Apple Looks Set For A Rebound After A Tough Fiscal 2016

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Apple (NASDAQ:AAPL) published its Q4 FY’16 earnings on Tuesday, October 25th, posting its third-straight year-over-year decline in quarterly revenues, amid falling shipments across its product lines and a sharp slowdown in sales from Greater China. That said, things should look up in the holiday quarter, with the firm expecting to return to growth as it ramps-up production of its well-received iPhone 7. Below, we provide some of the key takeaways from Apple’s Q4 earnings release and what it could mean for the firm going forward.

We have a $120 price estimate for Apple, which is roughly in line with the current market price.

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iPhone Remained Lackluster, But Expect Some Holiday Cheer

While Apple launched the new iPhone 7 in late fiscal Q4, the device didn’t meaningfully contribute to Q4 earnings as it was on sale for just about two weeks of the quarter, with supply remaining significantly constrained. iPhone shipments declined by about 5% year over year to 45.5 million units, as sales continued to be driven by the iPhone 6S, which was relatively poorly received compared to the iPhone 6. Average selling prices also fell to $619 from about $670 last year, impacted by the low-end iPhone SE ($400), which was launched earlier this year, and potentially due to discounting of the iPhone 6S. That said, we expect things to pick up significantly over the holiday quarter, with shipments rising year over year, as supply constraints for iPhone 7 ease, while Apple also benefits from the setback faced by its high-end smartphone rival Samsung Electronics, which recently had to discontinue its flagship Note 7 smartphone, after a series of fires and overheating incidents. Apple also expects iPhone ASPs to recover sequentially, reaching levels similar to its 2015 holiday quarter.

Gross Margins Are Trending Lower

Apple’s gross margins remained flat sequentially and declined by about 190 bps to 38% on a year-over-year basis. Guidance for the holiday quarter was also disappointing at 38.0% to 38.5%, well below the 40.1% margins the firm posted last year.  There are likely multiple factors driving this. Firstly, Apple has been contending with FX headwinds amid the strengthening of the U.S. dollar. About two-thirds of revenues come from overseas and the USD is up by about 3.5% versus global currencies on a trade-weighted basis. Secondly, the firm’s pricing power for many of its products, such as the Mac, has been diminishing, owing to ageing industrial design and a lack of meaningful upgrades. Costs also appear to be escalating. For example, the iPhone 7 is reported to be more expensive to build compared to its predecessor, as it sports more advanced components and higher storage capacity (related: Apple’s Flagship iPhone Keeps Getting More Expensive To Build)

Chinese Woes Continue

Apple’s sales to greater China declined by about 30% year over year to about $8.8 billion, accounting for about 80% of the firm’s overall revenue decline for the quarter. While this is partly due to FX headwinds (RMB down by about 5% versus USD over the last year) and a weak macroeconomic environment in China, Apple is being hurt by competition from Chinese rivals, who have shorter product life-cycles and offer products at significantly lower price points. The firm’s share of the Chinese smartphone market has slipped from 12.4% in Q3 2015 to about 8.4% in Q3 2016, according to Counterpoint research. That said, the rate of the year-over-year decline should reduce over the holiday quarter, as supply of the new iPhone 7 — which has been seeing strong promotional activity from Chinese carriers — improves, while sales of the new Apple Watch Series 2 also ramp up.

Apple Watch And Services Business

Apple’s Services business and the Apple Watch have been viewed as two potential long-term growth drivers for the company, but their performances over Q4 were in sharp contrast. Services revenues rose 24% year over year to an all time record of $6.3 billion, driven primarily by the App store, which saw 43% growth for the quarter, and Music sales, which were up 22%. The service revenue growth is very positive, considering that the rate of growth in Apple’s iDevice installed base has actually been slowing down amid falling shipments. This could potentially indicate that per-device spending on services is actually trending upwards.

While Apple’s doesn’t break out the performance of the Apple Watch, sales appear to have declined significantly. Research firm IDC estimates that shipments fell by roughly 72% year over year to just 1.1 million units. Moreover, the 22% revenue decline in Apple’s other products segment (which includes Watch) also indicate that things are not going well for Apple’s first wearable device. That said, Apple should see a sequential rebound during the holidays, leveraging the recent launch of the Watch Series 2, which sports some new features and an improved user interface.

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