What’s Driving Our $120 Price Estimate For Apple?

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Apple (NASDAQ:AAPL) has had an eventful year, headlined by the launch of the new large-screen iPhones and the introduction of Apple Watch – the company’s first new product category in the post-Steve Jobs era. The stock is up by about 40% year-to-date, and the company looks set for a record holiday quarter, amid strong demand and advanced upgrade cycles for the new iPhone. We have increased our price estimate for Apple from $110 to about $120, to account for stronger projections for iPhone ASPs and gross margins. In this note, we take a look at some of the key factors driving our price estimate for Apple.

Our $120 price estimate for Apple is slightly ahead of the current market price.

iPhone: New Storage Mix Strategy, 6 Plus Will Drive ASPs and Margins

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Apple’s prior lack of a large-screen smartphone had been a liability of sorts, with many customers flocking to premium large-screen Android phones from vendors such as Samsung (PINK:SSNLF), which made big screen sizes the centerpiece of their smartphone strategies. With the launch of the iPhone 6 and iPhone 6 Plus, Apple has effectively filled a void in its smartphone lineup and looks set to gain market share in the premium smartphone market. The phablet market (phones with screen sizes of 5.5 inches and above) – which the iPhone 6 Plus will cater to – is expected to be the fastest-growing segment of the smartphone market, with IDC forecasting phablet shipments to grow at a CAGR of around 60% between 2014 and 2018. [1]  In comparison, sales of regular smartphones are expected to grow at an annual rate of around 5.5% in the same period. We estimate that iPhone shipments will grow by 15% in 2014 to around 176 million units, while rising by 8% in 2015 to about 191 million units. China, which is seeing surging 4G penetration, will prove to be a near-term driver for iPhone sales. However, we expect growth rates to taper off over the long run, falling to about 2% by the end of the Trefis forecast period owing to increased market saturation and possibly longer upgrade cycles for smartphones.

Bucking the trends in the broader smartphone market, Apple’s new handsets are likely to see significantly better average selling prices (ASPs). While Apple has maintained its usual 16 GB capacity for the base version of iPhone 6, which retails for $649 (off contract), it has bumped up storage capacity on the mid and top-tier models to 64 GB ($749) and 128 GB ($849). We expect this to have a meaningful impact on iPhone ASPs and margins, since the 64 GB model is proving to be the most popular owing to its significantly higher storage per dollar. This is likely to bode well for margins as well, since we estimate that the 64 GB model will cost just about $20 more to manufacture compared to the 16 GB model. The iPhone 6 Plus, which is priced at a $100 premium to the iPhone 6, will also have thicker margins, since its bill of materials is estimated to cost just $15 more compared to the iPhone 6 ($200 vs. $215). [2] We expect ASPs to increase to around $630 in 2014, while they should improve to about $685 in 2015, given the full year impact of the new models. However, we see the current strategy as providing only a one-time price bump for Apple. We think that ASPs will begin to decline from 2016 onwards, falling to below $550 by 2021, as the company sees increased competition and possibly lower pricing power in an increasingly saturated smartphone market.

Apple Watch Will Aid Revenue Growth, Bolster The Ecosystem

Apple has entered the wearable technology space with the Apple Watch. While the device will fundamentally provide a gateway to an iPhone – allowing users to receive notifications, send messages, access maps and use Siri, Apple’s digital assistant – it will also offer health and fitness features and the ability to run its own apps. The watch will have a starting price of $349 and will hit stores in early 2015. Although the wearable technology market remains in its infancy – global shipments of smart watches and activity trackers stood at around 2.9 million units as of Q1 2014, according to ABI Research – we believe that Apple’s entry into the space will significantly expand the market and take it mainstream for multiple reasons. Firstly, Apple seems to have addressed some of the key shortcomings of previous smart watches. The Apple Watch offers relatively premium design and aesthetics, sports a relatively intuitive user interface and offers advanced health and fitness features. Apple is also working with third-party developers to develop an app ecosystem for the watch. Secondly, the watch is effectively an upsell to iPhone users – who are surveyed to be wealthier and more engaged on their phones compared to users of other smartphone platforms – and this could provide a strong foundation on which Apple could build its wearable business. [3] Apple Watch could also help to keep customers in Apple’s ecosystem since iPhone users who also own the watch are likely to see higher switching costs if they plan to move to other smartphone ecosystems. That said, the watch could face some challenges. As things stand, the full set of use-cases for wearable technology remains unclear and the category as a whole still lacks a so called “killer app.” Additionally, the incremental utility that the Watch offers over an iPhone beyond advanced fitness tracking remains questionable.

We estimate that Apple will ship about 18 million units of the device during CY2015, which translates to about 9% of our modeled iPhone shipments for that year. We believe that watch shipments will grow at a CAGR of about 12%, rising to about 36 million units by 2021 as the use cases improve while pricing falls, making it accessible to more consumers. While Apple has yet to disclose specific pricing for its various watch models, it’s likely that the price range for the lineup will be wide, given that the company will use materials such as gold on high-end models. However, we believe that the $349 base model will account for the bulk of the sales, and we are forecasting an average selling price of $400 for 2015. We expect ASPs to decline going forward, falling below $300 by 2021, as the company could launch low-end models or offer legacy models at value prices. While estimates for the Apple Watch’s bill of materials and manufacturing costs are not available yet, it is safe to assume that gross margins will be healthy. The electronics subsystems of the watch are largely integrated onto a single chip, and most other components (excluding casing and straps) are likely to be standardized across watch models. We estimate that the Apple Watch will have gross margins of around 42% during 2015, with the number falling to around 37% by 2021.

iPad Could Struggle Due To 6 Plus, Market Saturation

The iPad has been struggling of late, with shipments declining for three quarters in a row on year-over-year basis. As of Q3 2014, Apple’s global tablet market share stood at 23%, compared to 29% a year ago. [4] Although Apple recently refreshed its tablet lineup, introducing a thinner and faster version of its iPad Air, along with a slightly improved iPad Mini, we do not see these products significantly reversing the decline. Global tablet sales growth has been slowing due to an increasing preference for large screen smartphones, and the impact of this trend is likely to become more pronounced for Apple with the introduction of the iPhone 6 Plus. Additionally, the iPad is viewed as a premium tablet, which is more popular in developed markets where penetration is higher. For instance, in the United States, over 40% of adults own tablets and it seems unlikely that penetration has much room for growth since tablets are often shared among users unlike mobile phones. [5] There is also a lack of interest among tablet owners to upgrade their devices frequently, unlike smartphones owners who are incentivized by carrier subsidies and new wireless technologies. Much of the growth in the tablet market is coming from developing markets such as China and India, where lower-priced tablets have been gaining traction. While Apple has a lower-priced offering of its own in the form of the base iPad Mini, which now retails for about $249, it seems unlikely that the device will be able to bring in volumes for Apple, given that many Android tablets retail for well below $150.

Growth Potential, Margin Upside From Apple Pay and iAds

Apple’s mobile payments service, Apple Pay, was launched in the United States in October. Although many mobile companies have tried, somewhat unsuccessfully, to make a dent in the mobile payment space, we think that Apple Pay could gain traction due to its ease of use and its partnerships with key retailers and payment networks. The service got off to a strong start, with over 1 million activations in the first three days and vendors like McDonald’s reporting that the service accounts for around half of all their tap-to-pay transactions. While we do not expect Apple Pay to contribute much to Apple’s earnings in the near term, it could offer scope from a margins and growth perspective. According to the Financial Times, Apple is believed to be receiving a transaction fee of about 0.15% from banks on purchases made through Apple Pay. Margins will be attractive, since Apple is unlikely to assume financial risks (fraud related risks, for example), while its cost base is also likely to be relatively small and largely fixed. The service also has significant scope for growth, given that mobile in-store payments in the U.S. are set to rise from around $2 billion in 2013 to around $189 billion by the year 2018, translating to a CAGR of about 148%. [6] The service will face its first big test in the form of the 2014 holiday shopping season and we will be closely watching for data on the same.

While Apple’s iAd mobile advertising platform hasn’t lived up to its potential, the company has been looking to rekindle interest by unveiling a series of initiatives that make the platform more accessible and effective for marketers. Apple has reduced the minimum campaign spend for ads to just $50, opening the platform up to a much larger base of advertisers. The company also recently introduced support for programmatic buying on iAds, meaning that advertisers will be able to purchase iAd inventory in an automated fashion through demand-side platforms and ad tech companies instead of using Apple’s proprietary interface. This could allow iAd to better integrate with larger advertising campaigns. Apple is also becoming more open to sharing user data, making some of its iTunes and App Store consumer data sets (such as movies, apps, books downloaded) available to help advertisers better target their ads. [7] While iAd is currently insignificant to Apple’s broader financials, it could make sense given its growth prospects. According to eMarketer, mobile advertising is expected to grow by around 83% this year to $18 billion in the United States, surpassing other forms of media including newspapers ($17 billion) and radio ($15.5 billion).

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Notes:
  1. A Future Fueled by Phablets – Worldwide Phablet Shipments to Surpass Portable PCs in 2014 and Tablets by 2015, According to IDC, IDC, September 2014 []
  2. iPhone 6 Plus: $100 Costlier for Consumers to Buy—Just $15.50 More Expensive for Apple to Make, IHS, September 2014 []
  3. iPhone Users Earn Higher Income, Engage More on Apps than Android Users, comScore, August 2014 []
  4. Fueled by Back-to-School Promotions and US Growth, the Worldwide Tablet Market Grows 11.5% in the Third Quarter, IDC, October 2014 []
  5. Mobile Technology Fact Sheet, Pew Research, January 2014 []
  6. THE FUTURE OF PAYMENTS: 2014 [SLIDE DECK], Business Insider, September 2014 []
  7. Get Ready for More Mobile Ads on Your iPhones as Apple Launches New iAds, AdWeek, November 2014 []