Apple: Waiting On iPad Air 2, Mini 3

Aug.25.14 | About: Apple Inc. (AAPL)

Summary

Apple bears have harped upon weakness in the iPad line as a signal that the company has lost its innovative touch.

The iPad is a more durable good than the iPhone. As such, analysts should expect relatively lengthy inventory turnover times for the iPad.

Apple stock still deserves a buy rating largely due in part to its aggressive capital return program.

On July 23, 2014, Apple (NASDAQ: AAPL) filed financial results for its fiscal 2014 third quarter ended June 28, 2014. In all, Apple racked up $7.7 billion in quarterly profits off $37.4 billion in Q3 2014 revenue. The results compared favorably to the prior year, when Apple reported a respective $6.9 billion and $35.3 billion in Q3 2013 net income and profits. Apple's corresponding press release highlighted its iPhone, Mac and Services segments as the primary engines driving 20% earnings per share (EPS) growth.

Bears, such as Jim Edwards of Business Insider, may highlight weakening iPad sales to support their ongoing thesis that Apple has lost its mojo for innovation. Last May, Edwards went so far as to suggest that the iPad business was already "collapsing." For his part, Edwards referenced market share statistics, while also citing decelerating iPad sales growth between 2011 and 2014. The bearish analysis, however, neglects the new product cycle. Long-term Apple shareholders may take solace in the idea that consumers are anticipating looming iPad Air 2 and iPad Mini 3 launches, which will restore interest in this tablet line.

Do Not Compare iPads to iPhones

2010

2011

2012

2013

Q3 2013

Q3 2014

Apple Revenue

$65.2B

$108.2B

$156.5B

$170.9B

$35.3B

$37.4B

iPad Revenue

$5.0B

$19.2B

$30.9B

$32.0B

$6.4B

$5.9B

iPad Unit Sales

7.5M

32.9M

58.3M

71.0M

14.6M

13.3M

iPad Revenue Per Unit Sold

$666.67

$583.59

$530.02

$450.70

$438.35

$443.61

iPad % of Apple Revenue

7.7%

17.7%

19.7%

18.7%

18.1%

15.8%

Click to enlarge

Source: Apple Earnings Releases and SEC Filings

Apple iPad sales growth has indeed decelerated over the years. Between 2010-2011 and 2011-2012, Apple iPad revenue did advance sharply by 284% and 60.9%, respectively. From there, Apple iPad segment revenue declined from $6.4 billion to $5.9 billion, or by 7.8%, between Q3 2013 and Q3 2014. On a per unit basis, iPad revenue also deteriorated from $666.67 to $443.41, largely over the past four years. For his part, Apple CEO Tim Cook has argued that consumers were opting to purchase older hardware - at sharp price reductions. The 16GB iPad Air with Wi-Fi connectivity has regularly retailed for $499.00. In recent weeks, major retailers have offered significant price discounts on the current line of iPad Air and iPad Mini tablets, in anticipation of new product updates.

Meanwhile, the iPhone product line has continued to surge in popularity. Apple closed out its latest quarter having shipped 35.2 million iPhone units for $19.2 billion in segment revenue ($545.45 per unit). The iPhone platform achieved respective 13% and 9% year-over-year growth in unit sales and revenue through Q3 2014. The iPhone then generated 52.8% of the $37.4 billion of third quarter sales at Apple. In comparison, the iPhone accounted for $25.1 billion, or 38.4%, of total net sales throughout all of 2010.

For now, the typical smartphone consumer may be in the market for the unlocked, contract free 16GB iPhone 5S, which does retail for $649.00. Major carriers, of course, offer $450.00 in subsidies, if consumers agree to the terms and conditions of a two-year service contract. The average consumer would therefore purchase the 16GB iPhone 5S for $199.00. AT&T (NYSE: T), Sprint (NYE: SS) and Verizon (NYSE: VZ) are willing to effectively pay the upfront difference in exchange for ongoing fees. As such, mobile customers have been more so willing to purchase a new handset every other year.

Major cellular carriers do offer $100 in subsidies on the iPad, if consumers agree to the terms and conditions of a two-year contract. These subsidies are non-applicable, however, if customers simply opt for iPad tablets that feature Wi-Fi connectivity only. In any event, the average up-front out-of-pocket iPad costs ($499.00 for Wi-Fi 16GB iPad Air) are more than double those associated with the iPhone ($199 for 16GB iPhone 5S with 2-year service contract). As a more durable good, Wall Street analysts should expect lengthier inventory turnover times on the iPad relative to the iPhone. Going forward, iPad sales performance will likely exhibit cyclical peaks and troughs that largely correlate to product release dates.

Deconstructing Market Share Data

Apple bears, such as the aforementioned Jim Edwards, should acknowledge the idea that Google (NASDAQ: GOOG) (NASDAQ:GOOGL) Android versus Apple iOS market share comparisons may be somewhat misleading. The Google Empire has been largely built upon bait-and-switch tactics, where the company literally gives away product at cost in order to drive traffic toward its higher margin online search and advertising businesses. Android has particularly emerged as the preferred operating system for original equipment manufacturers that peddle cheap phones throughout emerging markets.

Alternatively, Apple executives have historically maintained a bias toward return on equity, where the company is willing to concede nominal market share in order to deliver solid bottom line profitability. Apple has positioned itself as somewhat of a luxury brand deserving of premium pricing power. Apple has largely refused to participate within notable smartphone and tablet price wars, while still generating the majority of profits within the mobile space.

A brief review of successive reports out of comScore and IDC may confirm the presence of the dominant Android - iOS duopoly. An August 6, 2014, comScore press release presented estimates that Android (51.9%) and iOS (42.1%) systems combined to operate 94% of the U.S. smartphone subscriber market through the April to June quarter. Apple was also the leading smartphone original equipment manufacturer, with its 42.1% share.

On July 24, 2014, research firm IDC released a report listing out the top five tablet vendors on the global marketplace through the second calendar quarter of 2014. Apple, again, closed out this latest quarter as the top tablet vendor, with a 26.9% share of the market. In terms of share, Apple did lose traction within this space since Q2 2013, when the iPad controlled 33.3% of the tablet market. According to IDC, "Other" unit shipments grew from 16.4 million to 21.9 million, between Q2 2013 and Q2 2014. In terms of mark share, "Other" improved from 37.0% to 44.4% over the past year. Again, the IDC "Others" category was likely mostly composed of cheap Android machines shipped to the third world at razor thin margins.

A November 5, 2013, supply chain report out of IHS presented estimates of $274.00 in bill of materials and manufacturing costs for the 16GB Wi-Fi iPad Air that now retails for $499.00. Again, the iPad platform did average $450.70 in per unit sales through 2013, when Apple sold 71 million tablets for $32 billion. The triangulation of IHS data alongside Apple financial statements would suggest that the iPad generates $225, or 45%, in gross margins per unit. In all, the iPad generated an estimated $14.4 billion out of the $64.3 billion in total gross margins for Apple in 2013.

New Products and The Bottom Line

Going forward, the Apple product mix and financial results will reflect the secular shift towards phablets in mobile. The term "phablet," of course, is a play upon words suggesting the fusion of traditional smartphone and tablet features within one machine. In keeping with its historical product cycle, Apple will launch the iPhone 6, iPad Air 2 and iPad Mini 3 prior to the 2014 Holiday Season. The technology commentariat has largely agreed that the iPhone 6 will ultimately branch off into two separate 4.7-inch and 5.5-inch screen handsets. For the sake of comparison, the iPad Mini now in stores features a 7.9-inch screen. A more powerful A8 chip will likely power the latest round of smartphones and tablets out of Apple. The A8 may achieve 2 GHz clock speeds, which would be a first, for Apple.

As a worst-case scenario, iPhone 6 related excitement and buying interest would counteract any single-digit percentage decline in iPad sales. Most likely, the iPhone 6, iPad Air 2 and iPad Mini 3 machines will symbiotically improve sales growth throughout the entire Apple ecosystem. In 2013, Apple did ship 150.3 million iPhone units, at an average $607.45 price, for $91.3 billion in revenue. For 2015, Apple may ship 200 million iPhone units at $650.00, for $130 billion in revenue. That year, the iPad segment may also grow to 80 million in unit sales at $500.00 per machine, for $40 billion in segment revenue.

Last April, Apple announced that it would be expanding its capital return program to $130 billion. As part of this capital return program, Apple pledged to buy back $90 billion in stock by the end of 2015. In all, the program may tally up to 720 million shares being re-purchased at an average price of $125. As a result, Apple shares of common stock outstanding may fall from 6 billion to 5.3 billion over the course of one year. As such, Apple may be due for 12% earnings per share growth through buy backs alone. Marginal iPhone and iPad sales and profits will be the literal vanilla ice cream on top of the Apple pie, when juxtaposed against this aggressive capital return program. Apple stock is still deserving of a buy rating.

Disclosure: The author is long AAPL.

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.