A 'Refreshing' Exit For Apple's iPhone Channel Inventory

| About: Apple Inc. (AAPL)

Summary

AAPL draw-down of over 4M iPhone units from its channel inventory was the largest draw-down (by-far) in the product's history.

The iPhone SE enabled the company to drain the channel of significantly more iPhone 6S and 6S+ units than it previously projected.

The iPhone channel inventory level and mix exiting FQ2-2016 sets up a favorable quarter with the expected product refresh in September.

In a previous article following Apple's (NASDAQ:AAPL) fiscal Q2, I estimated that the company would need to draw down its channel inventory by around 2.5 million iPhone units in order to meet the $2 billion channel inventory draw down (across all product lines) that the company projected on its FQ2-2016 earnings call.

That 2.5 million units turned out to be significantly less than the actual number of iPhone units (4.0 million units) that AAPL cleared from the channel in FQ3-2016. My 2.5 million unit estimate was significantly off for a couple reasons (the latter being the most significant):

  • I projected iPhone channel inventory draw down based on an ASP of $640, which turned out to be $45 higher than the actual ASP of $595 - a factor of both forex and a strong mix of the SE model.
  • Actual channel inventories were reduced by $3.6 billion (across all product lines) compared to the projected $2.0 billion, of which the majority the company said was related to the iPhone.

Performance within the iPhone product line:

To understand the full dynamics of the unprecedented iPhone channel inventory draw-down, it's first important to look at how the various models performed:

  • The iPhone SE: The iPhone SE's popularity was underestimated by the company, but it was able to adjust production to satisfy demand. AAPL stated that the iPhone SE was in short-supply for basically the entire quarter, although it was in supply-demand balance by quarter's end. This popularity also was seen in the $65 y-o-y drop in ASP, of which $20 was attributed to forex.
  • The iPhone 6S and 6S+ underwhelmed: It is not a "shocker," but the 6S and 6S+ has not sold as well as expected, which was no more evident than in Tim Cook's response to a question about the upgrade cycle on the earnings call:

...the iPhone upgrade rate for the iPhone 6S is very similar to the iPhone 5S. And I guess in retrospect, maybe that was a predictable thing, although we didn't predict it in the beginning. (Emphasis added)

How iPhone product performance factored into the massive channel inventory drain:

Simply put, the iPhone SE played a major role in AAPL's quarter in a couple of ways:

  • Demand stimulus: It helped AAPL hit the high-end of its revenue guide by creating a new demand stimulus for the product category that makes up the majority of the company's revenue.
  • Unit volume target: Although AAPL states it does not manage to The Street, it is widely-known that The Street puts extreme scrutiny on iPhone shipment volumes, not ASP. The iPhone SE enabled AAPL to not only hit unit shipment expectations, but it also helped it drain significantly more 6S and 6S+ units from the channel than it had projected. AAPL stated on its earnings call that the 4 million unit channel draw-down was of the "higher-end" iPhones, which one could logically infer were 6S and 6S+ units.

Implications for FQ4 and the iPhone 7:

While it might be easy to assume that the strong iPhone SE performance was a one-time benefit, it will certainly factor into the current quarter's performance (FQ4-2016), which is expected to include a product refresh (the "iPhone 7"):

  • Low-end of target channel inventory: By enabling AAPL to clear the channel of 4 million iPhone 6S and 6S+ models, the company exited the quarter in a favorable position as shown by Cook's response to a question on the earnings call about iPhone channel inventory:

...we were able to end basically right at the bottom end of our range and we view that as a good thing, not a bad thing. Obviously the revenues could have been much higher if we would have expanded the channel, but if you don't need to do that, that's not how we think about the business. (Emphasis Added)

  • Model composition of channel inventory: In FQ2-15, the company drew down 1 million iPhone units in advance of the 6S / 6S+ refresh in Sept-2015 and also exited at the low-end of the 5-7 week forward-looking channel inventory target. What is different about this year's channel inventory is that the mix is likely much more favorable for the product refresh. As the SE was in supply-demand balance by quarter's end, you would have to assume that the channel inventory is far more favorable with a 'healthier' mix of SE units combined with a substantially reduced amount of 6S / 6S+ units.

AAPL has positioned itself, via the unexpected success of the SE, to unburden itself from excess 6S and 6S+ units heading into the expected product refresh in September. FQ2-2016 was a positive quarter for AAPL on a number of levels, but one of the most significant and least discussed was its ability to clear the channel of a couple million more units of the underwhelming 6S and 6S+ than it had originally projected.

I believe Cook's uncharacteristic commentary about a specific product's channel inventory during his "prepared remarks" to open the earnings call underlies the optimism that was recaptured during FQ2-2016:

iPhone accounted for the vast majority of the channel inventory reduction. iPhone unit sell-through was down just 8% year on year, an even greater improvement over the March quarter than we predicted, and we expect the September quarter sell-through comparison to improve further. We feel good about our channel inventory levels and believe they position us well for the months ahead. (Emphasis Added.)

Disclosure: I am/we are long AAPL.

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.