There really wasn't a whole lot that was new or insightful in Apple's (NASDAQ:AAPL) Q&A session, and I'm certain many of you have already read Apple's headline figures, so I won't bother with regurgitating those numbers.
The stock reported a great quarter, and from what I saw, there's a fairly strong possibility based on channel inventory commentary from Apple's management that the business will report phenomenal Q2'16 earnings as well.
Apple's outlook range was in-line with consensus estimates. So investors are pilling back into the AAPL trade with the stock up by 5% in Wednesday morning trade.
After everything people went through in January 2016, we've finally gotten ourselves over the big psychological hump. So, now that we've gotten ourselves past the hair-raising quarter, investors can finally sit back and get more comfortable (hence, we're seeing a massive relief rally, which I will explain in more detail later).
What are investors looking forward to?
Investors are buying in anticipation of Apple's 10-year anniversary iPhone. The average portfolio manager's investment timeframe is roughly 8-12 months, which makes AAPL perfectly suitable for an anticipation trade for a major product release cadence (even for the institutional types as well). I recall a Bloomberg report that mentioned retail investors were the primary participants in the mid-year to September rally.
So, by extension, it's likely the whales are just waking from their slumber and piling back into the AAPL trade (haven't we seen this before?) I mean, do you guys remember 2012 to 2013 where even the moron pundits on television were speculating that the stock would trade below $300?
Keep in mind, this was before the 7:1 stock split, and yes there was this options trader on a Comcast owned TV show that said something that ridiculous. I wish I could remember his name or find some footage so we could collectively laugh about it.
Why the massive rally?
Let's just borrow Hilary's campaign slogan, "when bears go low, the bulls go high!" Yep, that's basically what happened. So, now that we have lived through an "Apple first quarter," where Apple "built a wall" underneath the stock price, and reassured the Republic of Apple investors a better future, we can finally get on with our lives as some good folks "fat fingered" the buy switch this time around.
I mean, we can all agree that it's nice to feel comfortable, for once - right guys?
Fund manager surveys showed a reduced allocation to tech. So, fundamentals were there, but many were too afraid to approach Apple's Q1'17 volatility and were also confronted with opportunity cost.
Furthermore, the consensus was within the ballpark, but only after a series of revisions to earnings/sales estimate. The vast majority of sell-side analysts moved estimates lower throughout Q4'16. This was mostly driven by data on sell-through, retail inventory, and supply chain checks. So, everyone working at a buyside desk understood earnings results were going to be at the high-end of outlook, but weren't completely convinced given the 2016 drop.
In my prior article, I suggested a flat to slightly positive quarter. But I'm not going to lie. I started out with expectations of 10%-unit growth in September, but I had to readjust my expectations incrementally lower as the months went on. The data became less convincing as we moved nine weeks into Apple's FY'17 or CY Q4'16. Plus, the Trump effect exacerbated things, causing a swoon in the stock price. Once expectations reset, and Trump was viewed less negatively, the stock recovered.
I call this the Apple investor cycle. But, there's no reason to get pessimistic here.
Here's what's next
I believe Apple's management was conservative on its outlook. I make this point because of this key comment on the earnings conference call:
"Despite stronger demand than last year, we added only 1.2 million units of iPhone channel inventory across the quarter, significantly less than the increase of 3.3 million units a year ago. And we exited the quarter near the low end of our 5 to 7-week target channel inventory range." - Luca Maestri
OK, so what is he saying?
Remember, what made Q2'16 such a horrendous quarter was due to the sheer number of iPhone 6S units hanging around on shelves not being sold it was overstocked. Since Apple recognizes revenue when it sells into the wholesale retail channel, and not when customers buy the iPhone (excluding when Apple sells iPhones via its retail stores or website), the impact was exacerbated. This is because Apple could no longer sell into the wholesale channel (mainly mobile carriers). Because the carriers were having difficulty selling the phones that were shipped a couple months ago, they too had to wait for inventory to get leaner before we saw the usual stabilization of unit shipments by Q3' and Q4'results.
Hence, analysts were caught off guard because channel "overfill" is hard to measure because shelves are usually stocked by Q2 of Apple's fiscal year, as Apple's supply chain always catches up to demand once we get past the holiday quarter. So, the sell-side lost some visibility on the retail channel due to seasonality and underestimated the likelihood of units exiting the channel at an even slower pace.
So, when Apple mentions that it subtracted 2 million iPhones in the channel (compared to prior year), and yet shipments were up 5% y/y in Q1'17 - it means the next quarter will be significantly better. Q2'17 is not supply constrained, as AAPL's production capacity still sits at 75 million units from Q1'17 build-up. I'm anticipating demand will likely replicate the iPhone 6 cycle where q/q units were -18% versus -32% q/q for iPhone 6S. Inventory risk is significantly lower, so even if end-consumer demand were to fall short, we're not as exposed to "channel burn."
Perhaps results will be much better than what analysts are willing to forecast or what Apple will indicate, as I'm starting to view 64 million iPhone units as a reasonable baseline. And if Apple opts to keep an additional 2 million units out of Q2'17 then 61 million iPhone units seems attainable.
But then again… that brings me to the next point. Apple users don't know that the next iPhone is going to be "huuuge." So, consumers aren't going to hold back on purchases, as iPhone 8 isn't really on the radar, yet sources close to the supply chain know Apple's working on something big. Perhaps a breakthrough product, which is kind of funny. Apple's missing headphone jack is "actually" setting us up for Apple's next major design breakthrough, which is supposed to be thinner, better, and so forth.
The point is, Apple customers are buying the 7 because they expect the 7S to be a re-skin with better components. So, Apple's management decided to set us up with a half iPhone 8 versus the real iPhone 8.
So, the 7-cycle turned into the S-cycle, and the S-cycle is now the 8-cycle. Yet consumers don't recognize that fact yet. Way to switch the script!
Here's what was released by Michael Olson over at PiperJaffray (just this morning):
We believe most consumers are not aware of the potential for a more significant upgrade coming in the fall, due to the 10th anniversary of the device and will, therefore, not hold back on upgrading now. Specifically, nearly two-thirds of respondents in our survey of 1,000 U.S. iPhone owners were not aware that this year is the 10th anniversary of the iPhone; we believe awareness outside of the U.S. is even lower.
Furthermore, the earliest estimates I received (12AM and 4AM in the morning) for Q2'17 iPhone units, by Amit Daryanani from RBC Capital Markets, was conservative at 53.8 million units whereas Michael Olson forecasted 53.5 million units. This is tremendous, because it means there's room for analysts to move expectations higher without chasing investors out of the AAPL trade.
So, I'm working with a 61 million to 64 million iPhone unit range for Q2'17, which is way higher than sell-side expectations. However, I think it's certainly doable despite concerns over China, as I believe remaining geographic markets can offset weakness in China.
Furthermore, if I'm not mistaken, Apple reduced inventory in its Chinese channel, so maybe that picks up a little more as Apple can recapture that lost opportunity once we reach supply/demand balance in the upcoming quarter. Furthermore, the dollar has weakened to the RMB since the beginning of 2017, so pricing recapture won't be as big of a headwind. I'm confident Chinese customers will respond to lower pricing as the currency markets eases off the overcrowded RMB trade.
The Chinese Government is in full panic mode and is clamping down on currency outflows by regulating, reviewing and restricting large outbound cash transfers. So, there are some added structural drivers for an RMB rally over the next three-months thus making China a sleeper catalyst.
This quarter was set-up so perfectly for investors, and yet many have missed the boat. However, I believe that next quarter results will be more robust, hence markets are pricing in some meaningful upside to both revenue/earnings. Currency headwinds will likely diminish, consumer refresh seems on track for 5%-unit growth with some more room for upside if Chinese consumers re-emerge (which they most likely will).
But even beyond next quarter, the pent-up hype of the iPhone 8 will keep investors onboard this rally for a while longer.
I'm re-rating Apple from buy to high conviction buy. In an upcoming AAPL article I will assign a revised price target and offer a FY'18 estimate as well.
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