Apple And Q2 Results: Still A Tough Road For Watch

| About: Apple Inc. (AAPL)

Summary

Apple Watch sales continue to perform poorly according to analysts.

Discounted Apple Watch prices may disprove the hypothesis of the 80-20 Rule for Apple profits from the Watch.

Apple will report quarterly results Tuesday with expectations for both earnings and sales to decline YOY.

So how bad is it really when it comes to the Apple Watch? I don't claim to know, but I would propose that Apple (NASDAQ:AAPL) ventured into the wearables category due to the relative growth the category was exhibiting, and what retailers were contributing to the conversation with Apple. Where there is growth and demand, Apple clearly desires to be.

The Apple Watch was heralded to be an awe-inspiring product in early 2015, when the company unveiled the product and pre-orders suggested the Watch was to be nothing short of a dominant player in the wearables category. Flash forward no more than a year later and the Watch is seemingly finding itself a "Lost Leader" and wanting for greater sales through the existing framework of retail distribution. If we revisit an article from April 2015 titled "Apple's Watch Strategy Embraces The 80-20 Rule," we come to find that pre-orders did in fact indicate consumers would proliferate more sales of the Apple Watch at the low-end of the pricing range. This has definitively come to fruition even though I would not be of the opinion that the 80-20 Rule has come to fruition. Apple simply hasn't sold enough of the Apple Watch product line to benefit from that hypothesis to date. It doesn't mean that hypothesis won't be proven long term, but it is not likely given the rate of sale presently. In other words, if we acknowledge the current rate of sale for the Apple Watch Sport, which is relatively low for the wearables category and smartwatch sub-class, the Apple Watch Sport would have to come down in price prior to the next iteration.

That is exactly what has happened to the Apple Watch Sport. The latest update regarding the Apple Watch signaled a price decrease for the Apple Watch Sport alongside the addition of new applications focused on health and wellness. What we can extrapolate and deduce from both the rate of sale and Apple's price reduction for the Apple Watch is that the next Apple Watch iteration will find the product line with less potential gross profit than the first generation of Apple Watches. This will undoubtedly make the 80-20 Rule even harder to achieve for Apple. So while the hypothesis of the 80-20 Rule was seemingly sound due to the initial pre-orders and subsequent early adopter participation for Apple Watches, the practicality of the hypothesis is found unachievable.

Moreover, "Apple's Watch Strategy Embraces The 80-20 Rule" discussed the Apple Watch bands. In this regard, the author was found to be accurate with his forecast and statements that follow:

Even though much attention has been given to the higher-quality watch bands, it would appear that the majority of people are opting for the sports bands. At least judging by pre-order data from Slice, there is tepid demand for higher-end watch bands made of metal and leather. The Milanese Loop would appear to be the best selling watch band out of the non-Sport options, which may give Apple confidence that consumers will value band innovation that moves away from traditional watch bands. The leather band options will likely remain quite niche. My Apple Watch observations would back these claims as I actually thought the sport bands were more comfortable and bold than some of the leather bands.

The higher end Watch bands have been a horrible product implementation for Apple. The consumer needs this added expense almost as much as they need the totality of the Watch accessory. For all intended Watch purposes, the consumer simply doesn't need the Watch that duplicates the function of the iPhone. Apple has had great difficulty selling through high-end watch bands, which can be identified more easily through Amazon.com watch band sales. The JETech 42mm Milanese Loop Stainless Steel Bracelet Strap Bands for Apple Watch 42mm All Models has been offered at the significantly reduced price of $19.99 for the last two months and inventory is still available for the product. Even through Amazon's "Deal of the Day" program, the product is found with plenty of inventory available at more than a 75% discount.

To serve as an update to my recent article that outlined how poorly Apple Watch sales have been since the heavily discounted period of Q4 2015, analysts have indicated the weakness in Apple Watch sales in kind. Fortune.com published an article this week titled " Apple Watch Sales Have Plummeted, Analyst Says." The Fortune.com article highlights ITG Investment Research senior analyst Matthew Goodman's considerations regarding Apple Watch sales.

Sales for the smartwatch during Apple's second fiscal quarter were down 40% compared to the company's fiscal first quarter ended December 26, ITG Investment Research senior analyst Matthew Goodman wrote to investors on Thursday. He added that if Apple had the same trouble globally as it did in the U.S., the company sold 3.1 million units worldwide during the period.

For research analysts Apple Watch sales are not hard to come by as I've demonstrated in previous articles. The notion that because Apple doesn't disclose Watch sales means nobody knows what the sale's trends happen to be is erroneous. Goodman's firm, ITG Investment Research, is able to gather point-of-sale and inventory data from Apple Watch sales around the nation and as such he added the following commentary regarding Apple Watch sales post the price reduction for the products recently:

According to Goodman, whose company uses proprietary data to track Apple Watch sales, the price cut was beneficial for Apple. In the first week following the price cut, U.S. sales doubled compared to the previous week, he cited in his note. However, Goodman added that sales declined to their earlier levels just a week later.

In short, Apple has found that even by lowering the price of the Apple Watch, the promotional strategy is finding advanced sales difficult to sustain. Given this anomaly, it is likely that the Watch sales are not just hindered by pricing but general usefulness. Hopefully, future iterations of the Watch will address sales and usefulness concerns. This hopefulness is mirrored by Goodman's long-term view of the Watch in the following statement:

Longer term we are more constructive as we think use cases and popularity for the Watch will grow meaningfully," Goodman wrote to investors.

Furthermore, ITG Research is not the only group recognizing weakness in Apple Watch sales. KGI forecasts Apple Watch shipments will fall 25% YOY and be below 7.5mm units vs. 10.6mm in 2015. All the warning signs were issued in Capital Ladder Advisory Group's Apple Watch disseminations over the last two months.

"The company cites two reasons for the forecast. First, that the wearable device market is still a fledgling one, not yet mature in terms of behavior. But KGI's Ming-Chi Kuo also believes the Watch itself falls short …

"Kuo argues that the device lacks killer applications as yet, and the form factor has room for improvement. He also believes that the limited battery life and reliance on the iPhone for functionality are holding back demand."

The Watch is just a minor piece of the total revenue and earnings pie that makes up Apple Inc. and investors are keenly awaiting the company's quarterly results. Apple Inc. will report Q2 2016 results on Tuesday. The average analyst estimate for Apple Inc. earnings is $2.00 on revenues of $51.97 billion for the quarter. It is important for investors to recognize that both the earnings estimates and revenue estimates for the Apple Inc. Q2 2016 period represent double-digit declines. Not exactly the powerhouse results of yesteryear for the company, even though the stock admittedly trades at a discount to its peers.

With the iPhone representing a significant portion of Apple's sales and earnings, the iPhone will greatly contribute to the company's quarterly results. Expectations for the iPhone are underwhelming as the product segment is expected to witness its first ever YOY declines. But again, it is important to pair this expectation with the year-ago period, where the iPhone 6 experienced pent up demand from Apple users who desired a larger screen size. The comparison is tough to compete with this year, and with possibly a limited iPhone 6SE audience for the Q2 2016 period. Another impediment to iPhone sales for the Q2 period likely came from Samsung's Galaxy S7 launch. Bloomberg reported that Samsung likely shipped some 9 million S7 units during the most recent period, which would have pressured sales for the iPhone.

It's not likely that iPad sales will help Apple's total sales results either, as this product segment has been in decline for the last eight quarters.

Working in favor for investor sentiment through the second quarter was the favorable gross margin guidance previously offered for the quarter by Apple. The midpoint of the company's gross margin guidance is roughly 39.5 percent. This guidance is pretty high for the company and if the USD remained relatively constant from the year-ago period, this could prove beneficial to Apple Inc. results in Q2 2016. But it remains to be seen.

There are and will be many ideas put forth for investing in shares of AAPL post the company reporting Q2 2016 results. Should shares of AAPL find themselves below $100, I will be considering acquiring shares myself. While I can easily acknowledge the current share price as seemingly undervalued, I also can understand the reason behind institutional ownership valuing the company this way. In kind, I think fellow Seeking Alpha contributor Michael Boyd states it best with the following:

Apple is a high-end consumer products company, and the company deservingly gets a discount to the market as a result. This is driven by the risk that underlies businesses currently earning high margins in expensive consumer goods. Other luxury peers have long been plagued by similar issues; Michael Kors (NYSE:KORS), Restoration Hardware (NYSE:RH), and many other high-end retailers all bear the same cross."

Consumer goods companies exhibit boom and bust cycles that seem to restrict certain classes of investors to maintain an investment in the category of consumer goods for extended periods of time. In a sense, consumer goods companies are only as good as the next product and total addressable market associated with that next product. The Watch was touted to be that next great product for Apple. Even as they have sold millions of Watches into retailers around the world, the replenishment cycle for the product will likely be underwhelming based on the proliferating sales from research analysts and discounting from Apple itself. Such sales reporting of the Watch, coupled with a desire from investors to find Apple with the next great product, has kept shares of AAPL underappreciated for some time now. With Apple Inc. reporting results and offering guidance this week, the company has the opportunity to either find its share price appreciating or depreciating further. Stay tuned to the after-hours session on Tuesday investors, as it will likely be a headline event when Apple Inc. reports.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.