Life as I know it...

AAPL Becomes Largest Watch Brand in World by Revenue

It is VERY likely that AAPL has become the largest watch 'brand' in the world, as measured by revenue. During its September 2016 special event when it launched the iPhone 7 / 7 Plus, as well as the AAPL Watch Series 2, AAPL CEO, Tim Cook, put up a very interesting slide. It showed AAPL as the second largest watch brand in the world, as measured by revenue, just behind Rolex for 2015 - a year in which AAPL only shipped watches for 9 months. I believe that slide needs to be adjusted:

After looking at the numbers and relying on some very intelligent analysts who have put forth reasonable quarterly estimates on AAPL Watch shipments for the past four quarters (June 2016 through March 2017), it is very easy to conclude that AAPL has overtaken Rolex in TTM revenue, and by a rather large margin - approximately $650 million. Rolex revenue has been stagnant and estimates have pegged its annual revenues at $4.5 billion to $4.7 billion, annually.

Further to this assertion is commentary that was recently provided by AAPL Management when discussing its Fiscal Q2 earnings:

Cook on state of the Watch product:

Opening Remarks:

"Apple Watch sales nearly doubled year over year. Apple Watch is the best-selling and most loved smartwatch in the world, and we hear wonderful stories from our customers about its impact on their fitness and health."

Analyst Q&A:

"We have seen the watch as a really key product category for us since before we launched it. We took our time to get it right, and we've made it even better with the Series 2 offering. And we're really proud of the growth of the business. The watch units more than doubled in six of our top ten markets, which is phenomenal growth, particularly in a non-holiday quarter. And so we couldn't be more satisfied with it."

Name another company that can enter a stable industry over 100 years old & become the most lucrative player inside of two years...

One Caveat:

It is important to note that AAPL is likely the largest watch BRAND as measured by revenue, but it is not the largest WATCHMAKER by revenue. The consolidation of watch brands under one company has created conglomerates like Swatch, which includes the Swatch brand, Omega, and Breguet (just to name a few). The luxury brand conglomerate LVMH has a number of luxury watch brands including Hublot, Bulgari, Zenith and Tag Heuer.

32GB Entry-Level iPhone? Keep Dreamin....

The public has been calling for AAPL to raise its entry-level iPhone models from 16GB to 32GB - a move the company recently made on the iPad Pro's (and added to the price to compensate). AAPL is all about squeezing margins out of its hardware.  This is no more true than looking at the way AAPL has historically adopted components for its products - if it doesn't think the latest version of a component is going to make a difference for the customer experience, they won't spend the extra money to include it.  Examples of this include:

  • Foregoing the latest QCOM RF transceiver on several iPhone models because they didn't feel like the networks would actually enable the faster wireless speeds 
  • Being one of the last handset OEMs to adopt an 802.11ac BT / WLAN Module to enable faster wi-fi speeds.  
  • Consistently undercutting other OEMs on RAM - others have been piling in 4GB of RAM in their smartphones for years now - AAPL went to 2GB in September-2014 with the new iPhone 6 and 6 Plus handsets
  • Moving the new 9.7" iPad Pro power wall adapter down to 10W, when the iPad Air 2 (an inferior product ships with a 12W plug).

The iPhone 6 and 6 Plus models were the first iPhones that included a 128GB storage configuration, and also the first in the product's history that eliminated the 32GB storage option.  The new storage configurations are 16GB / 64GB / 128GB, with each tier adding $100USD to the price. AAPL also eliminated the 128GB storage configuration on the legacy models (e.g., iPhone 6 and 6 Plus) and did not offer it on the new 4" iPhone SE.

Something very interesting happened to the iPhone's Average Selling Price (ASP) when AAPL changed the storage configurations and added the larger 5.5" Plus models (which started at $749 off-contract for 16GB) in September-2014 with the iPhone 6 and 6 Plus variants.  Even with currency headwinds, iPhone ASPs jumped significantly Y-O-Y:

  • FQ1-15: $687 (+8%)
  • FQ2-15: $687 (+15%)
  • FQ3-15: $660 (+18%)
  • FQ4-15: $670 (+11%)
  • FQ1-16: $691 / $740 Constant-Currency (0% / 8%)

What's Driving Record iPhone ASP?

FQ1-16 (Dec-15) produced the highest iPhone ASP in the history of the most profitable product franchise, both on an actual and constant-currency basis.  However, the trend of rising ASPs really started with the iPhone 6 / 6 Plus.  While one could argue that the iPhone 6 Plus (with its incremental $100 price-point) is driving ASPs higher, the fact remains that the iPhone 6 and 6S models are still the most popular handset within the installed base.  Mixpanelshows that as of April 15th, the iPhone 6 and 6S constitute over 52% of all iPhone usage,while the 6 Plus and 6S Plus represent a little over 14%.

So while it is true that the 5.5" models are helping overall ASPs, there is something going on with the 4.7" models (6 & 6S) that is a much bigger factor.  As AAPL continues to add better cameras with more functionality (e.g., 4K video), people are finding that 16GB just isn't enough storage as they still like their photos stored locally (on the handset). So, what they're doing is jumping from the entry-level 16GB to the mid-level 64GB and shelling out an additional $100. According to an analysis by IHS Technology below, NAND flash storage prices continue to fall and are now at ~$0.35 per GB.  So, 16GB of storage is costing AAPL $5.50 and 64GB is costing the company an incremental $17. Meanwhile, they're charging the customer $100, which equates to an incremental $83 of margin on each 64GB convert. Note that the data is for a 6S Plus model, but is used to show the effect of additional storage from a component cost and incremental margin standpoint with all else being equal:

Source: IHS Technology - Estimated Cost of Apple iPhone 6S Plus (A1634)

The Bigger Issue With Offering a 32GB Entry-Level Storage Configuration...

If you believe, as I do, that the iPhone's record ASP is being driven more by people migrating up to larger storage configurations than by adopters of the larger 5.5" models at the higher price-point, then the bigger issue is the amount of customers that have been willing to pay the extra $100 for the extra storage that would feel comfortable with 32GB being enough:

"AAPL would lose significant revenue (and associated margin) from the "tweeners" who have been moving up to 64GB storage configurations at a $100 premium that would be happy to settle with 32GB of storage." 

If AAPL was to start offering a 32GB entry-level configuration at the same $649 / $749 entry-point (for the latest flagship 4.7" and 5.5" models, respectively), not only would they be losing margin by having to add in the extra 16GB of storage, they would also find a lot less customers moving up to the 64GB model.  After all, a lot of people likely fall into the "16GB is not enough and 64GB is probably too much" category.  ASP trends indicate that those people are playing it safe and shelling out the extra $100 at the luxury of excess capacity, rather than the risk of falling short of storage just when they're about to leave on a vacation.  If they had the option of a 32GB model, those people would likely resort to practicality and settle for the additional 16GB rather than pay the $100 premium for the extra 48GB.

The Bottom Line...

Could AAPL begin offering 32GB as the standard entry-level storage on new iPhone models?  Absolutely.  Should they? Financially-speaking - Absolutely Not.  The ASP trends' data proves that by keeping the entry level at 16GB, people desire the additional storage so much that they're willing to spend the extra $100 for the additional 48GB to move to the next storage tier (64GB). And for every person that does that, IHS' data would suggest it's an additional $100 on the top-line and $83 of gross margin.  83% margin is never a bad thing in tech hardware, and AAPL knows this better than anyone. 

Apple Channel Inventory - FQ3-2016 Takeaways

Despite my prediction of relatively flat iPhone channel inventory movement exiting fiscal Q3, Apple drew-down 600,000 units from the channel, which put them at the low-end of its 5-7 week forward-looking target range.  The draw-down is not all that surprising given that the 6S / 6S+ are both expected to launch in the current quarter and Apple has historically always taken down channel inventory in a quarter preceding an iPhone refresh.

Source: AAPL 10-Q Filings and Earnings Call Transcripts from Seeking Alpha

Katy Huberty of Morgan Stanley probed on this a bit with Cook in the Q&A:

  • Q: ...why drain channel inventory when iPhone 6 is selling so well?
  • A (Cook): As Luca mentioned, the channel inventory did go down by 600,000. We sold more units than we thought we would and so that was a part of that. The other part of it is that we always run with just the amount of inventory that we think we need. And so to the degree that sales are distributed in the countries with disproportionally with shorter supply chains, or the standard deviation demand is less, we would always choose to have less.  And so in this particular quarter, we were able to end basically right at the bottom end of our range and we view that as a good thing, not a bad thing. 

I interpret this as Cook basically saying that the sell-through was stronger-than-expected and that they chose the "conservative approach" to avoid future large fluctuations in channel inventory (e.g., FQ1 2013, FQ4 2013).

Here are a few things that I think the channel inventory movement means:

  • Apple will, as widely suspected, refresh the 6 and 6+ at the back-end of the current quarter (late-September) given the historical nature of draw-downs on this particular product.
  • Both Cook and Maestri indicated that the channel inventory exiting the current quarter was at the "low-end" or "bottom end" of the 5-7 week forward-looking range. If you assume, as I have, that channel inventory was likely at 5-weeks - this comes out to 3.29M units per-week (16.45M / 5-Weeks) of forward-looking demand. If you extrapolate this to the 13-week quarter, it implies forward-looking demand of 42.77M units. However, given the nature of refreshes with so many units back-loaded, it would be incorrect to assume that demand is equally weighted by-week throughout the quarter.  For example, during FQ4 2013 and FQ4 2014, the launch weekends of the 5S / 5C and 6 / 6+ accounted for 27% and 25% of reported unit sales for the quarter, respectively.
  • And one other thing - channel inventory reflects inventory held by 3rd party sellers, which does not include sales made directly by Apple - either through its brick-and-mortar or online stores.

AAPL Went Bullish...On Itself

I looked at the past 7 quarters of share repurchases (all of the quarters post-split).  During that period, the company repurchased 591.6 Million Shares (420.6 Million in Open Market and 171.0 Million through an Accelerated Share Repurchase (ASR) Program).  The total amount of open market purchases is $46 Billion at a weighted-average price of $109.37, which is ~15% higher than it trades today.  The Company was on a buying spree leading up to the holiday quarter.  In the September-2015 quarter alone, the company repurchased / retired 132 Million shares, the second highest quarterly repurchase in the period I looked at (they retired 162 Million shares in the September-2014 quarter).

In a recent discussion with Ovi Popescu he mentioned something to me that I didn't really think about when looking at the Company's FQ1-16 results - the relatively small amount of stock that the company repurchased during the quarter. As many know, the Company has a $200 Billion capital return program in-place, which is a combination of both share repurchases & dividends.  Through the December-15 quarter, the Company has returned $153 Billion of that $200 Billion, with $110 Billion coming in the form of Share Repurchases.  

But in the most recent quarter (Dec-2015), the Company only repurchased 46.4 Million shares - the lowest of the 7 quarters.  Now, to be fair, they only repurchased 53 Million shares last holiday quarter (Dec-2014).  There's always a big debate about share repurchases and the financial engineering that companies mess around with.  That said, I think AAPL truly buys back shares when it feels like the Company is undervalued.  I still think they believe it's undervalued, but the repurchases in Dec-2015 prove that they are a bit more cautious on that thought.

Note: Does not include shares that are retired as part of the net issuance of RSUs to employees.

FQ1-16 AAPL Channel Inventory

On its FQ1-2016 Earnings' Call on Jan-16, AAPL was probed during its analyst Q&A session about its iPhone channel inventory levels. This was odd in one sense. AAPL historically has disclosed the exact amount of channel inventory it builds or draws-down during its prepared remarks. This quarter, AAPL's CFO, Luca Maestri, merely said:

"We started the quarter below our channel inventory target range and thanks to an extremely successful manufacturing ramp; we were able to exit the quarter slightly above the low end of our target range of five to seven weeks of iPhone channel inventory." [Emphasis Added]

It was only during the Q&A, where Toni Sacconaghi pressed Maestri on the actual channel inventory levels when AAPL revealed exactly how much inventory it had built during the quarter. Maestri indicated that it had an iPhone channel build of 3.3 million units during the quarter. He went on to indicate that it entered FQ1-2016 significantly short of the 5-7 week forward-looking target. The 3.3 million unit build is a significant number of units and matches the highest channel build in the product's history - it built 3.3 million units during the FQ4-2013 quarter, which coincided with the launch of the iPhone 5S / 5C. Additionally, the combined sequential builds (FQ4-15 + FQ1-16) was 5.25M units - that is the highest sequential build ever. Here is AAPL's historical iPhone channel inventory dynamics with reported (sell-in) and underlying sales (sell-through):

Sources: Reported sales are from AAPL SEC Filings (10Qs & 10Ks); End Channel Inventory numbers are obtained from AAPL's earnings' call transcripts posted on Seeking Alpha.

Here's some food-for-thought on the channel inventory build in FQ1-2016:

  • When taking into account the channel build, underlying iPhone unit sales contracted 4.3% year-over-year, vs. the reported sales growth of 0.4%. This is interesting because of a comment made by Cook during the AAPL's FQ4 earnings' call in October, once again in the Q&A portion in response to a question posed by Toni Sacconaghi about expectations for iPhone growth:

"The same – my same response applies and I think we'll do quite good in iPhone. I do believe we'll grow this quarter as we put in our guidance that when you start with a number in the low 30s in terms of the percentage of the installed base that’s upgraded that had a phone pre the iPhone 6 and 6 Plus, that number still likely to leave a lot of headroom beyond December."

Cook is often very careful with his words so the fact that he believed the company would grow sales both in the December quarter and beyond implies that the company fell short of internal expectations on iPhone sales. It also is corroborated with the fact that AAPL would have missed the low-end of its revenue guidance range (an unprecedented scenario) but-for the booking of a $548 million settlement from Samsung in its "Services" revenue - as discussed by Chuck Jones of Forbes.

  • The 4.7% gap between reported sales growth (0.4%) and underlying sales growth (-4.3%) is the largest gap since FQ4-2013 when there was an 8.8% gap (reported sales growth of 25.6% vs. underlying sales growth of 16.8%).
  • To simply analyze channel inventory builds in historical context is not exactly an accurate measurement of the product health because the channel (3rd-party points-of-sale) have expanded significantly over the past few years - specifically in China. For example, AAPL was not selling the iPhone through the world's largest wireless carrier (China Mobile) when it had the 3.3M build in FQ4-2013.
  • However, the 5.25 million unit build that occurred between July 26, 2015 (beginning of FQ4-15) and December 26, 2015 (end of FQ1-16) is concerning. It means that AAPL has a lot of units sitting in the channel that it has already recognized revenue on that it will need to work-off during the March quarter (FQ2-16). This likely lends credence to the relatively low guidance that it provided for the March quarter and related commentary about March being a very tough compare.
  • In short, there are a lot of eerie comparisons this time around with iPhone channel inventory between what occurred in the FQ4-13 / FQ1-14 period, which may not bode well for Street expectations and actual performance. It should be noted, however, that the all-but-confirmed launch of an updated 4" iPhone in March-2016 (dubbed the iPhone 5se) could create new dynamics that haven't been seen before. It could be the first-time ever that AAPL has had two different timed iPhone release cycles in one fiscal year (assuming they bring out an iPhone 7 / 7+ in September-2016, as-expected).

I still think there is much headroom for iPhone growth both domestically and abroad. The research firm Mixpanel put out a report recently showing that 32.2% of active iPhone users are still using a 4" screen (5 / 5S / 5C) meaning they are either not enamored with the larger 4.7" / 5.5" offerings or are still waiting to upgrade. Additionally, the enterprise uptake of iPhones has been accelerating - Cook indicated at the BoxWorks conference that AAPL's TTM enterprise sales (ending in June-2015) were $25 billion - while that includes iPads, iPhones and Macs - I would suspect that the most significant acceleration of those sales is coming from iPhone. Lastly, the Android-switch rate that Cook keeps referring to is real - and that has nothing to do with whether the current installed base has upgraded or not.