- Supply constraints and mixed signals from high-end Chinese consumers have weighed on Apple shares.
- I anticipate demand pull-through from Q1’17 suggesting that 10% y/y sales growth in China is attainable from Q2’17 onwards.
- This more optimistic scenario isn’t priced into AAPL stock, suggesting meaningful upside to earnings for the remainder of FY’17.
There’s no clear consensus on how Apple Inc. (NASDAQ:AAPL) will perform in China, as retail channel checks suggest demand is robust in China.
However,the Chinese retail commentary wasn’t very supportive in the month of October, and I’m guessing that was attributed to Apple’s cautious stance on channel inventory, as Apple reduced channel inventory by a couple of weeks, which reduced production at the two major ODMs (other device manufacturers).
Since suppliers are further up-stream, the tepid commentary from the Chinese ecosystem can be rationalized as Apple failing to forecast demand (yet again) and ordering a modest sum of iPhone’s. So, Apple’s Q1’17 results will be capacity constrained, and lead times for the iPhone 7 is unlikely to balance itself until we move beyond the seasonally strong quarter. (See also: 3 Reasons To Buy Apple Inc. (AAPL) Stock Now)
Last year, Apple over-supplied its retail channel and ended the quarter with high levels of iPhone 6S/6S Plus channel inventory, which resulted in an 18% y/y decline in iPhone sales in Q2’16, as Apple could no longer sell into the retail channel. As such, the massive mishap resulted in the worst y/y comps seen in the iPhone segment.
So, what’s different this year?
The downside to Apple’s cautious approach for the iPhone 7/7 Plus equated into a missed opportunity to capture Samsung defectors given the mass recalls of Note 7, and rumored S7 Edge explosions. But then again, who could have predicted that Samsung was going to suffer such reputational damage?
However, once Apple moves past the seasonally strong quarter, there’s plenty of available capacity for components and manufacturing, hence smartphone shipments are expected to perform above seasonal trends as spill-over demand translates into a Q2’-Q4’17 themed iPhone story.
The irony is the 360-degree reversal from the prior year, as the exact opposite occurred in FY’16.
It’s difficult for investors to buy into this narrative, as sentiment weakened given three consecutive quarters of earnings misses from Q1’16 to Q3’16. We’ve become accustomed to negative Apple news, so seeing the silver lining is difficult, especially in an environment where election uncertainty and on-shoring of production may diminish gross margins.
The lack of conviction can be captured by the weak price action following the announcement of Q4’16 earnings. Initial checks from UBS suggested that Apple’s market position in China has diminished given mounting competitive pressure. In my prior article on Apple, I highlighted that Chinese demand during the early weeks of the iPhone 7/7 Plus launch was weak in comparison to 6S, as per UBS commentary.
However, recent data suggests that Chinese shipments may perform better than initial analyst expectations.
Gene Munster from Piper Jaffray mentioned on Friday that retail supply is more constrained in China than in the USA with retail channel inventory in the US much leaner than prior year:
Outside of the US, we are unable to capture iPhone availability at Apple Stores, but can capture similar data from 96 China Unicom stores in China. Inventory in China continues to be more constrained than in the US with around 16% total availability vs 47% in the US.
We checked 134 Apple Stores in the US for in-store iPhone 7 availability. 47% of SKUs that we checked were available for in-store pickup compared to 40% a month ago. By comparison, last year the iPhone 6S was at 100% availability at this time.
The Chinese consumption trend must have picked up momentum, as channel sell-out is strong compared to prior year. Or, it’s symptomatic of aggressive inventory management to capture demand from developed and emerging markets outside of China thus reducing availability in China.
While the Chinese geographic segment is likely to decline in Q1’17, shipments will likely accelerate as supply becomes more readily available in the following quarter thus translating into better results from China in Q2’ and Q3’.
I anticipate iPhone sales to grow following Q1’16
While I can acknowledge that it’s difficult to gauge the potential re-emergence of Chinese consumers, I anticipate that these supply constraints and negative commentary from the retail channel (while conflicting) can still be rationalized.
Apple’s performance in China will likely perform above seasonal trends next quarter, as spillover demand from Q1’17 could be far more meaningful than initial expectations. While Chinese brands are capturing market share in the mid to higher price segments, weakened Samsung brand perception should translate into Apple market share gains in the $600+ ASP (average selling price) category.
UBS Evidence Lab pointed out that weakness in consumer perception of Samsung was skewed towards APAC (Asia Pacific), which further supports the rationale that customers gained from Samsung will be concentrated most heavily in China.
The basic napkin math on China
I make this case, as Q1’ results tend to be 30% to 32% higher than Q2’ in the Chinese segment. This suggests that lost iPhone sales due to supply constraints will pull-through into the next quarter. So, even if Chinese iPhone shipments decline 10% y/y in Q1’17 given supply constraints, the demand will be recaptured in the following quarter, which means that if revenue were to decline by $1.72 billion due to non-existing iPhone 7 supply, the same figure could be added in the next quarter. (See also: 3 Reasons To Buy Apple Inc. (AAPL) Stock Following The Recent Sell-off)
Furthermore, demand for 7/7 Plus is above expectations, which suggests organic revenue growth could be 5 to 10 percent higher than prior-year (in-line with installed base expansion), which translates into Chinese revenue of $13.42 billion + $1.72 billion from supply shortages, equating into $15.4 sales assuming constant currency. This translates into 23.4% y/y revenue growth and after subtracting the 9% y/y decline in the Chinese Yuan, the Chinese segment will likely report $13.77+ billion in total revenue, which translates into 10.3% y/y GAAP revenue growth in Q2’17, in my somewhat optimistic scenario.
Android OEMs haven’t captured meaningful market share in the $600+ segment, so I’m not expecting meaningful defections from Apple due to supply shortages.
Chinese consumers that buy at the high-end of the market are more likely to wait for supply to free up, as opposed to buying from a different brand given the obsession over “brand image.” While cannibalization from cheaper phone brands remains a distinct possibility, the extreme high-end of the Chinese consumer base that can afford an $800 phone will stick with Apple whereas the emerging middle class will adopt cheaper domestic brands. Since both consumer segments are growing, I believe that Apple can grow its Chinese installed base organically.
I maintain the stance that Apple will outperform this year, as the next quarterly earnings will provide greater visibility on channel inventory, demand, and pass-through from Q1’17.
And while some may wait for the 10-year anniversary of iPhone, I believe the aged installed base will grow impatient and buy the iPhone 7/7 Plus anyway. Sure, the next generation model will provide meaningful feature improvements (assuming rumors are true), but the degree to which it will delay purchases of the current generation model seems overstated given current retail channel checks.
As such, I maintain the stance that earnings/sales can still grow low mid-teens this year. I intend to publish an article detailing my FY’17 financial model in the next week.
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