Above Avalon Podcast Episode 136: The Unit Sales Crutch

The most surprising part of Apple’s 4Q18 results wasn’t found with the numbers or even guidance. Instead, by announcing unit sales data would no longer be provided starting in 1Q19, management dropped a bomb on Wall Street. Episode 136 is focused on discussing Apple’s decision to move beyond unit sales. We go over how unit sales became a crutch for financial analysts. The discussion then turns to management’s new blueprint for how it wants Wall Street to judge Apple. Additional topics include Apple revenue and gross margin trends, Wall Street narratives, and Apple as a toolmaker.

To listen to episode 136, go here

The complete Above Avalon podcast episode archive is available here

Apple Outgrew Unit Sales

In 2014, Apple management surprised many by announcing they were not going to disclose Apple Watch unit sales once the product went on sale the following year. The decision was interpreted by many outsiders as Apple not thinking too highly of Watch’s prospects. As it turned out, nothing could have been further from the truth. Apple’s Watch disclosure decision ended up foreshadowing management’s recent announcement that it will no longer disclose iPhone, iPad, or Mac unit sales. While a number of factors are behind Apple’s decision, the simplest explanation for the disclosure change is that Apple outgrew unit sales.

Disclosure Changes

Apple announced four financial disclosure changes for the new fiscal year (2019):

  1. Unit sales data for iPhone, iPad, and Mac will no longer be provided.

  2. Gross margin data will begin to be broken out by services and products (i.e. hardware).

  3. Revenue corresponding to the amortization of the deferred value of bundle services (Maps, Siri, and free iCloud) will shift from products to services. The same reclassification will apply to costs associated with delivering the bundled services. The impact from these changes will amount to less than 1% of Apple’s overall revenue.

  4. The “Other Products” category will be renamed “Wearables, home, and accessories” to reflect the category’s primary revenue drivers (Apple Watch, AirPods, Apple TV, and HomePod).

Not surprisingly, most of the attention flowed to the first item. The thought of Apple no longer disclosing unit sales surprised most people and some went so far as to say Apple wants to hide something really bad in the coming quarters. Others acknowledged Apple made the right decision to move beyond unit sales, although it wasn’t a great development in terms of public company disclosure.

The Unit Sales Problem

Apple management’s decision to no longer disclose unit sales makes plenty of sense. In recent years, it was becoming increasingly clear that unit sales weren’t as useful of a metric for analyzing Apple’s business now as it had been in the past. The primary problem found with unit sales was how the data provided a limited look inside the Apple machine.

Consider the following items:

Unit sales became a crutch for financial analysts. The quarterly numbers were telling us less about Apple’s business and were instead providing a false sense of security to outsiders. As it turned out, unit sales were painting a less attractive picture of Apple’s business fundamentals.

The primary reason unit sales data lost much of its value is Apple’s significant growth over the years. With an iPhone installed base of more than 750M people, quarterly iPhone unit sales were providing less information about the iPhone business. Unit sales went from a measure of the market’s reception to iPhone to a financial data point more likely to be misinterpreted than anything else. The same can be said about the iPad and its installed base of 240M people. Years of unit sales declines gave many the impression that iPad was a dead-end. In reality, iPad fundamentals have been improving for years. Unit sales data was masking the improvement.

The one item that for which unit sales continued to prove valuable was deriving average selling prices. However, given the growing impact the gray market is having on Apple’s various product categories, and wider product price ranges, even ASP data has started to lose value in analyzing business fundamentals.

Revenue and Gross Margin

Analysts are making a big mistake in claiming Apple’s decision to move away from unit sales means management wants to be more like a services company. Claiming Apple is a services company in 2018 is no different than claiming Apple was a hardware company ten years ago. Both are incorrect.

Apple is a design company focused on developing tools for people. These tools allow people to get more out of technology without having technology take over their lives. This mission leads to a simple, but important, realization: Apple has to continuously develop new tools that people want. A question raised by such a mission is how best to measure Apple success and failure.

Management is painting a new long-term blueprint for how it wants Wall Street to judge Apple: revenue and margins. By having attention flow not just to revenue but also to gross margins, Apple ends up adding an interesting twist to the financial disclosure debate.

Revenue has been one of the most consistent metrics for determining how Apple is doing in the marketplace. Exhibit 1 depicts Apple revenue over the past eight years. Despite years of unit sales volatility, Apple’s revenue trends have been much smoother. The only hiccup in Apple revenue followed a surge in iPhone revenue in 2014 associated with the iPhone launching at China Mobile.

Exhibit 1: Apple Revenue (TTM)

Management will continue to disclose iPhone, iPad, and Mac revenue going forward. It’s difficult to see Apple not eventually disclosing Apple Watch revenue, or at least wearables revenue, as sales continue to grow.

However, revenue data by itself is unable to tell the full story. Management could juice near-term revenue by running with lower prices and margins in an attempt to grab market share. Such a move may boost near-term revenue at the expense of problems down the road. Vice-versa, Apple could be generating additional revenue by milking existing customers with excessively high prices and margins. The strategy contains various long-term risks when thinking about the health of the Apple ecosystem.

This is where gross margins enter the picture.

Gross margin data allows outsiders to dive deeper into Apple revenue. Strong revenue growth combined with steady margins tell us that Apple isn’t chasing market share with unsustainable pricing. Steady gross margins, despite higher-priced products, tell us that Apple isn’t milking existing users of profit, but is instead running with higher prices to reflect additional technology. Gross margins add much-needed context to Apple revenue.

Historically, Apple has disclosed one overall gross margin figure for the entire business. Given the lack of disclosure detail, we were only able to reach a few general takeaways about Apple’s gross margins.

  1. Given how Apple’s overall gross margins trend between 37% and 39% and iPhone represents such a large portion of the revenue, it’s fair to assume iPhone margins are somewhere around 40%.

  2. Based on management commentary, Apple’s Services business has gross margins that exceed the company’s overall margins. This tells us that Services gross margin exceeds 40%. My estimate pegs Services gross margin in the mid-50s.

  3. Based on management commentary, Apple Watch gross margins were lower than the company’s overall margins. This tells us Watch margins are somewhere around 25% to 35%. It is a fair assumption that iPad and Mac have a similar margin profile.

As shown in Exhibit 2, for the past four years, gross margins have trended within a narrow 200 basis point range. This hasn’t exactly told us a whole lot about the different variables driving gross margins. Based on Apple’s new margin disclosure, management will break out gross margins by hardware and services. Accordingly, we will be able to see whether or not Apple has been running with higher product margins to boost profits or merely to reflect higher component costs. (My suspicion is it’s the latter.) We will also get our first look at Apple’s Services margins which will help decode the various Services revenue growth drivers. In summary, providing more granular gross margin data is a big step forward from a financial disclosure perspective. While it may seem like an exaggeration, trading unit sales data for more granular gross margin data could prove to be more beneficial for analyzing Apple’s business fundamentals.

Exhibit 2: Apple Gross Margin (TTM)

What About User Growth?

One school of thought regarding Apple’s unit sales disclosure change is that management is gradually moving towards providing completely new metrics such as the number of users in the Apple ecosystem. Apple’s success would then be measured by tracking the total number of users and management’s ability to monetize those users. One way of doing this would be to take Apple revenue and divide the total by the number of users.

Presumably, rising revenue per user would be viewed as a good thing, while a declining revenue per user metric would be viewed negatively. However, there are a few issues to consider.

  1. It’s not sustainable. Unless Apple changes its pricing philosophy, the company will eventually begin to hit a ceiling when it comes to new user growth. Accordingly, why would Apple management elevate an unsustainable metric, especially since the company is moving away from unit sales given its unsustainable nature.

  2. Questions around usefulness. It’s not entirely clear how useful revenue per user actually would prove to be for analyzing Apple. Unless Apple breaks down revenue per user by hardware and services, the overall average won’t tell us much about the various moving parts.

  3. Bias towards services over hardware. By focusing on revenue per user, there is an inherent bias to elevate Services revenue given its more predictable and steady nature.

It’s All About Narratives

The decision to elevate revenue and margins while moving past unit sales is Apple management’s latest attempt to cement a new long-term narrative for the company on Wall Street.

People love great stories, and Wall Street is all about narratives. A strong narrative allows a management team to navigate rough waters while a weak narrative may result in depressed valuation multiples. Accordingly, Apple’s inability to find a sustainable narrative has been a thorn in management’s side for years.

Apple’s narrative problem was relatively straightforward: The key variables management focused on in earnings releases and conference calls weren’t sustainable. By placing an emphasis on unit sales, the inevitable slowdown in unit sales growth for its largest product categories posed a problem for Apple.

Forcing Wall Street to move beyond unit sales and focus on revenue and gross margins isn’t about driving home a Services narrative for AAPL shares. Instead, it’s a big step in elevating a capital allocation narrative. Compelling tools will lead to strong revenue trends and margins, which support attractive free cash flow and consequently more cash for buyback and cash dividends. The opposite is true as well with weaker product sales leading to a reduction in cash flow and less cash for share repurchases and cash dividends.

At the heart of this narrative is management's unique philosophy regarding how shareholder capital is used to generate future cash flows. Apple doesn't develop products to drive revenue. Instead, many ideas are passed over to focus on a few really great ideas. A narrative involving Apple's capital strategy rather than any one story based on a particular product like iPhone or Apple Watch will end up doing a better job of describing the company's design story. More importantly, a capital allocation narrative will be able to grow with Apple as the company evolves over time.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Apple 4Q18 Earnings Expectation Meters

Apple will report another good earnings report on Thursday. Revenue guidance for 1Q19 will be one for the record books as Apple will guide to its best quarter ever. However, when diving down deeper into Apple’s 4Q18 results, things may look a bit messier. The fourth quarter was one of transition for Apple as the company launched new iPhones and Apple Watches. It would not be surprising if demand for a number of product categories waned heading into September. However, stronger iPhone and Apple Watch ASP trends will more than offset unit sales weakness.

Estimates

The following table contains my Apple 4Q18 estimates.

The methodology and data behind my estimates are found in my full 3,600-word Apple 4Q18 earnings preview available here exclusively for Above Avalon members. (To become a member and access my full earnings preview, visit the membership page.)

Each quarter, I publish expectation meters ahead of Apple's earnings release. Expectation meters turn single-point financial estimates into more useful ranges that aid in judging Apple's quarterly performance. In each expectation meter, the white shaded area reflects my single-point estimate. The gray shaded area represents my broader expectation range. A result that falls within this gray range signifies that the product or variable being measured is pretty much performing as expected. A result that falls in the green shaded area denotes strong performance and the possibility of me needing to increase my estimates going forward. Vice versa, a result falling in the red shaded area has the opposite effect, potentially leading me to reduce my assumptions going forward. 

As with last quarter, I am publishing three expectations meters for Apple's 4Q18:

  1. iPhone unit sales

  2. "Other Products" revenue

  3. 1Q19 revenue guidance

iPhone

My expectation is for Apple to report iPhone unit sales between 44M and 48M units. A result north of 48M units would be considered strong while a sub-44M result would be considered weak.

Other Products

Apple's "Other Products" category is a catch basin for the following products: Apple Watch, AirPods, HomePod, Apple TV, Beats headphones, iPod touch, and Apple-branded and third-party accessories. The closer 4Q18 "Other Products" revenue is to $5B, the more likely it is that Apple Watch and AirPods results were strong. A result closer to $4 billion of revenue would reflect some Watch demand being pushed into 1Q19 due to customers waiting for Apple Watch Series 4.

Guidance

Apple’s 1Q19 revenue guidance has a good shot at exceeding Wall Street’s expectations. My $98B to $100B revenue guidance estimate is $5B to $7B higher than consensus. The discrepancy is likely explained by different estimates regarding iPhone unit sales mix and its impact on iPhone ASP.

My full 4Q18 earnings preview contains three parts:

  1. Setting the Stage

  2. iPhone, iPad, Mac, Apple Watch, and Services Estimates

  3. 1Q19 Guidance, Updated Apple Earnings Model, Final Thoughts

To read my full preview and receive my Apple earnings review later this week, sign up at the membership page

Above Avalon Podcast Episode 135: The Gray Market Factor

In episode 135, we look at how the gray market for refurbished and previously-owned iPhones is impacting Apple’s iPhone pricing strategy. The discussion begins with a closer look at iPhone ASP (average selling price) trends and my thoughts on how the gray market is impacting iPhone ASP. We then go over the three key ingredients needed to sustain a functioning gray market for iPhone. Additional topics include: iPhone durability, the iPhone Upgrade Program, iPhone residual values and depreciation, and future iPhone ASP trends.

To listen to episode 135, go here

The complete Above Avalon podcast episode archive is available here

The Gray Market's Impact on iPhone Pricing

The expanding gray market for refurbished and previously-owned iPhones continues to gain legitimacy and influence. According to my estimate, approximately 150M iPhones in use passed through the gray market. This means that nearly 20% of iPhones in the wild, including hand-me-down iPhones, were previously owned by someone else. Along with helping Apple expand its user base, the gray market is also impacting Apple’s iPhone pricing strategy in an unexpected way: by driving iPhone average selling price (ASP) higher.

iPhone ASP

A few years ago, consensus was convinced that Apple would need to lower iPhone pricing due to competitive pressures. The iPhone 5c and iPhone SE, while very different from each other, were positioned by many as attempts by Apple to address lower-priced market segments.

However, things changed in a big way in 2017. Apple became more aggressive at the high-end of the iPhone line. The iPhone X’s $999 starting price was one of the most talked about Apple topics last year. Apple also increased pricing for iPhone 8 and 8 Plus. Management expanded on its high-end iPhone pricing strategy last month with iPhone XS Max, the highest-priced iPhone to date. In what ends up being a sign of how far Apple’s iPhone pricing has changed, Apple’s “low-cost” flagship, the iPhone XR, is priced $50 higher than the iPhone 8.

Given higher-priced flagship iPhones, it shouldn’t come as a surprise that iPhone ASP has been on the rise. As seen in Exhibit 1, which tracks iPhone ASP on a trailing twelve months basis, a notable upward trajectory in ASP began in 1Q18 with the iPhone X launch.

Exhibit 1: iPhone Average Selling Price (ASP)

The rise in iPhone ASP has led some to conclude that Apple must have shelved its strategy for growing iPhone sales and the user base by lowering prices. Instead, Apple is said to be milking existing iPhone users with higher-priced models. This school of thought ends up ignoring how the expanding market for refurbished iPhones is contributing to new user growth and a higher iPhone ASP.

Gray Market Impact

A tenet of Apple’s iPhone pricing strategy has been selling older flagship iPhones at lower prices. For example, along with selling iPhone XS Max, XS, and XR, Apple continues to sell iPhone 8, 8 Plus, 7, and 7 Plus. Apple is even selling older models such as the iPhone SE and 6s Plus in select markets. The company is able to run with lower prices for these older flagship models due to economics of scale and improved production and assembly costs.

Traditionally, older iPhone models accounted for as much as 30% of overall iPhone sales. Having such a significant portion of unit sales going to lower-priced iPhone models kept a lid on iPhone ASP. However, things are changing. In 3Q18, non-flagship iPhone models likely represented just 20% of overall iPhone unit sales. As the number of customers buying refurbished and pre-owned iPhones through the gray market increases, Apple is seeing less demand for the lowest-priced iPhones in its lineup. Customers in lower price brackets have additional iPhone purchasing options at their disposal thanks to the gray market.

Despite weaker demand for lower-priced iPhones, Apple continues to see modest growth in iPhone sell-through demand. This tell us that demand for new flagship iPhones has not subsided. Instead, demand for higher-priced iPhones is growing. The shift in iPhone sales momentum from lower-priced, older flagships to higher-priced iPhones is contributing to higher iPhone ASP.

Gray Market Ingredients

Three key ingredients are needed to sustain a functioning gray market for iPhone.

  1. Good device durability and usability. Simply put, iPhones need to hold up over time. A phone that can barely last after two or three years of usage is not conducive to a vibrant used market.

  2. Strong demand for refurbished iPhones. Many of Apple’s competitors lack a vibrant gray market given the lack of customer demand for refurbished products from that brand. In addition, other brands directly address lower-priced segments. However, given Apple’s iPhone pricing strategy and the company’s aspirational brand, there is a considerable amount of interest and demand for refurbished iPhones at lower prices.

  3. Steady supply of gently-used iPhones. Services like early upgrade plans offered by mobile carriers and Apple’s iPhone Upgrade Program are resulting in a stream of gently-used, year-old iPhones being turned in by customers. This supply of used iPhones is needed to satisfy the demand for lower-priced iPhones.

Durability and Usability

At last month’s iPhone and Apple Watch event, Lisa Jackson, Apple VP environment,
policy and social initiatives, unveiled Apple’s latest environmental goal to eliminate the need to mine new materials from the earth. In order to stop mining new materials, Apple will focus on three things:

  1. Find new ways to make products with recycled or renewable materials.

  2. Make products last as long as possible.

  3. Recycle products properly.

Increased durability doesn’t just allow existing customers to use Apple products for longer. The products can also enter the gray market and eventually be used by more people over time.

When it comes to durability, Jony Ive and Apple’s Industrial Design group have been focused for decades on the topic as it relates to product design. Good product durability is one reason there is already a strong gray market for iPhone. It is true that Apple designers sometimes find themselves between a rock and a hard place in terms of durability. Mobile batteries are a prime example. The fact that iPhone users can’t easily replace batteries is a durability trade-off in order to achieve other usability goals. However, Apple’s embrace of an iPhone battery replacement program speaks to management’s desire to elevate device durability within its iPhone strategy.

Meanwhile, Apple’s focus on having iOS 12 support older iPhone models highlights management’s motivation to improve usability. By supporting iPhone models going back to the 5s, Apple is able to keep tens of millions of devices, many of which have likely passed through the gray market, running the latest software. This proves beneficial when it comes to keeping these iPhones in circulation.

Strong Demand

Apple has the most popular smartphones in the market. This popularity translates to strong demand for iPhones, even at higher prices. The reason iPhone sales are a fraction of overall smartphone sales is that Apple is only playing in certain market segments. Such a decision ends up providing a huge boost to the iPhone gray market as there is unfilled demand for lower-priced iPhones.

The gray market allows Apple to reach customers who may not otherwise be in the company’s traditional target market. While iPhones sold in the gray market aren’t included in Apple’s revenue, the company does benefit if sales are to new users. Apple is able to sell services and additional hardware to these new users over time. This cycle becomes that much more impactful assuming an iPhone ends up being passed on to three or four owners over its lifetime, with each ownership change occurring at a lower price.

Steady Supply

Services like early upgrade plans offered by mobile carriers and Apple’s iPhone Upgrade Program are made possible by a functioning gray market. Robust residual values make it financially feasible for users to turn in gently-used iPhones after making 12 monthly payments and walk away with the newest iPhone. Many of these gently-used iPhones that are turned in are then recirculated in the market to find a new home. This creates the supply the iPhone gray market needs to sustain itself.

Exhibit 2 highlights iPhone residual value as a percentage of original launch price. After the first year, iPhone residual value is approximately 40%. This means that an original iPhone 8 / 8 Plus owner trading in the device after a year can expect to receive 40% of the device’s original cost. The percentages come from iPhone trade-in values offered through Gazelle. It is important to note that iPhone users may find better trade-in values elsewhere, such as store credit through Apple.

Exhibit 2: iPhone Residual Value Percentage

Note: Trade-in values are for unlocked iPhones in “good condition” and for the lowest storage configuration.

iPhone depreciation appears to be high in the first year (62% on average). The rate of depreciation slows to 13% in the second year and 11% in the third year. All of these iPhone depreciation rates appear to be lower (iPhone has stronger residual values) than the rates of Samsung smartphones.

My theory regarding these residual value/depreciation rates is that iPhone trade-in programs offered by some mobile carriers are beginning to result in a supply of gently-used iPhone 8 and 8 Plus iPhones entering the market. This may be leading to some weakness in trade-in offers for these models from sites like Gazelle. Interestingly, the higher-priced iPhone X has a better residual value percentage than does the lower-priced iPhone 8 and 8 Plus. This could be due to the iPhone X launch taking place in November 2017. Meanwhile, there appears to be a better supply/demand environment for customers trading in two and three year old iPhone models, as seen by lower depreciation rates.

As the gray market for refurbished iPhones grows, it would not be surprising to see iPhone residual values improve slightly over time as demand for pre-owned iPhones increases.

Stronger Flagship iPhone Sales

Earlier this year, the WSJ published an article positioning the gray market as “a culprit to blame for slumping [smartphone] sales.” The scenario painted by the WSJ was that current iPhone users were turning to the gray market when buying iPhones. This was said to result in less demand for higher-priced flagship iPhones.

The problem for the WSJ is that their thesis was built on the theory that iPhone X sales were weak. In reality, Apple sold 60M iPhone X units since launch, which is an impressive feat. The WSJ’s factually incorrect stance ended up being widely held in the press, despite Apple management declaring quarter after quarter that the iPhone X was the best-selling iPhone.

While it may seem counterintuitive, a healthy iPhone gray market can boost sales for higher-priced flagship iPhones. A functional gray market makes it possible for services like mobile carrier upgrade plans and Apple’s iPhone Upgrade Program to exist. As the number of iPhone users take advantage of these upgrade services, Apple sees a growing stream of annual iPhone upgrades. In a market in which the overall iPhone upgrade cycle is getting longer, annual iPhone upgrades, even if representing a small percentage of sales, can play a role in stabilizing iPhone demand and boosting iPhone ASP.

Looking Ahead

Apple will continue to sell lower-priced, older iPhones in in select markets, like India. However, as the gray market for refurbished iPhones continues to expand, Apple will face less pressure to come out with lower-priced iPhones with fewer features in developed markets. This dynamic bodes well for the idea of higher iPhone ASPs over time.

In 3Q18, Apple reported a $724 iPhone ASP, a record-setting $118 higher than the $606 iPhone ASP reported in 3Q17. It will be difficult for Apple to report a similar jump in iPhone ASP in FY2019. Instead, the more likely scenario is that the long-term average for iPhone ASP gradually increases. Over the past 10 years, the mean iPhone ASP was $640. It is possible that this mean ASP will move towards $700 over time.

The iPhone gray market is turning into a long-term tailwind for iPhone ASP. A major implication from such a development is that iPhone ASP is more resilient and sustainable than it may appear at initial glance.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.