Increasing Apple’s Fair Value Estimate, But Shares Fully Priced

Perhaps the biggest near-term blemish in Apple’s report was its disclosure that Apple Watch gross margins are below its corporate average. We, and likely many others, projected the opposite. Apple’s near-term gross margins, and the contribution--or lack thereof--from the Watch, bear watching. We suspect that dismal Watch margins are a short-term issue, as Apple and its manufacturing partners face a production learning curve, and we still project healthy long-term gross margin and earnings accretion from the Watch over time.

We maintain Apple's narrow economic moat rating, but we expect to raise our fair value estimate to $140 per share shortly. We view shares as relatively fully valued.

Apple sold 61 million iPhones in the March quarter, slightly ahead of our above-consensus expectations. Sales in emerging markets were the bright spot, with China up over 70% from the year-ago quarter, while many other emerging markets saw iPhone sales growth of 80% or more. Average iPhone selling prices of $659 remained stellar, up 11% from a year ago, thanks to a richer mix of models with larger screens and/or increased storage. Strong iPhone unit sales and pricing helped Apple’s gross margins expand by 90 basis points, to 40.8%, despite currency headwinds from a strong U.S. dollar.

Apple expects June quarterly revenue in the range of $46 billion to $48 billion, which implies 23% to 28% year-on-year growth. The Watch will likely be the biggest growth contributor, but we project iPhone revenue to rise by a mid-teens percentage from a year ago. Gross margin guidance of 39% was disappointing, due to the Watch and other factors, but Apple has routinely exceeded its forecast in past quarters. We don’t foresee a sudden step down in profitability over time.

We estimate that Apple’s revenue forecast implies Watch revenue of about $4.1 billion in the June quarter, based on 5 million units shipped at a $750 average selling price, or ASP, and additional revenue from Watch band sales. We view Apple Watch as a clear early adopter product today, and we view a variety of Watch product reviews as falling in line with a device that most people can either live without, or wait for an improved version to be launched in the future. That said, in our view, Apple Watch reviews have been encouraging thus far, and we think the device has a good chance to make it to the wrists of tens of millions of mainstream users over the next few years, especially as the apps ecosystem and use cases for the product take shape over time. We maintain our view that the Watch will make up a high-single digit percentage component of Apple's revenue and gross margin dollars in the long-run.

The long-term iPhone story remains encouraging. Apple believes it is seeing a higher rate of people switching to iOS from Android than in years past, while still attracting many first-time smartphone buyers in emerging markets. Apple believes it is not only supplying the upper class in China, but the middle class as well. This bodes well for the size of Apple’s potential customer base over time. Ultimately, these emerging market sales aren’t being driven by switching costs around iOS, which we view as Apple’s primary sustainable competitive advantage, and source of its narrow economic moat. Instead, sales might be thriving due to less sustainable factors, such expanded distribution (mainly with China Mobile), brand image (which we view as fleeting in the long-term, as brands in tech are often unable to overcome technological inferiority), and a preference toward larger-screen phones. However, such outstanding iPhone growth rates simply can’t occur without the firm still making repeat iPhone sales to current and prior iOS customers, and we remain confident that Apple can use its variety of software, services and compatible hardware to retain a good portion of these first-time emerging market customers as well. Our narrow economic moat and positive moat trend rating remain intact.

Our new, higher fair value estimate--to $140 per share from $120--stems from three areas. First, we will lower our cost of equity for Apple to 9% from 10%. Our change in methodology is based on our expectations for lower inflation in the long-run and to better align with returns that equity investors are likely to demand over the long term. This change results in a roughly $10 boost to our fair value estimate. Second, we will raise our estimates for long-term Apple earnings growth beyond our explicit five-year forecast period, boosting our fair value by $5, as we have greater confidence in incremental earnings growth from the Watch, and perhaps new products in the pipeline, such as streaming television, and even possibly an Apple Car or enhanced CarPlay product.

The final $5 increase to our fair value estimate comes from improved long-term gross margin assumptions for Apple, mostly stemming from Watch sales, as we still believe this product will be gross margin-accretive in the long run. While this view contrasts with Apple’s near-term gross margin forecast of 39%, we should note that Apple has beat its guidance by at least 180 basis points in four of the last five quarters, so the firm’s 39% forecast could easily be conservative. More importantly, we view the combination of both the almost-instant pushout of Apple Watch deliveries into June, and the firm’s expected gross margin dip, as signs that the firm and its manufacturing partners are facing a bit of a learning curve. We were disappointed that Apple did not set the record straight whether future Watch margins would or would not exceed the company’s corporate average. We’re giving Apple a pass for now, and we anticipate substantial margin improvement from what we think is implied in the company’s near-term forecast.

We have two other theories on the subpar Watch gross margin guidance. First, while Apple Watch bands are likely high-margin accessories and should contribute to revenue over time, customers might not be preordering these bands right away, opting instead to own a single band that comes with their purchase. In contrast, protective cases, car chargers, or other iPhone accessories might be more likely to be bought at the time of the device sale. Second, in recent years, Apple’s new iPhone and iPad launches have feasted on the preferences of early adopters to buy devices with the most available storage. These step-ups in price to higher-storage models are extremely margin-accretive, with this year’s iPhone 6 and 6 Plus launch as a prime example. In contrast, the Watch carries no such upgrade for storage, and doesn’t have the same benefit of such a relatively effortless margin boost.

We view other data points from Apple as par for the near-term course. iPad unit sales fell short of our expectations, but given the iPad's margin profile far below the corporate average, cannibalization by larger-screen iPhones remains a welcomed trade-off. Mac continues to gain share within the struggling PC space, with sales in China up 31% from a year-ago, perhaps leading to higher iOS switching costs among affluent emerging-market customers as well. Finally, Apple raised its dividend 11% and added $50 billion to its buyback program, both of which were relatively in line with our expectations. In our view, Apple continues to do a commendable job of distributing excess cash to shareholders.

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