Above Avalon Podcast Episode 138: iPhone Pessimism Gone Too Far

There will come a time when the iPhone business is in big trouble. However, that day has not arrived quite yet. Episode 138 is focused on how the sheer level of pessimism facing iPhone hit an inflection point in 2018. Things have simply become too negative. The discussion begins with the iPhone’s impact on Apple financials. We then dissect iPhone hysteria to see how pessimism has changed and centered on a new type of narrative. Additional topics include demand for $999+ iPhones, the gray market, genuine risks and concerns facing iPhone, how the iPhone business is changing, and why wearables have to be part of the iPhone discussion.

To listen to episode 138, go here

The complete Above Avalon podcast episode archive is available here

iPhone Hysteria

With 2018 quickly coming to a close, a look back at the past 12 months leads to an interesting observation regarding Apple. On one hand, the company had a remarkably strong year when it came to pushing the Apple ecosystem forward. Every major product category was updated, with especially strong updates to Apple Watch and iPad Pro. iOS 12 experienced a successful launch, followed by strong adoption.

However, Apple had an awful year when it came to perception and media coverage. The first half of the year was all about iPhone X demand coming in weaker-than-expected. The past two months have been focused almost entirely on weak demand for iPhone XR, XS, and XS Max.

We are in the midst of an iPhone hysteria phase that has reached an inflection point. Attention is being given to data points that are not good indicators of the underlying strength of the iPhone business. Meanwhile, little to no attention is being given to the items that are genuine risks and concerns facing iPhone. We are now starting to see this hysteria and pessimism spill into how the rest of Apple’s business is perceived.

The iPhone Matters

If there is one widely-held opinion about the iPhone, it would be that the product still matters to Apple. The iPhone is directly responsible for 60% of Apple’s revenue and 65% of Apple’s gross profit. However, those percentages ignore the role the iPhone plays in driving Services and wearables revenue.

According to my estimates, approximately 80% of Apple’s Services business is in some way tied to the iPhone. Revenue drivers such as the App Store, iCloud, licensing, and AppleCare are closely tied to either iPhone sales or the broader iPhone installed base. With wearables, Apple Watch still requires an iPhone to set up. Taking into account the preceding items, the iPhone is responsible for more like 75% of Apple revenue and 85% of gross profit.

Dissecting iPhone Pessimism

The difference in opinion when it comes to iPhone is found with how best to analyze the business. In addition, there is disagreement as to Apple’s iPhone pricing strategy and where the iPhone fits within Apple’s broader product strategy.

There was quite a bit of iPhone pessimism in 2018. Pundits, analysts, and reporters concentrated on a specific narrative. Instead of focusing on the usual risk factors given for iPhone, such as competition from Android manufacturers or lower profit margins, attention was given to the lack of unit sales growth and higher pricing. Apple’s decision to no longer disclose iPhone, iPad, and Mac unit sales only added fuel to the fire.

The following quotes were pulled from articles published since Apple reported 4Q18 earnings last month.

WSJ:

“[Apple’s 4Q18 earnings] offered affirmation for two main pillars of Apple’s current strategy: promoting its software-and-services business and raising prices on its flagship iPhones to compensate for slower growth in unit sales.”

Bloomberg:

“The iPhone maker is transitioning from a business driven by the number of devices it ships into one that leans on pricier products and more sales of software and services to drive revenue.”

Business Insider:

“As Apple also alluded to this year when it decided to no longer announce unit sales in its earnings reports, growth across its most popular product lines, like the iPhone, is beginning to slow down. Price hikes help compensate for less business.”

On the surface, the preceding quotes may sound rational. Raising iPhone prices to offset slowing unit sales may pass the smell test for casual observers. Arguing that Apple is promoting services to offset slowing hardware sales probably won’t raise many eyebrows.

However, each quote shows a fundamental misunderstanding of Apple’s business model and the rationale behind management’s decision to push higher iPhone prices.

The common thread found in each quote is that slowing iPhone sales have led Apple management to desperately seek out revenue growth elsewhere. As a result, Apple is said to be making questionable product and strategy decisions. Higher iPhone prices are positioned as nothing more than an attempt to squeeze more money from existing iPhone users. Some people are going so far as to draw a parallel between Apple’s current iPhone pricing strategy and the company’s disastrous Mac strategy from the 1990s, which played a role in nearly bankrupting the company.

Meanwhile, Apple services are positioned as nothing more than a lever Apple is pulling to squeeze extra money from iPhone users. How Apple uses services to add value to its hardware and become a stronger content distributor is given little to no attention.

Things are Overdone

The sheer level of pessimism facing iPhone has hit an inflection point. Things have simply become too negative. The infatuation with quarterly iPhone unit sales is leading many observers to reach incorrect assumptions about business fundamentals.

Quarterly unit sales data have been telling us less about the iPhone business for years. Here were annual iPhone sales over the past four years:

  • 2015: 231M units

  • 2016: 212M

  • 2017: 217M

  • 2018: 218M

Given how iPhone unit sales have gone nowhere for years, things may not look too great on the surface. However, dive deeper, and iPhone business fundamentals look completely different.

Despite a lack of iPhone unit sales growth since 2015, Apple has added nearly 300M people to the iPhone installed base during the same time period, including 80M in 2018 alone. Strong growth in the iPhone installed base has been completely hidden by flat unit sales trends. Given high loyalty and satisfaction within the installed base, these users will very likely upgrade to a new iPhone at some point in the future. In addition, these users are more likely to subscribe to and pay for various Apple services and even purchase additional Apple products including Apple Watch and AirPods.

Despite declining iPhone unit sales over the past four years, Apple has generated approximately $250B of gross profit from iPhone sales during the same time period. A portion of this profit is funding Apple’s R&D initiatives, including the products designed to eventually take value away from iPhone. Apple is also plowing some of this profit into M&A and capital expenditures such as new stores and data centers. The remaining cash is going to fund Apple’s capital return program.

iPhone pricing was one of the more controversial topics over the past year. While consensus continues to view Apple’s march to higher pricing as a mistake directly responsible for unit sales weakness, few are taking into account the impact of the iPhone gray market. The gray market is handling a growing amount of iPhone demand at the low end. This development is giving Apple the freedom to become more aggressive at the high end. In addition, iPhone trade-in values remain robust, reducing the actual cost of iPhone ownership. A very good argument can be made that the iPhone, even at $1,000, is underpriced when considering the role it plays in nearly a billion lives.

When it comes to gauging demand for higher-priced iPhones, Apple has sold approximately 75M iPhones priced at $999 or higher over the past year. The idea of Apple selling 75M computers starting at $1,000 each in just 12 months would have been unimaginable as recently as a year ago.

Genuine Risks and Concerns

The problem with iPhone hysteria is that due to infatuation with unit sales and higher pricing, genuine concerns and risks facing the iPhone are ignored. Attention is being placed on the wrong items.

There are three genuine concerns found with the iPhone business.

  1. Users switching from iPhone to Android.

  2. Users leaving the Apple ecosystem.

  3. Simpler, non-Apple devices handling use cases formerly given to iPhone.

None of those concerns can be monitored by simply looking at iPhone unit sales or ASP trends. Despite reporting flat to negative iPhone unit sales, Apple is still bringing new users into the installed base. This gives us confidence that the first concern is being kept in check. Strong loyalty and high satisfaction end up playing much larger roles in determining the health of the iPhone business than the quarterly fluctuation in iPhone unit sales.

Meanwhile, strong sales momentum found with Apple wearables and services, along with steady iPad and Mac sales, tell us that the Apple ecosystem continues to gain strength. This will have an impact when it comes to users deciding which smartphone to buy when it’s time to upgrade. Declining iPhone unit sales trends simply aren’t useful for determining if users are moving away from Apple.

However, the biggest risk facing iPhone is the inevitable competition from simpler, more personal devices. These devices will eventually be positioned as smartphone alternatives, handling some tasks formerly given to the iPhone.

While there are early signs of iPhone users being content with their current iPhone, as seen with the slowing upgrade rate, Apple appears to have expected such a development given the company’s focus on wearables. Apple Watch is rapidly becoming an iPhone alternative, handling a growing number of use cases formerly given to iPhone in addition to possessing entirely new use cases. This development means products like Apple Watch need to be part of the iPhone discussion. In reality, few people are even talking about Apple’s wearables platform.

The Road Ahead

It is certainly possible, maybe even likely at this point, that Apple will report a decline in iPhone unit sales in 2019. (Above Avalon members have access to my Apple earnings model, including my iPhone estimates.) Demand for flagship iPhones may indeed be coming in weaker than Apple management expected. (Forecasting iPhone demand is incredibly difficult.) However, such developments do not mean that the iPhone business is imploding or even in dire straits.

There are changes taking place in the iPhone business. The business is maturing. However, the largest change is something unable to be seen by just looking at unit sales or ASP. In recent years, the iPhone’s role within the Apple universe has been evolving.

In the beginning, the iPhone was the vessel for introducing Apple to nearly a billion users. While the iPod was Apple’s first genius mass-market item, the iPhone redefined the definition of mass-market for Apple. Years of mobile carrier expansion, which served as a natural tailwind for iPhone unit sales, ended back in 2015. The iPhone business is not going back to that high growth era.

While the iPhone remains the most effective tool for bringing new users into the Apple ecosystem, something that will continue even if unit sales decline in any given year, the iPhone is now becoming a stepping stone in getting Apple’s wearables platform off the ground. The Apple Watch still requires an iPhone to set up. It won’t be surprising if Apple’s upcoming smart glasses require an iPhone to set up. It’s not that the iPhone is the hub and wearable devices are the spokes of an Apple "wheel.” Instead, the iPhone is being used to promote more personal devices that will one day surpass the iPhone in terms of utility and value.

There will come a time when the iPhone business is in big trouble. One day, the value we place on wearable devices, such as AR glasses and smartwatches, will surpass the value we give to smartphones. However, that day has not arrived quite yet.

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.

Above Avalon Podcast Episode 137: A Cheaper Buyback

Given the magnitude of its buyback program, excess cash position, and free cash flow generation, no other public company is in as good of a position as Apple to benefit from stock market turmoil. Episode 137 is focused on how Apple can leverage its buyback program to take advantage of stock market dislocations. The discussion begins with my thoughts on the recent weakness in AAPL shares. We then look back at previous AAPL stock downturns to find a few similarities and takeaways. The discussion turns to Apple’s share buyback and the impact a change in stock price has on Apple’s buyback activity. Additional topics include Apple buyback scenarios, valuation, and the irrationality found in comparing a company’s stock price to its underlying health.

To listen to episode 137, go here

The complete Above Avalon podcast episode archive is available here

Leveraging Apple's Share Buyback

AAPL has had a rough two months. The shares are down nearly 20% from all-time highs, shedding $275 billion of market cap in eight weeks. Unprecedented does a good job of describing the fall’s magnitude and speed.

Apple’s dramatic stock price drop is now leading to a surge in pessimism towards the company. An increasing number of Apple management’s actions are being questioned while criticism is being thrown at various Apple products. In reality, most of this criticism is nothing more than a byproduct of a declining stock price. This has happened before, and a closer examination of previous stock price drops suggest Apple management will use the lower AAPL share price to its advantage by leveraging its share buyback program.

Why Is AAPL Down?

Surfing through Twitter over the long Thanksgiving weekend led to some Apple-related observations. There was no shortage of reasons being passed around for why the company’s stock price was in free fall:

  • Apparently, no one is buying the newest iPhones because they are too expensive.

  • Management must want to hide something really bad by no longer disclosing unit sales data.

  • Apple’s fortunes in China continue to sour.

In essence, there was a surge in fear, doubt, uncertainty, and overreaction.

People love to come up with reasons for why a particular stock or market index is up or down on any given day. Much of this is due to the human desire to add clarity to what is an inherently unknown process. Unfortunately, the only way to figure out why Apple’s stock price dropped more than 20% would be to poll every market participant as to why he or she sold or bought shares. Obviously, this isn’t feasible.

We know a few developments took place in recent weeks:

  1. Apple provided slightly weaker-than-expected 1Q19 revenue guidance and cautious commentary. Management cited uncertainty around supply for some of the new products, slowing demand in emerging markets (India, Turkey, Brazil, and Russia), and foreign currency headwinds.

  2. Apple announced it would no longer provide unit sales data, which came as a shock to Wall Street, who as a collective body relied on unit sales as a financial crutch. While consensus has been negative on the move, management’s decision makes sense given how unit sales have been telling us less about business fundamentals over time.

  3. Apple EPS estimates are being revised lower. While every analyst is guided by different motivations, many have cited Apple’s 1Q19 guidance and weaker demand for flagship iPhones as driving their lower estimates. Over the past month, FY2019 EPS estimates have been cut by 2% although many analysts have yet to update numbers. My FY2019 EPS estimate was cut by 7% due to a higher tax rate going forward and lower revenue attributed to a number of product categories. Above Avalon members have access to my current earnings model here.

  4. The broader stock market has been in disarray. The four largest companies saw nearly $800 billion of market cap wiped away in less than two months. On a combined basis, Apple and Amazon saw more than $500 billion in market cap evaporate.

While some market participants may have been swayed by one or more of the preceding developments, others may have been guided by unrelated matters. Accordingly, the most accurate explanation for why Apple shares lost $275 billion in market cap is because Apple shares were down. Selling pressure begets more selling pressure.

We’ve Heard This Song Before

Apple’s stock price has never been immune from rough patches. Prior to 2018, the most recent downturn occurred in 2015 and 2016. Over the course of a year, the stock traded down 30% from an adjusted $124 to $87. There was even a two-month span from November 2015 to January 2016 in which shares fell nearly 20%, reminiscent of AAPL’s recent downturn.

The 2015 and 2016 stock price decline was set within an environment of slowing iPhone sales. In November 2015, Apple provided weak 1Q16 revenue guidance. The implication was that iPhone unit sales growth would soon evaporate despite Apple having just reported 37% unit sales growth in FY2015. Wall Street quickly turned its attention to 2Q16 guidance to determine if iPhone sales weakness would be temporary or a longer-term trend.

Three months later, Apple’s 2Q16 guidance not only implied even weaker iPhone sales, but also an overall year-over-year decline in revenue. Many market observers became concerned about the long-term health of the iPhone business. Analysts fumbled over each other in a rush to cut estimates. AAPL shares ended up bottoming three months later and then went on to see two years of gains totaling 150%. Apple added $600 billion of market cap during this time period as its forward P/E multiple increased from less than 10x to 15x.

Apple went through an even steeper stock price decline in 2012 and 2013 when shares fell 37% from an adjusted $69 to $44. However, the circumstances around that decline were quite a bit different. Apple’s gross margins were evaporating due to the iPad mini launch. Apple’s revenue growth then began to slow as iPad sales imploded. There were also genuine fears in the marketplace that the iPhone would lose at the hands of Android smartphone manufacturers. In summary, the worry was that Apple’s long-term gross margin picture would deteriorate, resulting in less profits and cash flow.

Looking back at previous AAPL downturns, a few takeaways become apparent:

  1. Expectations reset. AAPL shares faced an earnings expectations reset. Either gross margin projections were dialed back or the company’s revenue growth projections were cut. Both changes had a negative impact on earnings expectations.

  2. Negative sentiment. The broader narrative around Apple had turned remarkably negative. In 2012 and 2013 it was about competition driving lower margins while in 2015 and 2016, it was based more on a slowing iPhone upgrade cycle.

  3. Bottoming process. AAPL shares put in a trough once market commenters and analysts stopped trying to call a bottom and instead assumed the stock would keep falling. In essence, once people stopping paying attention to AAPL and expectations had been reset, the shares were in a better position to begin outperforming.

It shouldn’t come as a surprise that the most recent AAPL stock price move is taking place during an earnings expectation reset. Analysts are cutting estimates due Apple’s 1Q19 revenue guidance and fears of slowing iPhone sales although it is debatable if overall iPhone demand is actually that much different from that of previous quarters. In my view, fears of an iPhone demand implosion are off-the-mark.

Similar to previous stock price downturns, AAPL stock weakness is also leading to a rise in criticism facing the company. Some people are convinced that Apple is getting greedy by charging higher prices for iPhones, iPads, and Apple Watches. Gross margin data, which Apple will break out between Services and hardware for the first time, will shine much light on the issue. My expectation is that margin data would show higher product prices are primarily to reflect the additional technology included in the latest flagships. Add in worries about slowing emerging markets growth and the U.S. / China trade tension boogeyman, and the result is a toxic brew of Apple revenue growth concerns.

The Buyback Wild Factor

Instead of going on the PR offense to calm fears about business and product demand, Apple management is in a prime position to stay quiet and take advantage of AAPL share weakness. Given the lower stock price, Apple can leverage its share buyback program to repurchase additional shares for the same amount of cash.

Apple began buying back shares at the end of 2012. Over the span of six years, Apple has spent $239 billion buying back 2.1 billion shares at an average price of $115 per share. As seen in Exhibit 1, Apple’s total number of shares outstanding has been on a steady decline and is now 25% below peak levels. This is another way of saying Apple has repurchased 25% of itself over the past six years.

Exhibit 1: Apple Shares Outstanding

Breaking out Apple’s buyback by quarter, it’s easy to see management’s decision to ramp its buyback pace following U.S. tax reform. Apple no longer has an excess cash dilemma with cash “stuck” in foreign subsidiaries.

Exhibit 2: Apple Share Buyback ($)

As Apple’s stock price increased, it took much more cash to repurchase the same number of shares. In essence, the share buyback became more expensive. For example, Apple repurchased 92 million shares via open market transactions last quarter to the tune of $19 billion. This total ended up being a little more than double the number of shares repurchased in 2Q16 (41M) via open market transactions, for which Apple spent just $4 billion on open market repurchases. Apple paid an average of $210 per share with its repurchase activity last quarter versus $98 in 2Q16.

Apple is currently spending $20B on buyback per quarter. As shown in Exhibit 3, assuming AAPL shares remain near $180, Apple will be able to buy back 330M additional shares over the next two years versus if Apple shares were trading at $230+. An additional 330M shares amounts to buying back seven percent of the company in just two years. This exercise assumes Apple spends the same $20B per quarter.

Exhibit 3: A Cheaper Apple Stock Buyback

If Apple shares trade down to $160, management would be in a position to buy back nine percent of the company in two years. This amounts to 30% more than what can be repurchased at $180, assuming the same $20B is spent on buyback every quarter.

For every $10 price drop in AAPL shares, management can repurchase an additional one percent of the company over two years, assuming Apple spends the same $20B per quarter on buyback. This produces an interesting dynamic as it is in Apple management’s best interest, from the perspective of the share buyback, for AAPL shares to decline in price.

Valuing Apple

Share buyback is not created equal. For some companies, buying back shares is a mistake and nothing more than a ploy to distract shareholders from mismanagement. For other companies, share buyback is a very attractive way to return excess cash to shareholders.

From Apple management’s perspective, as long as AAPL shares trade at an appropriate valuation, the buyback is an attractive way to return excess cash to shareholders. Apple is generating more than $50 billion of free cash flow per year, all of which can be returned to shareholders. Free cash flow is the cash left over after investing in the business and organic growth opportunities. Given Apple’s balance sheet, the company has about $125 billion of excess cash that can be returned to shareholders. Combining the excess cash with free cash flow generation, Apple is in a position to continue the current $20B of buyback per quarter for the foreseeable future.

The key ingredient required for Apple to properly leverage its share buyback is maintaining the buyback pace even in the face of market volatility and dislocation. This is where Apple management has a significant advantage over the market.

Tim Cook and Jony Ive are overseeing a design company tasked with coming up with tools for people. Given how Apple is a toolmaker, the market has had a very difficult time valuing the company’s future cash flows. Revenue and profits are the result of a successful product strategy built on intense collaboration and focus. Once a product ships, the Apple machine keeps churning, pushing out iteration after iteration in a process that is hard for competitors to match.

A consequence of this product strategy is that at any given moment, by just looking at the products Apple is currently selling, one is seeing only a snapshot of the Apple machine. Most of Apple’s long-term value is found with the process used to come up with future products. The market is not in a good position to value this process.

During periods of severe market dislocation, Apple’s market value can swing by hundreds of billions of dollars. For example, Apple’s enterprise value is currently $750 billion, down from $975 billion at the beginning of October. Apple management has an advantage when it comes to determining whether Apple shares are under or overvalued given the unannounced product pipeline. In addition, management is in a good position to judge how effective the Apple machine is in coming up with new ideas for future growth.

By capitalizing on the market’s worry, anxiety, and unease, Apple management can leverage the share buyback program to buy additional shares when Apple shares come under pressure. Given the magnitude of the buyback program and Apple’s free cash flow generation, no other public company is in as good of a position as Apple to benefit from stock market turmoil.

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.

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