Market Too Pessimistic on Apple

Brian Colello: Thanks for having me.

Glaser: So, let's start with those capital structure changes. They announced a pretty big increase to their stock-buyback program and increase to the dividend. What's your thinking behind these moves, and is the way they're going execute it something you think is going to add value for shareholders?

Colello: So they expanded the buyback. It was originally $10 billion and they upped to $60 billion. They said it was the largest buyback plan in U.S. history. We probably believe that. They increased their dividend by 15% and in between product cycles, because they launched a lot of new products in the December quarter, and there hasn't been any new refreshes. I think the big issue on investors' minds has been capital allocation and how do they put that cash to use.

The issue that Apple always has is they have $145 a share in cash, $99 of it is overseas. It can't be used for dividends or buybacks until they bring it back to the U.S. and pay repatriation taxes, which is probably an extra 30% haircut you would have to take. Instead, it looks like Apple will take on debt at probably really low rates, priced at something like 3%, probably less, in order to bring more cash into the U.S. to fund dividends, to fund the buyback.

So, the $60 billion plan, I think it's a good move because we think the stock is cheaper and are encouraged that Apple thinks the stock is cheap, too. I think it's been received positively by investors thus far. I also think it adds flexibility. If you were to go the other way and expand the dividend, rightly or wrongly, there is probably a perception that if you are a high dividend payer, that you can no longer innovate, you don't have good places for your cash. With the buyback, I think, it gets rid of that perception, and it's also more flexible. If something were to come along in terms of a big acquisition target, that's not necessarily what Apple does, but if something were to come along, Apple has a little more flexibility with the buyback. And with the stock being as cheap as we think it is, we think it's a good use of capital.

Glaser: Let’s take a look at the iPhone; it's one of the biggest drivers of the company still. Did we find out anything about kind of that mix of what kind of iPhones they’re selling. Before you were worried that they were selling more of the lower-end iPhones versus the higher-end. Any color on that in the quarter?

Colello: Sure. Just to start by going back to the forecast from January, which was obviously a disappointing forecast for the March quarter; it showed a sharp deceleration in iPhone sales. They sold 47.8 million units in the December quarter. If you look back to the 4S launch a year prior, they sold 37 million in the December quarter. They followed up with 35 million in the March quarter, so almost no drop-off at all.

So part of why the January quarter was so disappointing is now you have a much sharper fall-off from 47 million down to 37 million. Results came in, I think, at 37.4 million units, so basically in line with our expectations. Also concerning talk back from January was sellouts of the iPhone 4, and you saw more of a mix toward the older, cheaper models, which is something we think is inevitable in the long term as they sell in emerging markets. But I think it's happening a little more quickly than anticipated.

It happened this quarter. ASPs, average selling prices, fell 4% sequentially. So you did see a less favorable mix shift toward the older models, like the iPhone 4 and 4S, relative to the 5. So, in short, in March results came in in line with expectations. The real big concern is the June quarter forecast and what's implied in there.

Glaser: So is this a sign that the iPhone 5 just wasn’t as popular as the 4S, just didn’t resonate with consumers as well?

Colello: I think there is a bit of that. I think the biggest issue with Apple probably over the past six months is, they are still in the mode of attracting new customers to the platform. Obviously, they sell repeats to older 3GS and 4 customers, but the majority of smartphone buyers today, especially in the high end, we think are previous owners of feature phones, of older BlackBerrys, older Nokia models, older Droids, and so we think that's the target market. Those are the people that are buying phones today, and then internationally in emerging markets you have a lot of first-time smartphone buyers.

So, it's harder and harder to get those incremental new customers, because it’s either late adopters in developed markets or customers in emerging markets. They are little more price-sensitive. So we think that's why you're seeing the negative mix shift toward the older models in the near term.

Glaser: What did the iPhone forecast look like then for next quarter?

Colello: Sure. Well, the forecast is probably the big negative, and I think the stock is down as we speak, and that was a big driver of that. Revenue was $34.5 billion in total. I think Wall Street was looking for $39 billion. So a big miss there, and we think that investors would've been willing to give Apple a pass if a new iPhone is coming in the summer months. We've looked at some data points, and some chip customers say that Apple's going through their transition earlier than last year. So, we thought a summer one is on the way. Tim Cook clearly said on the earnings call that it's coming in the fall, "Exciting new products are coming in the fall of 2014." So, that runs a bit contrary to what we’ve seen, and that was disappointing.

If you looked at the after-hours trading [on April 23, after the earnings release], the stock was up 5% on the buyback news, but it came all the way back right after he made that announcement. So that's a clear negative. So that outlook, if there is no summer iPhone 5S, that is a weak forecast. It implies something like probably 27 million iPhone units sold, something in that range, which would actually be almost no growth from the year-ago quarter. So again, another sharper-than-expected deceleration in iPhone sales from March to June. And part of it, I think, goes back to your earlier question that maybe the iPhone 5 isn't resonating with as many customers as you would've expected. It's still doing well, but probably not as well as what we would have expected six months ago. So, the outlook is a bit of a concern.

We'll know more probably in a couple months. Again, if an iPhone is on the way [in the summer], it’s more understandable. If an iPhone doesn't come until late September, then this is a pretty poor outlook. It shows no growth, and it is a bit of a concern. Again, struggling or becoming more difficult to attract first-time smartphone buyers.

Glaser: So, if the iPhone launch is delayed into the fall, what does that mean for Apple's competitive position? Are they going to be able to sell much older iPhone 5s against things like this new Galaxy S4 from Samsung or the HTC One?

Colello: Exactly. Again, the iPhone 4S launched in fall of 2011, The first new phone came to Verizon, Sprint in the U.S., AT&T, a lot of customers on two-year contracts. So, we think those customers will start to come up for renewal in this summer. So, if you get to July, August, September, these customers are going to be faced with either buying a nine-month old iPhone 5, or waiting for the next model, or potentially buying one of those brand-new, relatively newer bigger-screen Samsung Galaxy S4s or HTC Ones.

So, in our view, we think Apple has a narrow moat. We think there are switching costs around the iOS platform. All of the positive data points we hear about Apple and the iPhone relate to customer satisfaction, happiness with the ecosystem, more data usage. In general, just better customer loyalty to the iPhone relative to Android and everything else. If an iPhone isn't here in the summer, and that's the decision that customers face, that's going to be put to the test really quickly for probably tens of millions of customers.

It's not the entire Apple story. They will still be selling to new customers and everything else. We think a good portion of customers will stay, but certainly we think they'll stay even more if there was a brand new iPhone on the way, rather than having to wait a couple of months. Apple would run the risk of potentially losing some customers elsewhere, and that's where our thesis on switching costs, again we think Apple will retain most customers, but we certainly don't want to see that test to the point where it's an old stale phone versus newer Android models. It’d certainly be an easier chance to retain customers if a new iPhone were here.

Glaser: Turning to some of the other products, was there anything surprising to you in the iPad or Mac business in the quarter? 

Colello: iPad sales were a little ahead of our expectations, though it sounds like they sold more into the sales channel, so not necessarily through to end customers. So iPad units were a little higher than expected, but if you make the inventory adjustments, it's about even. Mac was a little bit worse, but really not a surprise given a very dismal PC environment. They had some catch-up from the December quarter. They were unable to fulfill demand for the iMac and some of those problems.

So, iPads and Mac, in general, net-net kind of evened out, and even for the June quarter probably similar. We did see a negative mix toward the iPad mini again, plus favorable average selling prices, people buying the lower-priced product. We think that will continue in June, as well. We think that mix shift was maybe a little more than what Apple anticipated initially, but it's still a good move, because we think people are buying these devices rather than Kindle Fires, rather than cheaper Android devices. So, as long as they keep people within the Apple ecosystem, and especially if it drives more iPhone sales, so it's not going to be readily available. But if it keeps iPhone sales honest and relatively strong in the long term, because people want the ecosystem and want to tie it back to their iPad, the mini we think it's still a long-term positive based on that.

Glaser: So with that mix toward lower selling prices, what does that mean for gross margins, and what are your expectations on where margins are going to go?

Colello: Gross margins came in at the low end of their range for the March quarter, and [are forecast to be] even lower again for the June quarter. Again, as these products age, you are getting late adopters in every market where there's a launch, and so for that reason people tend to buy the lower-priced phones. So you are going to get a negative mix shift, especially when you have lower sales levels plus people buying the older products, the cheaper products, that will lead to the gross margin declines.

Inevitably, we think margins will decline in the long-term again as they start selling more iPhones into emerging markets, as the iPad mix probably goes toward cheaper models, and again, they sell the iPads more in emerging markets, as well. IPad is still much more of an early-adopter, developed-markets sort of product right now, so that's still in the earlier innings. But eventually once you get to emerging markets, the prices are going to decline, margins will decline. We factor that in. We think the stock bakes in an overly pessimistic scenario at that point. But even with our fair value estimate, we think there will be margin compression, and obviously it's just a matter of how much.

Glaser: So you're sticking with your current fair value estimate. What does that mean in terms of how attractive you think shares are today?

Colello: Yeah, we are sticking with the fair value estimate. We do think the stock is still cheap. With the stock trading at $400, we really think that implies that the market is telling you that iPhone unit sales are basically going to be flattish in the long term, that they're going to see no growth, even though the smartphone market is booming, even though Apple still has a chance to strike a deal with China Mobile and NTT DoCoMo, so they're even in China's largest carrier yet. That growth is being discounted--the market implies that they're going to lose a lot of share elsewhere; we disagree with that. So, at $400, there's a pretty pessimistic scenario for the iPhone baked into that stock price, and we think it's a little too early to make that call, and so we like the risk/reward trade-off.

Glaser: Brian, thanks for talking with me today.

Colello: Thanks for having me.

Glaser: For Morningstar, I’m Jeremy Glaser.