Sunday, September 29, 2013

Apple's iPhone Paradox

On Monday, September 23rd, Apple announced the company had sold more than nine million 5c and 5s handsets in the first weekend of sales. The surprisingly high unit sales number for Apple's newest iPhone handsets caused analysts to rewrite and reconsider their narratives on Apple's prospects for early success.  Speculation turned to talk of high channel supply of the iPhone 5c as the source of the expectedly high unit sales number. Analysts had previously cautioned Apple's apparent unwillingness to release a lower-cost handset for emerging markets would dampen the sales growth potential of the new models. 

Confusing matters even more, on September 23rd Apple filed a Form 8-K reiterating revenue and gross margin guidance for the September quarter and indicating revenue would be near the top end of the revenue guidance range of $34 billion to $37 billion and gross margin would be near the top end of the guidance range of 36% to 37%.

The Issue of iPhone Channel Supply
Apple ended the June quarter with about 11 million iPhone handsets in the global channel while also reporting an increase in component supplies. In the June quarter iPhone sell-through was greater than reported unit sales because Apple reduced channel supply in the quarter from about 11.6 million units at the end of the March quarter. In other words, more iPhones were sold to end users in the June quarter than Apple reported as unit sales. 

In the September quarter one year ago, Apple reported ending channel supply of 9.1 million units. At the time, iPhone 5 supplies were constrained and ending channel supply was below the desired range of 4 to 6 weeks of supply on a look-forward basis. 

Because Apple chose to replace the iPhone 5 after its one year in the market with two new models, the global channel could absorb as many of the new handsets as Apple could deliver. There's no issue with high iPhone 5c handsets shipments. Apple has always reported as units sold shipments to resellers when ownership of the devices change hands, not when those handsets are sold by resellers to consumers. Additionally, the iPhone 5c is sold in five different colors. This necessitates more product in the market as sales begin.

Apple's iPhone Paradox
Selling more than nine million new handsets while reiterating September quarter revenue guidance with millions of 5c handsets awaiting sales to customers might create an apparent paradox. But there's no mystery or conflict in the numbers. Apple's decision to focus its new handset efforts on the top tiers of the smartphone market and forego an aggressive effort to gain market share in emerging markets at this time is in line with Apple's approach to the company's primary product markets.

The graph below illustrates Apple's revenue mix over the first three quarters of FY2013:

iPhone revenue represented 53.8% of the company's reported revenue total over this 39-week period that ended in late June. In FY2012, iPhone revenue represented 50.3% of the company's reported revenue total. In the first three quarters of the fiscal year, iPhone revenue rose15.7% versus 10.7% revenue growth for the company as a whole. In FY2013 which ended on September 28th, revenue from iPhone sales may have reached 55% or more of Apple's revenue total. The iPhone remains Apple's principal revenue and operating income driver. Emerging markets can wait for now as Apple seeks gross margin recovery and a return to net income growth. 

Japan Rising
The graph below illustrates the fast rate of revenue growth in Apple's Japan revenue segment:

In both FY2012 and the first three quarters of FY2013, Japan has topped the scales as Apple's fastest growing revenue  region. In FY2012, revenue growth in the Japan region ran at a blistering 94.43% rate. At 23.37%, Japan's FY2013 revenue growth rate through the June quarter eclipsed the 15.07% revenue growth rate in Greater China and the 11.66% revenue growth rate for the Americas region. In the first three quarters of FY2013, Apple's Retail segment revenue growth rate was a comparatively slow 7.93%.

Regional Operating Income As A Percentage of Revenue
The graph below illustrates the percentage of revenue that has reached the regional operating income line over the most recent eleven fiscal quarters:

Again, Japan outpaces the performance of Apple's other revenue segments. In FY2012 and the first three quarters of FY2013, Japan has consistently delivered regional operating income as a percentage of revenue above or near the 50% line. It's no wonder Apple has secured a carrier agreement with NTT DoCoMo as it works out the details of an agreement with China Mobile. As Apple continues to focus its iPhone efforts on the top tiers of the smartphone market, adding NTT DoCoMo to the list of carriers will boost not only unit sales, but operating income as well. 

Emerging Markets Can Wait (For Now)
As the smartphone market continues to mature, Apple will address the hundreds of millions of potential customers in the world's emerging markets. But that time isn't now. Apple's next big step will be a carrier agreement with China Mobile. China is Apple's largest national market outside the United States and the only country other than the US to deliver 10% or more of Apple's reported revenue total. Apple doesn't currently have an iPhone revenue problem. Apple is first confronting the challenge of reduced operating income per revenue dollar due in large part to falling gross margin.

Adding China Mobile as an authorized iPhone carrier in the December quarter and ahead of the early 2014 Lunar New Year celebrations will "turbo charge" unit sales. The carrier will be added after the substantial completion of the global rollout of the new iPhone 5 series handsets. At that time the production ramp for the new handsets will accommodate the addition of the world's largest carrier. But Apple's continuing focus is on the top tiers of the smartphone market 

The Problematic iPhone 5
Not only were iPhone 5 handsets in chronic short supply following release last September, the model was beset with manufacturing challenges that contributed to the extraordinary $1.551 billion warranty set-aside that occurred in the March quarter. To address falling gross margin and the high warranty costs of the iPhone 5, Apple has not only changed the color scheme for the new iPhone 5s, the polycarbonate back of the 5c is easier to make and will allow for some cost savings. 

Sales of the 5c need to be measured not against the sales of the 5s, but against the sales potential of the iPhone 5 had it remained in the market for another year as Apple's mid-line handset. 

Channel Supply: Much Ado About Nothing
In the December quarter (FQ1 2014) iPhone unit sell-through will reach and most likely exceed 60 million units. Apple's decision to ship as many iPhone 5c handsets as possible into the global channel is a smart and prudent move. Because the iPhone 5c replaces the original iPhone 5 in the marketplace, there were no supplies of the product in the market prior to release. 

There's No Mystery In The Numbers
Apple entered the September quarter with about 11 million units in the global channel. Channel supply consisted in part of two handsets Apple has removed from the market. Building out channel supply to meet new product demand will remain a challenge for Apple through the December quarter. 

Apple's management has reiterated revenue guidance for the quarter not because of challenges with iPhone sales, but because the quarter began with 11 million units in the global channel and against a backdrop of negative unit sales growth from the iPad and Mac lines in the period. There's no conflict between Apple's reiteration of guidance and high iPhone unit sales in the period. An apparent paradox does not exist. Reported iPhone unit sales and unit sales sell-through for the September quarter will be high, but channel supply gains over the June quarter number may not occur. There's a distinct possibility Apple will report higher sell-through than unit sales in the quarter as Apple worked down channel supply prior to release of the new handsets.

Moving Forward
By this time next year Apple may choose to address emerging markets with a lower-cost iPhone handset. But Apple's biggest challenge at this time isn't iPhone unit sales growth. The biggest challenge is the company's increasing reliance on the iPhone line for revenue growth and aggregate gross margin performance. Management's obsession with customer satisfaction and attractive gross margin puts emerging market initiatives on the proverbial back burner for now.

Apple's Real iPhone Paradox
There's nothing inconsistent about Apple's iPhone strategy. The real paradox is that even without addressing emerging markets in this year's product line refresh, Apple's reliance on its most popular product line continues to rise. 

The lack of a MacBook Pro update in the September quarter exacerbates the unit sales pressure on Apple's oldest and most enduring product line. The iPod line is virtually immaterial to Apple's revenue and net income performance outside of each year's holiday quarter and iPod unit sales continue to decline.

An October refresh of the iPad line will no doubt reinvigorate unit sales. Expectations of the release of a Retina display iPad mini have already dampened sales of the existing model. The 9.7" iPad hasn't had a significant update since March 2012, when the first Retina display iPad was brought to market. 

Apple will first cement its position as the market leader in the high-end tiers of its current product markets. The iPhone refresh and the pending iPad refresh will boost the revenue performance of Apple's two most popular product lines. Urgency for Apple to address consumers in emerging markets is nothing more than misplaced anxiety. Apple's biggest risk moving forward is growth dependence on one line of product as the smartphone market matures.

Apple's revenue growth and the company's return to positive net income growth will be fueled in the December quarter primarily by the new iPhone 5 series handsets. The refreshed iPad line will also benefit the company's top line and bottom line.

While attention at this time is almost exclusively focused on the new iPhone handsets, the question isn't whether or not Apple's iPhone strategy will be a success but whether or not the pending iPad refresh will deliver unit sales growth to keep pace with the success of Apple's new line of smartphones.

Robert Paul Leitao

Disclosure: The author is long Apple shares