by Clement Thibault
Apple Inc (NASDAQ:AAPL), which manufactures and sells mobile phones, personal computers and digital music players along with related software and accessories reports Q3 2016 earnings on Tuesday, July 26, after the market closes.
1. Revenue and earnings forecast
Apple's forecast for Q3 2016 EPS is $1.38, on $42.1B revenue. That's not a mistake, even though it does look quite a bit lower than what one generally expects from Apple.
Here's why: first, Q3 is traditionally Apple's weakest quarter each year. It's their mid-year slump when no product launches or big holidays are on tap to pump up sales. That's where Q1 comes in. In fact, annually, Q1 is the only quarter—since the company's infamous, 7-for-1 stock split in June 2014—that cracks $3 EPS, almost doubling the company's Q3 number every year. Also worth noting, a year ago analyst consensus for Apple's Q3 2016's EPS was $1.98. Since then, the Q3 forecast has been slashed yet further—by a whopping 30%. Third, even compared to last year's Q3, when Apple reported $1.85 EPS on $49B in revenue, this year's numbers are lower; EPS is down 25% while revenue is down 14%.
Making matters worse, Apple already saw a decline in EPS and revenue last quarter (Q2) year-over-year. It seems likely they'll repeat this unfortunate achievement again later today. The bar has been lowered by analyst consensus, in hopes that no unpleasant surprises will rain on the investor party. But of course, because it's Apple, even if the company merely meets expectations, investors will be disappointed.
2. iPhone sales lagging
The iPhone's importance to Apple as a company cannot be overstated. Currently, the iPhone represents 60% to 65% of Apple's revenue during any given quarter over the past year-and-a- half. This figure becomes increasingly significant because iPhone sales are slowing.
Last quarter, Apple posted its first ever decline in iPhone sales. Indeed, the iPhone 6s has been the first iPhone that did not surpass its predecessor in sales. Worse still, the Samsung (KS:005930) Galaxy S7, probably the strongest iPhone competitor (sometimes referred to as the 'iPhone killer'), has been selling extremely well—as of May 2016, Samsung accounted for 37% of smartphone sales in the US vs Apple's 29%, according to Kantar Worldpanel. And coming up from behind are Huawei, now in third place, followed by Xiaomi, each looking to increase their own market share in this space. The fact that Samsung's device is newly introduced might explain the delta in sales, however all of this should still be worrying news for Apple.
Looking ahead, the as-yet-to-be introduced iPhone 7 is likely to be a better seller than the iPhone 6s or iPhone 6. With an expected release date of September 16, rumor has it the iPhone 7 will have significantly improved camera technology, and a variety of memory storage tiers. Still, Apple is facing a conundrum.
On the one hand, it needs to release a smartphone every year in order to keep up with the competition. On the other hand, it doesn’t have enough innovation mojo to justify a jump in model number every single year, which is why it's been stuck in the every-other-year, pattern of faux releases, where an "S" model is 'introduced', a cosmetic way of pushing out a 'new' device.
Now that competitors have caught up and are keeping pace with Apple, consumers are beginning to see the "S" model for what it actually is—a revenue generating gap filler. It wouldn't be a surprise to see the iPhone 7s – should it become a reality next year – flop, in much the same way as the current iPhone 6s.
3. Focus on service segment growth
Obviously, Apple is aware of its iPhone problem. It's too savvy a company not to be. Additionally, sales of its iPads and Macs have also declined, by 19% YoY in the last quarter for the iPad, and 11% YoY for the Mac.
While the company figures out the answer to its hardware problem, AAPL has decided to focus on the software segment of its business, and for good reason. Apple has approximately 600 million users, most extremely loyal to its devices.
That means there are 600 million potential customers for additional services such as Apple Pay, Apple Music, and iCloud, to name just a few. Last quarter, revenue from services totaled $6B, or 12% of revenue. Of all Apple's business lines, this is without a doubt the segment to watch.
If Apple doesn’t manage to sell more iPhones, (or iPads or Macs) it can always sell related services, which could nicely compensate for loss of revenue from smartphones. This is a savvy business move for a variety of reasons. To begin with, it entwines customers more deeply into the Apple ecosystem, and for convenience sake makes it simpler for them to leave competitive alternatives they may have already grown accustomed to. Additionally, revenues from services are not a seasonal proposition, are less cyclical, and are far less dependent on a customer shelling out hundreds of dollars ever year or two. Finally, Apple has all the cash it needs to create said services in order to replace third party competitors. According to Credit Suisse, services will be AAPL's next growth engine and will more than double its relative share of revenue to 30% of the company's total revenue.
4. iPhone SE: cannibal or savior?
This past March, Apple introduced the iPhone SE, a smaller, 4-inch device which retails for approximate $399, well below the iPhone 6's price tag. The rational for the smaller phone was simple. It would appeal to users who prefer a smaller phone; Perhaps more important though, the price would help spur growth in developing markets such as India.
Unfortunately, the iPhone SE has been too successful, to the point where the flagship 6's sales have been cannibalized, hurting margins from the significantly more profitable iPhone 6s. However, with the Apple's recent focus on software, we see the iPhone SE enlarging an already massive base of users wishing to add APPL services to their devices.
Conclusion
iPhone generated growth will have to come to an end at some point. And that's okay. The market is already pricing in a slowdown in growth, which is why we have been seeing Apple's share price drop below $90, although the market quickly realized that level was about 10% too low and reclaimed the current level, about $98.
Right now, Apple is stuck with a weak iPhone 6s, and equally weak software offerings. Still, we believe soon enough, its luck—and product lineup—will change. With the right amount of pre-release hype, the iPhone 7 will give the stock a boost.
More significant perhaps, it will give Apple some breathing room and the time to develop and enlarge its ancillary software options, which will continue to grow even if the iPhone ultimately stagnates. We don't believe Apple will be able to replicate its once-in-a-generation trick of creating an entirely new market out of thin air. At least not under Tim Cook's (so far uninspiring) watch.
Still, with their global presence and reputation, widely recognized brand, mountains of cash, the soon-to-be released iPhone 7 on track and solid expected growth for its software division, we believe Apple—the company that continues to brandish the world's biggest market cap—has a good 30% upside at its current share price.