Apple: Channel Inventory Analysis Suggests Upside For Unit Shipments

| About: Apple Inc. (AAPL)


Apple supply chain commentary from Luca Maestri implies iPhone units of 54.69 million with some upside in the form of China channel sell-in.

The Q1’17 extra week is less pertinent as comparison of inventory burn and build-up to 2H’17 Chinese demand recovery is more indicative.

Upon quantifying price elasticity, unit acceleration in China paired with initial expectations on shipments I believe there’s 5.7% sales upside to consensus.

Higher iPhone unit mix-shift contributes to margins. Hence I’m anticipating earnings to beat consensus by 8%.

Strength in Q2’17 will translate into diminished dependence on the iPhone 8 cycle, which is overall supportive of the interim rally in shares.

Following my prior Apple (NASDAQ:AAPL) analysis I wanted to provide more clarity on the Apple iPhone inventory situation and why it will contribute to an "earnings beat" in the next quarter.

Some of the readers on Seeking Alpha astutely commented on the extra week in CY'16 Q4 diminishing Q1'17 by a week.

The counter-argument waged by capsandiego is interesting, but I believe I have a deep enough read on the situation to gain conviction in my argument over the prevailing investor view.

So, I wanted to quantify inventory commentary inclusive of "the extra week."

The impact of 13 weeks in FY'Q1'17 versus FY'Q2'17 12 weeks, which compares to a 13-week FY'Q1'16.

So, Q2'16 was a 13-week quarter. Within that quarter the company still delivered results that were mind bogglingly weak. This was driven by supply-chain overbuild as Apple sold too many iPhones into the channel in Q4'15 and that it had to burn more inventory in the next quarter. CFO Luca Maestri mentioned in his Q1'16 earnings call transcript, "we were able to exit the quarter slightly above the low-end of our target range of five-to-seven weeks of iPhone channel inventory."

Basically, by the end of Q1'16 they had five weeks of channel inventory at the end of the quarter, which is the CFO's primary forward looking indicator, because if he forecasts the inventory figures incorrectly (which he did) we then end up with what occurs in the following quarter. Where he mentions, "It was a particularly challenging comparison to the record quarter a year ago, when iPhone sales grew 40%, as we entered last March quarter in supply/demand imbalance, which was recovered during the quarter. Also, this year we reduced channel inventory by 450,000 units while we increased inventory by 1 million units a year ago."

When Apple exited Q2'16, the management team mentioned that an added inventory reduction of $2 billion would be a Q3'16 headwind. So, what does this all translate into? Well, Apple sold 61.7 million iPhones in Q1'16 and 51.191 million iPhone units in Q2'16 after reporting a 500k unit reduction in the channel and mentioned that it exited at a low end of inventory with five weeks.

However, it was estimated that the extra week in the next quarter would offset some of the weakness in demand. So, Apple filled the channel with approximately 31.57 million iPhone units. We then transition into the next quarter, where sell-through was lower than expectations, so inventory in the channel exited at 19.68 million units (even after factoring the extra week). End-consumer demand was 51.2 million units (subtract ending inventory of Q1'16 with ending inventory of Q2'16 and we arrive at a 10-million-unit reduction in channel inventory over the quarter.

OK, so I'm hoping you're following the logic here. But Apple yet again mentioned that they had exited Q1'17 with five weeks of inventory in the channel. So, we must do the math again to find out what they're implying in terms of inventory reduction. But, basically, they stated that they only added 1.2 million iPhone units into the channel and exited Q1'17 with roughly 32.62 million units in the channel. They then guided to roughly 53 million iPhone shipments at high-end of the outlook range, and assuming five weeks of inventory (yet again) this implies 22.08 million units of inventory exiting Q2'17, which means end-consumer demand is roughly 54.69 million units when using the high-end of outlook.

Now, on strengthening end-market demand, Apple indicated inventory burn of 10.54 million units over the quarter, which is roughly 540k units higher than prior year. Some of the sell-side analysts have already added in half a million extra units to Q3'17 versus Q3'16 comps. But I'm kind of skeptical of this because, I don't think Apple forecasted demand correctly going into the next quarter because they had mentioned a 2-million-unit reduction versus prior-year, so I'm expecting Apple to add inventory to the channel right at the end of the quarter (above the implied 54.69 million units) in response to better than expected Chinese demand, which will force them to build upwards momentum in inventory. We're seeing some indications of this as order commitments are up 16% according to UBS analyst Steven Milunovich.

The analysis from Katy Huberty at Morgan Stanley indicates 0% constant currency growth on a $5 ASP increase in China. This means unit shipments remained flat y/y in China or perhaps down by 1% y/y. Somewhere in that range, but given recent F/X trends the USD/CNH has declined 1.7% since the beginning of January. And assuming the downtrend continues, the currency market is trending toward an approximately 4% decline over the quarter with the USD/CNH trading at appx. 6.50 to 6.60. Now, obviously, the key is the likely 4% reduction in price points in Mainland China, which gets affected by a 2.0 PED (price elasticity of demand) factor, implying 8% incremental unit demand from a modest price reduction in the quarter.

Given the Chinese segment alone is expected to compose 20% of unit shipments over the quarter, Apple will likely readjust the channel to reflect perhaps 8%-unit comp strength, or roughly 1 million extra units from price sensitivity alone.

I then anticipate a similar y/y unit trajectory between Q3'16 to Q4'16 as Apple sold in fewer iPhone units into the Chinese channel in general, which gives us room to anticipate 18% y/y unit comp improvement of which 8% is driven by price sensitivity. So, I'm anticipating something to the effect of a 2.9 million unit contribution from the Chinese segment on top of implied guidance, which suggests something to the effect of 57.59 million units. There may be some more variance to this, but in general I'm assuming a scenario where Apple will deliver decent upside surprise on units/currencies alone.

When I wrote my initial analysis, I was expecting unit comp deceleration at the mid-point between the iPhone 6/6S-cycle. But, upon including the impact of China and quantifying management commentary, I'm reducing my iPhone shipment estimate from 58.7 million to 57.59 million units.

This translates into a $771 million revenue reduction and $.02 EPS reduction to my initial Q2'17 estimate. Going into the next quarter, I'm now anticipating revenue of $55.9 billion and EPS of $2.18.

This is still much higher than conservative expectations of $52.84 billion sales and $2.02 EPS. But, the degree to which I'm expecting Apple to beat estimates is inline with Apple's historical blow outs as I'm anticipating a revenue beat of 5.7% and EPS beat of 7.9%.

Taken together investors can anticipate some upside to the outlook, and analysts have already conservatively modeled right below the high-end of Apple's implied outlook range. This further suggests investors can participate in Apple shares without worry over next quarter results as earnings-fueled buying will be more supportive over the duration of CY 2017, which is in stark contrast to prior year. This is before becoming entirely dependent on major iPhone hardware refresh.

As such, I continue to reiterate my high conviction buy recommendation on Apple.

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