Apple (NASDAQ:AAPL) is scheduled to release its fiscal second quarter results on April 23 after the closing bell. Last quarter, the company benefited from the early launch of the iPhone in China and the addition of NTT Docomo as a carrier partner in Japan, to post its highest-ever quarterly iPhone sales of 51 million units. Coming off the record holiday season, Apple should see a sequential slowdown in sales of both the iPhone and the iPad. However, some of the seasonal impact is likely to be offset by Apple’s iPhone deal with China Mobile (NYSE:CHL) earlier this year. China Mobile recently announced that it sold 1 million iPhones in February, and we expect the run rate to pick up in the coming months as the carrier expands its 4G network to new cities.
However, despite the China Mobile boost, Apple expects to record revenues of just $42-$44 billion in the March quarter, which at the midpoint signals a year-over-year drop for the first time in almost 10 years. Apple said that its expectations were driven primarily by channel inventory changes and not the underlying sell-through. The company exited the holiday quarter with supply almost in balance with demand for both the iPhone as well as the iPad, unlike last year when the iPhone 5 and the iPad mini were highly supply-constrained. While this helped Apple outperform during fiscal Q1, its second quarter is likely to bear the brunt of lower sell-in of the mobile devices. This, coupled with the expected decline in iPod sales, a strengthening U.S. dollar and higher software revenue deferrals, had a negative impact of about $2 billion on Apple’s overall guidance.
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The guidance disappointment led to a sharp sell-off in Apple’s stock soon after last quarter’s earnings announcement. This provided the company with an opportunity to buy back shares at lower valuations. Apple repurchased almost $14 billion worth of shares in the two weeks following the earnings call. We expect this to provide its Q2 EPS figures with a boost despite the lackluster top-line guidance. Also, going forward, we don’t expect major inventory changes of any kind, and the revenue deferrals should be accretive to the top line in the coming quarters. Our $620 price estimate for Apple is about 20% ahead of the current market price.
Software Adds Value Amid Industry Saturation
The software revenue deferrals are being made to account for the free software that Apple is bundling with its hardware sales. Apple recently made the decision to make available a significant amount of software, including the iLife and iWork suite, for free with new iDevice purchases. This is in keeping with Apple’s core philosophy of using software as a means to drive hardware sales – a strategy that has worked quite well with iTunes and the App Store.
By offering $60 worth of additional software (iWork and iLife) for free, Apple is offering more value with every new iPhone purchase while strengthening its OS ecosystem further. This will allow it to keep its device prices high in the near term, thereby maintaining the high-end premium appeal of the Apple brand.
However, Apple’s top-line growth will be a concern, with or without inventory changes, unless it can come up with a strategy to entice the population in emerging markets who cannot afford premium products. The high-end smartphone market seems to be nearing saturation levels, and carriers in developed markets such as the U.S. are increasingly looking to cut down on subsidy costs. Verizon and AT&T, which account for a bulk of the iPhone sales in the U.S., have increased the upgrade cycle for new smartphone purchases from 20 to 24 months. As a result, Verizon activated only 8.8 million smartphones during the holiday quarter – about 10% lower than the year-ago quarter. AT&T’s smartphone activations also dropped by more than 20% y-o-y. This resulted in Apple’s North American sales falling by about 1% over the same period last year.
China Mobile Deal And New Products
The addition of China Mobile to Apple’s list of carrier partners is a welcome development given this background of developed-market headwinds. China Mobile is the world’s largest wireless carrier, with a subscriber base of over 775 million that overshadows Verizon and AT&T by more than seven times. Although a large proportion of these subscribers are on 2G currently, China Mobile’s 3G penetration is growing rapidly and its 4G rollout is expected to drive more of its subscriber base to data services. 3G/4G penetration in the Chinese mobile market stands at about 35% currently, but China Mobile’s aggressive posturing and 4G launch could help the figure grow significantly in the coming quarters. This will expand Apple’s addressable market in China, thereby allowing it to not only bring more Chinese subscribers into its fold, but also generating developer momentum around its Chinese app ecosystem. Greater developer participation in creating apps for the Chinese market will not only help increase sales of the iPhone, but also the iPad and any new products that Apple may launch this year.
Our $620 price estimate for Apple doesn’t include the impact of new product categories that the company has said it will enter this year. This is because the company hasn’t officially declared any new products yet. However, there is speculation that two of those categories could be TVs and wearables (possibly watches). These new categories are unlikely to add a lot of near-term value to Apple given the company’s significant current market capitalization and the potential lack of a subsidy-based model that could incentivize faster upgrades of these new products. However, on their own, these products could be multi-billion dollar businesses for Apple and strengthen the iOS ecosystem further, thereby driving additional sales of existing products such as the iPhone or the iPad. For more information on these possibilities, see iWatch Could Add $50 Billion To Apple’s Value and Apple Television Could Be A $50 Billion Opportunity, May Not Drive Apple’s Value By Much.