Financial Alchemist

AAPL: The Anomaly of Disruption- Why an Event of This Magnitude is Rare

noreply@blogger.com (Turley Muller) — Tue, 21 May 2019 06:18:00 +0000

I read John Gruber's comments on Horace's piece (on Asymco) that stirred up thoughts I have long harbored. Horace talks about how people fail to grasp Apple because they focus on the products Apple sells- their physical attributes classifying them in a singular product category type, which is vastly different than the products Apple builds- the solutions its products provide to the user (jobs they perform). The iPhone fulfills a wide range of needs, which varies among users. In addition, the list of solutions Apple builds into iPhone has expanded and continues to lengthen. Hence, it can't be thought of belonging to a single category, such as a just a mobile phone.

Gruber adds that Horace's point explains why many analysts incorrectly categorized Apple as PC maker in a commodity industry (back in that era), and now view Apple as a wireless handset maker in a saturated market dependent on product replacement cycles. This fails to account for all the services and content being sold that the iPhone makes possible. In addition, this flawed thinking fails to account for accessories that the iPhone makes possible as well- the Watch and AirPods. These two collectively are a business the size of Netflix-- and turn an actual profit. Apple's ecosystem and massive user base should afford it a higher multiple, yet it trades closer to a valuation shared by stodgy hardware makers, as Horace laments.

Gruber reminds us that the same people who misclassify Apple are the same ones incessantly asking "where's the next iPhone?" Not literally an iPhone, but a new Apple product that is as successful. John's comments imply this is a very dumb question to ask. Read my statements below to see why I believe it's totally asinine. This was an "aligning of the stars" or "perfect storm" that Apple was able to take advantage because of its savviness as a technology integrator.

The introduction of the smartphone, namely the iPhone, was the product of a confluence of technologies that had simultaneously advanced to the point of feasibility allowing them to be implemented in mobile phones. Such things as 3G, miniature and power efficient components, micro GPS chips and antennas, along with services like Facebook, were in their infancy not existing until the latter part of the first decade of the new millennium.

The smartphone makers (non-Apple) did a poor job exploiting technological improvements. Palm's OS was developed for the very primitive Palm Pilots in the preceding era. Palm OS remained basic as it didn't evolve at the pace of hardware. Blackberry was similar. Old OS on new hardware. Microsoft took advantage of the then powerful hardware with its Mobile Windows OS, replete with menu bar drop down lists and file explorer. And, many other desktop Windows features that had no business on a mobile device. It was a very poor fit and buggy. Pre-iPhone devices had small displays due to the physical keyboard taking up so much real estate. Those devices had touchscreens, but they were the resistive type which responds to pressure, hence the stylus that's lost in the first week. These devices had internet browsers but the web experience was unbearable rendering them useless. Special mobile versions of websites were required. So while hardware had become robust, mobile operating systems were less than ideal, and in the case of Palm and Blackberry- their OS had been designed when hardware performance was not so robust. Apple enters and takes advantage of the current technological capabilities (as well as improving further); the iPhone was a coherent package of the aforementioned coupled with a revolutionary mobile OS that unlocked their full potential. In short, Apple was an integrator- combining 3G (2nd iPhone), mini components, new touchscreens (capacitive), iPod, Palm PDA-like apps, AND- HTML browser offering the full web experience for the first time.

To understand how the iPhone was a once in a lifetime product in terms of impact and popularity, look at all the features that had to come into existence at roughly the same time. It was the collective whole of these items that allowed the iPhone to be so revolutionary. The genesis of the iPhone depended on many events outside Apple's control, as it didn't invent 3G, ARM processors, and so on. Apple just saw the possibilities and understood what it would take to bring them into fruition. Critics question Apple's innovation abilities since the company has not introduced a product as revolutionary (or close to) as the iPhone more than a decade ago. Considering that many of the required technologies were all evolving on separate paths, for them to congeal and become to synergistic making the iPhone possible- is a very rare event.

HARDWARE:

Processors- low-power, high output, small.
Battery- high capacity, small footprint.
3G- data speeds making the Web tolerable.
Wifi- small radio, internal antenna (not a card with antennae protruding from the side like PC)
Capacitive touchscreen- swipe gestures, virtual keyboard- larger display, no stylus.
Flash storage- fast, low power needs, no spinny disks like early iPods.
Camera- multi-megapixels offered decent/fair pics (no comparison to flip phones).
GPS- small chip/antenna, power efficient.

SOFTWARE:

OS- touch-based, virtual keyboard, continuous zoom and scroll (pinch & swipe).
Widgets- stocks, weather, calculator etc borrowed from Mac OS.
HTML mobile browser- it's combination with swipe/scroll gestures.
Predictive text- not totally new but Apple integrated in virtual keyboard- after the letters T, H, are entered, the keyboard knows X is not a possibility to shrink that key's strike (landing) space and predicts E and I (and other possible letters) are probable subsequent inputs, thus it expands their keys' landing zones.
Maps- Apple's built-in native app (Google's API) vs other mobile maps.
YouTube- Apple's app with YouTube API.
Apps- games and services-based apps- Yelp, IMDB.

The functionality and popularity of smartphones largely stemmed from services from non-hardware entities. The marriage of social media and mobile devices was highly synergistic. Who likes to come back from a long night at the bar or long vacation trip and transfer photos from a camera to a computer to then go post on FB? It's much better to do it that when it happens. It was the existence of such services (and new possible ones) that when intelligently crafted for mobile devices boosted the their appeal- both smartphones and services, in a perpetual feedback loop.

SERVICES:

Social media- Facebook, Twitter, services born from mobile- IG etc.
Google maps- the service integrated into Apple's app coupled with GPS.
Photo / Video sharing services- Flickr, YouTube.
iTunes- music and movies.
Product reviews / price compare- Yelp, Amazon.
Web-based Information Services- weather, stocks (Yahoo), news, sports scores, integrated in device-side clients (apps).

When one considers the number of devices that were replaced by a singular smartphone, it is is difficult to believe that we will see something like the iPhone (its impact) anytime soon, if ever in a lifetime.

CONVERGENCE:

PDA- Palm pilots, electric rolodex, etc.
MP3 Players- iPods.
Cameras- Digital and disposable.
Video Players- personal DVD players.
Audio Recorders- dictation devices etc.
Navigation devices- in-car, hand held, etc.
Watches.
Alarm Clocks.
Timers- forget the one on the oven.
Books
Newspapers
Cable TV
PCs
Calculators
Personal planners- physical notes, calendars, to do lists.
Radios- local broadcasts, scanners for ATC, police, fire, and rescue etc.
Wallets- paper tickets and boarding passes, reward cards, credit cards (where accepted).

There are probably more items for each list that could be added, but I think the point is clear. The iPhone and smartphones in general have had such a monumental impact due to the integration of a plethora of features and functionalities that existed elsewhere, on other devices or in other forms. The iPhone introduced an OS that could unlock and capitalize on the hardware that was coming available. It further leveraged services to make the iPhone a highly useful and usable device. It is the most successful product ever. Taking the global population and adjusting for people too old, or not old enough, who don't have mobile access, or the financial means- we are probably looking at close to 1 out of 5 eligible humans who are iPhone users.

The success of smartphones have been based on the multiple needs they fulfill. The jobs that they do for the user, some formerly tasked by other devices and means. That explains the colossal impact. The inception of the smartphone hinged on many physical technologies that had to be contemporaneously present for such a powerful product to be born.

Because this depended on so many parties, in so many places, along with a number of pre-existing and future services- it is not logical to expect that Apple, or anyone else for that matter, can or will introduce anything close the societal impact that smartphones have had. At least not for a longtime.

AAPL: How Popular are Apple's iPhone Financing Plans in the US? Here's a Look

noreply@blogger.com (Turley Muller) — Wed, 15 May 2019 22:09:00 +0000

Apple offers iPhone financing through 24-month zero-interest installment loans funded by Citizen's Bank (US). How popular is Apple's financing product? From the data I have gathered, the take-rate is pretty low- less than 1 million per quarter. It's probably not as low as it appears considering that a very low percentage of iPhones are bought at Apple retail stores.

The loan payments are charged to the user's credit card each month through autopay. It's almost like financing the financing. It could be buyers don't want to fool with an installment loan and have it affect their credit report when they can just use their credit card to finance the purchase. That's less than ideal if the balance isn't paid down or off in short time. Credit card interest rates are typically relatively high, and the full balance of the purchase accrues interest from the start.

The Apple plans are more advantageous since it's just the monthly payment (opposed to full balance) that would accrue credit card interest fees. Given that Apple's stores are typically located in very affluent zip codes, it's likely very few buyers need financing plans.

With these plans, iPhone users can give back their iPhones to Apple after a year if they buy a new iPhone. Apple will pay off their loan balance. And the process restarts itself.

How does Apple offer 0% financing? Especially given that not Apple, but a bank is the lender?

Apple sells the loans at a discount. If a customer buys a 720 iPhone and agrees to 24 monthly payments of $30, Apple will sell that loan for perhaps $680. The bank earns $40 in interest income on $680 loan. Apple sweetens the deal with the bank by opening a bank account where proceeds from the loan sales are deposited. Apple has to keep a compensating balance at Citizen's- likely equal to the outstanding loan principal. Apple disclosed this arrangement in its most recent 10-Q due to the new accounting rules requiring restricted cash to be separated out on the balance sheet.

Most often, when a company has a restricted cash balance it is due to credit quality concerns. Lenders will require cash to be set aside for collateral purposes, especially when a firm lacks other suitable assets to pledge as security.

That is not the case here. Banks have to hold a minimum amount of deposits, or required reserves. If a bank takes in $100 of deposits they might only be able to make $90 in loans and having to keep only $10 of depositor's money on-hand (or on deposit at the Fed). If Citizen's originates $1M of iPhone loans and Apple deposits $1M in an account at Citizen's, then it doesn't eat into the bank's lending capacity. Since banks only have a finite amount of allowable lending capacity. They don't want to waste loanable funds on low margin loans when the bank has the opportunity to lend at higher interest rates. With a compensating balance on deposit, there is no opportunity cost for the bank, thus it will accept a lower rate.

Plus, Apple reduces their cost of credit risk through loss-sharing agreements. In short, by reducing Citizen's credit and opportunity cost, Apple doesn't have to take as large of a haircut on the loan sales as Citizen's will accept earning a lower interest rate.

Citizen's has disclosed the balance of "merchant partnership" loans which are the Apple iPhone financing plans f(or most quarters). Apple has only reported restricted cash for the most recent quarter- 2Q19 ending in March. The restricted cash balance included in non-current assets lines up with Citizen's numbers. I don't know what the restricted cash in current assets is from. The caption says "primarily" which obviously means not 100% so my take is the amount classified as current is related to something else.

Taking the disclosed balances, I calculated the amount of new iPhone loans for each quarter. Using an assumption for ASP, the number of iPhones sold under installment plans can be calculated.

The change in loan balance from quarter to quarter does not represent the amount of new iPhone loans extended since the previous quarter's balance will be paid down to some degree. Thus, the amount of payments made on the outstanding balance must be calculated first.

I didn't take the time to try to be super accurate by incorporating more realistic assumptions since these numbers are so low it's not really worth the time. However, this should be roughly accurate.

Assumptions:

1) 24 month Average loan life (none paid off early).

2) No payments are made on loan balances in the quarter which they originated.

You can see in the table the big jump for the quarters that the iPhone X and iPhone Xs / Max were introduced.

5G Primer and Expectations (for early stages of US 5G networks)

noreply@blogger.com (Turley Muller) — Wed, 15 May 2019 02:33:00 +0000

5G is often described as revolutionary, delivering 20 gigabit speeds with near zero latency that will enable a number of disruptive technologies, such as augmented/virtual reality, mission critical communications, autonomous vehicles, an so on. 5G's vision is radically different than previous generations, but for smartphones 5G is just another typical, evolutionary step. The exceptional figures for speeds and latency being talked about do not pertain to smartphones. Carriers are looking to 5G for new revenue streams, particularly from businesses and government.

The real excitement over 5G is more business/industrial oriented, than it pertains to the mobile consumer. Technologies such as edge cloud computing, industrial IoT (Internet of Things), autonomous driving, telemedicine, etc. stand to benefit the most. For mobile consumers, 5G will enable augmented/virtual reality use cases, along with online gaming where low latency is imperative. Many things that 5G promises don't even exist yet.

TERMINOLOGY:
5G encompasses a wide range of qualities that vary based on purpose and coverage area, which is determined by the frequency of spectrum.

5G can come in 3 different forms-
1) Low-band - highest coverage, lowest speeds (slow)
2) High-band- lowest coverage, highest speeds (currently extremely rare)
3) Mid-band- blend of coverage and speeds (currently non-existent)

DATA SPEED & COVERAGE COMPARISONS FOR DIFFERENT SPECTRUM

The high band consists of millimeter wave frequencies above ~30GHz which is being used for Fixed Wireless Access (FWA), or broadband to the home. Currently, there are very small areas in handful of cities with mmWave 5G. mmWave coverage will always be very sparse, and it won't be relevant for smartphone users anytime soon. mmWave is more suited for specific use cases. For the purpose of this report, ignore the mmWave 5G as the focus here is smartphones.

COMPARISON OF PERFORMANCE QUALITIES FOR LOW AND MID-BAND SPECTRUM

5G below 6GHz frequencies will provide macro coverage and is what smartphones will typically use. In the US, carriers are planning to use their current low-band spectrum for 5G as mid-band spectrum is not available yet, but the FCC is working on relocating incumbents in the desired bands to make available for 5G. Using unlicensed mid-band spectrum is also being considered. Frequencies in the 3.5GHz - 5GHz range (mid-band) don''t travel as far as low-band, resulting in a lot less coverage area than 600MHz - 700MHz. This will create coverage gaps if carriers overlay mid-band spectrum across their low-band cell site foot print.

Low frequencies (low-band) do not provide the speed and latency of the higher frequency mid-band spectrum, and the amount of low-band spectrum currently licensed is most likely not adequate for wide carrier signal (100MHz) channels required for high data speeds.

MID-BAND SPECTRUM (above 3GHz) WILL ALLOW FOR 100MHz CHANNELS

COVERAGE AREAS FOR DIFFERENT 5G SPECTRUM BANDS

INTRODUCTION:

This report includes a brief primer on 5G wireless technology along with my expectations for 5G smartphones/service in the US over the next couple years. The main thesis here is that I don't expect performance for 5G smartphones will be noticeably different/better than advanced versions of LTE early on. 5G will not be be "must have" feature for smartphones.

The 5G that smartphone users will encounter in the US isn't fully 5G because it is unlikely carriers can meet the 100MHz channel size defined by 5G standards. Nor will US carriers use new, higher frequency spectrum (Sub-6GHz) in early stages. T-Mobile and Verizon have only around 100MHz most markets. AT&T has 1.5x to 2x that in some markets, but for all carriers the spectrum is broken into small blocks and spread across many bands. In addition, carriers still have to allocate spectrum to their legacy LTE and 3G networks.

The addition of mid-band spectrum along with minimum100MHz channels are major factors in 5G performance that will be absent in the early stages. 5G will increase capacity which boosts data speeds, but it is when those efficiency gains are combined with more high frequency bandwidth that results in large throughput increases.

As 5G networks and mobile handsets begin rolling out this year, I do not expect 5G network coverage will be widespread for at least two years. The 5G currently being deployed will not provide the full potential that 5G envisions. This "Early 5G" as it pertains to smartphones is more of an evolution of LTE. "True 5G" is many years away. The real promise of 5G is sub-millisecond latency, or delay, which enables such use cases such as a virtual reality and autonomous vehicles. Low latency and multi-gigabit speeds are possible from EHF spectrum, or millimeter waves, which is broadcasted from small cell sites having a several hundred meter radius. Millimeter wave 5G coverage will be limited to a small number of locations.

LTE TO 5G:
5G and LTE have similarities as number of standards have been introduced in LTE-Advanced (Pro) and carried over into 5G. LTE evolves into 5G opposed to being discrete like 2G, 3G, and 4G. 5G is built on top of a LTE core network which is possible since this is the first time a new wireless generation uses the same waveform and multiple access as its predecessor- LTE and 5G use OFDM. The range of spectrum (mid-band) where smartphone data speeds could be considerably higher (due to wider channels and wavelength) is currently assigned to other radio services.

LTE continues to evolve. Initially peak data speeds for LTE were thought to be 100Mb/s. versus 2Gb/s possible today. Telecom execs have mentioned that years ago they never fathomed that LTE could deliver the speed and performance it does today. LTE has been able to continue improving by adopting 5G technology. A number of 5G standards, such as carrier aggregation, 256-QAM and Massive MIMO, (and others) are being introduced on LTE networks, as they evolve to becoming a "5G" network. The real distinction between LTE and 5G is the RAT (radio access technology)- the air interface or 5G radio at the cell site and modem in the mobile device. 5G enables wider carriers and scalable sub-carrier spacing. Devices will be connected to the same network as calls and signaling are always handled by LTE and data by 5G, if available.

DATA SPEEDS CONTINUE TO INCREASE FROM ADVANCES IN LTE

Deploying 5G is not super complex. Cell sites are upgraded to meet LTE-A standards, which includes more antennas for MIMO, to name one. The LTE upgrade is the biggest part. For 5G, antennas are replaced with upgraded models that connect to LTE and 5G simultaneously. A 5G baseband, or radio chip is also installed at the cell site (base station). Then all is needed is a software upgrade.

5G SMARTPHONES:
Several 5G smartphones will be introduced this year, but the iPhone will not be one of them. There have been rumblings that Apple risks being late to the 5G game. IDC stated Apple could face a tough 2H19 due to the coming 5G and foldable devices from its competitors. I find that to be a ridiculous statement; we've seen how the foldables hype has unfolded, and there is no appeal for a 5G smartphone given the lack of 5G networks.

I am not convinced a 2020 5G iPhone is truly necessary. If 5G coverage is sparse, performance is questionable, and iPhones cost more, then it undoubtedly makes little sense to add 5G connectivity until those drawbacks subside.

Tim Cook would not talk specifics, but did say (paraphrasing) Apple is always looking at different technologies and selects the right time when those things come together, especially from a cost point of view. There are a lot of added costs for handsets to support 5G due to the need for more RF content and increased antenna complexity. Historically, battery and connectivity performance has been poor for early versions of new generation wireless technology.

Will consumers buy a higher-priced device with potential connectivity/battery performance issues coupled with the likelihood 5G coverage will be limited? And, especially given that initial 5G speeds will not be significantly better than advanced versions of LTE? And, how much to users value higher data speeds? For web browsing, most often it is browser processing power and server-side factors affecting speeds, especially when a webpage is stuffed with ads.

The are considerable challenges for implementing 5G in smartphones due to the huge number of spectrum bands and unprecedented bandwidth requirements, and this is compounded by the need to support simultaneous 4G LTE and 5G connections. Smartphones will need to make space for the added 5G components. Dual LTE/5G connectivity needs two primary antennas which requires an additional DC converter. MIMO requires 4 antennas to support 4 receive paths, and the vast range of spectrum bands that must be supported increases the RF content in a device. I would think shrinking the battery foot print would be the easiest solution to free up real estate. Of course, this comes with the sacrifice of battery life which is less than ideal given the power consumption obstacles 5G adds. Premium handsets incorporate envelope tracking with power amplifiers minimizing power consumption, but ET's are only expected to 60MHz of bandwidth which will increase PA voltage for wideband 5G transmissions. The impact on iPhones is likely less, given iPhones already support multiple antennas along with possessing power consumption excellence.

The 5G networks that currently exist in the US are the millimeter wave variety suited for Fixed Wireless Access. It is unclear when Sub-6GHz 5G for smartphones will be available in the US. US carriers won't be in any hurry to light up their networks until they can get 5G smartphones in their customers hands. This will likely revolve around the timing of a 5G iPhone considering nearly half of US smartphones are iPhones.

5G NETWORKS- NSA 5G NR (vs SA):

The 5G network in current development is termed NSA 5G NR which stands for Non-Standalone 5G- New Radio. Non-standalone indicates that its not a new/separate network, but rather a new radio with 5G technology standards attached on top of an existing network. NSA networks use for LTE for the network core.

The other type of 5G network is SA, or standalone, where the network is its own entity- a "True 5G" core. Standards for SA 5G are still being finalized so it will be years before standalone networks exist. NSA represents an intermediate step on the path to full 5G service.

The industry has decided on the diagram in the middle illustrated below- NSA to EPC (LTE)

It's hard to know how big an improvement Sub-6GHz 5G in the US will be versus the advanced versions of LTE because - advanced LTE is a lot like 5G and the major differentiator- mid-band spectrum with 100MHz channels - won't happen in the US near-term. That said. I do not expect mobile 5G in the US will be dramatically better than LTE speeds currently possible today.

5G SPEEDS DEPICTED ARE FOR mmWAVE- LOW-BAND 5G SIMILAR TO LTE-A

5G TYPES:
There are two types of 5G service classified by their frequencies. They are drastically different. Data speeds increase as frequencies increase.

1) mmWave (Millimeter waves)
mmWave is located on the EHF band (extremely high frequency) which are frequencies above 20GHz and capable of delivering data speeds as high as 20Gb/s. This requires using large blocks of spectrum to construct channels as wide as 1000Mhz. AT&T and Verizon have significant high-band spectrum holdings and both have installed mmWave service in several markets. Despite its mind-blowing speeds, mmWave 5G is of limited use due its very short range (several 100 meters) and poor propagation qualities requiring line-of-sight transmission. It's likely it will be used solely for fixed wireless access. Typically antennas are installed on utility/light poles every several hundred meters. In essence, mmWave networks are a collection of glorified WiFi hotspots.

According to a Google study, it would cost over $400B to install antennas on 13 million light poles for covering less than half the US population. To put this in perspective, The Big 4 US carriers collectively spend less than $50B annually on wires capital expenditures. Some of that spending is for maintenance capex- replacing worn out and malfunctioning equipment.

High-band spectrum is relatively plentiful since it's of little use other than in outer space. Radio waves at such as high frequency are absorbed in the atmosphere limiting the range to several hundred meters. Within range, they require clear line-of-sight from base station transmitter to receiver on user equipment.

2) Sub-6GHz-

Sub-6GHz 5G is subdivided into two types:

Low-band spectrum- (600MHz - 2.3GHz US) currently used by 3G & LTE.

Highest propagation and range
Slowest data speeds ~200Mbps

Mid-band spectrum- (3.5GHz -5GHz)

supports urban areas
high speeds ~2Gbs

Sub-6GHz 5G is what mobile devices will use due to its longer range which provides a much wider coverage area. 5G radios can be installed on existing cell sites opposed to mmWave requiring a massive number of micro-sites. Sub-6GHz 5G will use mid-band spectrum somewhere in the 3.5-5GHz range. Current wireless networks use low-band spectrum- frequencies between 600MHz - 2.3GHz. 5G carriers (broadcast signals) are supposed to have 100MHz channel widths compared to 20MHz possible with LTE. Advancements in wireless technology has allowed LTE to increase bandwidth beyond 20MHz through a method called carrier aggregation which combines several 20MHz carriers.

Since mid-band spectrum is not available to deploy in the US yet, AT&T and T-Mobile are refarming low-band spectrum in the 600-700MHz range for 5G. This will serve as an anchor due to its superior range and coverage qualities, however data speeds will be inferior.

The US needs to find a solution to its shortage of mid-band spectrum. The 150MHz of MB spectrum expected by 2020 won't get it done, especially if it's split among 2,3, or 4 carriers.

There are some creative ways to boost bandwidth by sharing unlicensed spectrum that LTE-LAA, LTE-U and 5G are able to take advantage. There has been a debate about sharing 5GHz band which is currently used by wifi.

Many countries have 100's of MHz of mid-band spectrum in contiguous blocks that can provide wideband channels. This will give them the edge in data speeds for the early stages of 5G service.

FREQUENCIES FOR MID-BAND SUB-6GHz 5G

5G FREQUENCIES- ALL BANDS:

US 5G OUTLOOK:

TMUS and AT&T claiming to have nationwide coverage (Sub-6GHz) by the end of next year. Currently, the US lacks mid-band spectrum which is the global standard for Sub-6GHz 5G service. The FCC is working on freeing up mid-band spectrum by relocating incumbents. This process has been slow and doesn't appear it will conclude in the near future. In the meantime, Verizon and AT&T have been deploying 5G on their high-band spectrum (mmWave), used for fixed wireless access, in very select locations.

Mobile coverage supplied by Sub 6GHz 5G is being rolled out by AT&T, T-Mobile, and Sprint on their current low-band spectrum - primarily in the 600MHz to 850MHx

T-Mobile stated that its 5G service will improve average speeds from 30 Mb/s to 60-70 Mb/s, and expect that in two years average speeds can increase to more than 100 Mb/s. They expect in 5 years real-life speeds will reach 300 Mb/s. LTE is capable of delivering the same performance. I don't think AT&T 5G will be significantly higher provided that it won't use mid-and spectrum with wider channels.

There are a couple reasons to expect an unremarkable speed boost. First, data speeds are not as fast for low-band compared to higher frequency spectrum. Second, and most important, US carriers don't have a ton of low-band spectrum to begin with. Verizon has a little more than 100MHz and AT&T little more than 150MHz in most markets; that's insufficient for the 100MHz carriers that 5G standards call for. The quantity of spectrum and channel bandwidths are the major determinants of data speeds.

AT&T:
AT&T is using band 5 (850MHz) and band 12 (700 MHz) for 5G. As shown in the maps below, AT&T only has 10MHz blocks in most markets. AT&T's total 5G spectrum holdings amount to around 50MHz for 700MHz Band 12 and 25MHz for the Band 5 (850MHz). Band 12 is used for LTE as well, thus I doubt AT&T will be using all of it for 5G. My guess would be with Carrier Aggregation AT&T likely use 40MHz carriers (4 x 10MHz).

Stated many times before, the real secret sauce is a single, wideband 100MHz channel, not a bunch of narrow channels lopped together. The guard bands separating aggregated channels consume spectrum leading to the inefficient use of spectrum.

MULTI-CARRIER 5G IS SIMILARLY INEFFICIENT AS LTE CARRIER AGGREGATION

AT&T has 130MHz of 24GHz mmWave and 400MHz of 28GHz mmWave that has been deployed in several markets. It does not seem AT&T will ramp mmWave deployment significantly in the near-term. It's chief engineer is cautious on mmWave since they have little idea how real-life performance will turn out being that it's a totally new technology. It makes sense to evaluate the performance of real-world users before investing in a wide scale deployment.

10MHz CHANNELS FOR OF MAJORITY MARKETS (Memphis has 15!)

10MHz CHANNELS FOR OF MAJORITY MARKETS

Historically, carriers have acquired additional spectrum to dedicate to new generation network builds, as they did for 3G and 4G. This holds true for the 5G mmWave networks as VZ and T acquired roughly 1000MHz and 500MHz, respectively. Regarding Sub-6GHz spectrum, US carriers have not boosted holdings as of yet. FCC will have to make mid-band spectrum available before 5G performance really takes off. In short, for 5G service to be robust and ubiquitous, US carriers have to obtain additional spectrum, specifically in the mid-band frequencies.

VERIZON:
Verizon appears to be solely focused on mmWave 5G as it has given little indication it is actively pursuing Sub-6GHz 5G. I assume this is due to the lack of spectrum VZ currently licenses. VZ management did comment that they expect new technology allowing LTE and 5G to share the same spectrum will be available next year. This would eliminate the need to take spectrum away from its LTE network to solely dedicate to 5G. However, VZ management appears to be more focused on enhancing its current LTE network.

VZ's 5G efforts are focuses FWA (Fixed Wireless Access) that delivers gigabit broadband to the home. Verizon has a fiber broadband product- Fios. However, typically the last leg of th FTTH (fiber to the home), from the street to the house- is not economical when it involves digging up driveways/yards and running wires above ceilings and through walls. Cable broadband providers have an incumbent advantage from the long-existing coax cable connections found in virtually every residence. Eliminating the need to run fiber to the home allows FWA carriers to compete with cable companies. Verizon is also targeting businesses which it says are the majority of its FWA subscribers.

To justify the investment in 5G, carriers are looking for ways to monetize the service. FWA provides those opportunities especially regarding businesses which are less price sensitive.
It is hard to envision how smartphone 5G service could be monetized because I don't think mobile users would pay a premium for faster data speeds when they are already fast.

I've read reports that propagation has been much better than expected, as well as reports that it's terrible. An analyst at BTIG tested Verizon's 5G network in the few hundred feet that it covered, and he was very unimpressed. While it appears mmWave is Verizon's sole focus,

SPRINT:
Sprint has the best prospects for early 5G service. It has nearly 200MHz of 2.5GHz spectrum, with as much as 180MHz in many markets. 2.5GHz is capable of higher speeds than the low low-band frequencies the other carriers are using. Management has stated its intentions of using the 2.5GHz for 5G, but their plans will depend on whether the T-Mobile merger is approved. Sprint hasn't posted a profit in over a decade. Sure, that's an accounting profit which includes depreciation and Sprint does have positive operating cash flow but that's wiped out with capex. Sprint is saddled with debt, and when maintenance capex requirements are considered, its investment capacity is constrained. Luckily, 5G doesn't require much investment beyond that required for upgrading LTE, which I think Sprint is pretty far along.

T-MOBILE:
TMUS is using 600MHz for its 5G network. The carrier only has average of 31MHz per market, with some having 40MHz, which is rather paltry. That explains why management only expects speeds to double to around 70Mb/s, as performance gains would be entirely due to 5G RAT given low channel bandwidth.

If TMUS and Sprint are allowed to combine, its 5G network has the potential to be more robust. It's unclear if T-Mobile's comments regarding expectations 100Mb/s speeds in two years were based on assumption of receiving regulatory approval for the merger. TMUS has 200MHz of mmWave spectrum, but appear to be focused on low-band rollout.
AT&T AND 5G E:
Last year, AT&T pushed out "5G E" network indicator on devices capable of connecting to its upgraded LTE service. AT&T's use of "5G" erupted in criticism and controversy, prompting a lawsuit from Sprint because those devices are not equipped with a 5G chip. AT&T's justification was that when users are connected to 5G E network they can receive much higher data speeds and that this network will be the foundation for 5G service, hence the "5G." and the "E" signifying the evolution to 5G. Sure, it's misleading but I it's not entirely far-fetched when considering that advanced LTE networks include 5G technology. In addition, without mid-band spectrum and capacity for 100MHz channel widths in the early stages, having a 5G radio does not lend significant advantage compared to advanced LTE- a primary thesis of this report. So it's likely that "5G E" won't be terribly inferior to AT&T's 5G in the early innings.

I have been pondering the reasons why AT&T would do this-- what this implies about the company's plans and expectations for its 5G service as it relates to smartphones. It is surprising (and telling) that AT&T would display 5G on 4G phones, a move that limits its potential to promote/sell 5G devices and service in the near future. Many subscribers will think they already have 5G because it says so on their phone.

The whole sales approach is based on emphasizing what the consumer does not have and why he/she needs what this new product/service does have. Product differentiation is key. The LTE indicator is a constant reminder to users they do not have 5G. Yet, now that some see 5G, it is challenging trying to sell folks something they believe they already have. Of course, this works both ways as it makes it harder for AT&T's competitors to gain these users' attention.

AT&T's "5G E" ploy suggests the company's expectations for its 5G service are pretty low in the near-term. Given that the majority of AT&T's subscribers are iPhone users, fall 2020 would be the earliest point AT&T would have a 5G device with broad appeal.

This would also confuse iPhone users, thus it is surprising Apple would go along with it. Apple could use 5G as a proposition for accelerating upgrades. However, it is less surprising if a 5G iPhone is not imminent. In addition, I am certain that Apple's 5G marketing communications will clear any confusion surrounding the not real "5G E."

CONCLUSION:
In the US, 5G networks won't offer significant improvements on smartphones for some time given the amount & frequency of the spectrum. The challenges of building 5G into smartphones raise questions about performance and create a scenario of more expensive smartphones. For me, I would just rather have advanced LTE and prefer the carriers use spectrum for it, opposed to taking from it to dedicate to 5G.

The carriers have to start somewhere with 5G, and they are starting to dip their toes in the water. The pace of the rollout will be gradual opposed to the more aggressive pursuits we observed with 3G and 4G.

For the iPhone-
Not having 5G in 2020 is a risk because carriers will only promote devices that can run on their new network service, and won't recommend the devices that can't. I am not sure how strictly that will apply for the case of 5G (opposed to 3G & 4G). It's hard to know how far along carriers will be on 5G in a year's time and how confident they will be in its service. In addition, carriers might not be aggressively promoting their 5G service if they are not charging more for it. The lack of promotion wouldn't cause a loss of iPhone users, but it could limit the ability to attract new users as well as spur upgrades if carriers aren't offerings promotional deals.

All of this could be a different case internationally.

There is a risk of having a 2020 5G iPhone. Users may delay upgrading if 5G iPhones are more expensive and have less battery life, along with other performance questions that typically surround the introduction of new generational wireless devices. And, if 5G coverage is sparse and data speed improvements aren't exceptional, there would be even less impetus to buy the first 5G iPhone.

(AAPL): Update on Apple's Short Interest for 4/30/19

noreply@blogger.com (Turley Muller) — Sat, 11 May 2019 09:36:00 +0000

The number of Apple shares sold short declined 8.3M to 52.7M as of 4/30/19. Apple's short interest had been averaging around 40M shares until 2/28 when it spiked to almost 97M, increasing 56.9M in a two week period. This was a result from Apple's accelerated share repurchase program (ASR) that kicked off in February. I discussed the ASR and short interest back in March. Now that Apple reported Q2 results and filed its 10-Q, we have confirmation of the ASR and details of its size.

55M shares were delivered to and retired by Apple. This roughly lines up with the 56.9M share increase in short interest for 2/28/19. Since then, short interest has fallen by 44.2M shares.

If we assume this was entirely due to the banks covering their short positions related to the ASR, then there would still be over 10M AAPL shares remaining to be bought as of 4/30. Of course, the short selling and covering is not solely on the part of the banks handling the ASR.

If you think short selling was increasing, then the amount of shares covered for the ASR were more than 44.2M. If others were covering their short positions too, then the amount purchased for the ASR was less than 44.2M.

In any respect, it appears that the initial delivery of shares was only 80% of the $12B purchase commitment, thus there will be more shares repurchased beyond the 55M. It's hard to know just how many more shares since the price of AAPL has run up, but could be as much as 10M more. The program is set to expire in August.

The (possibly) 20M shares remaining for the ASR and Apple's own open market repurchases should continue to help support the AAPL's share price.

Apple (AAPL): Apple Pay Revenue Estimates and Future Potential

noreply@blogger.com (Turley Muller) — Thu, 25 Apr 2019 15:02:00 +0000

Since its launch 4 years ago, Apple Pay has seen strong growth in active users and transaction volume, but revenue has been relatively inconsequential. The challenge facing Apple Pay to impact the top line is straight forward: it is widely estimated that Apple only collects 15 cents for every $100 in credit card purchase value, thus it would require $1T (trillion) in PV just to generate $1.5B in revenue. Even then, one or two billion barely nudges the needle for a company with $260B annual sales. Annual transaction value for credit cards is over $3T in the U.S. and more than $10T globally. Thus, Apple Pay would have to capture a significant portion of global transaction volume and/or boost its percentage take in order to become a significant revenue contributor. Debit transaction volume is not quite as much as credit volume, but Apple likely collects less than a penny per debit transaction. It is possible the economics are more favorable internationally.

APPLE PAY NON-REVENUE BENEFITS:
While revenue from POS (point-of-sale) transactions would still be modest with widespread Apple Pay usage, Apple stands to benefit in other ways. First, Apple Pay can increase platform loyalty and enhance the value of Apple's overall ecosystem. Second, AP gives Apple a foothold in the payment space from which it can expand into other verticals. Apple could move into a processing like PayPal, or become an POS (point-of-sale) acquirer like Square. We have already seen Apple expand into online payments as well as peer-to-peer payments with Apple Cash. Most recently, Apple partnered with Goldman Sachs to become a credit card issuer.

Another benefit is Apple Pay places Apple at the beginning of the chain in the payment process. Being at the start of a process (or the gateway) is immensely valuable. Amazon dominates online retail because it's the first place (sometimes only) that a consumer checks for an item he/she needs. Google succeeds because anyone looking for something on the internet comes to them first. With the popularity of the iPhone, Google now shares billions to Apple annually because when users need to find something on the internet, they pull out their iPhones. To keep Apple from switching search engines or building one, Google pays to be the default search option. If Apple Pay becomes the standard in which consumers make purchases, Apple gains leverage over the card networks and issuers, as well as merchants.

APPLE PAY REVENUE ESTIMATES:
Apple Pay has done $387M in total sales (1Q15-2Q19 ), $175M in revenue for FY18, and $242M in the last year. While Apple has not announced Q2 results yet, I am basing my estimates from the disclosure at last month's special event that Apple Pay has reached 10B transactions.

Apple Pay revenue is calculated from multiplying Apple's commission of 0.15% (or 15 basis points) by the total value of transactions where Apple Pay is used. We calculate total transaction value from multiplying the number of Apple Pay transactions by the average transaction amount.

1) # of Transactions x Average $ Value per Transaction = Total Transaction Value
2) Total Transaction Value x .0015 (commission) = Apple Pay Revenue

My estimates are based on management comments from earnings conference calls and other disclosures which are shown in the table below. I have the highest degree of confidence in the assumption for the Apple Pay commission (U.S. transactions), followed by the estimates for transaction volume. Last, the estimates for average transaction amount are guesses.

For a couple of quarters, Apple has given transaction volume figures and for most quarters it has provided year-over-year growth rates. Taking the two together, we work backwards to estimate transaction volume for earlier periods.

The industry average credit card purchase is higher than $50, but I believe Apple Pay is less. The only guidance we have for the average Apple Pay transaction amount is a comment from 1Q17: "100's of millions of transactions and billions of dollars in purchase value." This implies that transaction volume was 200M or greater and that average transaction was $50 or less. This assumes purchase value was $10B or less, otherwise the comment would have been: "over $10B" or "10's of billions." I use $25 per transaction for my estimates.

The sum of the number of transactions since launch is slightly more than 10B which is consistent with Apple's recent disclosure of attaining 10B cumulative transactions.

For FY19, Apple Pay revenue will reach $330M, and if growth can continue at 100%+ revenue will hit $775M in FY20. These estimates could be too high since I am assuming that all transactions are credit card payments. While the number is certainly not 100%, credit cards are the vast majority. I do not adjust for this since it is likely offset by the low estimate of average transaction value.

IMPORTANCE TO APPLE MANAGEMENT:

It is apparent that Apple's ambitions for Apple Pay extend well beyond its revenue potential from contactless payments. If that were not the case, I don't believe Apple would talk-up the service as much as it does, nor continue to expend effort and resources on development. Surely, not all of that for a business that perhaps in the future only generates modest revenue. Practically on every earnings calls, management boasts about Apple Pay's success despite having little to no effect on the quarter's results, as they have occasionally conceded. Obviously, they believe the future holds bigger and brighter things for the service.

Just to highlight how serious Apple is about AP, look at the case of the new Apple Card. This is the credit card Apple is introducing in partnership with Goldman Sachs. As the issuer, Apple stands to collect 2%-2.5% (interchange fee) from the merchant. Obviously, the economics are much better as a card issuer. Apple offers cash back rewards of 2% on Apple Pay purchases and 1% for purchases where Apple Pay is not accepted and the card is physically swiped (inserted). After accounting for the cost of rewards, the economics look less attractive, but still much better than the Apple Pay transactions from 3rd-party card issuers. This is especially true for Apple Card transactions that Apple only has to pay 1% if Apple Pay is not used. One would think Apple would prefer Apple Pay not be used since those transactions are more lucrative. Since Apple is the card issuer, an Apple Pay transaction does not result in any additional revenue. So why would Apple spend 1% for the use of Apple Pay when there is no financial benefit? Obviously, Apple's goal is to increase Apple Pay usage and is willing to spend money for it. Naturally, the next question becomes "Why would Apple spend money to increase usage when even if Apple Pay becomes ubiquitous, revenues would still be relatively small?" I believe that is the crux. Apple sees AP as much larger than just POS transactions because it makes no sense to pay 1% to your card holders to boost a business that only collects 0.15%. In short, Apple's vision for Apple Pay longterm is ambitious and is therefore seriously committed to accelerating its adoption.

APPLE PAY GROWTH POTENTIAL:
Apple Pay revenue will continue to increase as merchant acceptance continues to grow and as the service expands into new markets. If Apple Card succeeds in attracting a large user base, Apple Pay usage will accelerate domestically.

International usage is much higher than in the U.S. as 80% of transactions occur abroad. The Apple Card addresses this gap. Domestic users don't have much motivation or incentive to use the service, and many are unsure and/or do not ask if the merchant accepts Apple Pay. For their entire lives, people have been in the habit for reaching for their wallets when making a purchase, not their phones. This will change for Apple Card users since they are essentially paid 1% of the purchase amount to use Apple Pay.

Payment card terminals that accept EMV (chip) are also equipped with NFC to handle contactless payments such as Apple Pay. EMV began rolling out across the U.S. a couple years ago and has become the new standard. Not only does this help Apple Pay since it increases merchant acceptance, it should also help lift usage on the part of the consumer. In general, the process of inserting and reading a chip card takes considerably more time than swiping. This is a situation where contactless payments provide a noticeable advantage to the user. Merchants that have busy checkout lines also benefit from a quicker transaction process.

Apple Pay has potential for online and in-app payments. Since these transactions do not involve physical cards, merchants pay higher fees for "card not present" transactions due to the increased risk of fraud. It is possible that the acceptance of Apple Pay reduces such fees since it decreases the risk of fraud. In addition, Apple Pay online payments is beneficial to users since it eliminates the need to have to enter credit card information as buyers can simply tap or click the Apple Pay button and be done with it. Merchants benefit as it reduces the friction in the checkout process moving the customer from product selection to sale with fewer steps increasing the likelihood that more transactions reach completion which also helps merchants capitalize on impulse purchases. Personally, I have encountered situations where I went to purchase an item to later discover my wallet was not nearby causing me to abandon the purchase.

The full potential of Apple Pay is not currently clear. Apple firmly believes Apple Pay has vast potential as evidenced by its continued efforts and the introduction of Apple Card.

Apple (AAPL): A Look at Management's Guidance

noreply@blogger.com (Turley Muller) — Sat, 30 Mar 2019 16:58:00 +0000

This purpose of this post is to provide some historical data points as a more detailed analysis will be forthcoming in a future write-up.

The tables below depict Apple's quarterly guidance versus actual results. The tables begin at 2Q13 when Apple began to start providing "real" guidance opposed to low-ball figures that it always exceeded by a wide margin. That guidance reflected the absolute minimum results that management was essentially 100% certain it would achieve. The revised guidance dropped the EPS forecast and added ranges for expected revenue, gross margin, and operating expenses. Most significant change- accuracy.

Apple exceeded the high-point of its revenue guidance only 4 times (or 33%) for the 12 quarters spanning FY16-FY18. The margin was no higher than 1.5% and roughly averaged 1%. Revenue was on the high-end of guidance for 6, or half of the quarters FY16-FY18, and twice below the midpoint.

FY15 was different story as performance in China and the iPhone 6/6+ surprised everyone. Revenue for 1Q15 exceeded guidance by 12%, yet that margin shrank in the ensuing 3 periods with each period's forecast more accurate than the previous one. Perhaps Apple overshot for 1Q16-2Q16 as it was close to missing revenue entirely. Those have been the only two quarters revenue has come in on the low-end of the forecasted range. Last quarter (1Q19) was the only time Apple failed to reach the low-point of sales guidance.

In short, it's quite likely that Apple's revenue will be above the midpoint of its guidance, but exceeding the high-point is not a given.

Revenue guidance is typically a $2B or $3B range, the latter is common for December quarters. Just twice has Apple given a $4B range, which occurred in the last two quarters. The first time, Apple missed by a mile. What does that portend for the results of this quarter given the revenue is range is $4B again? Does the embarrassment of huge miss last quarter alter management's psychology, or rather its confidence in the outlook provided to investors? The natural reaction is more conservative guidance- numbers certain to achieve. However, Apple can't be too conservative and low-ball guidance since it will freak the market and the stock will get crushed.

Take a look at the $59B-$55B revenue guidance Apple provided for this quarter, 2Q19. If we assume guidance is based on management's desire to give numbers low enough it is certain to reach AND also high enough not to shock investors- wide range of $4B allows it to do both.

What are management's actual expectations? Is Apple really expecting revenue to come in on the low-end between $55B - $57B? But also tacked on and extra $2B to the range making the high end $59B so guidance would not look weak?

Or, does Apple actually expect revenue on the high-end of $58B - $59B but expanded the range down to $55B on the low-end to limit the possibility that it misses revenue guidance entirely? Perhaps a mixture of both, adding $1B to the top and bottom of the range?

I am inclined to believe that Apple is targeting the high-end for 2Q19. The Street expects the same as consensus stands above the midpoint at ~$57.5B. I am expecting 2Q19 revenue to top $58B. While still a 5% Y/Y decline similar to 1Q19, iPad and Mac will benefit from easier Y/Y compares coupled with channel fill from the introduction of new iPad and iMac models.

UPDATE- Apple (AAPL): Number of Shares Sold Short Explodes

noreply@blogger.com (Turley Muller) — Tue, 19 Mar 2019 15:53:00 +0000

In the last Financial Alchemist report, I wrote about the massive increase in the number of AAPL shares sold short according the 2/28/19 report. I speculated that it had to be a single entity, likely a hedge fund that was at the center of such a large change in short interest. However, what did not occur to me was the possibility that this was linked to Apple's accelerated share repurchase program. This involves an investment bank essentially going short the stock as part of the process. Kudos to genius Daniel Tello at AAPL Model for pointing this out.

The ASR process:

Apple enters into an ASR agreement with an investment bank and pays full cash amount upfront.
The bank borrows AAPL shares from portfolios of its brokerage clients and/or other brokerage houses, using the cash from Apple as collateral. The investment bank is now effectively SHORT.
The investment bank delivers Apple the borrowed shares, equal to 85% of the payment, and outstanding shares are reduced immediately.
The investment bank goes out to the open market and buys AAPL shares to cover its short position returning shares that it borrowed.
When the ASR is complete, the bank settles with Apple the net remaining shares owed, further reducing outstanding shares.

We should expect to see a significant reduction in Apple's share count when it reports 2Q19 results. The effect on EPS is less known since the share count used in the calculation is a weighted average of outstanding shares over the quarter. However, it will be quite lower, and the ASR does not reflect the shares Apple might be buying back on its own using a 10b-5 plan.

Apple (AAPL): The Number of Shares Sold Short Explodes According to the Latest Report

noreply@blogger.com (Turley Muller) — Sun, 17 Mar 2019 16:54:00 +0000

The number of AAPL shares sold short as of 2/28/19 increased by 56.9M or 143% from the previous report date on 2/15/19. Short interest stood at 96.8M shares representing 2.1% of the float versus 39.9M shares or 0.9% of the float 2 weeks prior. This is an unprecedented move for as long as I can remember. For the 21 two-week periods prior to the most recent report, the average absolute change was 3.2M shares sold short with a standard deviation of 2.4M shares. The average. absolute percentage change is 7% with no two-week period every exceeding 20%. Thus, for the last year there the period to period changes have been quite small.

So what happened in the last two weeks of February that led to the short interest more than doubling? Even when Apple announced it weak guidance and that it would no longer report unit sales causing the stock to tank, short interest only increased 15% or 5.2M shares. The stock has been on the rise and sentiment has seemed to improve. Thus, a change of this magnitude in AAPL short interest doesn't make any sense.

What could make sense is that a hedge fund, or a few people with a lot of capital placed a massive short bet. It's highly unlikely that large number of typical investors just all of sudden simultaneously decided to go short on AAPL. That would imply that overall sentiment had soured which doesn't seem to be the case. There have not been any negative news or significant developments, and the stock has been rising. It is hard to fathom that this increase was caused by a large number of investors. Most likely a person(s) is making a huge bet that AAPL is going lower. Perhaps as high (or even higher) as 50M shares, or $8.7B in value. If they haven't already covered they are enjoying a $600M paper loss. If they have covered, they don't have anything to show for their efforts since AAPL has not been lower in the days since the last report. It will be interesting to see where AAPL short interest stands when the 3/15 report is released.

APPLE (AAPL): Estimating iCloud Revenue and Paid Subscribers

noreply@blogger.com (Turley Muller) — Sat, 09 Mar 2019 17:47:00 +0000

For some of Apple's services, details such as revenue and number of users are better known than others. iCloud is one such service that Apple has provided little disclosure making the number of paid subscribers and revenue a mystery. Using various data points and tidbits of disclosures, I estimate iCloud revenue was $3.3B in FY18 and ended with 155M paid subscribers. Paid subscribers has grown to ~170M as of 1Q19.

INTRODUCTION:
Apple’s Services segment has grown faster than 20% annually for the last 3 years. While still a relatively small portion of total company sales, Apple Services generate predictable, high margin revenue streams. Apps and licensing are the two largest components, generating about 50% of segment revenue. AppleCare, Apple Music, and iCloud round out other major services. Revenue from Apple Music and AppleCare is not difficult to approximate. Apple disclosed AppleCare revenue for FY14, FY15, and FY16 ($3.2B), and indicated revenue was flat in FY17. In FY18, AppleCare growth ignited as Apple expanded distribution to resellers, as well as bundling with iPhone financing plans. For Apple Music, management occasionally reports the number of paid subscribers and Y/Y revenue growth rates. Taking the monthly price for a Music subscription and multiplying by the number of paid subscriptions, Apple Music revenue can be estimated.

Apple has never provided any meaningful hints as to the potential size of its iCloud business, revenue-wise or number of paying users. It's likely that iCloud's contribution to total company revenue was so small it was never worth mentioning. That changed a couple years ago, when management regularly touted iCloud's performance on conference calls. Since 2Q16, almost every quarter TC has stated iCloud revenue grew very strong double-digits, or very very fast, and a couple quarters growth was over 50%. However, without a reasonable estimate of base revenue for a starting point, that commentary is not of much help.

Unsurprisingly, estimates for Apple's iCloud business are all over the map, ranging from less than $2B to more than $5B in FY18. Based on the calculation of paid subscribers, I estimate for FY18 iCloud generated $3.3B from an average of 136M paid subscriptions. Apple ended FY18 with 155M paid iCloud subscribers. That number will rise to $4.7B in FY19; and by 2025, iCloud could potentially generate over $15B in revenue annually.

METHODOLOGY:
iCloud revenue is the product of the number of subscribers and the amount they pay (for a monthly plan). That monthly amount users pay is one of three possibilities (plans) which in aggregate forms a blended amount- the ARPU (average revenue per user). The challenge is coming up with a reliable estimate for paid users.

Estimating iCloud revenue is dependent on first arriving at a solid estimate of paid subscribers. For paid subscribers, there are not any concrete numbers known. Two years after its introduction, iCloud reached 300M users (paid & free). In early 2016, an Apple executive said there were 782M total iCloud users. Today that number could be as high as one billion. The number of total users is of little use since the portion of paying users could be anywhere in between zero and the combined total, presenting a wide range of error.

Taking information that Apple has disclosed, such as total number of paid subscriptions (includes Apple Music, iCloud, 3rd-Party), along with Y/Y growth rates for iCloud revenue and Y/Y growth for number of 3rd-party subscriptions, we can back into a number of iCloud subscribers.

iCLOUD ARPU ESTIMATES:
Estimating iCloud ARPU is more art than science. There is not any hard information to incorporate; surveys and developing a logical narrative are the only available guidance. iCloud plans are offered in 3 monthly tiers - $0.99 / $2.99 / $9.99. Using intuition and data from surveys, we can calculate ARPU based on estimates of the mix (subscription tiers).

Every iCloud user receives 5GB of storage for free, a paltry amount that Apple has never increased. This pushes users to pay for extra storage. There are 3 tiers- 50GB, 200GB, and 1TB for $0.99, $2.99, and $9.99 per month. The vast majority of paid users fall in the low tier. Generally, users start at the free tier and then move up the tiers as they require more storage. 5GB is not ample for hardly anyone. Users either pay for more storage or choose to store only partial amounts of their data. 50GB is sufficient for most users. However, over time, users who take lots of photos and videos will find themselves needing 200GB. The 1TB tier is the least popular; it represents a single digit percentage of paid users and is typically includes family plans and photography/graphics enthusiasts. I estimate ARPU is approximately $2.00/month which is based on a percentage mix of 65/30/5 for low/mid/high tiers.

ICLOUD PAID SUBSCRIBER ESTIMATES:
Apple reported in Jan-17 (1Q17) that it had 150M paid subscriptions which includes Apple’s own services and 3rd-party content offered on its stores. Therefore, the max that iCloud paid subscriptions could total is less than 150M at the end of CY16. Factoring in Apple’s paid music streaming subscribers of 20M, that number has to be less than 130M. In addition, knowing that there were many 3rd-party subs at 1Q17, iCloud subs would be a good bit less than 130M. How much less? 20M, 50M, 80M? It depends on the number of 3P subscriptions, which like iCloud, is not known. We only know that as of CY16 end, neither iCloud nor 3P subscriptions exceeded 130M, individually and collectively.

In 3Q18, Apple PR stated that the number of 3P subscriptions increased 95% Y/Y. In addition, the company stated on conference call that iCloud revenue grew by more than 50% that quarter. Additionally, Apple reported total paid subscriptions increased roughly 62% from 185M to 300M. Using iCloud revenue growth as a proxy for subscription growth, we solve for the two base amounts by finding the proportions A + B which total 158M in 3Q17 (185M including Music) which increase 95% for 3P (A) and 43% for Cloud (B) to amounts (A)2 and (B)2 in 3Q18, which total 255M (300M with Music).

A + B = 158
(A * 1.95) + (B * 1.43) = 255
(A+B+Music) * 1.62 = 300

KNOWN:
-Total Subscriptions & Y/Y Growth Rate
-3rd-Party Subscription Y/Y Growth Rate
-Apple Music Subs & Growth Rate

QUASI-KNOWN:
-iCloud Revenue Y/Y Growth Rate

UNKNOWN:
-Number of iCloud Subscriptions (3Q17)
-Number of 3rd-Party Subscriptions (3Q17)

By using 95% for 3P growth and 43% for iCloud, we can solve for the base amounts in 3Q17 that would produce 62% total growth for paid subscriptions. The result is 103M iCloud and 55M 3rd-Party subscriptions in 3Q17, increasing to 148M and 107M in 3Q18, for iCloud and 3P, respectively.

For periods other than 3Q17 and 3Q18, I use management's comments regarding iCloud growth to estimate the other periods in FY17 and FY18. Essentially, iCloud has grown 50%+ in some quarters, and others were colored as “very strong double digit growth.”

The growth rate for iCloud subs is estimated from iCloud revenue growth rate. The sub growth rate is less than the 50% revenue rate to account for increases to ARPU. It is highly probable that the bulk of iCloud revenue growth stems from sub growth opposed to a considerable increase in ARPU. Even as some users switch to higher-priced plan, the effects on ARPU are diluted by the addition of new users on the low tier plan. Sub growth likely contributed ~40% and increased ARPU added ~10%+ to the iCloud revenue growth rate.

3rd-Party subscriptions exploded after Apple began allowing subscription billing across all app categories. Originally 3P subscriptions were mostly limited to apps with an existing subscription business for content or services outside the App Store. Today, subscriptions are replacing in-app purchases for the monetization apparatus in many apps. Instead of a one-time payment to unlock premium features in-app, the features are only unlocked for a set period of time (subscription period). The ARPS (average revenue per subscription) is much lower, typically a few bucks for a subscription period of several months to a year, opposed to traditional subscriptions that usually cost $10-$20 per month.

Apple reported that users spent $1.55B and $2.7B on 3rd-party subscriptions in CY15 and CY16, respectively. This information is not particularly of great use since ARPU is unknown and using a rough estimate (based on average subscription prices) is imperfect since the purchase volume number covers the entire year thus contains subscriptions that were only active 1,2,6, etc. months. One-half of that $2.7B theoretically could have been earned in the last 3 months of the year. While imperfect, if we can infer a run rate from using the annual amount as an average- gross up $2.7B to $4B, and assume annual ARPU of $100, the result is 40M 3P subscriptions as of Jan 1, 2017. However unreliable, it is a starting point. The ballpark estimate of ~42M 3P subs (based on CY16 purchase volume) at the start of CY17 fits reasonably as it equates to 88M iCloud subs at start of CY17. When possible, I try to use various methods and calculations to test the reasonableness of the estimates.

iCLOUD REVENUE FORECAST:
I believe iCloud could grow to a $17B annual revenue business by 2025 as the number of paying users and ARPU increases. In the future, cloud services could potentially become as important as internet or wireless service. As an individual's life becomes increasingly more digital, there is a need for storing that digital information. What we think of cloud services today will different significantly from cloud services of the future. As Apple's installed base continues to growth with more users converting to paid users coupled with paying users upgrading storage plans, iCloud revenue will keep rising. One possible headwind to revenue growth could be sluggish ARPU growth stemming from price reductions and/or increased storage allotments. I expect Apple will increase the size limits on its tiers, but storage needs will be increasing as well muting the overall impact on ARPU growth.
Apple has over 1.4B active devices, including 900M iPhones in its installed base which is growing ~10% annually. I would put the number of unique users around 850M. With 170M paid iCloud users at the end of 1Q19, penetration equates to just 20% of unique users. This provides a long runway for iCloud revenue growth and the key to reaching $17B in 2025.

Visualizing Longer Smartphone Replacement Cycles

noreply@blogger.com (Turley Muller) — Sat, 23 Feb 2019 16:19:00 +0000

It is widely known that smartphone users are holding on to their devices longer as they upgrade to a new model less often. This lengthening of the replacement cycle is negatively impacting Apple's iPhone sales. The frequency at which smartphone users purchase new models has been slowing for many years now, but the impact has been less apparent. Sales to new users masks the declining sales to current users. If the percentage of iPhone purchasing a new phone in a year drops from 50% to 40%, sales will decline 20% Y/Y unless the 10% shortfall is offset by other sources of demand, such as first-time smartphone buyers or Android users. If sales to new iPhone users considerably outweighs the slowdown in replacement demand, it is hard to detect that change in purchase behavior. When the market becomes saturated and sales demand is dependent on current users, any slowdown in upgrades surfaces to the forefront.

The 4 major US wireless carriers report the percentage of their subscriber base that upgrades their device in that quarter, and the sum of those 4 quarters equals the annual upgrade rate. A 50% annual upgrade rate implies replacement cycle of 2 years, 25% would be 4 years and so on (1/.5, 1/.25). The upgrade rates carriers report understate the level of replacement activity as it only captures upgrades from THEIR current subscribers. Upgrades that occur at a new carrier when a subscriber switches wireless service aren't reflected in those figures. To account for those upgrades that carriers classify as gross adds, I use churn rates as a basis for an adjustment assumption. With out an adjustment, the upgrade cycle has extended from 3 years (2010) to recently (2018) longer than 4.5 years. We know that is too long, which is not a surprise since upgrade activity is not full captured. After adjusting, those rates go from 2.23 years (2010) slowing to 3.46 years in 2018.

I estimate the current replacement rate is around 3.5 years on average. Both AT&T and Verizon have a 80-85% take rate for installment plans on smartphone sales. The percentage of subscribers on installment plans has been stuck at 50% for more than years now at both carriers. If 85% of subscribers took an installment plan and upgraded every 2 years, then the percentage of subscriber base on those plans would be 85%, not 50%. That 35% represents users that were on installment plans that have since ended but have not upgraded to a new model. Doing the math, only 58% of smartphones (in use) purchased on installment are 2 years or newer, conversely 42% are older than 2 years. This equates to a 3.4 year replacement cycle which is consistent with the figure I calculated based on the method mentioned earlier. The absolute number is not as reliable or as important as the trend. The trend explains a lot and is illustrated in the charts below.

In the Fall of 2014, Apple introduced its first iPhone with a large screen display-The iPhone 6 Plus. The decline in upgrade rates quickly reversed as iPhone sales surged due to the considerable amount of pent-up demand for a large display iPhone model. After iPhone Plus mania subsided, upgrades rates resume their decline and have really collapsed in the last 2 years. When / Will we see another event like 2014? A massive upgrade cycle or "super cycle" has been expected for two years now, yet it has not materialized. However, an iPhone that is not upgraded this year, is an iPhone that might be upgraded next year. iPhones do not last forever; eventually, they will have to be replaced. As iPhone owners hold on to their devices longer, the amount of pent-up demand for future iPhones increases. So while Apple may have periods of weak iPhone revenue resulting from soft upgrades, there will be periods when upgrades rebound generating strong iPhone sales.

Dissecting Apple's (AAPL) Consensus Estimates for FY19

noreply@blogger.com (Turley Muller) — Mon, 18 Feb 2019 18:55:00 +0000

As depicted in the graphs below, Apple's revenue and EPS consensus estimates have come way down. The first sharp drop occurred in the beginning of January when Apple warned it would not meet guidance and issued a revised revenue forecast that was $7B lower than its initial guidance. The stock bottomed around $142, and gradually rose through the rest of January to the mid $150's- even as consensus estimates were still falling. After Apple reported Q1 results at the end of January, estimates took another leg down, but Apple's stock price jumped to over $170. Apple's stock price has anticipated decreases to consensus estimates as analyst revisions have lagged stock price movements. Apple's stock began its decline when it reported Q4 results at the beginning of November. Apple issued weak guidance and announced it would no longer report unit sales. The stock took a steep dive, but estimates only decreased slightly. And while estimates have dropped significantly in recent weeks, Apple's stock has rallied. This suggests that the bad news has been priced in, and that the market expects revisions to stabilize or perhaps even rise.

The table below highlights what appears to be a disconnect between revenue and EPS estimates. Revenues are expected to fall mid-low single-digits, but EPS is forecasted to decrease much more, as much as double-digit declines for Q2 and Q3. If we assume that Apple repurchases 125M shares each quarter, then net income based on those share counts coupled with consensus EPS estimates points to even a much larger Y/Y decline in net income. Those net income levels imply 300-plus basis point drop in net margin. Does this make sense?

As we saw in Q1, sales dropped 4.5%, but EPS rose 7.5% due to two factors. 1) EPS benefited from a lower share count. 2) Net income only fell 0.5% due to a lower tax rate boosting net margin by 100 basis points. Thus, with Apple expected to buyback considerable amount of stock, one would expect EPS to perform better than revenue as seen in Q1. However, upon closer analysis the forecasted relationship between sales and EPS appear to be reasonable.

There are 3 factors or headwinds that could offset the benefit of a lower share count. 1) Lower revenue causes a loss of operating leverage as fixed costs are spread over a smaller revenue base resulting in margin compression. Gross margins are pressured by depreciation expense that is independent of sales volume. Aside from depreciation, there are other fixed costs that affect gross margins. 2) Operating margins are affected by the levels of SG&A and R&D expense which are relatively fixed. R&D has been rising at a much faster pace than revenue for several years. With an expected smaller revenue base, these expenses will compress operating margins if they are at levels equal to or higher than last year's. 3) Higher tax rates will compress net margins thus negatively impacting net income. Apple is guiding to a tax rate of 17% for Q2 vs. 14.5% for the year-ago quarter. Apple's tax rates for Q3 and Q4 last year were 13.3% and 14%, respectively. If 17% is the norm for the remainder of FY19, then net margin will be negatively impacted.

Investors should keep an eye on the trends affecting these 3 factors- gross margins, operating expenses, and tax rates as they will be the primary drivers behind net margins which drives net income. Since EPS is net income divided by the share count, net income should be the primary focus since it can be safely assumed the share count will fall. We just don't have much visibility for what net income will do.

Impact of Licensing Revenue on Apple's Services Segment

noreply@blogger.com (Turley Muller) — Thu, 18 Oct 2018 03:46:00 +0000

Apple’s revenue from its Services segment has consistently exhibited growth. It’s the only area of Apple’s business not to have a down quarter over the past 6 years. It has accelerated in the last two quarters reported to over 30%/ While sales growth for iPhone, iPad, and Mac has been all over the map, Apple promotes its Services as a high-margin growth engine for the future. The Services segment includes revenues from Apple Music, Apple Pay, AppleCare. iCloud, iTunes, App Store, and licensing. On quarterly conference calls, management touts the success of its Services business and goes on to mention the unparalleled popularity of the App Store, Apple Music, iCloud, and so on. It reviewing transcripts dating back 10 years, I couldn’t find a single mention of licensing other than a couple instances where the CFO was explaining what was reported in the Services segment.

"we refer to as services and this will encompass everything we report under the heading of iTunes software and services today including content, apps, licensing and other services and beginning this month it will also include Apple Pay."

Goldman Sachs estimates that the licensing revenues have been growing over 40%, and currently amount to almost $2.5B per quarter, and they expect it to continue to grow almost 30% next year. This appears reasonable. We can dissect revenues the other Services components- App Store, AppleCare, iCloud, etc. and we are left with a $2B+ shortfall, most of which must be licensing related revenue. The bulk of this licensing is revenue from Google for search in Apple’s Safari browser. Since this is a confidential agreement Apple makes no mention it exists other than alluding to it in quarterly SEC filings. In the Management Discussion section of the Form 10-Q, Apple states licensing as a primary contributor to the growth of the Services segment. Contrary to earnings calls, where it’s never been mentioned. Below is a table displaying the quarters licensing was named as a growth contributor and the excerpts of those statements. All but 2 quarters since 2014 has licensing been included. Apps are mentioned for every quarter and AppleCare in more than half. AppleCare, however, is not a significant growth contributor. Unit sales for Apple Products that AppleCare is available for have been flat for past several years. Attachment rates have likely increased modestly. Since AppleCare revenue is deferred over life of the contract (usually 2 years), it does not have an immediate effect on the quarter in which it was sold since only 1/6 (at most) is recognized.It does affect revenues over the next 8 quarters if Apple continues to sell more contracts than previous quarters.

Below are the excerpts from the 10-Q

2013 Q3

iTunes, Software and Services Net sales of iTunes, software and services were $4.0 billion and $11.8 billion in the third quarter and first nine months of 2013, respectively, increases of $787 million or 25% and $2.4 billion or 26% compared to the same periods in 2012. These increases were primarily due to growth in net sales from iTunes, AppleCare and licensing.

2014 Q1

The increase in net sales of iTunes, Software and Services in the first quarter of 2014 compared to the first quarter of 2013 was due to growth in net sales from the iTunes Store, AppleCare and licensing.

2014 Q2

The increase in net sales of iTunes, Software and Services in the second quarter and first six months of 2014 compared to the same periods in 2013 was due to growth in net sales from the iTunes Store, AppleCare and licensing.

2014 Q3

The increase in net sales of iTunes, Software and Services in the third quarter and first nine months of 2014 compared to the same periods in 2013 was primarily due to growth in net sales from the iTunes Store, AppleCare and licensing.

2015 Q1

The increase in net sales of Services in the first quarter of 2015 compared to the first quarter of 2014 was primarily due to growth from iTunes and licensing.

2015 Q2

The increase in net sales of Services in the second quarter and first six months of 2015 compared to the same periods in 2014 was primarily due to growth from licensing and iTunes,

2015 Q3

Net sales of Other Products increased solely due to the launch of Apple Watch, and net sales of Services increased primarily due to growth from iOS app sales and licensing.

The increase in net sales of Services in the third quarter and first nine months of 2015 compared to the same periods in 2014 was primarily due to growth from iTunes and licensing.

FY2015

The increase in net sales of Services during 2015 compared to 2014 was primarily due to growth from Internet Services and licensing.

2016 Q1

The remainder of the year-over-year growth in net sales of Services was due primarily to higher App Store and AppleCare sales.

2016 Q2

The year-over-year increase in net sales of Services in the second quarter and first six months of 2016 was due primarily to higher App Store, licensing and AppleCare sales.

2016 Q3

The year-over-year increase in net sales of Services in the third quarter and first nine months of 2016 was due primarily to growth from App Store, licensing and AppleCare sales.

FY2016

The year-over-year increase in net sales of Services in 2016 was due primarily to growth from the App Store, licensing and AppleCare sales, The increase in net sales of Services during 2015 compared to 2014 was primarily due to growth from the App Store and licensing.

2017 Q1

The year-over-year increase in Services net sales in the first quarter of 2017 compared to the same quarter in 2016 was due primarily to growth from the App Store and AppleCare sales,

2017 Q2

The year-over-year increase in Services net sales in the second quarter and first six months of 2017 compared to the same periods in 2016 was due primarily to growth from the App Store and licensing sales.

2017 Q3

The increase in Services net sales in the third quarter and first nine months of 2017 compared to the same periods in 2016 was due primarily to growth from the App Store and licensing sales.

FY2017

The year-over-year growth in Services net sales in 2017 was due primarily to increases in App Store and licensing sales. Services net sales in the fourth quarter of 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information.

The year-over-year increase in Services net sales in 2016 was due primarily to growth from the App Store, licensing and AppleCare sales,

2018 Q1

The year-over-year growth in Services net sales in the first quarter of 2018 was due primarily to increases in licensing and App Store sales

2018 Q2

Services net sales increased during the second quarter of 2018 compared to the same period in 2017 due primarily to licensing, App Store and AppleCare. Year-over-year growth in Services net sales during the first six months of 2018 was due primarily to licensing, App Store and iCloud.

2018 Q3

Services net sales increased during the third quarter and first nine months of 2018 compared to the same periods in 2017 due primarily to licensing, App Store and AppleCare. During the third quarter of 2018, the Company recognized a favorable one-time item of $236 million in connection with the final resolution of various lawsuits.

Estimating 2Q 2012 US Smartphone Sales

noreply@blogger.com (Turley Muller) — Mon, 06 Aug 2012 22:26:00 +0000

Last week, Strategy Analytics published its estimates for 2Q12 US smartphone shipments; however, they can't been seen as reliable due to a number of problems. Whenever I read research or an article, or hear somebody quote market share figures from the large industry research houses, such as IDC, Gartner, Strategy Analytics, or Canalys, I cringe. Too often, I find wide disparities between these industry estimates and the numbers I know to be true- figures reported by manufacturers, carriers, resellers, etc. in press releases, SEC filings, and on conference calls. Another problem is that these research firms give little public explanation behind their methodology. A better framework is to first calculate sell-through, or sales to end-users which the top 4 carriers provide smartphone unit figures. These aren't 3rd-party estimates; they are actual sales figures from the horse's mouth. Since these numbers can be attained with a high degree of confidence, we can then hash out shipment estimates based on analyzing market and seasonal trends, as well as incorporating any guidance available from vendors and carriers/resellers.

Strategy Analytics 2Q12 US Smartphone Shipment Estimates:

source: Strategy Analytics

The first problem with SA's Q2 US shipment estimates is that its figures for Apple aren't shipments, they are sell-through. The 7.9M unit shipment estimate for Apple is the sum of activations reported by AT&T, Verizon, and Sprint. To be consistent with measuring shipments, as we assume SA is doing for the other OS platforms, sales to iPhone carriers and resellers (i.e. Best Buy, WalMart, Radio Shack, etc) need to be measured.

Second, the activation figures used only include 3 carriers, however iPhone is available through 16 carriers in the US. Even though these carriers are very small and many weren't online during the entire quarter resulting in relatively low activations, there would be considerable iPhone shipments into these channels due to the need to build a stock of initial inventory.

SA is assuming that iPhone shipments equals sell-through. Apple reported that channel inventory declined by 300K globally, hence 26.3M units sold-through versus the 26M units shipped. Apple specifically stated that China shipments were impacted from a reduction in channel inventory which was high at the start of the June quarter due to the iPhone 4S launch at China Unicom and the addition of China Telecom in the March quarter. Therefore, sell-through in China was significantly higher than sell-in (shipments) which resulted in the reduction of channel inventory. Apple stated the China channel inventory impact was more than $1B of iPhone revenue, which would equate to more than 1.5M units. Therefore, channel inventory had to increase by 1.2M units outside of China to equal the net 300K decrease in global channel inventory. Given that Apple added 12 carriers in the US, coupled with only a 12% sequential decline in activations at the top 3 carriers, we can attribute much of the 1.2M channel inventory build to the US.

Third, we know the 7.9M figure for 2Q12 and the 5.9M figure from 2Q11 aren't the correct numbers to use. Tim Cook stated on the conference call that iPhone sales were up 47% year over year in the US. Using the activations figures as SA did, the Y/Y increase is only 34%. Therefore, we know that shipments don't equal the activation, or sell-through numbers that SA incorporates.

So for SA's estimates to be reliable, or even taken seriously, they must be consistent in what they are measuring. If they are measuring shipments, then SA should use shipment figures for Apple, not sell-through. Obviously, shipment numbers are a lot harder to ascertain than sell-through figures since US carriers report smartphone sales or provide metrics to calculate it.

Using the erroneous activation number, SA calculates that Apple captured 33% of shipments. SA also says Android shipments were 13.4M units and RIM shipped 1.6M units. Where or how did SA come up with these figures? We know the RIMM figure doesn't make sense. Taking the revenue numbers RIMM reported for the US for the May quarter, and adjusting for June month being much weaker than February, ASP's are highest in US, and significant portion of service revenue comes from high ARPU customers (such as enterprises) in the US, Blackberry shipments were most likely around 1M units, not 1.6M units SA estimates. So what about the Android number? That's a tough one to reliably estimate. However, we can make some meaningful assumptions for estimated shipments from sell-through estimates which are much easier to calculate given that carriers provide smartphone sales. Using the underlying trend of sales to end-users, we can then make assumptions of whether or not carriers & resellers would be increasing/decreasing or maintaining inventory levels.

Financial Alchemist 2Q12 US Smartphone Sell-Through Estimates:

AT&T & Verizon reported smartphone sales of 5.1M & 5.9M, respectively. Sprint stated that 81% of handset sales were smartphones, and given the upgrade rate and gross additions, Sprint sold around 3.3M smartphones. T-Mobile hasn't reported quarter results, but sold 2.5M in Q1, so estimating 2.4M units would likely be appropriate. Then comes the wild card: the other carriers. They consist of very small regional post-paid players and national prepaid carriers which probably account for about for 30M subscribers. It's a hard number to quantify. It's also hard to quantify smartphone sales for those carriers as well. However, they only make up 10-15% of the market, and the percentage of smartphone sales is lower due to the high cost of hardware which isn't subsidized much for prepaid plans. A conservative estimate would be that the "other carriers" roughly resembles T-Mobile.

In total, I estimate that 19.2M smartphone units were sold to end-users in 2Q12. SA estimates that 23.8M units were shipped, or sold into the channel. So is it reasonable that shipments exceeded sell-through by 4.6M? If sell-through were expected to increase by 4.6M units in Q3 it would, but it's very unlikely that it will by that much, if at all, for a couple of reasons. 1) Carriers are tightening their upgrade policies, charging higher fees and lengthening the time period until one is eligible for a fully discounted upgrade. 2) Smartphone penetration has reached over 50% at the top carriers (62% at AT&T, 71% at Sprint), thus the pool of potential first-time smartphone buyers is shrinking. 3) Seasonality- typically demand softens in the summer, and gradually accelerates into the back-to-school period and holidays. Q3 generally sees the widest divergence between sell-in and sell-through as carriers build inventories. In sum, unit shipments likely exceeded sell-through slightly (20M units), or at best, only modestly (21M). The vast majority of any excess sell-in would consist of Android units, however.

At the top 3 carriers, Apple captured 55% of smartphone sales to end-users. For the entire US Market, I estimate Apple's market share was 42%. In terms of share of sell-in, iPhone would likely only be lower by 2-3%. It's highly unlikely that it would be as low as 33% Strategy Analytics estimates. Estimating the sell-through for the other platforms is more difficult, since only Verizon provided Android figures. But taking data reported by RIMM and Nokia, as well as other company sources, unit sales and market share can be estimated with a modest degree of confidence.

source: FA estimates, company reports

My method for estimating US smartphone sales mirrors the method used by Ben Evans from Ender's Analysis. In being conservative, I model a higher volume of unit sales to the other carriers (non-Big Four).

In short, industry research firms such as the ones mentioned in the opening paragraph often don't produce reasonably accurate estimates. This instance is just one example of many where I have encountered considerable factual evidence to the contrary. The best approach is to always take the figures reported by the industry players as we know that those are accurate. From there, we can make more reliable estimates with regards to the unknowns.

Warranty Expense Crimps Apple's Margins in 4Q10

noreply@blogger.com (Turley Muller) — Thu, 28 Oct 2010 15:31:00 +0000

Apple Inc (nasd:AAPL) reported a 36.9% gross margin for Q4 2010 which ended in September. This caused worry among investors especially since management stated on the earnings conference call that the decline was due to higher cost structure of iPad and iPhone and the exceptional value it is delivering to consumers. However, a considerable portion of the decline was due to warranty expense which there was no mention on the call.

At the time Apple recognizes revenue for the sale of a product, it also records its estimate warranty expense in costs. It is just an estimate, thus actual warranty costs may vary. When there is an actual warranty cost incurred, it is not recorded to expenses on the income statement since Apple already accounted for warranty expense at the time of sale. Instead, actual cost incurred are recorded as reduction to the warranty expense reserve.

Apple’s warranty accruals had been averaging around 1% of revenue for the first three quarters of FY10, or roughly ~$150M. In Q4, warranty accruals ballooned to $457M, or 2.3% of revenue.

If estimated warranty expense had remained constant in absolute dollar terms ($150M), GM would have been 38.4% vs 36.9%. If If estimated warranty expense had remained constant in as a percentage of revenue (1%), GM would have been 130bps higher at 38.2%.

The silver lining is often estimates of warranty costs are overly conservative resulting in much smaller accruals going forward. This could potentially happen with Apple if actual costs incurred fail to materialize, Apple would make much smaller accruals going forward, hence boosting gross margins.

FA Estimates for Apple (AAPL) Q1 2010

noreply@blogger.com (Turley Muller) — Mon, 25 Jan 2010 18:32:00 +0000

Apple Inc. (nasd:AAPL)- Apple reports Q1 2010 results after the bell today, January 25th.

Below are my expected numbers:

Tailwinds Q1 2010:

1) Improving economic environment and consumer spending.

2) New iMacs released in October.

3) iPhone expansion into China, Korea, and additional carriers in current markets.

4) iPhone 3GS channel fill due to supply constraints in Q4.

5) Strengthening international demand for Macs, iPhones, and iPods.

6) iPhone “halo effect” benefiting Mac demand.

7) USD weakening should lift ASPs from sales abroad.

8) iPod sales mix shifting towards touch models should lift iPod ASP.

Headwinds Q1 2010:

1) Unavailability of higher priced iMac models in December.

2) GM pressure for shipping costs from iMac refresh.

3) Higher provision for warranty expense stemming from defective 27’ iMac units.

4) iPod product life cycle maturing, potential market nearing saturation, and cannibalization of iPhone/iPod touch demand.

5) Competition from low-price notebooks and netbooks resulting in MacBooks appearing to be much more expensive.

On balance, tailwinds were much more stronger than headwinds that Apple faced in Q1 2010. Thus, Apple should report an extremely strong quarter.

Disclosure: Long AAPL

My Comments on Bloomberg TV Interview with Apple Analyst

noreply@blogger.com (Turley Muller) — Tue, 24 Nov 2009 18:56:00 +0000

Broadpoint AmTech analyst Brian Marshall recently appeared on Bloomberg TV to discuss Apple’s iPhone exclusivity agreement with AT&T. Marshall believes that Apple should move away from its exclusive AT&T agreement and begin offering the iPhone through Verizon. He believes adding Verizon could boost iPhone unit sales by 14M. Marshall states that AT&T’s exclusivity ends in June 2010, and explains why Apple would benefit by offering the iPhone through Verizon. Fortune’s Apple 2.0 and Silicon Alley Insider summarized several of Marshall’s points, which I believe aren’t entirely accurate.

Here is a video of the Bloomberg TV Interview

1) Apple receives a $450 subsidy.

Incorrect: Apple receives a $400 subsidy.

I know from talks with Best Buy managers that the subsidy is $400. Best Buy purchases a 16GB iPhone from Apple for $542, and sells it for $199 with a 24 month service contract. AT&T reimburses Best Buy $400.

A 16GB iPhone without a contract commitment costs $599. If the subsidy were $450, then that price should be $650, or AT&T would be leaving $50 on the table. In addition, the math suggests $450 subsidy is too high given the ASPs implied by the cash value of iPhones sold reported by Apple.

2) After AT&T loses exclusivity that subsidy will drop to $300 for all carriers, domestic and international.

Incorrect: Subsidy shouldn’t change.

Tim cook addressed this issue on Apples Q4 2009 conference call (from Seeking Alpha):

Gene Munster – Piper Jaffray

We’re looking at the iPhone, it’s pretty clear we’re still in a greenfield opportunity here, but if you start to go to multiple carriers can you talk a little bit about the pricing of the phone when you go from exclusivity to multiple carriers? And obviously, not specific but any sort of color we can have in terms of pricing dynamics change on the phone from you to the carrier?

Timothy D. Cook

Our pricing is confidential, Gene, so it’s not something I could comment on in detail but generally speaking from markets where we’re already selling I would not expect to see a wholesale price difference as we bring on other carriers. However, the end user price is really set by the carriers themselves so you may or may not see a street price difference.

Gene Munster – Piper Jaffray

So when you go from exclusive to multiple carriers, you wouldn’t necessarily see change in pricing that you are charging the carrier? Is that correct?

Timothy D. Cook

That’s correct.

Handset subsidies are a function of ARPU, or a subscriber’s monthly service bill. The ARPU across all AT&T customers is ~$51 compared to iPhone ARPU of nearly $100. Since the ARPU is nearly double, this allows a greater degree of subsidy recapture, thus allowing for a higher subsidy to applied to a mobile device.

3) iPhone users represent 4% of total AT&T subscribers.

Incorrect: iPhone users represent about 14% of AT&T’s total wireless customer base.

AT&T has roughly 11.3M iPhone users. On the June call, AT&T said it had nearly 9M iPhone customers. AT&T has 81.6M wireless subs, with 63.4M being postpaid.

Brian Marshall stated: “roughly 4% of the AT&T users of the iPhone, consume about 40% of the overall network bandwidth.”

It’s not clear exactly what Marshall was referring to when he mentioned 4%, but most people took it to mean iPhone users constitute 4% of AT&T’s customer base. I assume he got his figures mixed up. The 3.2M iPhone activations in September period would equate to 4% of AT&T’s subscriber base. If he meant 4% of iPhone users, or about 450K, consumer 40% of AT&T’s bandwidth, then I would think AT&T would address those users since they represent 0.6% of AT&T’s wireless subscriber base. It wouldn’t make any sense to allow such a miniscule portion of customers affect the quality of service of the overall network.

4) iPhone activations from new AT&T customers made up more than 90% of postpaid net additions in September quarter.

Not Meaningful: Gross additions not net additions should be used as the metric.

iPhone activations from new AT&T customers totaled approx. 1.28M. AT&T reported 1.39 postpaid net additions. However, AT&T attracted 3.57M new postpaid customers, and 2.18M postpaid customers left AT&T, resulting in 1.39 net additions.

Comparing iPhone activations from new AT&T customers versus net additions is a faulty metric, since net additions is dependent on gross additions and the number of disconnects (churn). The more meaningful metric is comparing new iPhone additions to postpaid gross additions, which was 36% (1.28M / 3.57M). Using net additions is meaningless.

To imply that the iPhone was responsible for 92% of AT&T’s increase in postpaid customers is inaccurate. The 1.28M figure represents a portion of AT&T’s gross sub additions, therefore, it shouldn’t be used in a comparison of net additions. Subscriber churn affects subscriber net additions, and isn’t directly related to the iPhone’s ability to attract new customers.

Let’s say AT&T activated 2.28M Blackberry devices from new AT&T customers. That would equate to 165% of postpaid net adds, whereas iPhone was 92% of postpaid net adds. Is that meaningful? Not really, since it’s possible that the figure can exceed 100%. Let’s say 2.28M iPhone activations were from new customers, then that 92% would be 165%. Since the ceiling can exceed 100%, we don’t know is 92% or 165% or whatever the figure, is good or bad.

5) AT&T’s contract ends in June 2010.

Unknown: I have heard from sources at AT&T the contract runs until the end of 2010.

Neither AT&T nor Apple has publicly commented as to when the exclusivity ends. It was reported last year that Apple and AT&T extended their agreement until the end of 2010. It would make sense that the agreement runs until the end of the year since it commenced in the beginning of 2007. Even though the iPhone didn’t go on sale until June 2007, it was announced that January, allowing AT&T marketing rights for the time preceding the actual product launch.

Many assume that the deal will end mid-2010 since Apple introduces new iPhone models during that time of year. However, all we know is that the exclusivity agreement will end at some future time, but when that is exactly is anyone’s guess.

Disclosure: Long AAPL

Apple Inc (AAPL): Weaker Dollar Will Benefit Revenue Growth and Margins

noreply@blogger.com (Turley Muller) — Tue, 03 Nov 2009 13:45:00 +0000

Apple Inc. (nasd:AAPL) Rising gross margins stemming from increased recognition of deferred iPhone revenue has been a key factor in propelling Apple’s share price and EPS. I believe the next major tailwind will be increased revenue growth and higher margins arising from the falling U.S. Dollar. In 2009, 46% of Apple’s total revenue came from overseas, up from 43% in FY08 and 41% in FY07. Including European Apple retail stores, revenue generated in Europe was roughly 30% of total revenue in FY09. International markets are a key source of Apple’s revenue and growth, and a declining dollar is beneficial for the firm. Apple’s performance for the past several quarters was challenged by headwinds from the strengthening USD. Going forward, Apple should benefit from the dollar’s decline. This will lift international revenue growth and boost margins. Alternatively, Apple could choose to lower prices abroad to stimulate product demand to drive volume. I believe many investors overlook the fact that Apple derives nearly half its revenue outside the U.S., thus don’t consider the considerable impact coming from a weaker USD.

The USD had been on a long-term weakening trend up until late 2008 when a string of financial institutions collapsed and panic ensued. This led to a massive influx into U.S. Treasuries, hence the USD. This caused a temporary rise in the USD as investors all over the world sought refuge in securities perceived to be the safest.

Around April/May 2009, money began shifting out of USD leading to the currency weakening. In effect, USD depreciation is a resumption of its previous long-term trend. However, this recent fall in the dollar comes with several new factors that support a long-term dollar decline.

1) Massive stimulus and bailouts

2) Budget deficits

3) Diversification away from USD

4) Weak dollar policy to boost exports and domestic manufacturing

I expect the dollar to continue it’s weakening trend and a return to levels pre-fall 2008. From October to about May, the USD rose considerably, before starting its slide mid-year. Apple generally hedges against currency fluctuations usually 3 to 6 months out, therefore the rise in the USD late-2008 likely didn’t much of an immediate impact. Eventually, the effect of the stronger dollar is felt as new hedges are set at less favorable exchange rates. Apple had warned on its earnings calls that a stronger USD would negatively impact gross margins, thus stated it a as factor for guiding GM lower. However, cheaper components, higher iPhone revenue recognition, increased supply chain efficiencies, and foreign currency hedging more than offset the temporary rise in the USD. Apple mentioned in its 2009 10-K filing that the stronger USD did have a negative impact on revenue growth abroad for the full year. When hedges expire, Apple can either raise prices to offset the stronger USD or elect to accept lower ASPs in USD terms. Even though the USD began to fall back in April/May, it’s likely Apple has yet to feel the full benefit of the dollar’s decline due to currency hedges still in effect.

The tables below compare product pricing from Apple’s online store for France, U.K., Canada, Australia, and Japan at most recent exchange rates versus rates in early 2009 when the USD was at its highs. Some of the pricing includes VAT, so the price differential between U.S. product prices and Euro zone is overstated, but the focus here is the difference between most recent prices (weak dollar) versus prices when the dollar was stronger during late 2008 - early 2009. In Europe, where Apple receives nearly 30% of its total revenues, prices have risen more that 20% in USD terms. In general, that would equate to a 6% increase in overall ASPs.

A weaker dollar does imply higher product costs since Apple sources components and manufacturing outside the U.S., namely Asia. However, the negative impact of a weaker dollar in terms of product costs is much less than the benefit of higher ASPs in USD terms. This is because: 1) costs are a smaller percentage of overall selling price 2) Apple enters into long-term supply agreements and also has significant leverage over suppliers 3) China’s currency is fixed to the USD as it prefers a weak currency to support exports.

In summary, Apple faced currency headwinds for much of FY09 which I expect will turn into tailwinds for FY10. This factor hasn’t been mentioned much in the investment community. A weak dollar will boost ASPs (in USD terms), hence international revenue growth as well as lift gross margins. Apple could also choose to take advantage of the weakening dollar by cutting prices where it sees elastic demand. Therefore, I expect GM will continue to show strength aiding in the growth of Apple’s bottom line.

Disclosure: Long AAPL.

Apple Inc (AAPL): Q4 2009 Estimates

noreply@blogger.com (Turley Muller) — Mon, 19 Oct 2009 14:48:00 +0000

Apple (nasd:AAPL) reports its Q4 2009 results on Monday, October 19th. I am expecting revenue to increase 19% (Y/Y) to $9.374B and EPS to increase 25% to $1.57. I expect gross margin to rise sequentially to 36.7% from 36.3% reported in Q3.

Revenue growth will be driven by strength in the iPhone, iTunes, and software segments. Mac units sales will be up (Y/Y), but Mac ASPs will be down resulting in slightly lower Mac revenue (Y/Y). iPod revenue will be down 10% due to lower unit volume and ASPs.

Earnings growth will be driven by the higher sales mix of high-margin products such as iPhones and software.

Disclosure: Long AAPL

Apple Inc (AAPL): Current Valuation Still Reasonable

noreply@blogger.com (Turley Muller) — Tue, 11 Aug 2009 22:43:00 +0000

Apple Inc. (nasd:AAPL) $162.83- Despite Apple shares rising more than 100% from its 2009 low of $78, the stock still appears to be attractively valued especially as a long-term holding. Using cash-flow and non-GAAP earnings, AAPL trades at less than 15x on a trailing 12-month basis. Since sales and cash flows were likely significantly depressed over that time period due to the sharp economic contraction, demand should improve considerably in the quarters ahead. Thus, forward multiples would be even lower given the anticipated rebound in sales and earnings growth.

The modest price multiple at which AAPL currently trades leads me to conclude that investors are: 1) Attributing the slowdown in Mac and iPod segments to a permanent secular decline, rather than temporary weakness consistent with economic contractions. 2) Ignoring/underappreciating the growth potential of the iPhone and products yet to be introduced.

Non-GAAP Earnings & Cash Flow:

Apple has reported $5.72 GAAP EPS for the past 4 quarters combined (ttm). However, over the same period, Apple has earned $9.23 in non-GAAP EPS (ttm). The non-GAAP figures are a better representation of Apple's earnings power since iPhone revenues are recognized in the period sold and not deferred over a 24 month time frame as is the case with GAAP EPS. The GAAP EPS numbers grossly understate Apple's profitability and cash-flow generation.

Looking at the difference between GAAP revenue and non-GAAP revenue for the past 4 quarters, GAAP revenue would be $7.7B higher, or 22.3% if Apple were not required to account for iPhone sales using the subscription method. Reported EPS (ttm) would have been $3.51, or 61.4% higher as well. The most noticeable difference is the effect iPhone sales have on profit margins. Since the iPhone carries the highest margin for Apple hardware, there is a dramatic impact on gross and net margins when subscription accounting is reversed. Gross margin rises from 35.5% to 39.6%, and net margin increases from 15.0% to 19.7%.

GAAP Revenue (ttm) has increased 12.2% compared to the prior trailing 4 quarters, yet non-GAAP sales increased 29.7%, more than double the rate of GAAP revenue growth. GAAP earnings growth (ttm) versus the prior 4 quarters was 11.7% ($5.72 vs. $5.12). However, non-GAAP EPS (ttm) increased 66.3% ($9.23 vs $5.55) compared to the same period for the prior year.

From June 2008 to June 2009, Apple's cash holdings increased $10.35B, from $20.77B to $31.12B. On a per share basis, cash/share increased $11.38, or 50% from $22.85/share (June 2008) to $34.24/share (June 2009). Apple generated $10.26B in free cash flow over the last 4 quarters, or $11.28/share.

It is clearly evident that the reported GAAP figures widely understates Apple's true performance. Therefore, investors should focus on the non-GAAP numbers and cash flow when evaluating Apple.

Valuation Metrics:

Even though stock values reflect future cash flows, we can examine Apple's performance over the last 4 quarters (ttm) to use as a conservative proxy since the recessionary backdrop has most likely depressed revenue and earnings. Apple's GAAP EPS (ttm) of $5.72 translates into a historical P/E (ttm) of 28.5x. That would appear to be quire a rich valuation, especially given the multiple compression that has occurred in the overall equity market. Or, at least, imply significant future growth.

However, investors should know that evaluating AAPL based on GAAP accounting is completely flawed. To compare apples to apples, investors must gauge Apple using its non-GAAP figures relative to peers/market. Apple uses subscription accounting methods to account for iPhone sales which spreads handset revenues over 24 months by accruing unrecognized revenue in a deferred revenue account that is stated on its balance sheet. Apple's non-GAAP EPS (ttm) is $9.23 which equates to a trailing P/E of 17.6x. That is a stark difference than the misleading GAAP P/E of 28.5x.

Considering that Apple has $34.24/share in cash & securities that could theoretically distributed to shareholders, Apple trades at even a lower multiple based on non-GAAP EPS ex cash. If we strip out $34.24 cash/share from AAPL's $162.83 share price, we are left with $128.59/share which essentially reflects the value of Apple's operating assets. In addition, interest income must be stripped out of earnings before calculating a P/E multiple due to the assumption that the cash stockpile would be distributed, hence no longer contributing interest income to EPS. For the trailing 4 quarters, Apple earned 33 cents per share (after-tax) in interest income. Apple is trading 14.4x ex-cash (ttm) based non-GAAP EPS ex-interest income of $8.90.

When there is a large disparity between interest yield (interest income/cash) and earnings yield (EPS/Price or 1/PE), the large cash balances can skew the value of the (non-cash) operating assets. When short-term rates were over 5% (pre-tax) and Apple traded at 20+ multiple, the earnings yield was roughly equivalent to the cash yield. Therefore, there was little or no difference between the standard P/E and P/E ex-cash & interest. Now that current short-term rates are near zero, Apple's cash holdings contribute very little income to total company earnings.

If Apple used its $31.1B for a stock buyback, it could reduce share count by 191M to 718M. Non-GAAP EPS (adjusted for interest income) would rise to $11.21 translating into a P/E (ttm) of 14.5x.

In the past year, Apple's cash position has increased by $10.35B or $11.38/share giving a P/CF (ttm) of 14.3x. Trailing free cash flow was slightly less at $10.26B giving a P/FCF (ttm) multiple of 14.4x. Removing the value of cash and interest income (from share price & FCF), the P/FCF multiple drops to 11.7x.

Recall that this valuation exercise has been based on historical earnings, not expected future earnings which is more appropriate since investors only care about future cash flows. However, I used trailing earnings since those figures are known while future earnings are not. I am confident that Apple's next 4 quarters will be better than its previous four. The economy has been in a deep recession for the past year, but has begun to improve. Apple has managed to withstand the downtown reasonably well; and with the success of the iPhone/App Store along with the possibility of new products, Apples growth should accelerate moving forward. Thus, I am reasonably confident that Apple's valuation multiples are even lower on a prospective basis.

Price Implied Expectations:

Trading for less 15x trailing earnings and ~12x expected earnings, AAPL on the surface appears cheap. Historically AAPL has traded at much higher valuations, yet expected growth was much higher too. In addition, investors are demanding a higher required rate of return on equities by paying lower price multiples. The increase in equity risk premium inherent in all stocks has led to the decline in P/E ratios. Investors perceive greater risks and are less sanguine about the long-run prospects of equity returns. This accounts for a portion of Apple's low valuation relative to its historical premium.

The primary reason why the investors are assigning a paltry price multiple is due to expected declines in Apple's growth rate. In my opinion, the current share price reflects the expectation of Mac growth commensurate with the industry average, declining iPod growth, and iPhone growth that will peak and rapidly decline to the industry average in a couple years. In short, Apple is priced as if its growth is quickly maturing, such as MSFT or DELL who both saw their margins compress as growth stalled. All firms eventually fall victim to the industry/firm life cycle. However, is this expectation likely for Apple's future? That is the key question.

I don't believe that overly optimistic or unrealistic expectations are priced-in AAPL shares. I believe the current outlook implied by the share price is conservative, but not entirely unlikely. The future of Apple's growth hinges on innovation and new products/services, as it does for most firms. Many firms are unsuccessful at being able to continue to innovate, staying relevant and avoiding being commoditized. In short, Apple's share price doesn't give much value to its ability to innovate and reignite growth. In my opinion, it's the belief whether or not Apple can continue to introduce products that wow consumers that determines if AAPL is over/under valued.

Apple's Record of Successful Innovation and Execution:

1) iPod's Dominant Market Share-

Apple's unit market share has exceeded 70% in the U.S. for years as it has successfully continued to ward off competition leaving carcasses by the wayside. Many powerful companies such as Dell, Sony, and Microsoft have attempted dethrone the iPod only to fall short or outright fail. Apple has been able to keep iPod prices relatively high as its revenue share of the U.S. PMP market is higher than 90%.

2) Apple's iTunes store is largest music retailer-

Tunes surpassed Best Buy and Wal-Mart to take the top spot is sales volume. Apple should increase its lead as bricks and mortar stores cutback on music selection due to high inventory cost and required floor space. Demand for physical music continues to decline as consumers shift to buying digital music online. Competitors have followed with online music download stores, yet they have made little dent in iTunes market share.

3) Retail stores generate highest revenue/sq.ft. and foot traffic-

It's quite indisputable that any retail strategy has been as successful as Apple's retail stores. Apple leads in performance metrics such as revenue/sq.ft. and visitors/store etc, but its retail strategy also has been extremely successful in promoting its brand and introducing customers to its products. Other computer makers' retail efforts have failed, such as Gateway and Dell. Many third-party computer and electronics resellers have also disappeared, such as CompUSA and Circuit City. It's quite evident that it's a very challenging environment to navigate. Apple continues to open new stores and is expanding considerably abroad.

4) Turn-around of Mac business and domination of premium segment:

Mac unit sales increased 38% in FY08 and 40% in FY07, which was more than 3x the PC industry as a whole outpacing the industry in 18 of the last 19 quarters. Even though Mac unit growth has slowed to single-digits, its share of the premium price segment has exploded. According to NPD, Macs made up 91% of sales for PCs priced $1000 and above for June 2009, up from 88% in May. This compares to 66% share Mac had in Early 2008. I believe Apple had about 40% share of the premium market in 2007. It is quite evident that Apple is the only PC manufacturer than can command a premium for its products.

5) Large and increasing share of smartphone market-

Even with the experience and industry footing incumbent mobile handset makers possessed, Apple was able to enter the market and quickly gain share. According to several surveys, the iPhone has the highest satisfaction rates by a considerable margin. Industry competition is very intense, yet Apple is the one to catch in the smartphone segment.

6) iTunes App Store-

One year after launching, the iTunes App Store offers 65K applications and has seen over 1.5B downloads. Other firms have followed with their own mobile app stores, yet haven't been able to duplicate nearly as much developer and consumer interest. Nintendo mentioned last quarter that Apple's App Store is impacting its handheld gaming business.

These remarkable achievements illustrate a common theme. Apple has been able to enter new product markets and become the leader that others must chase. Even though many competitors have attempted to duplicate Apple's strategy, most have had hardly much success, at least in terms of stealing business from Apple. A popular concern among Apple investors is that increasing competition from the number of firms following in Apple's footsteps. They believe that others will eventually catch Apple (iPhone, App Store, iTunes Music),hence its lead is only temporary. However, this has been a concern for ages and yet to come to fruition. That is not to say it won't happen as there is a real possibility that it will eventually. But given Apple's proven track record of disrupting, dominating, and defending its new endeavors, it's likely Apple will remain the innovative leader for sometime.

Apple's share price may reflect declining iPod growth and decelerating Mac growth, but it doesn't reflect potential new products which are a certainty. The success of those new products are less certain, but Apple makes products/services that complementary to its others, rather natural extensions. Basically, Apple products help drive sales of other products as well as increasing switching costs creating customer "lock-in."

Apple's products elicit the some of the highest customer satisfaction scores for their respective categories which has created immense loyalty and a powerful brand.

Conclusion:

On a non-GAAP basis ex-cash, Apple is trading at less than 15x trailing EPS. Considering the economy has been going through the worst economic downtown since the Great Depression, Apple's trailing earnings are depressed. As the economy turns up, earnings will normalize at a higher level. In addition, iPhone sales should continue to exhibit strong growth and drive free cash flow. Therefore, investors should be highly confident that future earnings will be considerably higher. On a forward earnings basis, AAPL's price multiple is 10-12x, a valuation representative of maturing growth. However, Apple has a long track record of innovation and using products to promote and attract consumers to its other offerings. Looking at the many remarkable achievements by Apple any the many stumbles by competitors, it can be argued that AAPL deserves a premium multiple, not a multiple reflective of ordinary growth.

Disclosure: Long AAPL

Apple Inc (AAPL): iPhone's Substantial Impact on Gross Margin

noreply@blogger.com (Turley Muller) — Wed, 29 Jul 2009 10:00:00 +0000

Margins held steady Q/Q at 36.3% (down 10 bps) versus expectation of ~200 bps of margin contraction due to mounting headwinds.

Management issued Q4 GM guidance of 34%, 100 bps higher than Q3 33% GM guidance (which AAPL exceeded by 330 bps).

Considering the number of challenging cost environment Apple's Q3 performance and Q4 GM guidance are huge positives.

(1) Apple was able to maintain gross margins for Q3 and (2) According to Apple's guidance, I expect GM to hold in Q4.

The past two quarters have seen a significant lift in gross margins compared to the 3 periods prior (3Q08-1Q09) in which GM held steady at 34.7%. The rise in GM has be a major factor in the near doubling of the stock price since the January low. In the 2nd half of FY08, management started a chorus that it expects 30% GM for FY09. Even when GM turned out to be healthy for Q1 & Q2, Apple maintained its 30% GM outlook. This had many analysts and investors worried.

Last October, I reported Apple's FY09 Gross Margin Expectations Too Low arguing that GM will for FY09 will come in way above the 30% guidance. In January, I wrote Apple's FY09 EPS Estimate Too Low stating that the forecasted decline in FY09 EPS by analysts wasn't not going to happen and that earnings should increase by at least 5-10% versus FY08. (For the 3 quarters already reported for FY09, EPS is up ~8% versus the same 3 quarters for FY08.) The main thesis was gross margins would come in significantly above expectations mostly due to high margin iPhone revenue becoming a larger share of total sales.

1) Mitigated numerous factors pressuring margins.

- Transitioned entire notebook line.

- Cut prices across entire notebook line and/or added increased performance.

- Back to School promotion (Mac discounts plus free 8GB iPod touch).

- Revenue mix shifted towards lower margin Macs from weak business spending affecting the Mac Pro line.

- Component prices increased, coupled with higher commodity and energy prices.

Apple repositioned its entire notebook line, cutting prices significantly on Macbook air, and on 15" and 17" inch Macbook Pros. Apple also introduced 13" Macbook pros in place of the older aluminum body Macbooks. Macbook prices were cut anywhere from $100-$300. In addition, Apple kicked off its "Back to School" program that offers discounts on Macs plus a free iPod touch valued at $229. As a result, coupled with weak business spending, revenue was skewed towards the lower-margin models.

2) Guidance of 34% translates into GM likely coming in the 36%-38% range.

- Past 4 quarters GM has exceeded guidance by an average of 370 basis points.

- GM guidance has increased sequentially 3 quarters in a row. (2Q-32.5%, 3Q-33%, 4Q-34%)

Apple has routinely sandbagged on GM guidance by and average of 350 bps over the past 11 periods, and 370 bps for the last 4 quarters. In addition, over the past 10 quarters, when Apple has raised guidance sequentially, GM either rose or remained flat sequentially except for one instance. The scatter plot of change in guidance on x-axis versus change in actual GM on y-axis demonstrates managements accuracy in forecasting GM at least with respect to direction. Therefore, we can expect GM will up or at least flat in Q4 even in light of the challenging headwinds.

iPhone Contribution:

The profitability of the iPhone has played, and will pay a major roll in Apple's overall gross margins. Since Apple refuses to comment about product level margins, the iPhone's significance is often missed. Apple neglects to mention the iPhone angle due to the fact it doesn't want to discuss product level gross margins. The reasons for doing so are vast: firms desire to "cry poor" for the more money they rake in, the more money others will want to get a piece of. This extends to customers, carriers, suppliers, and competitors. Apple repeatedly exclaims it doesn't want to create an "umbrella" that would attract competitors to enter and undercut it. Therefore, much of the GM upside has been due to iPhone revenue being and increased percentage of total revenue, and since iPhone revenue is deferred, this trend will continue to intensify. I have been writing about this effect for nearly a year.

According to my Apple model, (which is i consider accurate being that its EPS variance has been 4 cents, 2 cents, 1 cent, and ZERO for the past 4 quarters) iPhone contributes an equal amount to EPS as does the Mac segment, and will surpass Mac's EPS contribution in the quarters going forward.

In Apple's 10-Q filings, it breaks out deferred revenue and deferred costs for iPhone and AppleTV reported on the balance sheet. Since AppleTV is a minute sliver of deferred revenue it is assumed that its impact on total deferred revenue (AppleTV + iPhone) is immaterial.

Looking at 4Q07, GM of deferred revenue (1- (deferred costs/deferred revenue)) is 27.5%. It was low since Apple received monthly revenue payments in place of an upfront subsidy as is the case today. 4Q08 comprised of the first quarter of subsidized 3G handsets, thus the bump in GM on the DR/DC on the balance sheet. Notice the non-current GM of 51.9% is 6.5% higher than the 45.3% GM of the current. This results from the non-current bucket comprising of a larger mix of 3G iPhones since much of the legacy (2.5G) iPhones have migrated to the current bucket.

Examining the trend, we can see that GM in the current bucket improves dramatically, at a much faster pace than the non-current bucket. This is due to the mix of new iPhones becoming a larger overall mix in the current bucket, whereas the non-current bucket is already majority of newer iPhone sales. The overall result is than GM are approaching near 60%, which I estimate iPhone GM is currently. This is evidenced by the rising GM Q/Q, especially in the non-current bucket which is impacted more by current sales.

My bottom-up iPhone gross margin estimate is 58.4% for the assumed mix, with the iPhone 3GS 32GB garnering the highest GM and the iPhone 3GS 16GB carrying the lowest of the 3 models.

The Bottom Line:

Deferred revenue as stated on the balance sheet has been increasing substantially. The gross margin attached to this deferred revenue has also increased significantly. Thus, going forward Apple will recognize higher iPhone revenue carrying a higher gross margin. As iPhone revenue as a percentage or share of total revenue increases, the impact of the higher iPhone GM on overall GM will intensify. This will assuage margin pressures Apple faces in other areas.

I wrote last year that the iPhone would cause Apple's overall GM to skyrocket, but I also posited another possibility. Apple would use iPhone GM to subsidize price cuts on other products to stimulate demand and ultimately avoiding an adverse impact on overall GM associated with such price reductions. As we just witnessed, Apple cut prices on its Mac line-up, and there hasn't appeared to be any noticeable impact on overall GM. Going forward, Apple is guiding Q4 GM to 34%, suggesting GM in the 36%-38% range, thus there doesn't appear that these price reductions will have a dramatic impact on its overall GM.

Apple Inc (AAPL): Examining the Prospects of a Low-Cost iPhone

noreply@blogger.com (Turley Muller) — Thu, 05 Mar 2009 07:18:00 +0000

Apple Inc (nasd:AAPL) For some time, many have speculated about an arrival of a $99 iPhone. Some analysts expect a low-cost model with scaled back features, such as 2.5G instead of 3G, no GPS, and possibly a smaller form factor. While I believe a lower iPhone price point is possible, I don’t expect Apple to go backwards by removing features that reduce device functionality to achieve a lower-cost offering. The price of the handset is much less significant than the lifetime cost of the required $30/month data plan. Therefore, crippling device functionality to lower handset price makes no sense when the primary cost component is the data plan.

I believe if Apple were to pursue reducing the price of the iPhone to the consumer, it should first explore offering alternative pricing that doesn’t necessarily lower selling price and margins. Offering cheaper data plans that coincide with less usage would allow consumers to be able to pay according to usage, rather than being required to pay for unlimited when their usage is actually quite limited. Carriers would apply less subsidy and charge more for the handset, yet consumers would still save over the life of the contract. Carriers would still benefit from increased demand even though ARPU may not be quite as high. Carriers could capture the iPod touch demand that arrises from those who wish to avoid the required data plan.

Low-Cost Model With Less Features- Unlikely:
While unit demand increased dramatically from previous price reductions, ($599 - $399, $399 - $199), I don’t expect unit demand to be nearly as responsive to a $100 price reduction, from $199 to $99. At this price level, demand elasticity begins to evaporate, as consumers are less responsive to further price cuts. At $199, the iPhone is competitively priced, opposed to when it was priced out of the market at $599. The bulk of the pick-up in demand from cutting handset price has already been realized.

Reducing hardware cost is another challenge. Eliminating or scaling back certain features through cheaper or fewer components won’t significantly impact build costs. The obvious modifications that many have cited are removing GPS, 3G baseband, and installing less flash memory for media storage. These actions would likely only lower component cost by $15-$20. Additional cost reductions could be brought about with a smaller form factor, however the savings wouldn’t be great enough to offset the burdens it would create on the software development side.

Perhaps the most crucial aspect is it’s the cost of the service plan, not handset, that is the most costly. The iPhone requires signing a 2-year contract for the $30/month smartphone data plan. Over the life of the agreement, this amounts to $720. For those who currently have a $15/month data plan for a non-smartphone device, the incremental difference over 24 months is $360. However, AT&T offers a bundled unlimited text & data plan for non-smartphone devices for $30/month, instead of $35/month ($15 data + $20 text), which raises the monthly price difference to $20, or $480 over 2 year contract for those affected customers. AT&T subscribers who use a smartphone other than the iPhone wouldn’t pay more since the price of the data plan is the same as the iPhone.

Lowering the iPhone handset price by $100 accomplishes little in the sense of affordability due to the $720 24-month cost of the required data plan. I frequently track online discussion forums (such as AT&T iPhone support) as an informal survey tool. The amount of discussion regarding the iPhone handset price pales in comparison to the required data plan. People tend not to have any problem with the $199 price, but are very vocal about the recurring $30/month for the data plan. In fact, there have been a couple individuals who weren’t adverse to pay $399 since they weren’t eligible for an upgrade, but were inquiring if there were a way to circumvent the data plan requirement. There is little evidence suggesting a $100 price drop will have a profound impact due to the large number of consumers who find the data plan requirement inhibitory.

Reducing the data plan fee, or eliminating the requirement altogether, would have the most substantial impact on demand. The problem with this alternative is that Apple receives a ~$400 subsidy based the higher ARPU generated by the data plan. Therefore, if the iPhone ARPU were to decrease from reducing the price of the data plan, then the iPhone subsidy would decrease as well.

Assuming that hardware costs can be reduced by $50, and the subsidy falls to $200 from $400, gross margin would decline to 33% from 58%. In order for earnings to increase, unit volume would have to rise by a factor of 3.5x.

Assuming a more generous subsidy of $250, perhaps with required $10/month plan, gross margin would only fall to $43%, but volume would have to increase more than 2.3x.

A scenario where a $20/month data plan produces a $300 subsidy, gross margin would only drop 800 bps to 50%, and volume would only have to rise 75% to be cash flow neutral. However, consumers still face an incremental $480 increase from the data plan, which will limit the impact on demand.

Even if the economics of reducing hardware and service costs were to make sense, there are other issues. Crippling device functionality takes away from the user experience, which is the primary focus of Apple products. Substituting 2.5G would significantly worsen web browsing and video streaming.

The tests I have been conducting show iPhone 3G data speeds are currently 7-8x faster than 2.5G. In the months following the 3G iPhone release, speeds were only 2-3x faster than EDGE. Obviously, AT&T has made substantial progress in improving its network, which significantly enhances the iPhone user experience. With many competing devices beginning to offer 3G, a slower iPhone might damage consumer perception and lessen its appeal. The iPhone is designed for heavy internet usage, thus a much slower connection would dramatically lessen the iPhone experience. This move would probably only save $5-$10 in hardware costs.

Removing GPS would only save ~$5 in component costs as iSuppli lists the price of the GPS radio at $3.60, and the impact on user experience would be considerable. Many apps are designed around the user’s current location, which requires GPS to obtain an accurate position. The integration of location services with other iPhone features is a major factor that differentiates the iPhone from other devices. Therefore, without any real cost benefit, offering a model without GPS makes no sense.

Altering the form-factor is another alternative for reducing costs. A smaller device could reduce hardware costs to a degree, yet it would require a relatively large size reduction to meaningfully affect hardware cost. This would pose several challenges. Apps are developed for a specific display size, thus duplicate versions may be required to accommodate different displays. The challenge may be further exacerbated due to input commands being handled by the multi-touch display. Therefore, modification may be needed not just for output, but input as well. In addition, a smaller viewing area would reduce the user experience, and a smaller area for input commands may cause navigation to suffer. To achieve meaningful savings, the handset size would have to be reduced to a point at which the user experience would highly suffer.

I don’t believe there should be any change to the iPhone hardware since potential cost savings are rather insignificant. The only exception would be offering 2.5G models in markets where 3G is unavailable as long as it were accompanied by a cheaper data plan. This might help spur demand in non-3G markets where consumers must pay $30 for 3G service and aren’t even able to take advantage of the faster speed.

Possible Alternatives:
The best course of action would be to offer multiple data plan choices, and adjust the handset price accordingly by applying less subsidy. The consumer would have to pay more on the front-end, yet would save money over the 24 month agreement. A cheaper data plan results in less handset subsidy which would be absorbed by the consumer. Thus, it wouldn’t affect the economics of the iPhone with respect to Apple, yet it would provide flexibility for consumers. If a particular individual plans to use very little data, then he/she could select a cheaper plan with less data usage included. They would pay more for the handset, but would still save money over 2 years from the cheaper monthly cost of the data plan. The savings will come at the expense of AT&T, yet it’s not a real expense, rather the opportunity cost of not receiving $30/month for the unlimited data plan. However, this could be offset (or overcome) with sufficient increase in demand.

A scenario with a $10/month data plan would raise the handset price to $349, a $150 increase, but reduce lifetime service fees by $480. Including the price increase of the device, net savings over 24 months is $330. A second scenario with a $20/month plan for heavier data usage would increase the iPhone price $100, to $299, but lower service fees $240 over 2 years, resulting in net decrease of $140. If an individual pays the extra $100 for the cheaper $20/month plan, and later decides he/she needs the unlimited data plan, the carrier could offer a $25/month instead of $30/month since $100 was collected on the front-end. If one wanted to switch to a smaller data plan, then the handset discount could be recovered from lowering the monthly fee by less than the full amount.

There is one scenario of a low-cost model that I do think is a possibility. Bernstein Research’s Toni Sacconaghi has broached the idea of an “iPod phone” which makes a lot of sense. The premise is that music is moving onto many basic mobile phones which may pose a threat to iPod sales. The concept of a converged device means that users won’t prefer to carry both a phone and an iPod. For those who don’t want an advanced phone with internet capability, such as the iPhone, but want a media player combined with a basic mobile handset, an “iPod phone” would be a suitable match. Essentially, a iPod classic or nano could be married with a basic mobile device that wouldn’t require a data plan. Possibly, it may offer some “widgets” such as stocks and weather, but not email or internet browsing. The sole purpose would to counter iPod defection from those using their mobile phones more and more as a music player. I don’t foresee such a device anytime soon, however it remains a viable possibility down the road.

I do believe a $99 iPhone is inevitable. However, it wouldn’t be a “low cost” model, rather Apple could offer the current iPhone model for $99 in light of an introduction of new advanced models. I expect new iPhone models to arrive this summer, which will have faster processors, and advanced graphics chips that will allow multiple apps to run simultaneously and video capability. There has been an un substantiated rumor that AT&T might buy back iPhones since current 3G owners would be ineligible for a subsidy on a new iPhone model if one were to come this summer. These phones could be sold for $99 or less. AT&T has been running deals for $99 on refurbished iPhones.

Apple’s iPhone Vision:
Management has stated it doesn’t intend making an iPhone for everybody. Apple says it isn’t interested in selling the most units, but rather committed to being the leader in the market segment it prefers to serve. Comments from Apple contradict many pundits and analysts that claim the firm is limiting the iPhone’s potential by addressing such a small portion of the overall mobile handset market. However, Apple is a company that demonstrates patience. Steve Jobs once said rather than crossing a river to get to someplace else, Apple waits for the other side of the river to come to it. The smartphone market is growing considerably, thus there isn’t much reason to stoop down into the basic handset market that will be contracting.

Disclosure: Long AAPL

Apple Inc (AAPL): Snapshot- Apple's Cash Growth

noreply@blogger.com (Turley Muller) — Mon, 23 Feb 2009 06:46:00 +0000

Apple Inc (nasd:AAPL) $91.21- Here's a quick snapshot of Apple's cash holdings over the past 9 quarters. In the case of Apple, it's extremely important to focus on cash flow opposed to accounting (GAAP) income due to the massive build of deferred revenue on its balance sheet. Total deferred revenue is $9.7B, $7.3B of which is iPhone related. Accounting EPS is often a poor gauge of a firm's actual earning power due to the many ways to legally (and illegally) inflate, obscure, or mislead actual performance. However, all one needs to do is follow the cash. The concept of investing is inserting cash into a vehicle that will return a larger cash amount back in the future. Cash flow, not earnings, best reflects a firm's investment prospects.

Apple's cash holdings swelled from $11.9B (Dec '06) to $28.1B (Dec '08), an increase of $16.2B. In terms of cash per share, Apple reported $31.20/share for Dec '08, and increase of $17.76 from the $13.44/share reported Dec '06. In the last 8 quarters, Y/Y cash growth has averaged north of 50% (per annum).

Just in the past 4 quarters, Apple's cash has ballooned $9.7B from $18.4B. Cash per share has increased more than $4 the past two periods, and last quarter (Dec 08), cash/share rose $10.71 from prior year quarter. What gives this cash holdings data meaning is the comparison to EPS. Apple's TTM EPS is $5.39, but TTM increase in cash/share is almost double, $10.71. Obviously, iPhone sales are responsible for the wide disparity.

Using price multiples as a valuation metric, Apple trades at 17x TTM EPS, but only 8.5x TTM cash/share. That's a massive difference, and many make the mistake of using PE ratios to compare Apple to its peers which is unreliable due to the EPS distortion caused by iPhone revenue referral.

Of course, the market is forward looking, as TTM ratios are less meaningful due to being historical-based metrics. However, the iPhone should continue to exhibit decent sales being a solid product in a growing market segment. This will cause the disparity between accounting EPS and cash flow to continue. Considering that Apple has historically traded at 40-50 TTM PE multiple, valuation is attractive on a long-term investment horizon. In my opinion, the short-term economic challenges are priced-in, but the long-term competitive advantage and earnings power is being ignored. That's the nature of the current mood of the market, and AAPL will probably go lower before it goes a whole lot higher. Eventually, when the economy shows signs of regaining its footing, and investors are comfortable owing stocks again, AAPL will go much, much higher. Downside risk is somewhat limited due to Apple's cash position and strong products that should at minimum, support valuations not terribly too much lower than the current share price.

Yet, risk still exists, and I would imagine shares stay range bound $75-$105. Apple's fundamentals provide strong support, but breaking through resistance above ~$105 and ~$115 will require sustained money flow from cash coming off the sidelines. Hence, participation by institutions and funds that have longer-term investment outlooks. Recently, Apple hasn't been able to sustain any sort of rally off positive news as traders have been quick to take profits, as well as selling/shorting into market weakness and rises of increased pessimism. If/when the equity investor were to return, Apple would be a popular choice at current levels.

More Financial Alchemist Analysis on AAPL

Disclosure: long AAPL

Authentidate (ADAT): Remote Patient Monitoring Presents Significant Opportunity

noreply@blogger.com (Turley Muller) — Fri, 06 Feb 2009 03:36:00 +0000

Authentidate Holding Corp (ncm: ADAT) $0.27- Authentidate is attractively positioned to benefit from the expected flood of spending aimed at modernizing healthcare IT. Remote patient monitoring, also known as telehealth, is one area where Authentidate stands to capitalize due to its unique and superior product solution. Patient home monitoring is expected to be a $12 billion industry by 2012. ADAT will earn $120M in revenue if it achieves just 1% penetration. This compares to $6M in revenue Authentidate earned last fiscal year. There are a decent number of patient monitoring devices deployed currently, yet very few have actual “telemedicine” functionality, whereby a patient’s vitals are electronically transmitted to the healthcare provider coupled with any patient instructions subsequently relayed back to the patient. According to an InMedica study, there were less than 1 million telehealth subscribers in 2008, yet that number is expected to climb to over 55 million by 2016.

ADAT has 37 cents per share in cash, yet it is not currently profitable. Management expects to achieve cash flow breakeven in the near-term. Although ADAT has been putting up double-digit revenue growth, the slow pace of industry modernization has made achieving Authentidate’s potential elusive. I believe the new telehealth business aspect coupled with government spending and reform will accelerate the pace of revenue traction. My previous ADAT articles are here.

Company Description: (from ADAT 10-k):

Authentidate Holding Corp. (Authentidate or the company) is a worldwide provider of secure workflow management software and web- based services. Authentidate and its subsidiaries provide software applications and web-based services that address a variety of business needs for our customers, including increasing revenues, reducing costs, raising service levels, improving productivity, providing automated audit trails, enhancing compliance with regulatory requirements and reducing paper based processes. Our scalable offerings are primarily targeted at enterprises and office professionals and incorporate security technologies such as rules based electronic forms, intelligent routing and transaction management, electronic signing, content authentication, identity credentialing and verification and web and fax-based communication capabilities to electronically facilitate secure and trusted workflows. Authentidate currently operates its business in the United States and Germany with technology and service offerings that address emerging growth opportunities based on the regulatory and legal requirements specific to each market. In the United States the business is engaged in the development and sale of web-based services largely based on our Inscrybe™ platform and related capabilities. In the United States, we offer our patent pending content authentication technology in the form of the United States Postal Service ® Electronic Postmark ® (EPM). In Germany the business is engaged in the development and sale of software applications that provide electronic signature and time stamping capabilities for a variety of corporate processes including electronic billing and archiving solutions. Our web-based services and software applications are compliant with applicable digital signature rules and guidelines. We sell our web-based services and software applications through a direct sales effort and reseller arrangements. See USPS EPM.

Company & Industry Background:
Authentidate has struggled to gain revenue traction primarily due to the glacial pace of modernizing the IT infrastructure within the healthcare industry. The industry can be characterized as one with excessive “paper pushing” which swells the overall cost of healthcare. Evolving to an electronic document workflow paradigm would significantly reduce costs, errors, and turn-around times. The reason that healthcare has slow to move away from paper records and postal delivery is because the primary players haven’t been appropriately incentivized. HMOs experience the greatest benefits by reducing labor costs and working capital needs, yet those savings hinge on physicians converting to e-document platforms. Doctors have been hesitant to implement technology since the benefits to physicians haven’t been adequately communicated. In addition, physician thinking tends to be revenue-oriented, as opposed to cost oriented, generally solving high or increasing overhead costs with higher billings. Essentially, the thinking focuses on boosting revenue by “how do I charge more,” instead or focusing on boosting the bottom line by reducing expenses. Since patients, or rather customers, only pay a very small portion of their medical bills coupled with the absence fee comparisons and the inelastic nature of demand for healthcare treatment, medical practitioners have considerable pricing power. An individual’s cost for healthcare is pushed off on HMOs, insurance companies, and Medicare, which in turn spread those costs among its base of participants.

Instead of increasing efficiency and eliminating unnecessary costs, doctors can maintain profits with higher and/or additional fees that ultimately raise everyone’s cost of healthcare. As a result, HMOs and insurers have implemented fee caps for certain services and treatments, which essentially eliminates pricing power. However, some medical practitioners will choose not to accept specific types of medical coverage (or insurers chose not to cover specific physicians), or physicians will abandon treatments/services with unfavorable fee reimbursement caps. Even with restrictive fee caps, a physician could increase his/her bottom line from greater cost efficiency/productivity by migrating to an electronic document platform. Not only can overhead costs be reduced, time and other resources can be freed up and deployed for new revenue opportunities. Some doctors spend considerable time attending to office visits based primarily on paperwork issues for approvals and signatures, etc.

In my opinion, the catalyst for widespread migration to modern information technology is the Obama administration. For years, the government has been encouraging electronic medical records and electronic form remittals, but progress has been slow due to the reasons I outlined earlier. However, Mr. Obama’s goal is to have all medical records digitized in five years. According to the NE Journal of Medicine, only 4% of physicians use electronic health-records systems. The economic stimulus bill includes $20B for healthcare IT alone. Authentidate isn’t directly engaged indigitizing health records as it focuses more on the secure processing of electronic medical forms and signatures. However, as the industry migrates towards e-health records, it will become substantially easier for Authentidate to market its IT solutions. Mr. Obama understands the importance of technology and the benefits it provides; one has to look no further than President Obama’s fight to keep his Blackberry as evidence to his commitment to technology. Mr. Obama is also aware of the potential cost savings healthcare IT can deliver, and his ambition to make healthcare more affordable and available to all will require implementing IT solutions such as the ones offered by Authentidate.

Telehealth Monitoring:
According to a SUNY Fredonia 2008 study, the patient monitoring industry is expected to reach $12 billion by 2012. Authentidate entered into a joint venture with EncounterCare forming ExpressMD, which uses EncounterCare’s Electronic House Call patient monitoring appliance with Authentidate’s Inscrybe web-based software platform. The combination allows physicians to remotely monitor their patients’ vitals and adjust treatment accordingly. The benefits are immense. The patient receives higher quality care since the increased amount of data available provides better diagnosis and treatment. In addition, the monetary savings are substantial due to the reduction in doctor office/emergency room visits. Several studies have suggested telehealth monitoring can reduce healthcare related costs by at least 50%.

Patients visit their physician several times a month, or even a week, just to have their vitals taken. HMOs cap physicians billing at $137/month for this type of service. Thus, no matter how many times any one individual visits his/her physician’s office to have vitals taken, the attending doctor will take in no more than $137. This results in these types of visits using a disproportionate amount of a physician’s resources that aren’t proportionally monetarily compensated. In addition, it is estimated that the average monthly transportation billing for these types of patients is $527. Telehealth home monitoring reduces transportation costs by 80%. Due to the transportation cost savings, as well as other associated expense reductions, HMOs permit physicians to bill at $199/month if patient is on a telehealth home monitoring program.

Incentives for adopting remote patient monitoring exist for all major parties- patients, physicians, and insurance providers. Doctors can take in more revenue with less office visits. This frees up office space, time, and other resources for treating other patients, hence increased revenue opportunities. Thus, it’s not just the extra $62/month that doctors can generate with telehealth, it’s also the opportunity cost of lost revenue from office visits that can be recaptured with home monitoring.

Telehealth Monitoring Business Economics:
According to my sources familiar with the JV agreement, EncounterCare and Authentidate split the $30/month revenue (per device) 50-50. Authentidate earns an additional $8/month for services provided through its Inscrybe platform. This brings Authentidate’s revenue to $23/month. Yet, Authentidate can charge $50/month to third parties, such as pharmaceutical and medical research companies for access to data reporting. According to a source, a research group in Florida has implemented 2000 units thus far. Drug companies and researchers can measure the efficacy of their products being used in treatment, since patient vitals data can show the response to such treatment.

ExpressMD™ Solution (from company website):

The complete ExpressMD solution combines Electronic House Call™, an advanced in-home patient vital signs monitoring system with a web application that streamlines the practitioner’s job anywhere they have Internet or a Windows mobile communication device. The in-home portion includes the latest in simple-to-use monitor devices for unassisted patient vital signs measurement as well as question-and-answer mode for manual input. The self-contained home unit is perfectly suited for patients that require repeated assessment and reminders of their care plan schedule while practitioners can easily monitor patient progress remotely. Patients can review their own vital statistics history or even view and order products specific to their condition that support their care plan.

This proven system improves overall care outcomes for patients with chronic illnesses such as COPD, CHF and Diabetes. It delivers better continuity of care for elderly or special needs patients, as well as many others with chronic illnesses such as chronically ill pediatric patients. Patients using the ExpressMD in-home monitoring system have shown dramatic improvements in medication and therapy compliance. The overall effect produces significant reductions in the overall number of physician office visits, emergency room visits and hospital readmissions.

It provides intelligent routing to alert on-duty caregivers whenever patient vital signs are outside of the practitioner pre-set ranges. Parameters are set to automatically route to caregivers based on patient specific needs, payer preference and location. In addition, care providers can remotely access the system from Windows communications devices, delivering true portability of care management.

Some of the additional services available to the ExpressMD solution by adding Inscrybe™ Healthcare are: verification of physician and practitioner credentials allowing online input, review, update and electronic signature of medical documentation such as prior authorizations, care plans and physician orders. With this option, practitioners can customize a care plan for each patient based on their vital signs history that optimizes therapy results and improves patient quality of life. There is an online diagnosis and treatment library for physicians or practitioners. Additional services for physicians like the Care Plan Oversight module to support allowable reimbursement reporting and online entry of physician orders are also available.

ExpressMD Joint Venture Press Release (June 10, 2008):

The joint venture called ExpressMDTM Solutions will provide in-home patient vital signs monitoring systems and services to improve care for patients with chronic illnesses and reduce cost of care by delivering results to their health care providers via the Internet. ExpressMD Solutions will combine EncounterCare's Electronic House CallTM patient vital signs monitoring appliances with a specially designed web-based management and monitoring software module based on Authentidate's InscrybeTM Healthcare platform. ExpressMD Solutions will enable unattended measurement of patients' vital signs and related health information. Patients' data will then be securely sent electronically to each patient's health care provider for review. ExpressMD Solutions will be designed to aid wellness and preventative care, and deliver better continuity of care to specific patient segments such as the elderly, special needs or pediatric patients with chronic illnesses who require regular monitoring of serious medical conditions.

According to a January 2008 research study conducted at the State University of New York at Fredonia, the demand for patient monitoring systems in the primary healthcare sector in the United States is forecast to increase 5.9 percent per year to an estimated $12 billion market by 2012 based on expected contributions to positive therapeutic outcomes and efficiencies. Additionally, the study indicates that the market for self-monitoring activities will also expand as treatment for chronic care patients, especially patients with asthma, diabetes and heart disorders focuses on preventative care.

Using ExpressMD Solution's offerings health care providers will be able to easily view their specific patient's vital statistics and make adjustments to the patient's care plans via the Internet. ExpressMD Solution's easy to use patient monitoring system is intended to provide patients with increased peace of mind and improved condition outcomes through a combination of care plan schedule reminders and comprehensive disease management education on their in-home communication unit. The service will provide intelligent routing to alert on-duty caregivers whenever a patient's vital signs are outside of the practitioner's pre-set ranges.

Health care providers and health insurers also are expected to benefit by having additional tools to improve patient care, and reduce overall in-person and emergency room patient visits. "EncounterCare's expertise with in-home patient monitoring technologies and Authentidate's expertise in online healthcare systems and securely managing patients' documents has allowed us to shorten the development cycle and ready this solution for delivery in record time," said Ron Mills, CEO of EncounterCare Solutions, Inc. "The ExpressMD Solutions joint venture will allow Authentidate and EncounterCare to leverage existing portions of our respective healthcare products as well as existing healthcare industry relationships from both companies," said Ben Benjamin, President of Authentidate Holding Corp. "The telemedicine market is a large market that we believe will benefit from our document management capabilities. By entering this market through a joint venture, we will be able to strongly penetrate an emerging market, while expanding the use of our platform within the health care community.

ExpressMD Signs First Contract with Cyntrist:
On July 8th 2008, it was announced that Authentidate and EncounterCare had signed their first user contract with Cyntrist, for use in remote monitoring of Diabetes patients located through out the Southeastern U.S. The opportunity in the Diabetes space is colossal. In a recent study, the CDC reported that 24 million Americans (8% of population) are afflicted by Diabetes, a number which has increased by more than 3 million in just two years. The ExpressMD solution provides physicians with the ability to remotely monitor patients’ glucose levels, weight, etc. on a daily basis and adjust treatment as needed. Not only does this enhance the quality of patient care, it reduces the need for regular office visits, thus reducing the cost of medical care. The advantages are compelling, and with such a large addressable market, ADAT may benefit substantially.

Authentidate Outlook:
Using a conservative projection of the industry achieving $6B in 2012, Authentidate stands to capture at least 3%. This equates to roughly $200 million in annual revenue. Assuming 70% margins, EPS would be slightly less than $4.00 given the $105M+ tax-loss carry forward. Due to the degree of operating leverage in the revenue model, profit margins could be considerably higher, and expand with volume due to increasing returns to scale. Using the same margin assumptions, but a $12B market with 5% capture, ADAT would earn over $9.50 per share. The potential is staggering. However, just assuming a 1% capture of a $6B market would produce EPS of $1.00. Assigning a 15X multiple gives a $15.00 share price, or 55X current share price.

Conclusion:
The reason that ADAT shares trade at such a low price, below cash, is due to the lack of investor awareness of the massive revenue opportunities. As evidenced by the scant daily trading volume, and the lack of participation in online discussion forums and conference calls, very few investors follow ADAT. Many that did, abandoned ADAT years ago when the company was rapidly burning though cash without much promise of increasing revenues. Authentidate has been bringing its cash burn under control, down to $1.5M last quarter compared to cash burn of $4-5M per quarter in earlier periods. In the last two quarters, revenue growth for the U.S. business has averaged more than 50%. As the speed of IT adoption in the healthcare industry accelerates, revenue growth could increase to 5000%. As I have said in earlier articles, the Authentidate’s primary challenge has been the industry’s slow pace to modernize. The new administration along with increased spending and reform, will expedite this transformation. Health benefit providers are beginning to incentivize doctors to adopt cost saving solutions such as the ones offered by Authentidate. I believe it won’t be long before Authentidate’s offering gain meaningful traction.

Disclosure: Long ADAT

Apple's FY09 EPS Estimate Too Low

noreply@blogger.com (Turley Muller) — Sun, 11 Jan 2009 00:16:00 +0000

Apple Inc (nasd: AAPL)- Apple’s FY09 EPS estimate continues to be revised downward and now stands at a $5.08, a level Apple should easily exceed. The consensus FY09 estimate represents a 5.2% decline from FY08 $5.36 EPS, although revenues are forecasted to increase 11.8%, or $3.8B to $36.3B. Thus, analysts are expecting significant margin compression. Specifically, the consensus estimates for EPS and revenue imply net margin will be 12.8% in FY09, a decline of 2.1% from 14.9% recorded in FY08.

It’s not that I don’t believe the recession will take a major toll on Apple, it will. Instead of achieving 35%-40% earnings growth likely to occur in a normal economy, Apple’s EPS should increase at least 5%-10% in FY09. Due to deferred revenue recognition and upward margin pressure, it’s very unlikely Apple’s earnings will decline, certainly not to the 20%-30% magnitude some analysts predict.

I believe there are two major factors being ignored with respect to FY09 estimates that suggest higher earnings. First, there are multiple factors in play that argue against margin deterioration. This includes lower product and overhead costs, and a more favorable sales mix towards high margin products. iPod revenue (as percentage of total sales) will be much lower in FY09 which is significant since iPod has the lowest margins. iPhone and software have the highest margins and will contribute a much larger portion of Apple’s total revenue.

Second, Apple will recognize a sizable amount of deferred revenue associated with high margin segments, such as iPhone and AppleCare. Also, Apple’s $25B cash position will produce a decent amount of income. Thus, without even having to make a single sale, Apple should still produce $2.67/share in incremental after-tax income.

Assuming 19M iPhone unit sales, incremental taxed EPS for iPhone segment would be $2.99/share. Combining deferred revenue, interest income, and iPhone sales; I estimate incremental EPS will be $4.04. Apple would only have to earn $1.04/share in its other segments to meet the FY09 consensus.

According to Yahoo Finance, the lowest estimate for FY09 is $3.70 (High- $6.00). I have been seeing many estimates being revised down to the mid-to-low $4 range. In my opinion, these estimates are ridiculously low. Canaccord Adams puts FY09 EPS @ $3.70 (31% decline) with an $80 price target and Morgan Stanley’s FY09 estimate is $4.37 (18.5% decline) with price target of $95.

PROFIT MARGIN OUTLOOK:
I recently did a detailed analysis of Apple’s profit margin outlook and concluded that FY09 gross margin expectations are too low. I highlight some of my main points below.

-Favorable Cost Environment:
All of the factors listed below should lead to lower costs, hence higher margins. At the least, provide margin stability by eliminating upward pressure on costs. Considering most of FY08 was marked by a commodity bubble and $100-plus crude, FY09 should be a much more favorable cost environment.

1) Raw Material / Component Prices
2) Energy- Transportation / Overhead
3) Occupancy / Labor (stable)
4) Marketing
5) Scale Benefits & Shared Costs

-Margin Expansion From Increased iPhone Revenue:
The primary driver for higher margins for FY09 is iPhone revenue. The iPhone generates substantially higher margins than the Mac and iPod segments. Due to the subscription accounting whereby iPhone sales are recognized over 8 quarters, the margin effects were minor for FY08 since only $1.84 Billion of iPhone revenue was recognized. This equates to roughly 5.7% of Apple’s total FY08 revenue.

Most analysts and myself included, expect iPhone revenue to come in above $7B for FY09. Not only will the iPhone supply more than 20% of Apple’s total sales (FY09), the subsidy payment agreement of the new 3G model translates into even higher margins compared to the legacy iPhone. I calculated that the gross margin of the new 3G model was 55% in 4Q08.

If Apple recognized iPhone revenue in the period sold, instead of deferring, 4Q08 gross margin would have been 39% compared to GAAP 34.7%, net margin would have been 20.9% vs. 14.4%, and EPS $2.69 vs. $1.26. As deferred revenue continues to pile up on the balance sheet, the portion recognized in current quarterly revenue will continue to increase each quarter.

-Other Margin Drivers:
There are several other factors that could aid profitability this year. First, software revenue, which has huge margins, will be much higher in FY09. Apple is releasing new iWork and iLife editions, and it’s expected to release Mac OSX 10.6 “Snow Leopard” this year. MobileMe also carries high margins, yet even though revenue won’t be much, the yr/yr incremental will be sizable. Second, Apple will incur and recognize more of its high margin AppleCare revenue.

Looking at operational expenses, such as SG&A and R&D, these items should fall on a percentage basis (of total sales) due to leverage effects if sales continue to increase as expected. Looking at the table one can see the trend in declining operating expense and rising profit margins.

The other side of the margin equation is selling price. Margin compression can still occur even while costs are decreasing if selling prices drop more. Apple’s brand is unique and it products command premium prices. Apple’s products are highly differentiated which eliminates price competition. I don’t expect Apple to make drastic price reductions. I recently explained why Macs sell at premium ASPs.

SALES OUTLOOK:
The Street is expecting sales to increase 11.8%, or $3.8B to $36.3B (FY09) vs. $32.5B (FY08). By default, Apple’s sales will increase $3.5B from recognizing 4.85B in current deferred revenue. Apple will also take in around $400 million from iPhone carrier payments and $650 million in investment income. Thus, even with out making a single sale in FY09, Apple will still post nearly $6B in revenue.

Total FY09 iPhone revenue will likely increase by at least $5B, implying Apple’s other revenue is expected to decline if consensus sales growth is $4B. Most analysts expect iPod revenue to drop significantly, coupled with either a slight increase/decrease in Mac sales. I see iPod unit sales declining 25%-30%, but iPod revenue only dropping 15%-20% due to the shift towards the higher ASP touch model.

-iPhone:
According to my estimates, Apple will report iPhone FY09 sales of $7.0B, $3.1B originating from new sales, and 3.9B from recognition of deferred revenue and carrier payments. This assumes Apple sells 19M units. With 56% gross margins, iPhone will contribute $2.99 in EPS. Hence, all other segments only need to earn $2.09/shr to meet the Street’s estimate.

I estimate only 60 cents of $5.36 FY08 EPS is associated with iPhone, which leaves $4.76 from all other segments. This means FY09 non-iPhone EPS could decline 55% or $2.67 to $2.09 and match the $5.08 consensus if iPhone can pull in $2.99/share.

-Mac:
With new MacBooks released in Q1, and new desktops expected in Q2/Q3, FY09 Mac sales should continue to grow despite the weak economy. MacBook hasn’t seen a redesign since being released in 2006. This has provided little reason to replace/upgrade. Looking at unit sales growth, it is evident that the product line had become very tired and in need of a refresh as growth began to lag desktops. There are probably 5M MacBooks that may be replaced in the coming year.

Mac revenue has grown roughly 40% for the past two years, and under favorable economic conditions, I would expect growth to continue if not exceed that pace. Given the harsh economic conditions, I expect single-digit unit growth for FY09.

-Pod:
Unit sales will probably see a sharp decline in FY09 due to the economic landscape and product saturation. The iPod touch model will be popular causing unit sales to exceed forecasts. In addition, the touch will boost ASPs, which will soften the decline in dollar sales.

-Music & Software/Services:
Music segment revenue increased 34% to $3.34B in FY08. Music sales will continue to demonstrate strong growth due to the direct placement of the iTunes music store on the iPhone and iPod touch allowing purchases/downloads in seconds over cellular and Wi-Fi network connections. The iTunes App store could add up to one billion in additional sales this year.

Software sales could get a billion dollar boost from iWork ’09, iLife ’09, Snow Leopard, and MobileMe plus other titles. Typically software delivers high profit margins, thus these software introductions should offer margin support.

CONCLUSION:
When considering the amount of high margin deferred revenue and interest income Apple will recognize this year coupled with multiple drivers lending margin support, it’s unlikely Apple’s earnings will fall in FY09. Apple won’t earn $7 to $8 in EPS possible in a favorable economic climate, but EPS won’t decline as analysts predict.

Apple already has $2.67 in incremental EPS in the bag. Including my estimates for new iPhone sales, the incremental EPS effect is $4.04. Considering SG&A and R&D expense, I estimate that EPS from deferred revenue recognition, interest income, and iPhone sales will be $3.43. Adding Mac, iPod, and all other segments, EPS will easily top the $5.08 concensus.

Disclosure: Long AAPL

Apple Inc (AAPL): Taking a Look at Mac Pricing

noreply@blogger.com (Turley Muller) — Sat, 20 Dec 2008 00:24:00 +0000

MAC DEMAND CONCERNS:
For past couple months, Wall Street’s concern du-jour for Apple has been Mac demand. No PC/consumer electronics firm is immune to this economic downturn, but many analysts believe there is substantial downside risk for Mac sales. Analysts claim the contracting economy is causing changes to the complexion of industry demand that could have further negative implications for the Mac segment. Specifically, the slowdown in consumer spending will cause industry demand to contract, and within the computer industry, demand will shift away from Mac to lower-priced PCs. This double-blow presents a considerable threat that Mac sales will come in way below expectations. Some argue the popularity of netbooks and other low-price PCs present a major challenge for Apple since Macs’ price points encompass the high-end of the spectrum. Thus, Apple lacks a low-price offering within the price range where demand has been and will continue to be strong.

Given the pullback in spending and the shift to lower-priced PCs, analysts have been calling for Apple to introduce a cheaper Mac to become more competitive. Many were expecting just that when Apple unveiled its new MacBooks last October. Missing from the event were price reductions. The legacy white plastic, low-end MacBook received a $100 price cut ($1099 $999), but the mid-range model’s price ($1299) was unchanged, and the high-end MacBook price increased $100 ($1499 -> $1599). This was a disappointment for those who were expecting price cuts of $200-$300, at minimum.

There was ample speculation for Apple’s Black Friday discounts. Most analysts/journalists were predicting larger than usual discounts, 15% compared with Apple’s typical discounts of 5%-10% from previous years. However, Apple offered modest discounts that were inline with its previous Black Friday promotions. Some were disappointed, notably Shaw Wu of Kaufman Brothers: “We would have hoped that with its nearly $25 billion net cash position and very favorable component pricing environment, that Apple would have taken slightly more aggressive action on pricing given that consumers are still hurting from the tough credit environment.” Ben Reitzes of Barclay’s Capital says “like to see Apple get more aggressive in terms of pricing.” The crux of the matter is that if Apple believed steeper discounts would significantly lift demand then it would have cut prices more aggressively.

Aside from the Mac Mini and legacy plastic MacBook (October price reduced to $999), Apple doesn’t offer a sub-$1,000 model. In September, Kathyrn Huberty at Morgan Stanley cut her price target on Apple citing slowing global PC sales. The next Monday, Huberty cuts her rating on Apple, and slashes her price target to $115 from $178 based on the concern that “PC unit growth is decelerating and the remaining source of growth is increasingly in the sub-$1000 market where Apple does not play.”

According to NPD, Apple had 66% market share for the above $1000 price category, and 14% overall. In an August 2008 NPD study, Apple’s market share for the past 12 months in the above $1500 price segment was 69%, up from 41% in the August 2007 survey.

Huberty points out that revenue for the premium segment has been declining (y/y) every month since the winter, and that the sub-$1K market’s revenue has been growing. She concludes that consumer demand is shifting to the low-end, where Apple does not have a presence. In addition, Huberty claims Apple is at risk because it’s highly exposed to the premium-end, where demand has been falling. However, Mac unit sales grew nearly 40% for 2008, and its share in the premium segment almost doubled. Mac sales have been growing roughly 3x the market.

Therefore, it’s Windows PC demand that is shifting to the lower-end.

If the overall industry is trending to lower price points, how does Huberty reconcile the sub-trend of increasing Mac demand, which is mostly confined to the premium segment? If Mac demand runs counter to the premium segment’s overall trend, one can’t make the assertion that there’s a strong correlation. There is a convincing relationship between ASP and growth for the industry, but not for Macs. The PC industry is comprised almost entirely of Windows PCs, thus demand for Windows machines determines industry demand. In short, Macs and Windows PCs are not similar product offerings. Some analysts, notably Huberty, appear to conflate the two. Macs are Windows machines, for one can install Windows OS on Mac hardware and use it just as if it were a Dell or HP. But, PCs such as Dell and HP can’t run Mac OS.

MAC VS WINDOWS HARDWARE:
The reason why demand has shifted towards cheaper PCs is because of substitution. A $1500 Windows PC may not be noticeably different from an $800 machine for most users. With economic fears engulfing the consumer, a less expensive PC still can do everything that a higher-end PC does, albeit with less performance. However, many consumers are not heavy users where such a difference would be detected. Even so, for most users, less performance can be tolerated. Therefore, the question is “What more do I get from spending more? What I am sacrificing by spending less?” For many, the answer is “nothing.” In short, there isn’t much difference. The consumer isn’t going to pay more if he/she doesn’t have to, especially in a tough economy.

Windows machines increasingly compete on price, and price alone. PCs have become commodities; there is little, if any differentiation among hardware manufacturers, especially desktops. Essentially, the sole proprietary aspect of a Windows machine is the brand name; most of the hardware components are sourced from 3rd party manufacturers. Whether it’s Dell, Gateway, HP, or Sony hardware makes little-to-no difference.

I understand why consumers aren’t paying-up for Windows PCs. How are HP, Dell, Acer, Toshiba, etc different from each other if they all use Intel chips, run Windows, and have many other of the same components? Consumers don’t see the value in paying a higher price for a Windows PC versus another. For a significant portion of consumers the main purpose of owning a computer is internet/email access, as well as ability to create documents. Any computer accommodates those needs, thus for many, price is the most relevant attribute. I believe this is the driving force behind netbook popularity. Many consumers desire a computer capable of performing basic tasks, such as email, internet, etc. Netbook CPUs are low-powered, and are not suitable for heavier usage, such as graphic intense games or spreadsheets containing complex formulas.

Consumers perceive less differentiation among Windows hardware, thus they are more likely to select whichever brand offers the best price for the desired configuration. Consumers are not necessarily shifting to cheaper PCs solely based on price. Consumers trade down because there isn’t sufficient value-added to justify paying a higher price.

Conversely, there is a stark difference between spending less for a Windows PC (or any amount) opposed to buying the higher-priced Mac. Mac OS X and the associated user experience are significantly different from Windows. Hardware isn’t the differentiating factor; it’s the OS. PCs are not substitutes for Macs. People who desire Macs have to spend more, but those who don’t care for Macs don’t have to pay the high prices due to the availability of less expensive Windows machines. Consumers desiring Windows OS don’t purchase Macs to exclusively run Windows since it would be a waste of money. Consumers purchase Macs for the value-added benefits supplied.

The robust growth in Mac sales demonstrates that consumers are willing to pay more for Macs. Mac’s 70% share of the premium segment suggests that Macs are essentially the only computers for which consumers are willing to pay up. Windows PCs can’t compete in the premium segment against Apple. Premium Windows PCs can’t even compete against lower-priced Windows PCs. Since Macs run Windows (many say Windows runs best on Macs), PCs don’t provide any value-added benefits over Mac. Thus, to create value to the consumer, PC hardware firms cut prices to make their machines relatively attractive. Since the Mac offers Windows OS plus Mac OS, it provides additional benefits that command a premium price.

PC prices have come down a great deal, and continue to fall. However, Mac ASPs have been relatively flat since 2003 (~$1500). It should come as no surprise that Apple’s GM has risen from 26% to 35%, while Hewlett-Packard and Dell have seen their margins shrink. Where are these analysts getting the notion that cheap netbooks will pressure Mac sales when notebook prices have been relatively cheaper for years?

APPLE’S MAC SALES STRATEGY:
The two main reasons why consumers buy a Windows PC instead of a Mac are 1) Unaware of added benefits 2) Aware of added benefits, but assign little value preferring a low benefit package at cheapest price, i.e. price-sensitive. For many, they choose a Windows machine because it’s cheaper. Consumers would pay more if they believed the incremental value added exceeded the incremental cost. Many are unaware/unfamiliar of the incremental value the Mac provides, thus Apple’s primary goal is to inform consumers most likely to perceive added-value.

The primary challenge facing Mac growth is educating the market about Mac benefits. Due to Apple’s tiny market share, its growth potential is massive. At the start of the decade, Apple’s share was roughly 1%-2% and will likely reach 10% by decade-end. The major catalysts to share growth have been the iPod, iPhone, and Apple’s retail store strategy, which have increased Mac curiosity and awareness. For the past couple years, Apple has been reporting that more than 50% of retail Mac sales are to new Mac users. This is no surprise since Mac sales have outpaced the industry by a factory of three (3x).

Remember that Apple’s share of the computer market has been in the low single digits throughout time, only in the last several years did Mac sales takeoff. Therefore, most haven’t used or possibly seen a Mac in the wild. With little or no Mac experience, an individual would have difficultly to justifying the higher price. In addition, consumers don’t actively seek to acquire more information on products that are relatively more expensive. One has to spend more time and effort learning about a product that costs more and ultimately may not be suitable or worth the price. Therefore, expensive, less-known products experience greater difficulty in making the short-list of a consumers consideration set for a given purchase decision. Apple believes its Macintosh provides a superior computing experience. There is evidence supporting that claim as Apple earns the highest satisfaction ratings and gets the best reviews from industry pundits. So, it’s more about informing consumers that its product is the best than it is making its product the best.

Apple leverages the popularity of its iPod and iPhone to heighten attention for Mac. These gadgets arouse curiosity and interest about the Mac, as well as driving traffic to its stores where consumers can experience Macs first-hand.

MAC PRICING STRATEGY:
Since Macs are highly differentiated and offer features/benefits unique to its brand, Apple is afforded significant pricing power. Apple believes since it offers a premium product it should charge a premium price. Exploding demand for Macs seen in the past several years demonstrates that consumers justify paying a higher price (relative to PCs) for the extra value/benefits unique to Apple. Apple believes that there are many potential consumers that would share the same opinion if they were more knowledgeable about Macs.

Cutting prices does little to advance product knowledge for the uninformed consumer. Macs would still be pricier, and the consumer still wouldn’t know why. Thus, reducing Mac prices wouldn’t boost substantially boost demand. Many analysts miss this point. Amazon’s best selling notebooks are all within the $350 - $600 price range. If Apple cut the price on the $1299 MacBook to $1000 or even $800, it’s still more expensive than the more popular, cheaper notebooks. The $999 legacy white plastic MacBook has been less popular at Amazon than the $1299 new aluminum MacBook. There is a bifurcation in the computer market- 1) consumers seeking lowest price 2) consumers seeking value-added. The former are buying netbooks and the latter are buying Macs. If price were as significant an issue as analysts claim, then the $999 MacBook (actually $910) wouldn’t be ranked #15 behind the $1299 MacBook ranked #7.

I believe it’s not the size of the price differential versus the amount of added benefits that is in question. To clarify, it’s not that consumers don’t believe that the higher price of Macs aren’t justified by their unique features, it’s that consumers aren’t aware or don’t care for Mac features. Those who are price-sensitive and seek bare-bones machines are a waste of Apple’s time to pursue.

Apple would have offered larger discounts (as analysts were predicting) on Macs for its Black Friday sale if it thought lower prices would materially affect demand. Unit sales wouldn’t increase very much, but dollar revenue would decline (lower ASPs) when customers are willing to pay the higher prices.

Apple still has an abundance of potential consumers willing to pay premium prices for a computer that Apple has not yet penetrated. It is these consumers that Apple is chasing, the mid to high income demographic, which are less price-sensitive and receptive to a product that offers value-added benefits. Generally, these consumers understand that “one has to pay more to get more,” and that if a product is cheap, “then it’s cheap for a reason.” In addition, sometimes saving some bucks might result in owning a product that is unsatisfactory, or possibly worthless. In these circumstances, one often is forced to make another purchase since the original product was a dud. Thus spending the extra cash, on the margin, makes the most economical sense. In essence, by spending more, one may be actually be paying less considering the long-term costs and product life.

On the 4Q08 conference call (from Seeking Alpha), Steve Jobs remarked: “There are some customers which we choose not to serve. We don’t know how to make a $500 computer that’s not a piece of junk, and our DNA will not let us ship that. But we can continue to deliver greater and greater value to those customers that we choose to serve and there’s a lot of them. And we’ve seen great success by focusing on certain segments of the market and not trying to be everything to everybody. So I think you can expect us to stick with that winning strategy and continuing to try to add more and more value to those products in those customer bases we choose to serve.”

APPLE’S CHALLENGES:
The economic turmoil presents a significant challenge for Apple. As I mentioned previously, it’s not consumers that normally would buy a Mac trading down as some analysts suggest. Consumers either want the added benefits Macs provide, or they desire the basic functionality of Windows OS PCs. If one wants a Mac, then there are no other alternatives; Macs can’t be substituted by Windows PCs opposed to the substitutability of cheaper Windows PCs for more expensive Windows PCs.

The recession won’t cause cheap Windows PCs to take sales away from Macs, instead it will slow the rate that Macs take share from PCs. The higher-end consumer that Apple targets is less sensitive to the economic cycle, yet not immune. Consumers are less receptive to learning about/trying out unfamiliar products, as their mood to spend is subdued. During periods of rising asset prices, the wealth effect reduces the threshold for capturing a consumer’s attention and subsequently closing a sale.

I eventually expect Apple to address the popularity of the netbook segment by introducing a computing device in a tablet form. I imagine it will be something similar to the iPod Touch, yet with more power and viewing area. It will offer the same functions that consumers look for in a netbook, yet the form factor will be different.

CONCLUSION:
The popularity of low-priced PCs stems from the lack of added value for pricier Windows computers, rather than the inability/unwillingness to spend more for a computer. Lower prices are driven by the intense competition among Windows PC manufacturers whereby the primary differentiating factor is price opposed to other value-added benefits. The fact that Mac demand growth (which sell at higher entry price points) has been much higher than the industry indicates that Macs don’t compete on price, but rather features/benefits.

It’s incorrect to assert that Mac sales growth is vulnerable to netbooks or cheap PCs. The real challenge facing Apple in this rough economy is attracting new users and enticing current users to upgrade/replace. New models, the expansion of the retail store footprint, the halo effect from iPod/iPhone, and positive word of mouth are the primary driver in sustaining Apple’s Mac sales.

Disclosure: Long AAPL