What Does 2017 Have In Store For Apple’s iPhone Business?

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Apple‘s (NASDAQ:AAPL) fortunes are tied to the iPhone in a big way, with the device contributing over 65% of the company’s total revenues and over 75% of its gross profits, per our estimates. However, 2016 turned out to be a difficult year for the flagship device, which saw its first year-over-year decline in sales (down 12.5% to 137 million units for the first 9 months) amid a weaker uptake for the iPhone 6S, headwinds in the Chinese market and some early supply constraints for its latest iPhone 7. However, we believe that things should look up in 2017, as Apple takes advantage of some weakness at rival Samsung Electronics’ smartphone unit, while benefiting from the launch of a completely redesigned iPhone later in the year. Below we spell out some of the key factors that are likely to drive the iPhone business in 2017.

We have a $125 price estimate for Apple, which is about 10% ahead of the current market price.

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Weakness at Samsung and Anniversary iPhone Should Help Bolster Sales

We believe that the the iPhone 7 – which will remain Apple’s flagship offering for at least eight months this year – will see slightly better sales compared to the 6S over its life cycle. While this will be partly due to better features such as superior cameras and water resistance, the device could also win over customers from rival Samsung, which suffered a significant blow to its brand image after a botched double recall and eventual discontinuation its high-end Note 7 smartphone, following a series of fires and overheating incidents. This is a boon for Apple, given that popular Samsung devices such as the S7 Edge were at least partly responsible for the lackluster performance of the iPhone 6S. Moreover, Apple is expected to launch a completely redesigned 10th anniversary iPhone, sporting an edge-to-edge OLED display and other enhancements, in the fall of 2017. We believe that the device should set off a super-upgrade cycle of sorts, since it would mark the first complete iPhone re-design since 2014.

Chinese Headwinds Might Continue

Much of the contraction in iPhone sales during 2016 came from China, and we believe that things could remain challenging in 2017 as well. While this is partly due to a depreciating Yuan (The RMB is down by roughly 5% versus USD over the past year) and a weak macroeconomic environment in China, Apple is also being hurt by competition from Chinese rivals, who have significantly shorter product development cycles and offer feature rich products at lower price points. Apple’s share of the Chinese smartphone market slipped from 12.4% in Q3 2015 to about 8.4% in Q3 2016, per Counterpoint research. That said, we expect things to pick up towards the end of the year, as Apple launches refreshed versions of the iPhone.

iPhone Margins May Face Some Pressure

Apple’s iPhone margins could face some pressure in 2017. The iPhone 7 is reported to be more expensive to build compared to its predecessors, as it sports more advanced components and higher storage capacity (related: Apple’s Flagship iPhone Keeps Getting More Expensive To Build). Moreover, pricing power for the iPhone 7 could diminish as the cycle progresses, given its aging design compared to Apple’s rivals who have been offering modular devices, bezel-free designs and curved displays. Moreover, the appreciating U.S. dollar could also hurt Apple’s margins, as over two-thirds of its revenues come from overseas.  However, there could be two positives factors influencing iPhone margins in 2017. Firstly, the demand mix for the larger 7 Plus models, which command a $120 premium, appears to be stronger compared to previous iterations of iPhone. Secondly, the 10th anniversary device, which should launch in the fall could be priced at a premium, helping overall margins.

The Pixel Threat

Alphabet’s (NASDAQ:GOOG) subsidiary Google is now directly competing in the smartphone hardware market with the launch of its high-end Pixel handset. The device adopts the proven Apple model of offering well-designed hardware with tightly integrated software and services. Reviews of the device have been overwhelmingly positive, with critics praising its superior Android implementation, AI capabilities and camera. Analysts at Morgan Stanley project that Google could ship 5 to 6 million units of the device next year. While this pales in comparison to the 200 million+ smartphones that Apple sells annually, the Pixel could pose a legitimate threat to Apple over the long run for two reasons. Firstly, Google still has plenty of room to scale up its distribution footprint with wireless carriers, as Verizon is currently its only carrier partner in the U.S. Secondly, the switching costs around Apple’s ecosystem are also coming under threat, amid increasing proliferation of third-party cloud-based services which are largely platform-agnostic and enjoy significant network effects.

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