How The iPhone Can Drive Apple To A $1 Trillion Market Cap

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Apple’s (NASDAQ:AAPL) dependence on the iPhone cannot be understated. iPhone revenues as a percentage of Apple’s total revenues stood at around 69% during Q1 FY 2015. Moreover, growth in iPhone revenues stood at around 57% year-over-year for Q1, while the rest of Apple’s products and services combined saw revenues shrink by about 7%. The iPhone’s contribution to Apple’s earnings is even more profound, given its high gross margins. We estimate that the iPhone constitutes about 57% of Apple’s total value. While there has been a lot of speculation as to where Apple’s next wave of growth is likely to come from – rumored product lines include Apple branded electric cars and TV sets – we don’t presently see another product or market that will have the ability to move the needle for the company the way that the iPhone can (see Thoughts on an Apple Car). Case in point: if Apple is able to maintain iPhone gross margins and ASPs at present levels – versus a long-term decline according to our valuation model – it could add about $180 billion to the company’s valuation. For perspective, that’s more than the market cap of the big three U.S. automobile companies combined. In this note, we spell out our base assumptions for our valuation of Apple’s iPhone franchise and two possible iPhone-related scenarios that could result in a significant upside or downside to Apple’s stock price.

We have a $128 price estimate for Apple, which translates to a market cap of about $740 billion. Our price estimate is slightly ahead of the current market price.

See Our Complete Analysis For Apple Here

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What Our Price Estimate Factors In

Our price estimate for Apple assumes that the iPhone will see moderate volume growth through our 7 year forecast period, with both ASPs and margins declining. We believe that the assumptions are fair, given that Apple now has deals in place with most major carriers (new carrier adds are unlikely to be a meaningful sales driver) and the smartphone market in developed economies is approaching saturation. For example, U.S. penetration stood at about 75% during Q4 2014 according to comScore. Many carriers have also been scaling back on their subsidy programs or extending upgrade cycles, and Apple could be impacted, given its higher price points. However, we believe that much of the company’s volumes growth will come from China, where 4G penetration has been rising fast and the market for high-end mobile phones has been expanding (see Why The Saturating Chinese Smartphone Market Could Work In Apple’s Favor). We estimate that Apple held roughly 10.3% (about 193 million units) of the global mobile phone market in 2014, up from around 8.5% a year earlier. This was primarily due to strong pent-up demand and advanced upgrade cycles for the iPhone 6 and iPhone 6 Plus that offered the larger screens that Apple resisted adopting for nearly three years. However, we don’t see the volumes growth as a secular trend, and we expect Apple’s iPhone market share to level off at about 10.6% by the end of our forecast period (CY 2021 at 237 million units).

While we expect the iPhone to continue to command a premium compared to the broader smartphone market – owing to brand cachet, software and industrial design and value-added services – we expect the premium to decline over time. The smartphone paradigm has been largely set, and gaining an edge in terms of feature-based differentiation appears increasingly difficult. The recent evolution of the iPhone (from the iPhone 4 in 2010 to the iPhone 6 in 2014) is a testament to this, with upgrades largely related to better software/services, spec upgrades and larger screens. Additionally, competition is only likely to heat up further as the market matures. Design and user experience on Android phones is getting better and more vendors are beginning to focus on the high end of the market in a quest for greater profits. We assume that the iPhone will see average selling prices decline from an estimated $687 in 2015 to about $530 in 2021, with gross margins falling from 48% to about 38% amid higher competition and saturation in the smartphone markets.

Bull Case: $1 Trillion Market Cap On Stable ASPs/Margins, Growth In China

Apple has a strong history of disruptive innovation. If the company is able to launch truly revolutionary handsets rather than phones with incremental upgrades, it should be able to maintain or improve its pricing power over the long run. While we don’t have much visibility into future iPhone refreshes, hardware upgrades are rumored to include pressure sensitive touch screens, sapphire glass screens and superior cameras. Additionally, Apple has invested considerably in building a more robust ecosystem around the iPhone that could increase switching costs for the platform. If services such as Apple Pay, cloud services, potential music streaming, and iPhone oriented products like the Apple Watch succeed in locking customers into the ecosystem while attracting new users, Apple’s pricing power could benefit meaningfully (related: Brand Momentum, Solid Margins Should Drive Apple’s Watch Business Despite Some Shortcomings). If Apple succeeds in maintaining pricing and margins at current levels, it could result in a 25% upside to our price estimate, resulting in a $160 per share valuation. This would imply a market cap of about $930 billion.

China could also provide a meaningful upside opportunity. Apple gained significant traction in China during the holiday quarter of 2014 owing to the launch of the iPhone 6. According to research firm IDC, the company emerged the second largest smartphone vendor in China during Q4 (12.3% market share or over 13 million units), ahead of Samsung and home-grown brands like Huawei and Lenovo. The company moved a total of 46.3 million units in China last year, a 42% year-over-year increase. [1] Our internal forecast of iPhone sales assumes that the company’s Chinese shipments will approach 65 million units by 2021, with total shipments standing at 237 million units. However, if Apple succeeds in improving iPhone sales in China to about 100 million by 2021 versus an internal forecast of 65 million units, this would result in our global iPhone volumes forecast rising to close to 270 million units (a little over 12% of global mobile phone shipments). This would translate to close to a 10% upside to our price estimate for Apple or about $140 per share. If the company is able to both maintain pricing and margins at current levels while expanding shipments, this could result in a market cap of more than $1 trillion.

Bear Case: Android’s Progress In Premium Space Could Dent Valuation

Android dominates the smartphone landscape in terms of volumes, commanding over 75% global market share. Google’s (NASDAQ:GOOG) strategy has been to get Android smartphones into the greatest number of pockets as possible, by offering the operating system to vendors for free, eventually making money off online services and advertising. This has resulted in a lack of differentiation and most vendors have competed based on hardware specifications and price – and Android smartphones have lagged behind Apple in terms of overall user experience and design. This lack of differentiation is evident from the distribution of profits in the smartphone space. According to Strategy Analytics, Android vendors together accounted for just 11% of global smartphone profits, or $2.4 billion during Q4 2014, compared to the roughly $19 billion in profits commanded by the iPhone. [2]

However, most Android-based vendors are beginning to focus on improving design and aesthetics while adding unique features to handsets (ex. Samsung S6), while Google has been iteratively improving the overall software experience on Android (ex. Android Lollipop). Vendors are also focusing on delivering high-end devices that command better pricing and cater to customers looking to upgrade in a saturating smartphone market. For example, value handset champion Xiaomi has been increasingly launching well reviewed high-end models such as the Mi Note and Mi Note Pro. If this trend of Android vendors improving hardware, user experiences and design, backed up by Google’s solid software and services footprint, is able to reduce Apple’s mobile market share to about 8% – while reducing average pricing to $500 per unit and gross margins to 35% by the end of our review period – it could reduce our price estimate for Apple by close to 20% (price estimate of about $105 per share).

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Notes:
  1. Apple Plans China IPhone Trade-In Program With Foxconn, Bloomberg, March 2014 []
  2. Android Captures Tiny 11% Share of Global Smartphone Profit in Q4 2014, Strategy Analytics, February 2015 []