY07. Thus, even though unit volume has slowed materially, dollar revenue growth has actually increased. I think that point is often missed from investors and the media primarily focusing on unit sales.

iPod unit sales only grew 5% (y/y) for 1Q08, but dollar sales increased by 17% due to a higher average selling price (ASP). After 8 consecutive quarters of declining ASP, the Touch reversed that trend as ASP rose to $181/unit in 1Q08. You would have to go back 6 quarters to find a higher ASP. We have seen a decline in ASP since Q1 mainly due to the price cut for iPod Shuffles, which management stated has had a very positive effect on volume. 

In the September quarter (Q4), ASP fell to $150, primarily due to the back-to-school promotion. I surmise that ASP might have been $20-$25 higher otherwise. Going forward, I expect the recent trend of declining ASPs to reverse. ASPs will rise due to the sales mix skewing towards the Touch model. The July opening of iTunes App store, along with the September’s introduction of the 2nd generation Touch model at reduced prices, will substantially boost demand.

The purple shaded area of the sales table highlights the periods where ASPs dropped stimulating unit sales growth. It’s also apparent that revenue growth slowed due to the lower ASPs. The green area shows the periods where ASPs increased significantly; unit sales stalled, but revenue growth accelerated due to the higher ASPs.





The graph below depicts unit volume at various ASPs; the basic demand curve. Due to seasonality effects, data points are plotted according to quarter. Elasticity of demand is quite visible as quantity demanded is barely responsive in the $400 to $250 price range, then turns very elastic from the $250 to $150 price range as the demand curve flattens.



iPod Product Line:
Primary Attributes:

Touch- PDA, internet/email, wide screen video, games, other software (applications) 

Classic- massive storage

Nano- video w/ size and price

Shuffle- size & price

Touch: (iPhone) is the purest form of a converged device with its broad array of applications. It’s a perfect “all-in-one” device that’s small/light enough to be carried on one’s person. A converged device doesn’t totally eliminate the need for multiple devices. Instead, it reinforces the importance of having dedicated devices to accomplish specific needs. I know many consumers myself included) that have an iPhone and multiple iPod models to serve different purposes. A recent LA Times article reports that some iPhone users are also buying a Touch just for gaming purposes.

Classic: Primary feature is its massive storage capacity. It can serve as the chief repository for all one’s media as well as a dedicated media player. I connect my classic to my home stereo system which plays music throughout the house. Substituting my iPhone (or Touch) involves limitations. First, the capacity is much less, but most important, it ties up the device which means I am unable to use the other features.

Shuffle: This is perfect for outdoor and/or physical activity. This model is quite durable and very difficult to damage. Even if one manages to destroy his/her shuffle, then he/she is only out $50. Contrast this with other iPods which are more easily damaged and cost much more to replace. Thus, I’m not too inclined to jog or lift weights with my iPhone. Plus, the Shuffle’s diminutive size, measuring 1 in x 1.5 in and weighing ½ oz, makes it ideal for physical activity. At $50 for 1GB, the Shuffle is very reasonably priced. This expands its appeal to those who are less enthusiastic about music to spend very much on a PMP. For instance, some listen to a basic FM radio Walkman while working in the yard or exercising since they are not particular about which songs they hear. A Sony Sports Walkman (with arm band) runs $44 at Best Buy, thus the Shuffle is price-competitive.

Nano: This has been the most popular iPod due to its attractive price and the improvements in storage capacity. I expect a significant portion of the Nano sales will migrate to the Touch model since Touch prices have come down. Originally, the cheapest Nano was $150, and the cheapest Touch was twice as much, $300. In September, the 8GB Touch was reduced to $230. At $150 one can buy a 8GB Nano, or for $50 more upgrade capacity to 16GB. From the consumer perspective, it may make sense to pay 33% more in price for 100% more in memory. Common thinking is that one might later regret not getting the higher capacity model. However, that has become a less pertinent issue due to increased capacity offered in the base model. 8GB could be sufficient for many people, whereas 4GB was not. Yet, for $80 more one can buy a 8GB Touch which is a quasi-mini computer. Thus, when evaluated from the perspective of- $50 buys more storage, and $80 buys a conglomeration of added functionality, it makes much more sense to buy a Touch now that its price has fallen from $300 to $230. Bottom line, if one is going to spend that much money for a Nano, why not spend a little more money and get many more features? I believe a number of consumers will share the same line of thinking and will be “pulled up” to a higher ASP purchase.






iPod- Product Line Evolution:
One of Apple’s key strengths is innovation and the ability to improve its products in short time. This is evidenced by the 6 upgrades to the Classic model since originally introduced in late 2001. There have been 6 generations of the “Mini/Nano” model since 2004. The advances in functionality have been very significant, all one has to do is compare the Touch to an early iPod model, or just compare the current Classic model to an early generation.

The iPod’s expansive evolution from its roots as basic music player. Early models included remedial PDA features such as contacts, calendar, and notes, yet entries/edits such the once ubiquitous Palm Pilot. adds virtually full internet functionality and email when connected to WiFi. This summer, the App store was launched offering thousands of applications, many are free. This is a radical change which makes the Touch more like a mobile PC. Throw in a cellular radio and the Touch becomes and iPhone. In essence, the iPhone is just a mutation of an iPod, and the Touch is somewhere in between, with the Classic and Nano models still retaining the original iPod characteristics.

The first iPod models only differed in capacity. In 2004, a smaller model “Mini” was added at a significantly lower price point. Being just music players (later video added), consumers would choose an iPod based on desired capacity and price. Most likely, that would be the only model he/she would need/want. The introduction of the Touch changes that scenario with its PDA and web browsing attributes and games.

The iPod took a giant leap with the Touch. The display is much larger than other iPods and includes touch screen navigation. Touch iPods also include WiFi, users can access the web, e-mail, and utilize the widgets to grab updated weather, stock prices, maps, as well as watching YouTube Videos. It also has PDA applications, such as calendar and notes, as do other iPods, but the Touch’s qwerty keyboard significantly enhances functionality.



The evolution of the iPod line creates a higher possibility that an iPod owner would want more than one model. For example: Touch for PDA/internet & gaming, Classic as repository to store all content and as a de-facto stereo component, and a Shuffle for use during physical activities.



The iPod’s potential market is expanded by the Touch’s new capabilities, which may attract new consumers who had little interest buying a device strictly for music and video. Current iPod owners may buy a Touch for its PDA and web browsing features. The App Store has literally revolutionized the device’s potential, as gaming is becoming a prominent attraction.

iPod Growth Strategies:

Sales can only come from 3 sources: 1) Non-users of product category 2) Competitors’ customers 3) Firm’s current customers. Saturation occurs when the market can no longer expand from the addition of non-category users. Often, a industry shake-out occurs from firms switching focus from attracting new category users, to stealing competitors users. Weak firms are pushed out of the industry and a competitive equilibrium results. Capturing sales from competitors’ users becomes increasingly difficult. A much greater focus is then placed on extracting more sales from current customers. A firm can revolutionize a mature product (making current obsolete) to start a new life cycle.



3 Sources for Increasing Sales:

1. Non-Users- Don’t use product category: Attract new users



The number of consumers, who don’t own a PMP but potentially would buy one, is dwindling. If a consumer hasn’t purchased a PMP by now, the likelihood of purchasing one in the future is relatively low. With 174 million iPods sold and nearly 250 million total PMPs sold, it’s increasingly difficult to keep expanding the market to new users. Yet the market will continue to expand, albeit at a much slower rate.



In short, Apple can’t completely rely on new users to supply the sales volume as in previous years. Apple has been addressing this issue by reformulating its product line.



The Touch will expand the market since it’s not exclusively a music/video player. For those with little interest in music, then the web browsing, e-mail, and PDA features may be attractive. With the copious software available from the iTunes app store, it’s not hard to imagine some Touch owners not even using the music player. Considering gaming capabilities, the Touch is akin to handheld gaming devices, I, and many of you, know them as “Game Boys” even though today’s devices have advanced light years.

The Shuffle’s reduced price (under $50) makes it appealing to physically active individuals that desire to listen to music while exercising, but not very particular about listening to music at other times. 


2. Other’s Users- use competitors’ products: Increase market share



Apple’s iPod has more than 70% of the unit share of the PMP market. That number has held steady for past several years. With such a large share, Apple has already taken business from its competitors, thus less remaining to take now.



The iPod has roughly 90% of the market’s dollar, thus competing devices are the most part cheaper and target more price sensitive consumers. Apple just recently cut iPod Shuffle prices from $79 to $49 making iPods more competitive among lower-priced devices. I expect Apple may slightly increase its market share, but not to an extent large enough to boost sales growth significantly.


3. Current Users- iPod owners: influence to buy multiple devices / buy new device more frequently



iPod owners represent a large source of potential sales. They outnumber competitors’ users and possibly non-users likely to purchase a PMP in the near-term. A focus of Apple’s sales strategy is selling more iPods to current owners since they represent a colossal source of potential sales growth.



Increasing sales from current customers Apple must motivate the user to buy a new iPod more frequently (replacement cycle) and/or buy multiple units. 



PMP devices aren’t similar to printer ink, where more usage leads to more sales. Since usage doesn’t cause product consumption, the replacement cycle is longer. Speeding up the replacement cycle is more difficult than other products whereby it’s advised to “change every 3,000 miles” or “lather, rinse, and repeat” and “best if used by x date.”

Device enhancements from adding new features and expanded capabilities speed up the replacement cycle. Hence, the replacement cycle becomes an upgrade cycle. A number of iPod owners buy a new generation model because of better features even when their current device works fine. Innovation is key driver in generating more sales from current users. New enhancements have to be compelling to motivate the upgrade.

The heart and soul of the iPod line has been the Classic, later supplanted by the Nano. Apple’s new Nano generation adds new features, such as the accelerometer, which will stimulate the replacement cycle. 



Stimulating users to purchase multiple units is a challenge for this type of product. There is little need to have more than one PMP device since a user can only listen to one device at a time. Since devices are highly portable, there isn’t a need to buy multiple devices for use at different locations, unlike a TV perhaps. The challenge is to differentiate the product line by form and functionality.



Differentiation of the iPod model line encourages the purchase of multiple iPods vis a vis owning different models. The mini-PC/gaming functionality of the Touch, the reduction in size and price of the Shuffle, and massive storage of the Classic reduces the overlap of features. Thus, there exists a reason to own more than a single iPod model since the functionalities differ. An individual might own a Classic for storage, a Touch for internet/email and gaming, and a Shuffle for physical activity.

iPod Outlook:
Given the recent evaporation of global economic activity, iPod sales are likely to be the most effected Apple business segment. Due to iPod’s commanding market share coupled with its “lifestyle staple“ nature, Thus, iPods will continue to be in demand. A sluggish economy may reduce demand in the near-term, but it creates pent-up demand which will be realized with an up-turn in the economy.

It’s hard to argue that the iPod market is not becoming saturated, as Apple has sold over 174 million units. However, the Touch with 3rd-party applications opens the device to new consumer segments. Originally, the iPod only appealed to those consumers who desired a PMP (personal music player). The Touch offers much more than just a music player. It’s a gaming device, as well as a email and internet browser, and a personal organizer, and much more. With the advent of the iTunes App store, the potential for the Touch’s functionality is virtually boundless.  

The Touch presents the opportunity for attracting non-PMP users plus coaxing iPod owners to “trade up” to a device at a higher ASP. I didn't think the original Touch offered much value at the relatively high price points along with lacking 3rd party software capabilities. Now with the recent price reduction and iTunes App store launch, the Touch has gained significant potential. Initial demand of the 2nd generation Touch model released in September appears to be quite strong. There were widespread supply shortages during September and early October, and the Touch has continually been the #1 PMP seller at Amazon.com as well as a top 5 bestseller in the electronics category. The iPod sales mix will begin to skew towards the Touch boosting ASP. This will offset any slowing/negative unit growth effects on dollar sales.

The iPhone cannibalizes Touch sales, and probably the reverse is true as well. The magnitude of sales impact on one another is hard to know. I think the Touch provides a powerful gateway to the iPhone. Why carry two devices? The Touch provides an avenue to capture consumers who unwilling/unable to buy an iPhone. For instance, consumers may be locked in a wireless service contract, or use a different phone due to business purposes, may not live in wireless service area, or just don’t use a mobile phone. The Touch lets them become acquainted with a device similar to the iPhone, and when conditions permit, enhances the likelihood that they will purchase an iPhone. I am basing that assumption on the high rates of customer satisfaction.

Even though the Touch performs the same functions as other iPod models, it may not be the best choice for specific applications. This opens the door for consumers to own more than just one iPod model. The Classic can replace the CD player component for a home stereo system. The shuffle is ideal for outdoor/physical activities. The Shuffle should appeal to price sensitive consumers who previously weren’t willing to pay the high prices for iPods. These two factors should strengthen demand in light of a maturing market.




DISCLOSURE: Long AAPL

Monday, November 3, 2008

Taking an Alternative Perspective on Apple's iPod Growth

Apple Inc. (nasd:AAPL)- Analysts and the media have regularly cited slowing iPod sales as a major headwind for Apple shares. The iPod has been a major force in Apple’s total sales growth since it has been such a large percentage of Apple’s overall revenue. A common claim is that the iPod has been so successful, that everyone has one. A seemingly positive statement, some choose to take a negative point of view. For example, “ It’s not good for future growth because Apple is running out of new people to sell iPods to. Basically everyone who wants an iPod, already has one. While there will be sales resulting from the replacement cycle, it certainly won’t generate the magnitude of growth exhibited in the past. Therefore, iPod sales will significantly deteriorate.”

Apple has sold almost 175M iPods, and imagine if Apple created a new iPod that motivated iPod owners to upgrade, as well as appealing to non-iPod consumers. One can say Apple did, the iPhone. Apple reports iPhone sales in a separate segment apart from iPod, and it accounts for iPhone revenue using a subscription method that distorts actual performance due to spreading revenue over a 24 month period. If we were to combine iPhone sales, using traditional accounting, with the iPod segment, then we would get an entirely different picture. That wouldn’t change any of the overall numbers, but it would change the perception that iPod growth is rapidly slowing.

iPod Growth:
iPods were the primary growth engine for FY05 and FY06, responsible for roughly 58% of Apple’s total revenue growth for both years. In FY07, iPod segment generated only 14% of overall sales growth as iPod sales only increased 8% compared to 69% in FY06. Actually, revenue growth for the iPod segment ticked up in FY08, growing 10%.

Some cite market saturation as the major factor that will lead to a slowdown in iPod demand. Given iPod’s large revenue contribution along with having been the primary growth engine, critics predict a rough road ahead for Apple. As a percentage of total revenue, iPod accounted for 33% (FY05), 40% (FY06), 35% (FY07) and 28% (FY08). However, the iPod is becoming less significant for revenue growth due to the success of the Mac and iPhone segments. Yes, times have changed. It still seems that many have yet to catch on.

Apple’s revenue grew 35% in FY08 and 24% in FY07, yet the iPod was the slowest growing segment both years. In the last quarter (4Q08), iPod sales were only 21% of total revenue, and less than 15% not using iPhone subscription accounting. Thus, concerns about flagging iPod sales detrimentally impacting Apple’s overall business are stretched since the iPod is becoming less of a contributor. On a non-GAAP basis, the largest revenue contributing segments are the iPhone and Mac, which are the also the fastest growers.

Andy Zaky from Bullish Cross is a leading expert on Apple. Zaky recently wrote an excellent analysis regarding Apple’s dwindling reliance on iPod to fuel overall growth. He argues that too many are focusing on the slowing growth of the iPod segment and that they are misinformed as to the real impact any slowdown would have on Apple’s revenue growth.

Zaky writes: “Investors, the media and the analysts have consistently overstated Apple's dependence on the iPod for future revenue and earnings growth. In Q1 2008, the street, choosing to disregard iPhone and Mac revenue as being at the core of Apple's primary driver of future revenue growth, only focused on how iPod unit sales grew at a meager pace of 5% YoY.”

Zaky adds: “Even today, analysts and the media continue to question whether Apple could succeed in a recessionary environment due largely to the perceived uncertainty as to whether iPod sales can continue to grow in 2009. Several members of the media, including analysts and fund managers who don't cover technology stocks, continue to refer to Apple as the "iPod maker" or simply a "gadget maker" indicating that Apple's core business is derived from iPod sales.”

Viewing From an Alternative Perspective- iPod + iPhone Combined:
Arguably, The iPhone is just and extension of the iPod product line. Steve Jobs said “It’s the best iPod we’ve ever made.” The iPod segment has expanded with the Mini, Nano, Shuffle, and Classic model introductions. The iPhone is more/less a Touch with a cellular radio. Yet, one is an iPod and the other is an iPhone, at least judging by how Apple breaks out sales by product segment in its financial releases.

Until last quarter, whether Apple included iPhone revenue in the iPod segment, or reported it separately, there wouldn’t be much of a noticeable difference on the surface. This is because iPhone unit sales have been quite modest relative to iPod, and iPhone revenue is distorted from the subscription accounting that amortizes sales over 24 months. Management repeatedly said that iPhone wasn’t a significant portion of revenue. Very true using subscription accounting, 3% (Q1), 5% (Q2) 6% (Q3), 10% (Q4). Yet, the GAAP accounting treatment isn’t an accurate reflection of Apple’s business performance.

What if we took a different perspective and adjusted iPhone revenue to reflect the total amount earned in each period instead of the distorted subscription basis? And, what would it look like if iPod and iPhone were combined into a single reported segment?

Apple very easily could have decided to report iPhone sales as a part of the iPod segment, as well as using normal accounting. It’s all a matter of choice, the real figures stay the same. We probably wouldn’t still hear misguided comments such as “iPhone sales may be growing but it’s a very small revenue contributor. iPod is a huge revenue contributor and its sales are slowing.”

Without subscription accounting couple with combining iPhone sales with iPod, revenue dollar growth (Y/Y) for combined would be: 41% vs. 4% (4Q07), 47% vs. 17% (1Q08), 59% vs. 8% (2Q08), 26% vs, 7% (3Q08), and 184% vs. 3% (4Q08). With the iPhone’s $199 price tag and Apple’s plans to be in over 70 countries by the end of the year, we should expect to see growth figures like the 184% (4Q08) going forward. See the tables below.




Conclusion:
From a combined iPod & iPhone perspective, we wouldn’t hear these misplaced concerns of an iPod slowdown. Instead, it could be characterized as “Apple tackled the issue of slowing iPod growth by introducing a new iPod with cell phone functionality which has re-ignited sales growth in the iPod segment.” “Apple could sell another 175M iPods as users upgrade to the iPod cell phone.”

Disclosure: Long Apple

Tuesday, October 28, 2008

Apple's FY09 Gross Margin Expectations Too Low

Apple Inc (nasd: AAPL) - Apple’s FY09 gross margin should well-exceed management’s guidance of 30%. There are multiple factors that will support FY09 gross margins. 1) As iPhone’s revenue contribution to total company sales increases, overall gross margins will rise since the iPhone carries a very high GM. 2) There will be a more favorable component price environment created by plunging commodity and energy prices. 3) As production volume rises for the iPhone and MacBooks, scale effects and cost efficiencies will benefit drive down product costs. 4) Higher revenues supply leverage by spreading fixed costs across a higher revenue base.

Apple’s guidance is way too conservative; yet considering the economic landscape, management is exercising prudence. This cushion should help Apple exceed earnings expectations even if the economy adversely affects its business. With gross margin expectations so low, Apple’s revenue growth could turn out worse than expected and still match/beat EPS estimates. Alternatively, Apple could use the gross margin cushion for lowering prices to boost demand if warranted.

Market Reaction to Lowered Guidance:
On the Q3 2008 earnings call back in July, Apple guided Q4(Dec) gross margin down to 31.5% which concerned investors after reporting a healthy 34.8% for Q3 (June). Much more troubling was the 30% GM guidance for FY09, down significantly from FY07 average of 34.2% and 34.1% average for FY08’s first 3 quarters. Apple’s shares had an ugly reaction. The weak GM guidance was shocking surprise for Wall Street. Management didn’t provide a clear explanation for the reduced GM guidance. The general perception in the investment community was that Apple was planning to drastically lower its prices which was seen has having negative implications. The popular belief was that Apple must have started to see a dramatic slowdown in demand at higher price points. A few examples being mentioned- competition will intensify, other firms will introduce alternative products at much lower prices, consumers won’t be able to afford or willing to pay premium prices. Many dismissed the possibility that Apple could be providing overly conservative guidance. In addition, many were overlooking the possibility that Apple would only cut prices and accept a lower gross margin because there would be a positive impact on the bottom line.

Gross Margin Guidance Historical Overview:
Management developed the reputation for repeatedly low-balling its gross margin estimates. For the 5 quarters- 1Q07 to 1Q08, Apple exceeded its gross margin guidance by an average of 14.1%. Yet, that trend ended for 2Q08 & 3Q08, when Apple only beat GM guidance by 2.8% & 5.5%, respectively (4.1% avg). Therefore, when Apple provided that week guidance for Q4 on the July call, investors reacted very negatively since the guidance for Q2 & Q3 had been relatively accurate.

In 3Q08 (June) Apple reported its gross margin was 34.8%, which exceeded guidance by about 180 basis points. Management stated that several factors contributed to better than expected margins. First, the one-time true-up of contract manufacturer deferred margin added 70 bps. Second, the remaining 110 basis points resulted primarily from lower commodity prices, a more favorable product mix with respect to margins, and the leverage effect of higher-than-expected revenue.

For the reduced gross margin guidance for Q4, Apple gave three primary factors for the expected sequential GM decline. 1) The full quarter impact of the back-to-school promotion 2) A future product transition 3) The one-time true-up of contract manufacturer deferred margin realized in Q3 (June).



Q4 2008 Gross Margin Exceeds Expectations
:
Apple beat management’s GM estimates by a sizable margin (320 bps): 34.7% actual vs. 31.5% guidance. I was surprised because I had been expecting GM to come in at 32% with a possible upside of 50-100 bps. I expected the back-to-school promotion would have a larger impact on overall margin.

Apple offered students a full price rebate for 8GB iPod Touch ($299) purchased along with a Mac. The iPod sale is recorded, and then once it’s rebated, the sales price is applied as a reduction to sales for both iPod and Mac, in proportion of the iPod and Mac sale. This probably results in about 80% of the rebate being applied to Mac revenue and 20% to iPod revenue. This noticeably impacted Macbook ASP which fell $93 sequentially, from $1,440 in Q3 down to $1,347 for Q4. The decline year/year was $69.

The iPod ASP fell to $150, its lowest ever. However, the sequential decline was only $2 and $9 year/year. In September, Apple introduced new iPods carrying lower price tags. The 16GB & 32GB Touch dropped $100, and the 8GB model saw a $70 reduction. Even though the lowered prices only prevailed for roughly 3 weeks of the quarter, Apple shipped a good number of units into the channel before quarter-end to alleviate the wide-spread shortage Thus, the amount of units sold with the new pricing was larger than what one would expect given the short length of time.

4Q08 Gross Margin Analysis:
Management stated that improved component pricing was primarily responsible for GM exceeding guidance. I believe that component pricing will only get more favorable and should even have a more robust impact going forward. It’s likely that most products sold in Q4 contained inputs procured months back at higher prices, especially given Apple uses FIFO accounting method. In the coming quarters, components will have be acquired at significantly cheaper prices, and those price will likely continue to fall.

Apple said that higher carrier payments on legacy iPhones was a secondary factor contributing to higher-than-expected GM. This is perplexing. No 2.5G iPhone units were sold in the September quarter. Only 717K units were sold in the June quarter; the majority of sales likely occurred during the early half since supply was virtually gone by the end of May. In addition, a decent number of the June quarter sales were unlocked and exported. Therefore, the number of units generating carrier payments would have not materially increased in the September qtr versus the June qtr. Thus, if anything, payment revenue would be slightly better than flat. Yet, total revenue increased by $431M which would have diluted the impact on gross margin.

Actually, the population of first generation iPhones with revenue payments decreased in Q4. With no additional 2.5G units were sold during the period, the number fell since 2.5G units were replaced with 3G models. My understanding is that this would curtail the carrier payments on those units. I estimate over 3M units had attached carrier payments and by end of Q4, 500K to 1M legacy iPhones were replaced by 3G. Unless there is some huge one-time payout, or a similar agreement, payments from wireless providers should have decreased. Due to the massive subsidy being paid by AT&T on 3G models coupled with the fact that legacy iPhone customers could upgrade without penalty, It seems very unlikely that there would be any such payments that would materially affect GM. Another interpretation is that management expected higher fallout of original iPhones carrying shared revenue payments, thus the actual revenue decline was less than expected.

I believe robust sales of the new 3G model (that resulted in a near doubling of recognized Q4 iPhone revenue) had a meaningful impact.

Due to massive 3G iPhone unit sales, revenue recognized in Q4 almost doubled sequentially. iPhone revenue reported in Q2 & Q3 amounted to roughly 5% of total sales. Yet, Q4 iPhone revenue constituted over 10% of total sales. With iPhone margins around 50%, the impact is noticeable. Assuming GM for non-iPhone segments was 33.1% and iPhone GM was 49%, Q4 GM would have been 33.9%, or 80 bps lower is iPhone was 5% of total sales instead of 10%.

Gross Margin Outlook Q1 2009:
Gross margins might see a slight to moderate decline sequentially in the December quarter due to the reduced prices for iPods and the higher manufacturing cost associated with the new generation of MacBooks. Apple guided GM to 30%-31%; taking the midpoint of 30.5%, GM would decline 420 bps Q/Q. That’s a significant decrease which is tough to grasp because of the multiple factors that should benefit gross margin.

Positives-
1) There will not be the negative impact of the back-to-school promotion.
2) Commodity and energy prices continue to fall, and the drop-off in component demand is improving Apple’s product cost. I don’t foresee this trend reversing in the near-term.
3) Q1 iPhone revenue will increase (larger % of total sales) providing further GM support since iPhone margins are much higher than overall company GM.

Unknown-
1) How much higher production costs are for the MacBooks.
2) How conservative the guidance is.

Given the mix of favorable factors at play, product costs for new MacBooks would have to be very large to counteract the upward margin pressure AND drive GM down 420 bps. That doesn’t appear likely.



Financial Alchemist FY09 GM Outlook:
In addition to the items discussed above, the primary GM driver in FY09 will be the iPhone.

Using regular accounting, whereby all revenue/expense are recognized in period incurred, the 4Q08 GM was 39% compared to 34.7% reported using the subscription method. The non-GAAP figures Apple provided take out iPhone amortized revenue/product cost reported under GAAP, then adds total revenue/product expense for the units shipped during the quarter. This highlights the huge disconnect between accounting earnings and cash earnings. The subscription method, whereby revenues and product expense are amortized over 24 month period, causes the reported GAAP numbers to be highly misleading.

iPhone revenue would have increased by 3.79B, from 806M to 4.59B. This represents nearly 40% of total revenue. Granted, this includes AppleTV revenue, but its contribution is believed to be insignificant.

Also impressive is the leverage effect- operating margin is 27.9% vs 18.3% under GAAP. Apple expenses associated operating costs as incurred, and defers the product cost and revenue. This weighs on operating margin because only a portion of the revenue related to the expense is recognized. Theoretically, this benefits margins in the next period since the deferred revenue to be recognized will have had its associated SG&A fully expensed in the prior period. However, SG&A costs are necessary to operate the business, thus there will be new non-product expenses arising in every period. As deferred revenue builds, the amount recognized increases by quarter offsetting the related operating expenses. Selling and advertising costs associated with the iPhone should be the highest in the months following the launch. This creates a favorable situation where recognized revenue is rising coupled with falling non-product costs.

First: With subscription accounting, operating margins should improve as the amount of revenue recognized flowing from deferred revenue increases. Second: Overall gross margins will rise as the high-margin iPhone revenue becomes a greater percentage of total sales. Thus, going forward, the iPhone should lift margins.

I believe the low GM guidance for FY09 is overly conservative. The iPhone GM is likely higher than 50%. Q4 GM was 39% sales in the period fully recognized. We can see the upward trend. Thus, GM somewhere else has to sharply decline. The new MacBooks are likely to create some pressure, but how much? Hard to say until we get Q1 numbers. Even so, those costs should moderate with increasing production volume along with lower component prices.

Apple could also trade margin for volume if demand elasticity appears to be favorable. Hence, keep GM in low 30’s by using iPhone margin to subsidize price reductions on other products to drive volume. Apple consumers are not very price sensitive, therefore something Apple is not likely to do. Considering the economic backdrop, it’s not a bad alternative to have on the table.

Conclusion:
FY09 gross margins will come in way above management’s guidance of 30%. The iPhone, with it’s staggering margins, will become a larger contributer to overall revenue, thus it will drive GM higher. Management is being excessively conservative, and the ultra-low GM guidance provides a cushion in the event that Apple’s business considerably deteriorates. A more favorable commodity and component price environment will also lend support to margins. As management stated, costs from the iPod and MacBook transition should also decreases from volume manufacturing and cost engineering as the firm moves along the cost curve. AAPL shares are pricing in lower margins as analysts are looking for FY09 EPS to be flat versus FY08. Even in a tough economic environment, I foresee better results.


Disclosure: Long Apple

Monday, October 6, 2008

Apple to Surpass its iPhone Sales Goal of 10M in CY08

This article was a collaborative effort with:

 Andy Zaky  from Bullish Cross 


Based on the tremendous efforts by members at Mac Observer’s AFB and Investor Village's AAPL Sanity Board member howlongtoretire  to track IMEI iPhone numbers, Apple has drastically surpassed analyst’ Q4 iPhone sales estimates, and reached its goal of selling 10 million iPhones in 2008.  The consensus estimates for iPhone sales figures for Apple’s Q4 (calendar Q3) were calling for approximately 4 million units.  It now appears that Apple has sold at least 7 to 7.5 million iPhones in Q4—that’s nearly 80% above consensus.  Apple has far surpassed even Gene Munster’s bullish estimates of 5 million iPhone sales in Q4 according to the data.  


At MacWorld 2007, when Apple was trading at the same price it is today, Steve Jobs and Apple set a bold goal of selling 10 million iPhones in 2008.  Despite Apple’s consistent reassurances of meeting its goal, bearish analysts repeatedly raised irrational concerns about whether Apple could reach such lofty sales figures.   In January, Bernstein Research analyst Toni Sacconaghi, an analyst who rarely comments on Apple, started the “missing iPhones controversy” which led to a herd of naive analysts to reduce their iPhone sales estimates to numbers that fell well below Apple’s 10 million iPhone goal for 2008.  Sacconaghi forecasted that Apple would only sell 7.9 million iPhones in the period.  This obviously put considerable pricing pressure on shares of Apple in February.  


Kathryn Huberty of Morgan Stanley, arguably one of the worst analysts covering Apple, estimated that Apple would only sell 9.3 million iPhones for the year.  Apple now appears to be on track to sell nearly double that number.  Yet, Huberty and Sacconaghi aren’t the only ones.  Keith Bachman of BMO Capital also jumped on the bashing Apple bandwagon in February when he estimated that Apple would only sell 8.5 million iPhones in 2008.  Scott Craig of Bank of America also maintained bearish iPhone estimates in February with an 8 million iPhone sales target.  Several other analysts followed suit and were obviously dead wrong.  One would think these analysts would have learned from their mistakes, yet to no avail we see similar behavior from many of these very same analysts today.  


IMEI Number Tracking by Mac Observer’s AFB

An IMEI number or an International Mobile Equipment Identity number is a unique 15 digit code assigned to each individual iPhone found on the back of the box in which an iPhone is packaged.  Within this 15 digit code are two 6-digit numerical sequences crucial to determining the number of iPhones being produced.  One 6 digit number, known as the TAC, or Type Allocation Code, signifies a particular build or set of iPhones being manufactured.  The second 6 digit number is unique to each individual iPhone produced in that particular series—so that 1 million iPhones can be registered to a specific TAC.  In other words, one six digit code, known as the TAC, signifies a set of iPhones being produced whereas the other six digit code signifies each individual iPhone within the TAC set.         


Members at the Apple Finance Board at Mac Observer have been collecting IMEI numbers from new 3G iPhones sold during the period, and have been maintaining a spreadsheet of iPhone IMEI data points along with the purchase date, model, and production week.  By early September, Apple was on its 8th TAC, meaning that 8 million 3G iPhones had already been manufactured.  The actual number of handsets sold versus manufactured depends on a variety of factors including the amount of inventory Apple carries in its retail chain, defects that were destroyed, defects that were sold and then exchanged, display models etc.  


However, the latest IMEI data point collected by AFB was 9,190,680—an 8GB Black iPhone recorded as manufactured on September 29 and sold on October 5.  This suggests that even if a whopping 1.5 million iPhones of the total IMEI registered devices are unsold as of today, an unlikely assumption, it would still put 3G iPhone sales at 7.6 million units and 2008 iPhone sales at over 10 million units.  Coming into the quarter, Apple had already sold 2.42 million iPhones.  Thus, 7.6 million 3G iPhones sold puts Apple above 10 million units for the year.  


Net Applications OS Market Share:

The Net App OS share measurements based on web usage data lends further support to the IMEI tracking conclusions. In the weeks leading up to the 3G launch, iPhone OS share was rather consistent hovering at 16 bps. During this period, the population of iPhones remained static at 6 million units because inventory dried up weeks before. The share readings began to rise sharply subsequent to the 3G introduction. Due to the volatility and noise present in the data over the quarter, it’s not possible to make granular assessments. However, for the last few weeks of the September quarter, iPhone OS was averaging 34 bps. This suggests iPhone units increased by 6.75M. A small portion of legacy iPhones were replaced by 3G models resulting in those sales having no effect OS market share readings. Sales into the channel are not represented in the Net Applications measurement since the device is yet to reach the end-consumer.   This data together with the IMEI Number Tracking by the AFB highly suggests that Apple more than likely sold at least 7 million iPhones in Q4 and that Apple has surpassed its 10 million iPhone target.  

 

See my previous commentary: iPhone Q4 Sales Estimates 


Disclosure: Both Authors are Long Apple

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