- Apple has yet to saturate emerging markets, and income demographics point to further absorption possibilities for mid and high-end handsets.
- Foreign exchange will likely drive an earnings beat in the foreseeable future.
- Furthermore, research on the bill of materials points to a lower margin contribution from the mid-end category.
Things are getting interesting on the Apple (NASDAQ:AAPL) front, as I recently received research on emerging market demographic surveys from Credit Suisse and a bill of materials estimate from RBC Capital Markets. Needless to say, the figures on margin contribution and whether the impact from iPhone SE is net accretive to the shareholder base is somewhat contested among the investor base.
However, after taking into consideration the strength of Apple’s brand, product introductions, and handset replacement trends going into FY’17, I’m getting a lot more aggressive on the Apple stock. As such, I’m raising my Apple stock recommendation from a sell to a buy, as I anticipate meaningful momentum as we progress through the second half of Apple’s fiscal year. While I’m cautious on the upcoming quarterly earnings print out, the broad recovery in investor sentiment and shift in broad perceptions toward the next fiscal year gives investors the necessary fundamental argument to get back into the stock
Demographic mix points to installed base growth
Source: Credit Suisse
Apple’s penetration rate is fairly low in some of the more robust emerging economies according to Credit Suisse, which implies that Apple’s TAM (total addressable market) has yet to be fully saturated. The introduction of the iPhone SE at the mid-end implies that device shipments should begin to accelerate in some of the smaller geographic segments. I will be watching the geographic mix of revenue, as the incremental opportunities in these markets should become a more meaningful contributor to installed base additions.
Furthermore, it was noted that while emerging market consumers have less discretionary income to developed markets, the group that purchases Apple products are more affluent by nature and have enough discretionary spending capacity to purchase products at the mid/higher tiers. The population weighted average annual disposable income is $16,000 and remember, this is on a per user basis as opposed to per household. Inferring that data against macro reference points would require economists to compute average household sizes and employment rates for each separate market that’s averaged out with the income specific to Apple users. Clearly, that’s way beyond my scope of coverage, as I’m an independent analyst who doesn’t have the data sets to make like-to-like comparisons to macro models.
I come away with the impression that Apple’s product mix will shift towards entry-level high-end products similar to the pricing cadence of entry-level luxury cars in the automotive sector. This strategy is highly compatible with most high-end brands, and while I’m skeptical of Apple pushing price points any lower in the immediate five-years, I’m not going to completely rule out the possibility given the competitiveness in the space. That being the case, I’d rate further declines to pricing less likely, but feature additions typically reserved for higher-end phones to move further down into the product stack over time.
Foreign exchange will drive earnings results with buybacks less of a factor this year
Apple’s emerging market growth has slowed in some of the faster-growing regions. This was mostly driven by currency headwinds, which is expected to stabilize in the interim. I come away with this impression after reviewing various reports from the economist teams at Morgan Stanley and Bank of America Merrill Lynch. So, when you combine improving emerging market growth assumptions, which are driven by Apple store footprint/more aggressive pricing and diminished currency volatility – results are likely to exceed the consensus as we move through the latter half of the year. The dollar has consistently declined from the beginning of 2016 to the end of Q1’16. This implies that Apple’s GAAP non-adjusted revenue print out will be higher by 3 to 5 percentage points. I don’t adjust my models by excluding F/X impact because I believe that in years where the dollar is weak, the management teams will fail to mention the currency adjustment. But, when the dollar exhibits strength, the CFO gets together with his accountants to rationalize why results were a lot better by posting adjusted F/X figures.
While I’m a little muted on share buybacks this year, there’s perhaps added room for improvement going into the next annual review for capital returns. Apple usually makes an update to its capital return plans towards the end of April, so it’s worth keeping a look out for that event. However, investors could be disappointed by the buyback announcement as Apple's domestic cash position is limited, and raising debt does have limitations.
Bill of materials analysis still point to healthy corporate gross margins
The analysts over at RBC did everyone a real solid favor last week as they conducted their own bill of materials analysis. I’ve had my own share of run-ins with IHS iSuppli estimates on BoMs, as I’ve had to rationalize in prior articles why IHS figures could correspond to Apple’s reported gross income. The cost estimates required some serious over rationalization with Apple’s current cost structure. As it currently stands, the iPhone 6S and 6S+ material/manufacturing costs are likely closer to $330 to $355 when based off RBC’s figures. The iPhone SE has a bill of materials of $258, which implies gross margins of 35.3%. This negatively affects the margin mix, but I don’t anticipate that the consolidated margin figure will decline too significantly following the introduction of a mid-tier handset.
However, the net differential in margins on the low-end versus high-end is still significant. However, the ASP mix for the iPhone SE could potentially shift to higher memory configurations as weighted average retail price estimates from UBS point to consumers paying the added storage premium, which in the case of iPhone SE could imply ASPs (average selling prices) above $450. Therefore, gross margins for the SE line-up could average closer to 40% as opposed to the 35% implied margin for the base storage configuration.
To conclude, investors could get surprised by both the headline and outlook figure from the upcoming April 25th earnings report. This will be driven by F/X as shipment outlook was in-line or below expectations among the analyst consensus. Investors will likely pile back into the stock once there’s guidance that confirms revenue recovery in the back half of the year. Many analysts who have conducted supply chain checks believe the over production in Q1’16 contributed to the weak sales outlook for Q2’16. Assuming the supply chain kinks work out, and incremental iPhone SE unit estimates of 15 million prove to be accurate, investors can anticipate further valuation recovery in the back half of 2016.
Therefore, I'm raising my recommendation on Apple from a sell to a buy. I will update my price target in a future article.