What drives those headphones matters
Cirrus Logic (NASDAQ:CRUS) is presenting a very interesting dilemma today. Both Apple (NASDAQ:AAPL) and Cirrus Logic reported earnings. Apple, for its part, gave out really terrible guidance for its next quarter. This guidance was even worse than the low end of my models previously indicated, and indicates volume losses are larger than expected. It's thus no surprise that AAPL is down 6.5% as I type this.
However, that's when surprises start. CRUS is actually up 9.0% on the same day that AAPL is down so much. Why is this a surprise? Well, AAPL is CRUS' largest customer - by far:
We had one end customer, Apple Inc. that purchased through multiple contract manufacturers and represented approximately 76 percent and 78 percent of the Company's total net sales for the third quarter of fiscal years 2016 and 2015, respectively. This same customer represented approximately 67 percent and 75 percent of the Company's total sales for the first nine months of fiscal years 2016 and 2015, respectively. Samsung Electronics represented 11 percent and 15 percent of the Company's total net sales for the third quarter and first nine months, respectively, of fiscal year 2006.
Source: CRUS 10-Q
So if CRUS' most important customer by far is issuing horrid guidance going forward, why is CRUS still able to react positively? Apparently, this is down to the market believing the bullish thesis remains valid even in light of the massive AAPL letdown.
The Bullish Thesis
So what's this bullish thesis on CRUS? It has to do with the iPhone 7 launch. Beyond just the fact that the iPhone 7 could rekindle Apple's fortunes, there's also a major change which the iPhone 7 is rumored to have.
The massive change is that Apple is supposedly going to do away with the headphone port. Instead, Apple is going to drive headphones through its lightning port.
Now think about what it might mean to CRUS:
- First, each iPhone 7 will need an onboard DAC (Digital-to-Analog Converter) and amplifier, if only to drive the internal speaker. This, of course, won't need the same specs as the previous CRUS DAC which needed to be able to drive high quality sound through the headphone port.
- Second, the lightning port is fully digital. Meaning, it outputs a digital signal. For you to use headphones with it, you'll need those headphones to have their own DAC and converter. So, the thinking goes, CRUS could have increased content on the iPhone 7 - since every pair of Apple headphones bundled with the iPhone will also need to have one such DAC.
Hence as the iPhone 7 nears, this speculation heats up. The thesis can more or less be summed up as "Apple is gaining further content on the iPhone, so units dropping is not a problem - since even a single chip adds up a further 33% more content, which exceeds the volume drop."
This thesis seems to ignore the fact that headphone content will not be in addition to present-day smartphone content. It will just be as a replacement for it. Which takes me to the bear thesis.
The Bearish Thesis
As I said, there are two theses in conflict. And the bearish thesis is quite powerful as well. Let me state it:
- First, the iPhone is seeing shrinkage - and unexpectedly large shrinkage at that. This is unmistakable: CRUS consensus estimates will be going lower over the months ahead. This is how they stand now:
Source: Yahoo Finance
- Second, the gain in content with the iPhone 7 is far from certain. CRUS already has 3 audio chips inside the iPhone 6s, which was something of a surprise. When the 7 launches, it likely will have a single internal audio DAC to handle its small internal speaker. Then, the headphones supplied with each iPhone also will have their own DAC. But think about it - the bundled headphones are rather weak and low-end. Perhaps AAPL will choose to drive them with a lower-end DAC as well - since the DAC in the headphones will no longer need to have the specs necessary to satisfactorily handle higher-end headphones if those are plugged in. This is so because those headphones, to be connected to the iPhone 7, will have to have their own DACs, and thus the higher-end componentry can be left to the headphone manufacturers!
Said another way. Up until the iPhone 6s, the DAC on each phone had to be good enough not just to drive Apple's weak earpods, but also high-end headphones. With the iPhone 7, however, that goes away - the DAC on the earpods can be a weak DAC, tailored just to those limited headphones. The high-end headphones (which won't come with each iPhone and won't necessarily have CRUS DACs) will then have their higher-end DACs. The iPhone 7 can thus go from higher-end DACs to lower-end DACs with lower costs to AAPL (and lower revenue and profits for CRUS, or even the loss of the "socket").
It should be said this is pretty evident - why would you have a high-end DAC inside the phone if you then have no way to put its analog output outside the phone? The answer, thus, is "you won't have it."
This is a large risk for CRUS. It is not just facing certain volume decline, but the iPhone 7 is also far from being a certainty when it comes to higher CRUS content.
Indeed, it's easy to see a scenario where only two low-end audio DACs will be used in the iPhone 7. This would be in place of the components which are in the iPhone 6s today and which are rated as being good enough to drive high-end headphones.
Given what I stated, between the certainty of CRUS' exposure to Apple, a larger-than-expected volume drop for the existing iPhones and the likelihood of the iPhone 7 actually having less/cheaper CRUS content, I believe the bearish thesis will have the upper hand.
This might also be seen as a cost-cutting effort by Apple. Each year, Apple is facing a higher BOM (bill-of-materials) for its iPhone models even as the base prices remain static. Apple, now faced with volume declines, might be very interested in restoring some margins through such moves. Unfortunately, CRUS would be at the wrong end of this move.
Disclosure: I am/we are short CRUS.
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.