Tackling the AAPL Unknown

Humans hate the unknown. Some look towards charts and tables, while others simply create stories to turn the unknown into easy to understand answers. 

Apple is currently facing the following questions (I suppose you can say its my attempt at tackling the unknown): 

1) Is iPhone growth slowing?  Maybe. We don’t know. iPhone 5 supply/demand is not in equilibrium. Apple is currently selling every iPhone 5 it can produce. After reporting 81% annual iPhone unit sales growth in 2011, Apple is tracking towards 70% growth in 2012. Will growth continue to decline or can the iPhone 5 stem the inevitable for a few more quarters? 

2) How should we think about iPad? I’m left somewhat confused following Apple’s iPad event. Heading into today, my gut was telling me the iPad (3) was not selling too well compared to the iPad 2 - a sign that consumers’ needs were being met with a cheaper, lower quality iPad. I also assumed an iPad mini would be positioned as a content consumption device to the iPad 2 and 3.  

Instead, Apple revised the iPad (4), kept the iPad 2 alive (seemingly to float in no man’s land), and unveiled an iPad mini that by all measures is as capable as a full-size iPad and just as worthy as its larger, and more expensive, siblings.  Will iPad’s ASP continue to decline? Where are margins heading? Are consumers’ technology needs being met by iPad? Questions are certainly outnumbering answers. 

3) Will Apple introduce new product categories?  Maybe. We don’t know. We can assume that Apple has plenty of new stuff cooking in the labs, but we have few concrete details on anything.  Will 2013 be the year of the next “big thing”? 

4) Is the economy impacting Apple?  Maybe. We don’t know. Apple was able to survive the financial crisis of 2008-2009 without much damage, however Apple was a much smaller company at that time appealing to a more niche audience. Are consumers delaying technology purchases due to economic pressures?  Apple continues to have supply issues, but once demand/supply equilibrium is met, sales are increasingly disappointing as product cycles appear to be accelerating. 

Now compare today’s unknown with the “AAPL story” of early 2012:

1) The iPad (3) was widely expected to be introduced and replace the iPad 2 as the top-selling iPad.

2) The iPhone 4S was selling well and the iPhone 5 was widely believed to be in the works.

3) Overall product margins were making new highs and expected to continue.

4) Management announced a dividend initiation (which may have included some front-running by AAPL shareholders). 

AAPL observers had a much easier time turning the unknown facing Apple from January to April into a convenient and easy to understand story. AAPL stock also went up 50% during the same time period. Are the two related?  Does a stock go up or down due to a specific reason or is that another example of humans trying to cope with the unknown?

Apple’s unknown will eventually be packaged into a clean story. It may take a day, week, month, or year, but it will happen because humans hate the unknown. 

AAPL 4Q12 Estimate

Revenue: $36.2 billion (AAPL guidance: $34.0 billion/Consensus: $36.2 billion) 

• I expect iPad and iPhone to represent approximately 69% of Apple’s quarterly revenue.  

GM: 40.8% (AAPL guidance: 38.5%/Consensus: 40.4%)

• Apple’s margin will likely decline sequentially from 3Q12 due to the iPhone 5 and continued iPad 2 sales. A key question facing AAPL in the near-term is the margin run rate. In 2011, Apple reported a 40.5% gross margin, which increased to approximately 44% in 2012. Looking at 2013, I expect margins to decline a few hundred basis points to 42% related to the iPad mini and ongoing costs related to the iPhone’s new form factor.

EPS: $8.95 (AAPL guidance: $7.65/Consensus: $8.85) 

• I expect Apple to report 27% yoy EPS growth.  Interestingly, my $8.95 estimate is close to the Street’s $8.85 average, with 17 analysts projecting EPS higher than my $8.95. I attribute my low estimate to weaker iPhone sales, a lower iPhone average selling price (ASP), and a lower overall margin.

Product Unit Sales and Commentary

Macs: 5.5 million (12% yoy growth)

• Mac growth is slowing as tablets and smartphones satisfy many consumers’ computing needs. I expect double-digit growth in portables, driven by back-to-school purchases, to be partially offset by a modest decline in desktop sales due to stale models.

iPad: 18.4 million (65% yoy growth)

• I expect Apple to report record iPad sales for 4Q12. My iPad estimate assumes approximately 1.5 million iPads sold per week (including iPad 2 sales), which compares to the approximate 1.4 million weekly run rate last quarter. Supply/demand is in balance. Anecdotally, iPad 2 sales in education and business appear robust following the price cut, while lower component and manufacturing pricing should help limit drastic margin compression.

iPod: 6.1 million (8% yoy decline)

iPhone: 24.8 million (45% yoy growth)

• My estimate reflects 7 million iPhone 5 units and approximately 18 million iPhone 4S units (and to a lesser extent iPhone 4 and 3GS). Apple is currently suffering from a supply/demand imbalance for iPhone 5, which will limit sales in the near-term (including 1Q13). Other unknowns include the iPhone 4S sales run-rate prior to the iPhone 5 introduction and iPhone 4S popularity following the price drop. My 18 million iPhone 4S estimate reflects the impact from consumers delaying iPhone purchases ahead of the iPhone 5 release.  I am including a declining ASP due to robust iPhone 4S sales following the price drop (an observation partially derived from Verizon’s earnings which showed strong non-iPhone 5 sales, which I attribute to the price drop).  

When Apple releases earnings on October 25, investors will focus on product ASPs and margin. Publicized iPhone 5 supply shortages and iPad mini rumors should go a long way in explaining any moderate misses in iPhone and iPad unit sales, respectively. Nevertheless, any evidence of continued margin weakness and declining ASP in iPad and iPhone may push observers to reduce forward earnings, which have a high sensitivity to margins. A 100 basis point change in margin corresponds to a 3% change in Apple quarterly EPS.

AAPL 3Q12 Estimate

Revenue: $41.3 billion (AAPL guidance: $34.0 billion/Consensus: $37.4 billion) 

• I expect iPad and iPhone to represent approximately 75% of Apple’s quarterly revenue.  

GM: 45.5% (AAPL guidance: 41.5%/Consensus: 43.3%)

• Apple’s margin jumped to 47.4% last quarter, from 40.5% in 2011. Weaker iPhone sales should serve as a headwind for sequential quarterly GM expansion in 3Q12, although attractive component pricing will continue to provide support for yoy improvement (Apple reported 41.7% margin in 3Q11). 

EPS: $12.30 (AAPL guidance: $8.68/Consensus: $10.34) 

• I expect Apple to report 58% yoy EPS growth. 

Product Unit Sales and Commentary

Macs: 4.7 million (19% yoy growth)

• I expect Mac shipments to show continued strong yoy growth following updates to the laptop lineup at WWDC. Pent-up demand and early back-to-school purchases should help offset MacBook Pro with Retina display shortages.

iPad: 21.3 million (130% yoy growth)

• Apple will report record iPad sales for 3Q12. My iPad estimate assumes approximately 1.8 million iPads sold per week (including iPad 2 sales), which compares to the approximate 1.2 million weekly run rate during the last holiday quarter. Management commentary regarding continued iPad supply/demand imbalance bodes well for record iPad sales. Anecdotally, iPad 2 sales in education and business appear robust following the price cut, while lower component and manufacturing pricing should help to limit margin compression.

iPod: 6.6 million (13% yoy decline)

iPhone: 29.5 million (45% yoy growth)

• My estimate reflects an average 2.5 million weekly iPhone sales run rate. At the end of 2Q12, Apple reported 8.6 million iPhones in the channel inventory, a sequential increase of 2.6 million units. Backing out the inventory build, Apple reported an average 2.7 million weekly sales run rate last quarter. With supply/demand in balance and rumors of the new iPhone building, I expect the weekly sales run rate to decline into the fall.

When Apple releases earnings on July 24, iPad and iPhone sales, along with reported margin, will represent investor’s primary focal points. Apple’s prior commentary foreshadows a strong iPad quarter, surpassing the 15.3 million units sold in 1Q12. Any iPad sales number solidly above 17-19 million units will be looked at positively by the Street. With iPhone supply/demand having been in equilibrium for some time, Apple will not benefit from any significant inventory build this quarter, although carrier and country distribution expansion will result in solid yoy growth. Sell-side iPhone sales estimates have been set at somewhat realistic levels and one should not be surprised with sales between 25-30 million units, although iPhone sales estimates become somewhat irrelevant as we get closer to the new iPhone launch.

AAPL 2Q12 Estimate

Revenue: $40.6 billion (AAPL guidance: $32.5 billion/Consensus: $36.0 billion) 

• I expect iPad and iPhone to represent approximately 75% of Apple’s quarterly revenue.  

GM: 42.9%  (AAPL guidance: 42%/Consensus: 42.7%)

• Apple’s margin jumped to 44.7% last quarter, from 40.5% in 2011. Continued strong iPhone sales should benefit overall GM in 2Q12,  with attractive component pricing providing additional support. 

EPS: $11.45  (AAPL guidance: $8.50/Consensus: $9.81) 

• I expect Apple to report 79% yoy EPS growth, which is slightly less than the 83% yoy EPS growth observed in 2011.

Product Unit Sales and Commentary

Macs: 4.3 million (14% yoy growth)

• With no Mac updates during the quarter, I expect Mac shipments to show continued yoy growth, albeit at a slower pace than 1Q12. iPad cannibalization is also picking up as consumers bypass Macs for lower-priced iPads. 

iPad: 12.0 million (155% yoy growth)

• Apple sold three million new iPads during opening weekend (includes pre-orders that shipped for the 12 days leading up to the March 16 launch, but not iPad 2 sales).  My iPad estimate is primarily based on weekly sales run rates, using Apple’s new iPad opening weekend sales as a benchmark between slower iPad sales in January and February and the supply/demand imbalance at the end of March. Unlike last year’s iPad launch, Apple seemed to have a better handle with new iPad supply, as online shipment waits did not reach 2011 levels, even with a more extensive international rollout. My estimate assumes approximately 6 million new iPads sold during the last 3.5 weeks of March and an additional 6 million iPads sold in January, February, and the beginning of March. 

iPod: 6.8 million (25% yoy decline)

• Representing only 2.7% of estimated 2Q12 revenue, the iPod is a footnote. 

iPhone: 36.4 million (95% yoy growth)

• My estimate reflects an average 2.2 million weekly sales run rate and the addition of approximately 6 to 8 million iPhones into the distribution channel (approaching Apple’s desired 4 to 6 week range). For some perspective, Apple saw a 1.6 million weekly iPhone sales run rate during 2Q11 (pre-iPhone 4S).  My 2Q12 estimate assumes 38% yoy growth in the weekly run rate, which I think is reasonable given  the iPhone 4S and increased iPhone penetration at newer carriers (including Verizon and Sprint) and countries (China). 

When Apple releases earnings on April 24, many will look at iPad and iPhone sales as an indicator for continued strong consumer demand. I suspect Apple may be allowed some breathing room on iPad sales given the supply/demand imbalance and trickiness surrounding a new product launch. Meanwhile, iPhone lacked any significant interferences during the quarter, with results dependent on demand, and to a lesser extent, the number of units added into the distribution channel. 

Thoughts on the new iPad

Software and Hardware

Why has iPad been so successful?  Intriguing software?  Gorgeous hardware?  After using iPad 2 for a year, my connection with the device has been formed by the seamless interaction between software and hardware.  The iPad form factor seemingly disappears as I interact with iOS apps. Meanwhile, iPad competitors have focused on only one aspect of the software & hardware duplex; either shipping okay software (“okay” can be an overstatement) with mediocre hardware, or okay hardware (again, I am being generous) with buggy software. The new iPad’s improved hardware features, along with new apps, combine to form a package that can appear to be “magical” to the user. 

Motorola RAZR Syndrome

One of the bigger risks Apple faces is the “Motorola RAZR Syndrome”, or reliance on your current success at the detriment of your future success.  After three generations of iPads, it is clear that Apple understands its biggest competitor is Apple. The new iPad’s biggest competition will come from iPad 2, while the original iPad was iPad’s 2 biggest competitor. Even though the original iPad sold well, Apple continued to push the envelope with iPad 2, and now the same can be said with the new iPad. Cameras, a Retina display, faster guts, amazing software, improved battery life, and 4G LTE, all at the same $499 entry-level price point.  

iPad 2 Price Drop  

Although Apple devoted only a brief minute to iPad 2’s new $399 price, consumers will give the $100 price drop much more attention.  For many, price remains king.  While $399 is still a lot of money, consumers are starting to compare iPad to regular laptops, in which the $399 price tag doesn’t look nearly as steep. Similar to the iPhone 3GS and iPhone 4 being bought by former feature phone owners, the iPad 2 will continue to sell well as laptop owners look at iPad for the first time. 

More iPads in the Wild?

Up to now the iPad had been looked at as largely an “inside the home” device, confined to the living or play room.  With the original iPad not having any cameras, using an iPad at a social event, such as a family occasion, picnic, or concert, was questionable.  Apple’s new video and picture software (and improved cameras) will give people a greater incentive to bring iPad to different gatherings and events.  While iPad is still no where near as convenient to transport as iPhone, it is easier to transport than any other computing device.  As more iPads find their way into the wild, a whole new marketing realm will kick in.  While advertisements can be effective, seeing friends or family enjoy their iPad outside the confines of their home represents a brand new marketing angle. 

Jony Ive and New Product Form Factors 

The new iPad’s form factor has subtle differences from iPad 2 (the minor variances might even be hard for a normal consumer to see or feel). While Apple’s SVP of Industrial Design, Jony Ive, is intimately involved in any form factor change, no matter how minuscule, my gut tells me we might see some interesting new form factors for most, if not all, of Apple’s product lines over the next year. I think this is what Tim Cook hinted at at the end of the new iPad’s unveiling when he said, “Across the year, you’re going to see a lot more of this kind of innovation. We are just getting started.” What is the point of changing form factors that seemingly don’t need to be fixed?  How much can you change a phone or tablet form factor? Apple doesn’t settle. New product form designs will focus on greater functionality and feasibility, all while keeping design at the forefront. Dimension barriers will be dismantled. A new round of product design and manufacturing innovation is on the horizon and Jony is guiding the ship.