The 4-Inch iPhone 6c

Rumors of a new 4-inch iPhone 6c are once again making the rounds. The idea of Apple expanding the iPhone line to include simultaneous development of three different screen sizes is intriguing because it may be the missing piece that allows Apple to reposition the iPhone line for a more sustainable future. Given current smartphone market dynamics, it would be in Apple's best interest to continue expanding the iPhone line as the product matures. Not only would an updated iPhone with a 4-inch screen appeal to a certain segment of the market, but Apple could position the new model as a way to begin differentiating the iPhone line according to it's primary distinguishing feature: screen size. 

Current iPhone Line

The current iPhone line is effective in selling Apple's flagship phones (iPhone 6 and 6 Plus). Apple currently sells two-and-a-half iPhone 6 units for every iPhone 6 Plus sold. With the iPhone 5s and 5c, Apple relied on its existing strategy of taking last year's models and reducing the price by $100. Apple continues to have each price segment covered ranging from a contract-free $749 to $450. Apple's current pricing strategy is also supportive of the carrier subsidy model as the $450 differential between a 2-year contract price and contract-free price is upheld across the product line. 

Current iPhone Line

iPhone Line with iPhone 6c

A new iPhone with a 4-inch screen (the "iPhone 6c")  would have several longer-term implications for the iPhone line. For the first time, Apple would have three different-sized iPhone models under development (5.5-inch, 4.7-inch, and 4-inch) as the iPhone 6c would see an update from the iPhone 5s and iPhone 5c, including possibly a different design. More importantly, Apple would be able to position iPhone screen size, and not product age, as the primary pricing differentiator going forward. 

Apple wouldn't reduce the iPhone 6 and 6 Plus by $100 this year, but instead sell a new iPhone 6s and iPhone 6s Plus for the same $649 and $749, respectively. The iPhone 6c would be positioned as the device for those who want to spend less money on an iPhone while the iPhone 5s would occupy the "free with carrier contract" bucket. 

Expected iPhone Line with iPhone 6c - Year-End 2015

Note: Apple may change the case colors for 6s Plus, 6s, and 6c

Benefits of Selling an iPhone 6c:

• Drive consumers to iPhone 6s Plus and iPhone 6s. An iPhone 6c could be positioned to drive consumers to purchase the flagship models, the iPhone 6s and 6s Plus. After looking at the various options, including the iPhone 6c, consumers may be more willing to pay the extra $100 for the iPhone 6s. Apple relied on a similar strategy in 2013 with the iPhone 5c. While some thought the iPhone 5c would sell well, it ended up driving people into buying the more expensive iPhone 5s. This is a smart marketing decision by Apple designed to maintain the integrity of the iPhone line by getting consumers to buy the latest model, even though they may be satisfied with an older model at a lower price. Apple would benefit from earning additional revenue if consumers chose an iPhone 6s or 6s Plus over an iPhone 6c.
• Provide a good 4-inch screen experience for consumers. I suspect there is a certain segment of the population that would still prefer an iPhone with a 4-inch screen. While the larger 4.7-inch and 5.5-inch screen options would outsell an iPhone 6c, the ability to use an iPhone comfortably with one-hand, store the device in small pockets, or use the device during workouts make a 4-inch screen desirable for some consumers.

Segmenting Price (and Buyers) by Screen Size 

Apple has relied on reducing the price of previous year's flagship models to address price-sensitive consumers. Such a method has been successful in maintaining an "Apple-like" experience at lower prices. However, with Apple now selling two flagship models with different screen sizes, a new strategy is needed in order to set the iPhone on a more sustainable path. If Apple sticks with it's current strategy, within three years there would be an iPhone with a 5.5-inch display selling for anywhere between $299 and $0 with a two-year contract as Apple reduces the price by $100 each year. Not only would this be confusing from a customer's point of view, but Apple may be jeopardizing the iPhone's average selling price and the important iPhone upgrade cycle as consumers decide to buy older, less expensive models. 

Instead, the iPhone 6c would be the first sign that Apple is moving to a different strategy where specific screen sizes occupy set price tiers. To better view this strategy, replace each iPhone model nomenclature with its screen size. Apple now has three Phone tiers (5.5-inch, 4.7-inch, and 4-inch screens) designated for the $749, $649, and $549 price layers. This structure would remain unchanged from year to year with new models replacing the previous year's model. Meanwhile, older 4-inch screen models retain some of the old iPhone heritage of seeing price reductions over time.

iPhone Line Based on Screen Size as Primary Price Differentiator

Note: Apple will likely change iPhone case colors.

With the iPhone 6 is outselling the 6 Plus by roughly a 2.5 to 1 margin, I suspect many look at 5.5-inches as too large for an iPhone display. Taking a look at Android options, the best-selling phones also seem to come in less than that 5.5-inch range. Even in the scenario where screen sizes become a bit larger, Apple can adapt the strategy by simply relying on the concept of plus, regular (or just "iPhone"), and mini to denote three different screen sizes. The smallest screen option would then be the model to see price reductions over time.

iPhone Line Based on Screen Size as Primary Price Differentiator

Note: Apple will likely change iPhone case colors.

The "Cheap" iPhone

By segmenting the iPhone line according to screen size and shipping an iPhone 6c,  Apple would eventually be in position to ship the notorious "cheap" iPhone, a two-year old iPhone with 4-inch display that sells for less than $400 contract-free. Such a device would not be sold in areas with carrier subsidies, but instead be focused on emerging markets. Even though $400 is still a premium price for a smartphone, Apple's strategy would continue to focus on slowly, but surely, lowering the iPhone's entry level price. This plan represents a much more realistic option than taking a 4-year old iPhone 6 Plus and eventually selling it for less than $400. 

Apple is Getting Better at Making iPhones

Apple is likely doing a much better job at producing new iPhones at attractive margins. In the past, Apple's margin would suffer when there was a new iPhone form factor introduced, reinforcing the need to continue selling that device (with no changes) in subsequent years to recoup some margin. With manufacturing processes improving, Apple no longer has this need to continue selling the same flagship phones for years. Instead iPhone 6 and 6 Plus margins are much better to begin with and Apple can simply shift production to new models each year, while the 4-inch screen model (which Apple has already been producing for years) is the one to see price reductions over time. iPhone storage configurations are another way of Apple will be able to continue boost ASPs and margins. As the iPhone line matures, the current screen sizes will likely be around much longer than smaller iPhone screen sizes found with the iPhone 3G and 3GS, emphasizing the need for a more sustainable strategy of keeping prices stable.

Think About the Future

While the iPhone 6c is still a rumor, I'm confident that Apple management has been toying with the idea of changing its iPhone strategy in order to assure that the iPhone upgrade cycle remains robust. In addition, Apple would look to expand the iPhone line, both in terms of available models and price points. It is important to remember that there is much more to the equation than simply price. Apple could reduce the price of iPhone 6 and 6 Plus over time and its phone market share will increase. However, such a scenario may contain longer-term negatives that outweigh any near-term positives. Instead, by positioning screen size as the primary pricing differentiator, Apple is able to sell great iPhone experiences at different price layers without much in the way of collateral damage. An iPhone 6c makes a lot of sense. 

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Setting the Stage for a Larger Apple Share Buyback Program

Apple will announce an update to its capital return program next month (likely in conjunction with its 2Q15 earnings release). Earlier this week, I took a closer look at Apple's quarterly cash dividend. Turning to share buyback, I expect Apple's board to approve a $35 to $45 billion increase to the buyback program, bringing total authorization to $125 to $135 billion. With Apple stock currently trading at a 13x forward P/E multiple, management will continue to look at buyback as an appropriate way to return excess capital to shareholders. Assuming the share price remains in the current valuation range, Apple will likely continue buying back shares at a $45 billion/year pace. 

Share Buyback Authorization History

Apple initiated the stock buyback in fall of 2012. In the subsequent two years, Apple's pace of buyback exceeded its own timeline. As shown in Exhibit 1, the initial $10 billion authorization had a three year horizon, but Apple had bought back $10 billion of stock within a few months. The same can be said for the year-end 2015 target for completing the $60 billion of cumulative buyback authorization announced in April 2013. Apple spent $60 billion on buyback a full year ahead of schedule.

Exhibit 1: Apple's Capital Return Program Updates 

While some companies are notorious for announcing share buyback programs, only to never finish them, Apple would appear to be aggressively following its stated repurchase authorization. Management is showing confidence in the future product lineup as well as the belief that Apple's current share price remains attractive for buyback. Last year, the board announced a $30 billion increase in buyback authorization but not did provide a timeline for the buyback completion. Apple ended up buying back approximately $30 billion of shares since that time. By not providing any stated timeline for its authorization, the board may be giving management a bit more leeway to judge the proper pace of buyback given the stock valuation. 

Estimating the Share Buyback Authorization Increase

Apple currently has $90 billion of cumulative buyback authorization, of which $17 billion was remaining as of December 27, 2014. For a better understanding of how much the board will increase buyback authorization, it is crucial to estimate how much cash Apple will have at its disposal for capital return.  

Exhibit 2 highlights the main ingredients of cash for calendar year 2015.  Even though Apple has $178 billion of total cash, only $20 billion was located in the U.S. at the start of 2015.  Add in U.S. free cash flow and cash proceeds from expected debt issuances, and Apple will have approximately $75 billion of cash before taking into account share repurchases and dividends. Keep in mind, free cash flow already reflects payments made for acquisition of property, plant and equipment.

Exhibit 2: Projected Apple U.S. Cash - CY2015 

Assuming Apple will spend $11 billion on share dividends, there will be approximately $65 billion of cash available for share repurchases in 2015. Since Apple entered 2015 with $17 billion of share repurchase authorization remaining, it is reasonable to assume some cash has already been used to repurchase shares in the first quarter, leaving approximately $50-$55 billion of cash for buyback. This range forms the basis for my $35-$45 billion authorization increase estimate. Apple would likely still have buyback authorization left at the end of 2015, in which case it would roll over to 2016.

There are three scenarios to look for in terms of Apple's share buyback authorization increase:

Scenario A: Increase authorization by more than $40B. An authorization increase of $40 billion or more would mean either that Apple intends to increase the pace of buyback or the board is willing to give management more leeway in determining the best time for buyback with the expectation that most of the program will occur in 2016. However, since management had indicated it would assess the capital return program each year, there may not be much sense for the board to give authorization with a 2-3 year time horizon as that would leave less room for an increase in subsequent years. Evidence would seem to support the view that the board (and management) continue to think short-term in terms of its buyback authorization. 

Scenario B: Increase authorization between $30B and $40B. An authorization increase between $30 billion and $40 billion would be considered the middle ground, leading to a buyback pace similar to 2014. 

Scenario C: Increase authorization by less than $30B. An authorization increase of less than $30 billion would signal that share buyback may be slowing, unless the board is preparing to authorize additional increases later in the year (unlikely). One reason this may be an unlikely scenario is that the board would want to build flexibility into the program in case of sudden stock price swings. 

Exhibit 3: Apple Share Buyback Authorization Increase Scenarios

I view Scenario A and Scenario B as the most likely outcomes given the board's preference to give management a bit more share repurchase authorization in case of stock price opportunities. Given the current amount of cash in the U.S. and a slightly higher stock price valuation, a $35-$45 billion increase to Apple's share buyback authorization is the most likely outcome next month. In such a scenario, Apple's cumulative share buyback authorization may reach $135 billion.

This report was produced by Neil Cybart on March 27, 2015 and is not meant to be used as investment advice. 

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Protecting Balance Sheets from Paranoia

Google made waves yesterday announcing Morgan Stanley's CFO, Ruth Porat, will be its next CFO. Many were quick to point out Twitter CFO Anthony Noto also came from Wall Street in an attempt to frame Google's hire as evidence of the ongoing battle for talent between Wall Street and Silicon Valley. Instead, Google's hire deals more with paranoia than a battle for talent. Today's tech leaders are paranoid about becoming irrelevant. Such anxiety does not bode well when contemplating more practical business affairs, such as managing a company's finances and balance sheet. Companies may find success in a structure that combines the best of Silicon Valley with Wall Street. As technology minds worry about the future, financial minds are focused on managing the present.

Technology companies are more paranoid about everything these days. Larry Page seemingly wants to get rid of his day-to-day job to focus on the next big thing. Tim Cook constantly refers to the nonstop worrying that Apple executives go through in terms of competition and what products to work on. Mark Zuckerberg is always on the lookout for the next big thing before it negatively impacts Facebook. Jeff Bezos is continuously looking for ways to keep Amazon relevant in the booming ecommerce renaissance. Paranoia isn't an inherently bad thing when coming up with strategy, however, one complication enters the equation if paranoia begins to creep into the financial aspects of the business such as cash management, capital structure, and cash flow. A certain level of sanity and rationality needs to preside in terms of a company's financial management.

While a CFO has slightly different roles depending on the company and industry, the overall job description in tech is pretty straight-forward: manage the balance sheet and capital structure, in addition to giving input on the income statement and cash flow. The product remains the pinnacle while financial management takes on a supporting role. We are seeing a new breed of tech giants sitting on cash levels that will likely have implications on the operating environment for many years, assuming the cash is well managed. Enter Wall Street. I suspect Google hired Morgan Stanley's CFO for her knowledge on how to manage $64 billion of cash, including the best ways to structure M&A deals, handle more shareholder-friendly capital management actions, and make sure the financial statements are receiving proper care and attention. Porat will likely not be involved in figuring out Google's next big computing platform, just as Apple CFO Luca Maestri isn't designing an Apple Car. 

All of of this paranoia combined with keen sense to separate such anxiety from a company's financial management would represent a change from the past. In 2004, Microsoft's answer to holding $56 billion of cash was to issue a special one-time dividend of $32 billion, which is another way of saying they didn't know what to do with the cash and thought MSFT stock was too expensive to buy back. Today, management teams are looking at excess cash much more carefully, and in some cases, too conservatively, which is evidence for more in the way of thoughtful financial management. Instilling a sane lookout over the cash fortress will only pay dividends for years to come.

While Apple's capital return program has been well publicized, others have not participated in such shareholder-friendly alternatives, instead using cash (and stock) to continue buying the future. While there is nothing inherently wrong with such a strategy as long as value creation remains a priority, there will likely come a time when cash levels reach such a point (if that time has not already arrived) that CFOs will play a role in setting expectations and the narrative about a company's philosophy for holding excess cash.

While Google is still trying to figure out the next big thing, Facebook continues to rely on its network and reach to consolidate power and information. Meanwhile, Apple is focused on using design to create products that impact our lives and society, while Microsoft is trying to find its place in mobile. Regardless of what the next few years will bring in terms of how things shake out, those companies valuing long-term fiscal responsibility and stability are already thinking of the future. Paranoia is good for a company, until it brings on ruin. Placing safeguards in place to prevent this ruin from reaching the balance sheet is a smart move. 

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Analyzing Apple's Expected Cash Dividend Increase in April

Since Apple began its capital return program in 2012,  share buyback as rightfully received most of the press and attention compared to quarterly cash dividends. Apple has repurchased $73 billion of its stock, nearly three times as much as the $27 billion spent on cash dividends. However, from a signaling effect, cash dividends may do more than share buyback in portraying management's opinions and views about future business prospects. 

Management included language in its financial filings that Apple intends to increase its quarterly cash dividend each year. Next month, during the annual review of the capital management program, Apple's board will likely approve an increase to Apple's quarterly cash dividend to approximately $0.50 to $0.51/share, up 8% from the current $0.47/share dividend, which would represent a 1.6% dividend yield at the current stock price. The board approved a 8% dividend increase last year. While dividends have historically signaled a maturing company with slowing growth prospects, Apple looks to be a rare exception where its financial and capital capabilities are being decoupled from a product lineup that continues to see growth and momentum.  

Much of the significance underpinning Apple's buyback and dividends has been lost on market observers as the focus remains on the near-term trade, ignoring capital management's long-term signaling effect. While share buyback and dividends (both cash and stock) do not guarantee positive stock price moves in the future, market observers can use such activity as an indicator for how management views the future. By issuing a cash dividend, management is showing confidence that the business is supportive of a recurring cash expense going forward in the form of the dividend.

Exhibit 1 highlights Apple's dividend payout ratios over the past two years in addition to the expected payout ratios through 2016.  A dividend payout ratio is simply the cash dividends paid each year divided by annual earnings. The lower the dividend payout, the less of a burden the dividend payment is on overall earnings (and cash flow). A high dividend payout ratio would signify that the company either doesn't see much need to hold on to its earnings, or the dividend is too high.

Exhibit 1: Apple Dividend Payout Ratio

While it is hard to come up with direct peers, if comparing Apple's 28% payout ratio to companies with similarly valuable brands like Disney (20% payout ratio) and Nike (30% payout ratio), Apple is indeed running with an in-line divided payout ratio. Interestingly, given the strong expected earnings growth in 2015, Apple's divided payout ratio is expected to decline to 20% in the near-term.

From management's point of view, it makes more sense to increase the dividend each year at a rate that smooths out earnings volatility. This strategy would imply that even though Apple is experiencing 40% EPS growth in 2015, the dividend increase would likely remain less than 10%. If the situation was flipped and Apple's earnings were declining, the expectation would be that Apple wouldn't need to cut the dividend, but instead continue maintaining an orderly, gradual increase. 

Exhibit 2 takes a look at the amount of capital spent on dividend payments, which is found simply by multiplying dividends paid to shareholders by the number of shares outstanding. The data can also be found in Apple's cash flow statement. The key takeaway is that dividend expense is benefitting from Apple's aggressive share buyback program. As excess capital is spent on share buyback, Apple no longer needs to pay dividends on repurchased shares, reducing its dividend obligation. As a result, Apple is able to increase the dividend per share rate, while the total cost of the cash dividends increases at a much slower pace. This is yet another example of how current shareholders benefit from share repurchases. There is a possibility that management will take a look at this data and conclude that Apple can increase the quarterly cash dividend further, but the market has shown no expectation that such a sizable increase is required. 

Exhibit 2:  Apple Cash Dividends (Per Share and Total)

From an investor's point of view, cash dividends give off much more in the way of long-term management signaling when compared to share repurchases. With a dividend, management is unofficially tying the company to a long-term, recurring use of capital since any shareholder-friendly management team and board understands the negative consequences following a dividend cut. With share buyback, companies are not obligated to complete the program and have a much easier time slowing or ending the buyback without a significant market backlash. While there are few companies that purposely increase their dividends knowing they will need to be cut in the near term, there are some companies that find themselves in cyclical industries, such as energy and mining, where drastic swings in either pricing or demand may bring about the need to cut dividends. Apple's goal when setting its dividend would be to avoid this type of adverse situation where a dividend cut is required to maintain financial health during a more difficult operating environment. 

The other benefit of paying a cash dividend is that Apple's investor base is expanded as some institutions only invest in dividend-paying entities. While it is hard to quantify the impact this may have had on Apple's valuation, it is clear that with a $743 billion market capitalization ($605 billion enterprise value), it would be in Apple's best interest to not exclude any large shareholder group due to specific capital return strategies. 

Apple is in an interesting situation as fast-growing technology companies have traditionally not embraced paying cash dividends due to the signaling it may give concerning fewer growth opportunities. Apple management seems to be decoupling its financial philosophies concerning excess capital from a product lineup continuing to see growth. In a few weeks, Apple's board will approve an updated capital return program, including a dividend increase, that will align with management's view on Apple's long-term business prospects.

This report was produced by Neil Cybart on March 24, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe. 

An Illusion in Switzerland

It's a good time to be a ultra luxury watchmaker. Consumers across the world continue to value the craftsmanship and timelessness found in engineered works of art worn on the wrist. Young professionals continue to enter the luxury watch world with open arms (and wallets) looking to wear accomplishment and success. Watchmakers remain excited about the future as consumers associate luxury watches with ideals that go beyond price, materials, and marketing. 

Just like a soothing sunset can be ruined with a particular cloud cover forewarning of an upcoming storm, there are signs that the luxury watch industry is about to experience the closest thing it has ever faced to an extinction level event. Only a few luxury watchmakers, including TAG Heuer and a handful of others, have bothered to even wake up and take in the lawn furniture. Switzerland is under the spell of a widespread illusion. 

The upcoming storm is called utility, and Apple is at the front line of bringing it to the wrist. With Apple Watch, Jony Ive and company are looking to change the way we interact with technology, utilizing what some may say is the most efficient region of the body for a wearable device: the wrist. With proper line of sight and ergonomics, the wrist is arguably a better solution for a good portion of computing and communicating compared to carrying around 5-inch pieces of fragile glass in our hands and pockets.

The wrist's potential was discovered long ago as the modern day watch has been around for decades, yet we are now finding that the watch was only scratching the surface of what is possible for the wrist. Much of the luxury watchmakers' disregard for the upcoming utility storm relates to how the modern luxury watch industry has become complacent. Few watchmakers envision a world where consumers begin to look at the wrist as more than just a place for well-crafted jewelry made out of various alloys of precious metals and moving parts. Jewelry provides us a way to stand out from the crowd, be different, and show our personality, likes, and dislikes. Watchmakers are correct in assuming this type of emotion and feeling is hard to replace as price is largely removed from the equation entirely, leaving only the factors that Switzerland simply excels at: quality, care, timelessness, and prestige. The problem with this logic, however, begins to appear when considering that consumers desire only what they know. Today's wants and needs for the wrist are not good indicators for what will be in demand tomorrow. The world has never experienced personalized wearable computing. 

The Apple Watch will likely change what consumers demand out of a device worn on a wrist. The convenience and ease of interacting with technology will just be too much to forgo, similar to how smartphones became the preferred phone over a device that merely handled voice calling. While nothing will change with the desire to stand out and represent one's personality to the world through objects worn on the wrist, the ability of those objects to not only monitor and record data, but simply help its wearer use technology will change the buying equation. Everyone will want utility on the wrist. 

After initially dismissing Apple Watch as nothing more than a design student's class project, Jean-Claude Biver, President of the LVMH Watch Division and leader of TAG Heuer, has at least publicly shown concern that Apple may indeed be on to something with a device that puts utility on the wrist, although he continues to think the impact will be contained to the low-end, with ultra luxury watchmakers remaining relatively untouched. Swatch's co-inventor, Elmar Mock, who was responsible for positioning Swatch to address the Quartz Revolution in the 1970s, once again sees the sea change coming and describes it as nothing short of the most significant shift the watch industry has seen to date. The low-end of the watch market is worried, and rightfully so, but the ultra high-end continues to think that enough gold and craftsmanship will weather the storm.  

Critics have said that luxury watchmakers have lost touch with their customers. In reality, luxury watchmakers have lost touch with themselves. Watchmakers stopped giving the wrist the imagination it deserved. 

The transformation that the luxury watch industry will experience over the next few years will most likely occur much more quickly than people expect as desire can be a powerful motivator. Eventually, all watchmakers will be aware that the world has changed. By then, the first movers will have been relying on buzz and marketing to drum up support for mediocre products that may handle a few key tasks found in more complete utilitarian devices. The problem facing the luxury watch industry has been decades in the making: complacency and the illusion that the wrist would forever be a place for jewelry. The Apple Watch changes the equation by which quality will be judged. We will likely look back at this era with interest and intrigue, and wonder why luxury watch makers didn't see the upcoming storm approaching. 

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