Qualcomm FQ3 17 – Strong stomach

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Qualcomm has the stomach for a fight.

  • Despite the seemingly challenging situation the company is currently experiencing, I think the company has a better chance of beating Apple than it did of beating Nokia back in 2006.
  • FQ3 17A revenues / Adj-EPS were $5.3bn / $0.83 compared to consensus at $5.3bn / $0.85.
  • This was in line with consensus which has now been adjusted to account for the fact that royalties from the iPhone are no longer forthcoming.
  • Technology licencing revenues (QTL) fell by 42% YoY and 48% QoQ while QTL EBIT fell by 51% YoY and 56% QoQ highlighting just how significant the revenue generated by the iOS ecosystem is to Qualcomm.
  • Guidance for fiscal FQ4 2017 will be similarly impacted with revenues / Adj-EPS of $5.4bn – $6.2bn / $0.75 – $0.85 compared to consensus $5.6bn / $0.95.
  • While, Qualcomm has been transparent for many years about how QTL generates a disproportionately high share of profits, the market appears to have got its spreadsheets in a muddle and misread the impact of the lower revenues on QTL EBT margins.
  • These are expected to be around 66% which is the main reason why the EPS guidance is below consensus.
  • Included in this are the legal expenses that are being incurred to defend its business model, which I think in the long-run will be money well spent.
  • Most of the arguments that Apple is making to explain why it has an issue with Qualcomm’s business model have been made off and on for the last 15 years so the case it is bringing is nothing new.
  • These arguments were made most vocally by Nokia in 2006 and while the companies did come an eventual settlement, this time around the situation is quite different.
  • I think that these differences strengthen Qualcomm’s hand as:
    • First Contract validity: The dispute that arose between Nokia and Qualcomm in 2006 occurred because Nokia’s contract had come to an end and the companies were unable to reach agreement on terms for the renewal.
    • Nokia stopped paying Qualcomm as it had no idea how much to pay and instead accrued an estimate of the cost in its balance sheet.
    • The contracts upon which Apple has ceased payment have not expired and I can’t see any contractual grounds upon which to cease making payments.
    • As a result, I do not think that it will not be difficult to show to a court that Apple is acting in bad faith and to win an enforcement order.
    • Second: Third party suppliers. Apple does not pay Qualcomm directly as the payment is made by its manufacturing partners who make its products.
    • This means that Apple is getting involved in contracts that are in place between entities that have nothing to do with Apple other than it being the end buyer.
    • I do not think it will be difficult to argue that Apple has no real grounds to be involved in these contracts and is acting in bad faith.
    • Third: Non-standard essential patents. As Apple is no longer paying Qualcomm for its IP, it is not unreasonable for Qualcomm to sue Apple and its contract manufacturers for patent infringement.
    • Standard Essential Patents (SEPs) are those patents that have to be used to get a standard (like LTE) to work properly. One cannot design around them.
    • It is easy to prove infringement of a SEP (assuming that its valid) but patent holders are not allowed to be nasty when it comes to licensing terms.
    • When one contributes standard essential IPR, one agrees to license the technology to anyone who wants it.
    • This has to be done at a fair price and one agrees not to seek injunctions.
    • Historically, Qualcomm has tended to assert SEPs but this time it is asserting implementation patents against Apple and its manufacturers.
    • Implementation IPR is another kettle of fish entirely.
    • It is much more difficult to prove infringement as this IPR can be designed around, but when infringement is proved, the holder can pretty much do what it likes.
    • There is no limit to the royalties that can be charged, injunctions can be sought and the holder can force the infringer to redesign his product to get around the innovation.
    • If there is one thing that Qualcomm knows it is patents and I am certain that it has asserted implementation IPR that Apple is most likely to have infringed as well as patents that are fiendishly difficult to design around.
    • However, I am pretty sure that the engineers at Apple are now beavering away to work out how to do just that.
  • The net result is that I think of all the battles that Qualcomm has fought in the past (and there have been many), it has the best chance of winning this one.
  • However, to slug it out is going to take a long time it could easily be 2020 before this issue is fully resolved.
  • I think that this creates an excellent long-term investment opportunity in the stock but timing of entry is difficult to gauge and it is going to be a bumpy ride.

WWDC 2017 – Catch-up gems.

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Mostly catch up but studded with a few gems.

  • While Apple spent most its time catching up with innovations made by other ecosystems, there were a few areas where its announcements put it ahead of the pack.
  • Machine Learning
    • Apple is weaving machine learning into all of its services.
    • This combined with increasing integration of Apple’s own apps and services promises to enhance the user experience.
    • This includes new predictive faces (like Google Now) on the Apple Watch and photo recognition and organisation and smart responses predicted from the user’s history in other apps.
    • The demos were slick and effective but how well this will work in the field and with a user that does not use all of Apple’s Digital Life services remains to be seen.
    • Apple is working hard on AI but I think it still remains way behind Google, Baidu, Yandex and even Microsoft.
  • iOS 11
    • For the iPhone, iOS11 is an incremental update but one that focuses most attention on iMessage and the App Store.
    • Apple, is following Tencent in allowing users to do more and more with iMessage including the enablement of peer to peer payments using Apple Pay.
    • iMessage and Photos are the only two services that really got some attention this year leading me to think that these are the two areas where Apple is really trying to create stickiness.
    • This is particularly relevant as I observed yesterday (see here) that leaving iOS for Android was particularly easy as I don’t use iMessage.
    • The network effect can be particularly strong leading me to think that iMessage is now one of the most important services that Apple has.
    • I think that it is much more important than photos as Google Photos is just as good and makes it easy to move photos off iOS.
    • The App Store update aims to address the problem created by its own success which is that discovery of new apps and services is now pretty difficult.
    • New tabs aimed that highlight the new and cool stuff as well as give tips on existing apps is curated through the user’s history and aims to drive more purchases.
    • The aim is clearly to further distance itself from the humdrum experience of Google Play.
    • App Store is an area where Apple is extending its lead.
  • iOS 11 for iPad
    • However, it was for the iPad that the new iOS software really shines.
    • In conjunction with a solid update to the line, iOS 11 enables new functionality that takes the iPad even closer to the laptop.
    • The iPad now has a file system which combined with enhancements to multitasking and window management take its usefulness to a new level.
    • This includes the ability to drag and drop links, pictures and files from one place to another and to share them in multiple ways more easily.
    • This takes the iPad (particularly the pro) closer to a laptop in terms of functionality but it does still fall short.
    • Without support for a mouse and full fat office, the iPad cannot replace a laptop for most content creators although it is getting closer all the time.
  • Hardware
    • In addition to the iPad Pro, the iMac and MacBook Pro all received incremental updates that keeps them in line with the high end of the PC market.
    • Apple also launched a super high end iMac Pro all in one aimed at the professional who needs to spend more than $5000 on a computer.
  • HomePod
    • Apple also gave a sneak peak of a home speaker that aims to replace expensive WiFi Speakers but also has the functionality of Amazon Echo and Google Home.
    • This is a high-end speaker that sports features that are designed to produce excellent sound quality and functionality potentially rendering Sonos obsolete.
    • At the same time the HomePod has Siri embedded meaning that it can answer questions and control the smart home through HomeKit.
    • Apple has positioned this as something that the user buys for a high-quality audio experience with Siri coming as an added bonus.
    • This is a smart move because Siri is not that bright and is easily out performed by Google Assistant while being on a par with Amazon’s Alexa.
    • HomePod shows no sign of being open to developers other than through HomeKit and I was disappointed that Spotify and other music services have not been enabled on the device.
    • Hence, this a device for the Apple Music subscribers of which there are now 27m and not really for anyone else.
  • The net result is that while I think there are some very interesting moves being made around the productivity elements on the iPad, Apple is mostly keeping step with the competition.
  • The good news is that its edge as the best distributor of apps and services of third partied has yet to be matched by Google, giving it time to re-invent its hardware differentiation.
  • The valuation case in Apple is not nearly as strong as it was 6 months ago leaving me still preferring Microsoft, Baidu and Tencent.

Apple FQ2 17– New normal

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These days, Apple looks like an industrial. 

  • Apple reported reasonable results and in increasing both the dividend and the share buy-back program, ushered itself squarely into a new normal of pedestrian growth.
  • FQ2 17A revenues / EPS were $52.9bn / $2.10 broadly in line with consensus at $52.9bn / $2.02.
  • Gross margins were 38.9% at the high end of the guided range and slightly above consensus at 38.7% as the iPhone 7+ was a stronger contributor to the mix than anticipated, lifting profitability.
  • Unit shipments were:
    • 50.8m iPhones vs 51.4m expected with an ASP of $655 compared to $666 expected.
    • Note that a higher than expected inventory adjustment (1.2m units) more than accounts for the difference.
    • 8.9m iPads and 4.2m Macs also shipped with Macs faring a little better than expected.
  • Services continued to be very strong with $7bn in revenue growing by 18% YoY with Apple stating that it now has a total of 165m paid subscriptions.
  • This includes Apple Music, iCloud and the subscription services of others that it offers on the Apple App Store.
  • There is obviously a degree of double counting going on here where for example, Spotify subscribers who pay through the App Store are also included here.
  • In my opinion, this renders this number virtually meaningless as Apple is counting subscriptions of its competitors as its own although it will still be making some money from these subscribers.
  • This combined with both an increase in dividend and the share buyback program, indicate very clearly that there is no growth in this company unless it can conquer a new segment.
  • Having (rightly, in my opinion) given up on making a car (see here), there is no new segment in sight, and so I see Apple, by and large, growing in line with the world economy.
  • I suspect that it will swing above and below that average as new products drive replacement cycles but the long-term outlook is industrial in its nature.
  • The next swing is likely to come from the iPhone 8 for which speculation and anticipation is already at fever pitch.
  • This means that Apple has to come up with something pretty special to see another cycle that will push its revenue growth above its new long term average, albeit temporarily.
  • Fortunately, the valuation of the company is not too demanding with a PER of 13.0x but the buy case based on valuation has now evaporated.
  • I see very little upside other than income coming from the shareholder return programs.
  • I would prefer Microsoft, Baidu and Tencent for those looking for capital appreciation.

 

Apple vs. Qualcomm – Proxy war

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Apple’s intransigence plays into Qualcomm’s hands. 

  • Qualcomm has been forced to adjust its guidance for the coming quarter after being informed by Apple that it would not be receiving any royalties for the foreseeable future.
  • According to Qualcomm (as Apple has made no statement), Apple has ceased payment as it finds the contract terms unacceptable even though it does acknowledge that some payment is warranted.
  • Qualcomm’s new FQ3 16 guidance is for revenues / EPS that will be $500m – $800m (midpoint $650m) and $0.15 – $0.30 lower than the guidance given at the recent FQ2 16 results.
  • Although the issues that Apple has with Qualcomm’s business model are very similar, if not the same as the issues that Nokia had back in 2006, the circumstances are completely different.
  • These are:
    • First Contract validity: The dispute that arose between Nokia and Qualcomm in 2006 occurred because Nokia’s contract had come to an end and the companies were unable to reach agreement on terms for the renewal.
    • Nokia stopped paying Qualcomm as it had no idea how much to pay and instead accrued an estimate of the cost in its balance sheet.
    • The contracts upon which Apple has ceased payments have not expired and I can’t see any real contractual grounds upon which to cease making payments.
    • As a result, I do not think that it will not be difficult to show to a court that Apple is acting in bad faith and to win an enforcement order.
    • Second: Third party suppliers. Apple does not pay Qualcomm directly as the payment is made by its manufacturing partners who make its products.
    • This means that Apple is getting involved in contracts that are in place between entities that have nothing to do with Apple other than it is the end buyer.
    • I do not think it will be difficult to argue that Apple has no real grounds to be involved in these contracts and is acting in bad faith.
  • Apple’s intentions are clear in that wants a lower rate from Qualcomm and unlike Nokia, is not prepared to wait until current contracts expire before launching its proxy war via its suppliers.
  • Apple’s royalties are calculated on the wholesale price of the device which in this case will be the price at which the supplier sells the finished device to Apple.
  • I calculate that the supplier is paying Qualcomm 2.8% of the price of the device from making the below assumptions:
    • Qualcomm’s FQ3 17 royalty revenues from Apple would have been from calendar Q1 17 as royalties tend to paid one quarter in arrears.
    • Apple shipped 52m units in calendar Q1 with an ASP of $650 giving iPhone revenues of $33.8bn upon which it made gross margins of 45%.
    • This means that suppliers sold the devices to Apple with an ASP of $448 for a total revenue of $23.3bn
  • There are a number of caveats to this assumption:
    • First price cap: There is a price cap above which no royalties are paid.
    • This cap was originally meant for products like laptops with modems, but premium smartphones are now so expensive that they often hit this cap.
    • I have estimated that this cap is somewhere around $500 but if it is as low as $400, then the rate I calculate paid by Apple goes up to 3.1%.
    • Second pay up front: There is a pay-up-front option (which Nokia took advantage of) which allows the vendor to pay a lower rate going forward.
    • It is not clear whether contracts with the iPhone suppliers have made use of this option or not.
  • The net result is that I calculate that Apple is paying somewhere around 3% to Qualcomm which I think is at least on par with many other vendors.
  • The problem with patents as there is no real way to determine what should be paid to for them.
  • I have long believed that patents are worth either:
    • First: what an entity is prepared to pay for them or
    • Second: the present value of the cash flows that the patent generates.
  • This is why historical precedent is so important when it comes to patent licencing and here Qualcomm has a huge advantage.
  • Qualcomm has hundreds of agreements and more than 20 years of history as evidence that its agreements have not damaged the mobile industry, in fact, quite the reverse.
  • Furthermore, I think Apple’s intransigence on this issue and ceasing payments that it has already agreed to in writing, plays enormously to Qualcomm’s advantage.
  • Courts look poorly upon a refusal negotiate and acting in bad faith and I think that Apple has done more harm than good to its case here.
  • Hence, I think Qualcomm’s chances of prevailing against Apple are better than they were against Nokia which is all the more reason why it should fight tooth and nail to preserve its business model.

Mobile Payments – Trouble in paradise

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Mobile Payments are going the wrong way.

  • It appears that the usage of Apple Pay on the iPhone is now declining compared to where it was in June 2016, sending a worrying signal for the outlook for mobile payments in general.
  • The most recent data from PYMNTS.com (see here) shows that both adoption of Apple Pay and its usage are showing the first signs of decline.
  • Android Pay and Samsung Pay have yet to show this decline but I suspect that this is due to the fact that they have not been around long enough to show this trend.
  • Neither of these two offer anything that Apple does not and in almost every case, I think Apple does it better.
  • The percentage of iOS users surveyed that had tried Apple Pay fell from 23.8% in June 2016 to 21.9% in March 2017.
  • Furthermore, in March 2017, 48.6% of those users that had not tried Apple Pay said that they were happy with their current payment method (plastic card) compared to 37.0% in March 2015.
  • Of those that have used it, those that “use it at every opportunity that I get” fell from 48% in March 2015 to just 18.7% in March 2017.
  • It also appears that security, ease of use or the store’s ability to make the payment work are not the reasons for Apple Pay’s lacklustre performance but more the fact that paying with plastic is just fine.
  • I think that this is a great example of how important it is to offer a better experience when one is looking to drive adoption.
  • Paying with a mobile phone is no easier or convenient than paying with a card and in many circumstances, it is much more difficult.
  • This also explains why mobile based payments have been so successful in China despite being based on the much maligned (in developed markets at least) QR code.
  • The offline experience to do almost anything in China is dire when compared to USA or Europe which has meant that even QR codes offer a huge improvement in the user experience.
  • For example, when using WeChat Pay, the time required to buy a train ticket can be reduced to 5 minutes from 45 and wait time at a hospital can be reduced to 20 minutes from 2 or more hours.
  • This is the issue that I see with mobile based payments in developed markets.
  • Plastic cards have very high penetration and almost everyone accepts them.
  • At the same time payments using a mobile phone don’t particularly improve the user experience for the consumer which is what I think has led to the ambivalence that this survey is pointing to.
  • The net result is that to win the kind of adoption that China has, mobile based payments need to offer the user a compelling reason to use them.
  • Failure to do this could see adoption and usage decline to a niche of power users with the vast majority of users sticking with plastic cards which, by all accounts, are plenty good enough.
  • It looks like wallet manufacturers are going to be in business for much longer than anyone thought.

Apple FQ1 16 – One way street.

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iPhone benefits where Google could not.

  • Apple released excellent results highlighting that contrary to my previous view, iOS has been the main beneficiary of Samsung’s recent woes.
  • FQ1 17A revenues / Adj-EPS were $78.4bn / $3.36 compared to consensus at $77.3bn / $3.22.
  • iPhone was the main driver of the upside with 78.3m units shipped at an ASP of $695 beating expectations of 76.3m units at an ASP of $688.
  • In addition to the share gain, prices went up as the larger screen version of the iPhone saw its biggest contribution to the mix ever.
  • I think that has been primarily driven by Apple taking a good share of users that purchased the Note 7 and were left high and dry by the recall.
  • Users appear to have taken this opportunity to move from Android to iOS, a move which I think is pretty much a one-way street.
  • I find this surprising as the iPhone 6 is now in its third generation meaning that a large screen iOS device has been an option for users for 2.5 years.
  • This means that most high-end Android users have already purchased a new Android device despite a large screen iOS option being available.
  • This is what led me to believe that iOS would not benefit from Samsung’s Note 7 disaster but this logic appears not have been correct.
  • Instead it appears that the negative stigma surrounding the recall has been enough to encourage users to switch away from Android despite the fact that many apps will need to be repurchased.
  • I have estimated that around 2.5m users (see here) were affected by this incident of which I think around 2m have bought an iOS device and 0.5m a Google Pixel device.
  • This explains the strong performance of iPhone, the better mix towards the larger screen device (Note 7 is a large screen) and the geographic performance of Apple during calendar Q4 16.
  • It also explains Apple’s slightly cautious guidance for the coming quarter as this gain is likely to have been a one-off benefit.
  • FQ2 17E revenues / gross margin are expected to be $51.5bn – $53.5bn / 38% – 39% compared to consensus at $53.8bn / 38.7%.
  • This is bad news for Samsung as the crowd that bought the Galaxy Note 7 appear to have switched to iOS from whence they are unlikely to return.
  • Ironically, although Google has failed to win those users over to Pixel, it will still benefit as RFM research indicates that iOS users generate far more advertising revenues for Google than Android users in the same demographic groups.
  • These were good results but they do not herald the return to growth that the shares badly need if they are to see any real upward momentum.
  • I still think that the shares represent great value for income based investors but those looking for capital growth will remain better off with Microsoft, Baidu and Tencent.

Apple FQ4 16A – Margin gadfly

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Margin pressure from product mix is not a problem. 

  • Apple reported results that broadly met expectations although slight weakness in profitability is an indicator that some users are buying the cheaper iPhone 6s rather than the 7.
  • FQ4 16A revenues / EPS were $46.9bn / $1.67 compared to consensus at $47.0bn / $1.66.
  • Apple sold 45.5m iPhones which was in line with consensus at 45.0m but pricing was weaker than expected at $619 compared with consensus at $625.
  • Mac shipments fell 14% YoY 4.9m units mostly due to the overall weakness in PCs and iPad was also weak declining 6% YoY to 9.2m units.
  • Guidance was mixed with FQ1 17E revenues / gross margins expected at $76bn-$78bn / 38.0% – 38.5% compared to consensus at $75.4bn / 38.9%.
  • It is the miss on gross margin that has triggered the disappointment as a combination of higher overall revenue bringing greater scale benefits and a full quarter of the iPhone 7 should help profitability more than Apple is indicating.
  • This is especially the case as improving costs was the main reason for FQ4 16A gross margin strength which came in at 38% at the top of the guided range of 37.5%-38.0%.
  • Although Apple remains supply constrained on the iPhone 7, I suspect that the reality is that there is a slight mix shift towards the older and cheaper models.
  • Despite the new colours and no headphone jack, the new iPhone is not very different from last year’s model and the ecosystem experience for the consumer is the same as they run the same software.
  • Furthermore, I think that some consumers are put off by the lack of a headphone jack which could be driving them to upgrade their older models to the iPhone 6s rather than the 7.
  • Older devices have lower gross margins than new devices as the price falls more quickly than the cost to make them which could be responsible for this slight weakness.
  • Overall, the weakness is very slight and Apple is continuing to increase the number of users that it has in its ecosystem.
  • This is critical for its long-term outlook which I think remains pretty rosy as Google’s Android is still unable to offer much to induce users to switch away from iOS.
  • Gross margin variation due a mix shift is a normal factor in every business and this is what I think Apple is dealing with.
  • Gross margin pressure from competition is a far more serious problem and with Samsung is disarray and no real competitive threat from Google, I do not see this happening in the short-term.
  • The net result is a company in a commanding position but one that is struggling to find growth as it has high share in the segments that it addresses which are themselves increasingly saturated.
  • I do not see Apple going to lower tiers to find growth but instead it is looking for new product categories.
  • Of these there is little sign meaning that the medium term is likely to be one of very low growth but mighty cash flow generation.
  • For an income investor, this is a great place to be but anyone looking for short term capital growth should probably look to Microsoft, Tencent or Baidu.

Qualcomm vs. Intel – Storm in a teacup.

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Qualcomm thrashes Intel but not where it really matters. 

  • It appears that Qualcomm has once again demonstrated superiority over its peers when it comes to radio but I think it highly unlikely that users will notice.
  • Radio performance analysis specialists Cellular Insights have run a series of tests on the iPhone 7 powered by Qualcomm’s MDM9645M modem and the iPhone 7 powered by Intel’s XMM7360 modem to compare radio performance.
  • The results are startling and much more so than in the infamous “chipgate” episode where the A9 (iPhone 6s) made by TSMC resulted in 5-7% battery life than the same chip made by Samsung.
  • In this case the Qualcomm modem has consistently outperformed the Intel modem on 4G by 30% when the signal was moderate and 75% when the signal was at its weakest.
  • When the signal was at full strength, both modems performed similarly.
  • This does not come as a huge surprise as Qualcomm modems have for years been consistently better at performing in non-ideal radio environments giving it a major point of differentiation.
  • This difference is far greater than it was for chipgate but I doubt whether this is going to have users scrambling to check the model numbers of their devices prior to purchase.
    • First: Battery life is a major issue for every smartphone and is a concept that is very easily grasped by the consumer.
    • As long as there is a connection and the service works, most users will be satisfied, meaning that a difference in speed is less likely to be noticed.
    • A device that does not turn on or fails right at a critical moment is far more noticeable.
    • Second: Bleeding edge.
    • What Cellular Insights has measured is performance at the bleeding edge.
    • For example, in band 4 at -120dBm (very weak radio) Qualcomm manages around 30Mbps while Intel does around 12Mbps.
    • When I look at the Digital Life pie of smartphone usage there is not a single service that I think will be noticeably degraded by that difference to the point where the user will blame the radio.
    • Furthermore, almost all networks still have an underlay of 3G meaning that user will have some data coverage even in the advent that 4G fails completely.
  • Most tellingly of all is the fact that the iPhone 7 has been widely available for over a month and there has been not a single murmur from reviewers or users that one version of the device has a better radio than the other.
  • Consequently, I think that posterity will take note of this difference and move on with no real impact being felt in shipments of one variant or the other.
  • However, for Qualcomm this is an important demonstration that it remains peerless when it comes to radio modems.
  • This is critically important as this test is likely to influence device makers when they are selecting which modems to use in their products giving Qualcomm slightly better pricing power.
  • The general consensus out there is that radio modems are beginning to commoditise as LTE matures as a standard but this test clearly shows that this is not the case.
  • Despite this good news, Qualcomm still needs to expand its horizons into other device categories to keep growth going as smartphones are grinding to halt.
  • This is where its smart drone, IP camera reference platform and potential purchase of NXP semiconductors come into play.
  • This is bad news for Intel but I think it can quite easily shake it off as its performance inside the iPhone 7 is clearly good enough.

Apple – A stern test

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The iPhone 7 is a stern test of Apple’s brand. 

  • Removing the headphone jack will be a tough test of whether Apple’s brand is strong enough to wean consumers off a connector that they have loved for over 100 years.
  • Apple launched two new products and one new accessory at its annual launch event on September 7th.
    • First: iPhone 7.
    • The new device no longer has the 3.5mm headphone jack but comes with an adaptor in the box.
    • Users wanting to use traditional headphones will no longer be able to listen and charge at the same time.
    • The device also sports a brighter display, much improved camera (with wide angle and telephoto cameras on the 7+), a new home button as well as water resistance to 1m of immersion.
    • With the exception of the headphone jack, there is not much here that does not already exist on competing products although I suspect that when it comes to the camera, Apple’s combination of software and hardware will create a top notch experience and image results.
    • The iPhone 7 doubles the capacity of previous versions with the top size now being 256GB but the price is staying the same as the previous generation.
    • Second: AirPods
    • These are wireless Bluetooth headphones that automatically pair with the iPhone and Apple Watch with some very nice features that should create a great experience when used with Apple’s products.
    • They will also work with non-Apple products meaning that it the AirPods are using standard Bluetooth and so it will be important to see how well the audio quality measures up to wired headphones.
    • The AirPods also allow use of Siri with a double tap as well as voice calls and easy device switching.
    • The AirPods are very expensive at $159 and I expect them to sell only to the real top end of Apple’s fan base.
    • At the same time, Beats is incorporating the new technology into a range of its devices at more reasonable prices giving consumers more choice.
    • Third: Apple Watch 2.
    • Apple updated the Apple Watch adding water resistance to 50m making it good for swimmers as well as adding GPS to allow full activity tracking without the iPhone being present.
    • These went hand in hand with a nice new ceramic case and a version of the device which has Nike running software embedded at the factory.
    • However, what Apple did not do was provide an answer to the most asked question at the Apple Watch tables which remains: “Why should I buy it?” not “How much is it?”.
    • Hence, I do not see the Apple Watch 2 lifting the smart watch market out of its current decline and I remain very cautious on the outlook for wearables in general.
  • Apple is certainly taking a step forward in removing the headphone jack but at the same time it has given competitors material for marketing their products.
  • It also makes the device even more proprietary than it already was which is likely to anger some users.
  • The biggest risk here is not whether Apple will lose users to Android but whether users looking for a new phone will buy the 6s which is almost as good and still has the beloved 3.5mm jack rather than the 7.
  • If all goes well then I expect ASPs and gross margins to hold steady but should users shun the 7 for the cheaper 6s then ASPs, revenues and profits will come under pressure.
  • This is the big gamble that Apple is taking where clearly it is hoping that its brand is strong enough to force the industry and users to move on from something they have been using for many years.
  • I do not think that there is nearly enough here to drive a real replacement cycle (like the iPhone 6) but there should be enough to keep the ship steady while Apple searches for the next revolution.
  • Hence, I continue to think that Apple is a great long term investment as it offers great value but there is nothing from these launches that is going to drive revenues back to growth.
  • Samsung, Microsoft and Baidu are my top short-term picks.

Apple Q3 16A – High yield

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Apple as a bond is yielding 9.8%. 

  • Apple reported better than expected Q3 16A results as the iPhone SE sold better than its predecessor, the iPhone 5c, despite a much larger than expected channel inventory reduction.
  • Q3 16A revenues / EPS were $42.2bn / $1.42 compared to consensus at $42.1bn / $1.39.
  • As usual all eyes were on the iPhone which shipped 44.4m units to end users compared to consensus at 39.9m but did so at a lower price as ASPs were $595 compared to consensus at $605.
  • This is what was responsible for the better than expected results but iPad and Mac also fared reasonably well.
  • iPad shipped 10.0m units compared to consensus of 9.1m and the iPad Pro helped ASPs improve to $490 from $415m.
  • Mac shipped 4.3m units compared to consensus of 4.4m underscoring slow but steady market share gain in the PC market.
  • Q3 16A Services revenues grew by 19% YoY to $6bn underscoring that developers are faring better on iOS and are increasingly preferring to develop their apps for this platform before considering Google Play.
  • Guidance was also positive with Q4 16E revenues / gross margins expected at $45.5bn – $47.5bn ($46.5bn midpoint) / 37.5% – 38.0% (37.8% midpoint) slightly ahead of consensus at $45.8bn / 38.4%.
  • These good results underpinned another very strong quarter of cash flow with $10.1bn generated from operations, $13bn returned to investors leaving gross cash down slightly at $231.5bn.
  • With debt unchanged at $72bn this leaves the net cash position at $159.5bn.
  • Although the market was clearly relieved that the declines were not as large as had been feared, these numbers do nothing to alleviate Apple’s current problem.
  • In the eyes of the stock market, Apple has to produce growth in order to command a higher valuation and of this growth, there is no sign.
  • This is why Apple is unlikely to receive a rerating of its shares until it branches out into a new product area.
  • Apple Watch saw declines this quarter (see here) and I think that while Apple is building a car, it will never launch it (see here).
  • This leaves Apple unlikely to see much in the way of growth but it is continuing to distance its ecosystem from Google’s.
  • This gives me confidence that its superb profitability and cash flow are likely to remain intact for some time to come.
  • On that basis, I like to think about Apple equity as a bond and on that basis it is currently paying a coupon to its owners at a run rate of $52bn per year.
  • Hence, equity holders are earning a yield of 9.8% per annum with a very low risk profile.
  • For those that are not worried about capital growth, this is a no brainer as most companies with bonds yielding 10% are highly distressed.