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S&P Capital IQ


04/28/16 05:00:12 PM


Ahead of Mar-Q earnings results expected to be released after the close on April 25, we remain encouraged about AAPL's long term business prospects and maintain our Strong Buy opinion despite the current tough landscape for iPhone sales. We believe investors will be most focused on iPhone shipments for the Mar-Q (actual)/Jun-Q (guidance), outlook on margins, and details surrounding its capital allocation strategy. We highlight our views in this article.

According to Capital IQ consensus data, operating EPS for the Mar-Q is expected to be $2.00 versus $2.33 the prior year while revenue is seen declining 10% to $52 billion compared to $58 billion. We believe Mar-Q estimates are attainable and will mark the worst year-over-year revenue decline amid the current cyclical correction. For the Jun-Q, the Capital IQ consensus sees operating EPS of $1.75 and revenue of $47.3 billion.

IPhones, which we expect to comprise 64% of revenue in the Mar-Q, is anticipated to witness a 17% unit shipment decline (about 51 million units based on our estimates). We note extremely hard comparables, which are seen as the toughest in the iPhone 6S cycle (iPhone 6/Plus sales rose 55% during the Mar-Q in 2015), and challenging macroeconomic conditions at the start of the calendar year. Indications across the supply chain for manufacturers appear to show still soft demand for iPhones. Last week the Nikkei cited that Apple will continue its reduced production of iPhones in the Jun-Q (the company previously cut production by 30%) in light of weak demand for the iPhone 6S/Plus. While Apple is likely to keep inventories lean for the time being, we believe the current soft patch could result in higher iPhone 7 demand once released in late September as consumers hold onto their phones for a longer period. We project a Jun-Q trough of 45 million iPhone unit shipments, although a year-over-year decline of 5% would be less pronounced than the Mar-Q, before stabilizing/accelerating thereafter.

In late March, Apple released a smaller 4-inch iPhone SE (16GB starts at $399) and we think the aggressive price point will help it better penetrate emerging markets and should support higher Android switcher rates/grow the installed base of active devices. While the iPhone SE could potentially cannibalize some sales of its larger-screen devices in developed regions, the launch could also provide Apple with some cushion in the immediate term, although likely not enough to move the needle much (we envision 15 million in device shipments over the next 12 months). We believe a key metric to once again monitor as it pertains to iPhones will be what percentage of the installed base has thus far upgraded to a 6/6S device. This figure was around 40% in January (implies 60% of active user base have not upgraded since September 2014).

Mac sales, which we see representing 10% of Mar-Q sales, will likely remain steady. While this business has declined in importance, given the success of the iPhone, we think Macs are performing very well given the ongoing challenges being witnessed across the rest of the PC category. For iPads (estimated 8% of Mar-Q sales), we anticipate further year-over-year declines but see less pronounced declines ahead on better comparables and increasing efforts in the enterprise space . We do not think the launch of the iPad Pro (now in 2 screen sizes) will be enough to reinvigorate the business.

We expect AAPL's services business and other product offerings to comprise the remaining 18% of sales. The company began providing more details about its growing active installed base (1 billion) and services revenue in January. In the most recently reported Dec-Q, services revenue was $5.5 and grew 15% year-over-year. We continue to expect robust growth in services revenue but expect steep declines in Apple Watch sales, with no product refresh announced after the first year (starting price cut by $50 to $299 in March).

We believe margins will also be of high importance to investors this quarter, as we see a number of headwinds. The lower overall volume of iPhones as well as less favorable mix of products are our biggest concerns. Specifically, we see a greater mix of lower priced iPhone 6 and SE iPhones in the Mar-Q and Jun-Q as the higher-priced 6S devices witness muted demand. That said, we see greater services revenue and consumer shift towards higher memory devices as potential tailwinds to margins. Given this, we believe the gross margin will narrow from 39.8% in the Dec-Q to 39.4% in the Mar-Q. We see further compression in the Jun-Q, with the 39.2% Capital IQ consensus figure at risk.

As usually is the case during the month of April, we expect Apple's capital allocation strategy to be in focus when the company reports on April 25. Since the company began repurchasing shares and paying dividends in 2012, we note Apple has returned more than $150 billion in cash to investors (about $110 billion in buybacks through the Dec-Q and $40 billion in dividends). In calendar year 2015, Apple repurchased over $37 billion in shares and paid more than $11.5 billion in dividends (total cash returned nearly $49 billion). The company has the ability to comfortably increase its total capital return to investors by $10 million on an annualized basis given Apple's robust free cash flow generation and net cash position, in our view. While we see a modest increase of 3% to 5% in the dividend to please yield-oriented investors, we see an overwhelming majority of a planned capital allocation increase being used towards share repurchases. Given the underperformance in AAPL's stock price since last summer, we believe it likely will be aggressive on share buybacks.

Given our near-term concerns about iPhone 6S/Plus demand and limited visibility surrounding the consumer smartphone replacement cycle, we reduce our FY 16 (Sep.) EPS estimate to $9.00 from $9.21 and FY 17's to $10.02 from $10.27. We maintain our 12-month target price at $130, which reflects a P/E of 13X to our FY 17 operating EPS estimate. We note that this multiple reflects a premium to hardware peers but is well below the S&P 500 technology sector. We see shares partly supported by net cash per share over $28.

Conclusion: We think AAPL offers a compelling valuation (trading less than 11X FY 17 EPS and 8X ex. net cash), see fundamentals near a trough, and positively view potential product offerings later this calendar year (iPhone 7). We note Apple's significant market position in key areas, and high customer satisfaction and switching costs. We view the iPhone 7 as being the key to re-accelerating growth within the company and note that comparables will become much more favorable for that device. We positively view free cash flow generation, and believe the balance sheet will be increasingly employed for dividends and stock repurchases.


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