Apple's Performance in China is Key

A former Wall Street analyst discloses the topics that equity analysts and hedge fund managers are currently talking about. 

Apple reports earnings next Wednesday, October 27th. Here are the key discussion points among professional investors.


Key Issue 1: iPhone Sales in China

The iPhone remains the key component of Apple's earnings, with over 60% of revenue and a greater percentage of gross profit in 2015 coming from the product. With significant penetration in the US but only 18% unit share of the global smartphone market, a key component of iPhone growth moving forward is tied to international performance.

 

Within international markets, China remains the biggest area of opportunity. A key debate among investors is Apple's performance there, where a sizable and growing market for smartphones exists. Bulls believe Apple will be able to penetrate the market further with larger screen sizes and China's attractive growing middle class. Offsetting these positives are a slowing Chinese economy, a fiercely competitive market with Xiaomi and Huawei, and uncertainty around how consumers will react to the Apple brand. Growth here could be the difference between Apple meeting or missing iPhone expectations for F4Q and F1Q. 

 

Key Issue 2: iPhone 6S Sales in the US

With the iPhone 6S launch in late September, investors are eager to find out how the latest phone has sold. While the 6 has been out for over a year, only 25-30% of iPhone owners have actually upgraded to a 6 or 6+. Thus, a general argument for upside to sales estimates for the 6S is the remaining 70-75% of users who are using older iphone models. Apple owners are also much stickier than Android owners, meaning that many of the 70-75% will likely stick with an iPhone. Furthermore, Android owners are much less sticky than Apple owners and continue to switch to an Apple device, representing another area of potential upside. Offsetting some of these positives is the general perception that incremental upgrades on each iPhone are becoming smaller and smaller. Another headwind is the difficult comparison that they will face. The 6 phones were launched this time last year and were wildly successful after they eliminated one of the few remaining areas that Apple phones noticeably lagged competitors - screen size. Growing on top of that will be much more difficult.

Apple will report their fiscal 4Q ending September, but the focus will be on management's guidance for their F1Q ending December -- the iPhone 6S went on sale near the end of F4Q, so most of the sales will go into F1Q. That quarter also will also face a difficult comparison when Apple launched their iPhone 6. Expectations in this quarter are for roughly flat sales growth.

 

Key Issue 3: Longer-term Debate Shifts to the Ecosystem and Other Revenue Sources

Beyond near-term iPhone growth questions, investors question where other sources of revenue growth will come from. Apple is a behemoth $600+ billion company with massive scale, and growing on top of these numbers will not be easy. Products that would normally represent successful ventures for most companies would not move the needle for Apple. 

Many investors view the next area of growth coming from the general expansion of the Apple ecosystem, which drives other sales such as App Store or iCloud (Services) sales. Every Apple device that's sold adds to the ecosystem and increases the value of the services. Apple's services line currently represents 9% of sales and a likely greater percentage of gross profit given their higher margin profile. As a result, each additional dollar here would drive outsized profit growth. However, growth of the ecosystem would likely require Apple to move price points lower to include the lower-end consumer. Investors expect Apple to continue to attempt to do so (i.e. the iPhone 5C), but it is unclear whether they will have the same success in these segments.

AAPL Services Revenue Growth.png

 

The Watch and Apple Pay are also areas that are watched by investors, but expectations appear to be fairly low, with very little meaningful contribution to revenue or profit over the next several years.