Half of the year may be done, but the fun is about to begin.
I'll discuss some key questions regarding Apple's rest of 2014.
What's Apple's potential? It may depend on the Dow and the buyback.
Last week, I gave a brief preview of Apple's (NASDAQ:AAPL) second half of 2014, and why investors might appreciate the recent pullback. Apple shares have rallied since then, but still remain a couple of bucks off their recent highs. Well, the second half of the year is now here. There are many questions one could ask about Apple right now, and today, I'll look at five that I think are key for investors.
Question 1 - Can Apple raise iPhone prices, and who picks up the tab?
I noted in my prior article, and have discussed before, that Apple could be looking to get higher prices for its new iPhone(s). With the screen size being larger, and most likely Apple's costs for the phone going up, Apple was at one point rumored to be asking for a $100 increase per phone.
The first logical question is who takes the hit from this - the consumer or the carrier? If Apple does get an extra $100 per phone, could the consumer pay an extra $50 and the carrier subsidizes an extra $50? Maybe Apple gets $50 more on the smaller of two rumored phones, but $75 on the larger one. Would consumers be okay with a $229 starting price for the base version of the smaller model and perhaps $249 for the larger one? Remember, the base iPhone 5S started at $199 subsidized. Given how much consumer loyalty Apple has, I don't think an extra $30 or $50 a phone will cause that many people to think twice before buying. Now if Apple started the smaller model at a base of $299 and a larger phone was even more expensive, maybe that becomes an issue. What the carriers are willing to do though is just as important.
A price raise is important on two fronts. The first front is obviously revenues. In last year's fiscal Q4 period, the September ending quarter that contained the last major iPhone launch, Apple sold 33.8 million iPhones. The average sales price was about $577, as fiscal Q4 prices are generally lower due to older/cheaper phones sold earlier in the quarter pre-launch. However, imagine what Apple could do with an average selling price just $20 more. On 35 million phones, you're talking about an extra $700 million in revenues. Make that number an extra $50 or more, and you're talking about a revenue difference in the billions.
The other area that a price raise could make an impact is margins. I've referenced an analyst in the past that says Apple's gross margins decrease by around 225 basis points when Apple launches a new form factor phone. The iPhone 6 would be a new form factor phone, and there could be two different screen models. If Apple can get higher prices for its phones, it will offset some or perhaps all of the increased costs. Let's say Apple analysts as a whole are looking for a decrease of 200 basis points on the new form factor phone(s). What if Apple only has a 150 basis point increase, or even a 100 basis point decrease? On $40 billion of revenues, a little less than what analysts are currently looking for in fiscal Q4, 100 basis points of gross margins equals about $400 million in gross profits.
That extra few hundred million in gross profits could translate to a nickel when you get to the bottom line, holding all else equal. Remember, after Apple's split, we are no longer looking for $8 or $9 in quarterly earnings. At that point, a nickel wasn't seen as that big of a deal. But with current fiscal Q4 EPS estimates at $1.33, a nickel could be a huge deal. Pennies of EPS are a lot more important now.
Question 2 - Will Apple carry three different screen sizes for the iPad going forward?
There has been so much talk recently about the upcoming iPhone 6 launch and perhaps the launch of an iWatch. Lost in that discussion is Apple's second most important product, the iPad. In the first half of this fiscal year, the iPad represented more than $19 billion of Apple's revenues, nearly one-fifth of all revenues. You can view all of Apple's segment revenues on page 25 of the most recent 10-Q.
Although Apple's unit sales of the iPad were up very slightly in the first six months of the fiscal year, total iPad revenues were down about 2%. That's due to sales of the iPad mini, which have sent overall iPad selling prices down from where they were a couple of years ago.
Even back in late 2013, there were rumors of Apple going to a larger screen iPad, perhaps a 12.9 inch or 13.3 inch one. As a comparison, the current regular iPad has a 9.7 inch display, while the iPad mini has a 7.9 inch display. The article linked above states that Apple would be targeting the North American educational market with this larger screen iPad. Well, this could make even more sense now. Apple recently announced an update to iTunes U, bringing new tools to the iPad regarding educational content.
Like the iPhone, a larger screen iPad would probably go for a higher price than current versions. Margins on the iPad are a bit less than the iPhone, and when the iPad mini was launched, Apple took a hit to gross margins. A larger screen iPad could be a good way to get iPad sales going again, and it could help drive the bottom line if Apple can get higher prices to equal higher margins.
Question 3 - What happens with the buyback?
According to the 10-Q linked above, Apple had $14.1 billion remaining on the buyback at the end of fiscal Q2. Apple then added another $30 billion to the buyback. Theoretically, you could only say Apple had $44 billion plus remaining if you knew Apple had not bought back any more shares in this quarter.
Apple had about $18 billion in domestic cash resources at the end of the quarter, funds that can be used for the dividend and the buyback. Apple did take out $12 billion in debt to help with its capital return plans. Apple expects to return about $130 billion to shareholders by the end of calendar 2015 through the dividend and the buyback. But it can't use foreign funds to do so unless US tax law changes in a big way before that, which is unlikely. That's why you saw debt for a second straight year.
With Apple trading around $75 early in the quarter, split-adjusted, the company would be able to buy back around 590 million shares at that price. When you adjust for the split, Apple's end of fiscal Q2 share count was about 6.03 billion. Now that shares are around $93, an average price of that amount would only mean about 475 million shares. Should shares go even higher, the number of shares that could be repurchased would obviously go down.
With 7 calendar quarters left to repurchase that roughly $44 billion, an evenly executed buyback would be about $6.3 billion per quarter. Given that Apple shares were much lower earlier in calendar Q2, and the fact that Apple took out $12 billion in debt, Apple investors should be hoping that the company bought back at least $10 billion in fiscal Q3. With Apple taking out $12 billion in debt, the company obviously was going to put that money to work. If a significant amount of shares were not going to be bought back for another year, why take out the debt so early? If Apple bought back $10 billion during fiscal Q3, that would still leave about $34 billion for six calendar quarters, allowing Apple to be opportunistic should shares pull back in a significant manner. Apple has stepped in before when shares have dropped, and I would expect the same to happen if shares do fall again.
Question 4 - Will the Dow finally call?
One of the main reasons why most suggested Apple split its stock is to gain inclusion in the Dow Jones Industrial Average. Of course, if Apple goes to the Dow, it means another component has to leave. That could be a heated debate. Apple surely meets the qualifications to enter the Dow at this point, so it is just a matter of if the Index wants Apple. If Apple is going to be added to the Index, you almost have to wonder if a change would be made soon, before Apple starts launching products. If the Dow index wants to go higher, most people are assuming Apple will rally once these new products come out. Get Apple in now, and that could help get the Dow over 17,000, for example.
We can argue all day about whether or not Apple should be in the Dow, but Apple getting to the Index should be a positive for Apple shares. At the minimum, all of the funds that are required to own Dow components would need to buy Apple. Those funds having to buy Apple essentially becomes a mini-buyback. Additionally, you figure that some short sellers would have to cover, and that could propel Apple even higher. In my past articles, I approximated the value of Apple to the Dow at $5 a share.
Question 5 - Who should Apple worry about most?
Obviously, the major names people will throw out there are Samsung (OTC:SSNLF), Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL). I'll discuss the two names I'm most familiar with here. Microsoft is at a key point right now, having finished its acquisition of Nokia's (NYSE:NOK) devices and services business in late April. Additionally, Microsoft has recently ended support for Windows XP, and the company is trying to push sales of its Windows 8 powered devices. In fact, Microsoft recently announced a trade in program where it hopes Apple customers will ditch their MacBook Pros for Surface Pro 3s. The Surface will not kill either the iPad or the MacBook Pro, but it could dent some of Apple's sales. Since Apple is always held to a higher standard, the company must always issue great quarterly reports. A strong push from Microsoft on this XP-based refresh cycle could ding Apple a bit.
Google is always thrown out there because Google keeps branching out. It is not just an internet search giant anymore, and the Android platform continues to dominate. Google recently stated that Android's tablet share is at 62%, although its revenue share is likely less. Google has also made acquisitions of Nest and Dropcam (currently pending) to increase its presence in the home. Apple also is fighting to get in the home. Additionally, Google's Youtube is about to launch a music service. Apple's recent acquisition of Beats is Apple's extended push into music. The music space is getting very crowded, with Amazon (NASDAQ:AMZN) recently launching its own service in an effort to bolster its Fire phone launch.
An interesting name to watch though as time progresses is smartphone maker Xiaomi. The Chinese company is seen as the Apple of China, although its devices are towards the cheaper end of the scale. Apple's power will be closely watched when larger screen devices are launched later this year, as Samsung and Xiaomi already have popular larger screen phones. Xiaomi could seriously challenge Apple's standing in China, and perhaps eventually, a global push might be made. Xiaomi has a well developed ecosystem, something that we all applaud Apple for. I'm not ready to call Xiaomi a major global competitor for Apple yet, but the smaller company could cause some problems for Apple in China this year and next. From there, this will be an interesting name to watch.
With the second half of 2014 here, all eyes will be on Apple as the technology giant is ready to launch new products. It will be interesting to see how Apple's larger screen iPhones are received, but also the price at which Apple can sell them. We may also see a larger screen iPad, which could mean three different sizes of iPads available. Oh, and I really didn't even speak today about the potential iWatch, which many believe will be Apple's next big hit. Always be mindful of the competition, however. Microsoft is making a serious push, and Google will continue to expand. Xiaomi could also provide a challenge to Apple in China.
Today, I looked at some key questions regarding Apple, including the buyback and potential Dow inclusion. The buyback will continue to reduce the share count and improve EPS, and could set another floor in shares should they fall. Apple could also see a pop if the name gets added to the Dow 30. In the end, it should be a great second half of the year for Apple, its fiscal fourth and first quarters. With my fiscal 2015 price target on Apple being around $106 (or $111 with a Dow add), I think the stock will continue to perform well. I've continued to recommend buying on pullbacks, like the recent one that took us back below $90. Now that the second half of 2014 is here, get ready to talk about Apple in a big way, and I'll be here to cover the major events.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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