Apple Q3 Earnings Preview: Will The Chinese Momentum Hold Up?

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Apple (NASDAQ:AAPL) is scheduled to publish its Q3 FY’15 earnings on Tuesday, July 21, reporting on what is typically a seasonally muted quarter for the company. We expect the top line to continue to grow year-over-year, driven by sales of the flagship iPhone 6 in Greater China, with an incremental upside coming from the Mac and Apple Watch, which was launched during the quarter. However, gross margins could be impacted by foreign exchange headwinds, seasonality and costs related to a ramp-up of Apple Watch production. Apple has guided for revenues of between $46 billion and $48 billion and gross margins of between 38.5% and 39.5%. Here’s a quick look at what we will be watching when Apple publishes earnings Tuesday. [1]

We have a $144 price estimate for Apple, which translates to a market cap of about $830 billion. Our price estimate is about 15% ahead of the current market price.

See Our Complete Analysis For Apple Here

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Chinese Momentum Should Continue, But What’s The Outlook Like?

Greater China– which includes China, Taiwan and Hong Kong – has emerged as the biggest driver of Apple’s growth in recent quarters. Revenues from the region rose by 71% year-over-year to about $16.82 billion (over 3x the growth rate of Europe and the Americas regions) during Q2 FY’15. China also emerged Apple’s largest market for the iPhone, overtaking the United States. There are multiple trends driving the iPhone’s recent momentum in China. Firstly, the large-screen iPhone 6 and 6 Plus models have helped the company address a long-time disadvantage in the phablet loving Chinese market. Secondly, there’s growing penetration of high-speed mobile data services in China, and this is proving a big opportunity for premium smartphone sales. China Mobile, the largest mobile carrier in the world, added a staggering 27 million high-speed customers in April and May, taking its total 4G user base to over 170 million. High-speed users still account for just 21% of its subscriber base, allowing plenty of room for growth. [2] Moreover, the Chinese smartphone market has been slowing down (it actually shrank in Q1) and upgrade-driven sales and high-end devices are slowly accounting for a greater portion shipments, and this is proving to be a net positive for Apple (related: Why The Saturating Chinese Smartphone Market Could Work In Apple’s Favor).

That said, there are some concerns in the Chinese market that have been creating an overhang on Apple’s stock in recent weeks. China’s Shanghai index fell by roughly 30% in June, and investors have been concerned that this could have spillover effects on the broader Chinese economy, hurting consumption and demand for high-end products such as the iPhone. However, equities represent less than 10% of household wealth in China, compared with nearly 30% in the U.S according to a report from Credit Suisse. There also isn’t much evidence that previous stock market movements have materially impacted household consumption in China.

Moreover, Apple still appears very bullish about the iPhone’s prospects. The company is reported to have asked its manufacturing partners to prepare for an initial production run in the range of 85 million to 90 million units for its next-generation iPhone (expected to be unveiled in September) by December  31. ((Apple’s Early iPhone Call, WSJ, July, 2015)) This would be a 15%+ improvement (midpoint) from the 70 million to 80 million unit initial order that was placed for the iPhone 6. If the production reports are true, and the company does indeed see such high demand for next-gen iPhones, this could have a significant impact on our price estimate for Apple. We are currently modelling iPhone shipments of 230 million units for CY’16, marking a 5% jump over 2015. If we were to increase our iPhone shipment growth estimates to 15% for CY 2016, this would result in a 7% upside from our current price estimate.

Proof Points On Apple Watch Sales 

This is the first quarter since the Apple Watch went on sale. As noted before, we don’t think that the device will really move the needle for Apple in terms of sales or market cap in the near-term, but its performance will be important to Apple’s image nonetheless, being the first new product category in the Tim Cook era. As Apple will not be breaking out the Watch numbers, the lack of clarity around how the device is faring is creating some overhang around Apple stock. According to a widely cited research report by Slice Intelligence, online sales of the Apple Watch plunged by 90% since the opening week. Slice, which bases its research on electronic receipts sent to millions of email addresses following purchases, estimates that Apple has been selling fewer than 20,000 watches a day in the U.S. since the initial surge in April, with sales dipping to as low as 5,000 units on some days in late June. [3] We will be looking for commentary from management or specific proof points on how the Apple Watch is faring (related: Why Investors Shouldn’t Be Too Concerned About Recent Reports On Apple Watch Sales).

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Notes:
  1. Apple Q2 Earnings Press Release []
  2. China Mobile Operating Data []
  3. Opinion: Apple Watch sales plunge 90%, MarketWatch, July 2015 []