Recently, Apple (NASDAQ: AAPL) announced a new record for opening weekend sales of iPhone – 9 million units were sold globally, with most versions of the new iPhone 5s sold out by Saturday.
The 5c is basically last year's iPhone 5 dressed up in bright plastic and moved down US$100 in price. The 5s is this year's new model featuring a new A7 processor and the TouchID fingerprint sensor.
Additionally, Reuters reports:
Apple tweaked its financial forecast to reflect the higher sales, an unusual move for the company… It said gross profit margin would come in at the top of its previous forecast of 36 percent to 37 percent.
Finally, the adoption rate of the new iOS 7 is phenomenal – over 32% of users upgraded in just 48 hours. Now it is over 50%. For comparison, Android OS from Google (NASDAQ: GOOG) version "Jelly Bean," released 14 months ago, is still running on only 45% of Android devices.
Why the year-long price contraction?
The simple answer is contracting margins. A more elaborate answer is more complex. To begin with, we should note the company's recent earnings history.
In Apple's most recent earnings release (July), while revenue increased slightly year-over-year, income fell sharply – almost US$2 per share to US$7.47. Margins fell from 42.8% to 36.9%. However, surprisingly strong iPhone sales reported in July (31.2 million) gave a lift to the company's stock, driving it up over US$500 before it slipped back to US$450. It has since recovered to the US$490 range.
Driving this are two investor fears:
1. Apple no longer innovates.
2. Competition from Google's Android and Microsoft's Windows Phone 8 from Microsoft (NASDAQ: MSFT) drives prices and margins down.
Both of these have just been proven false.
For point No. 1: the 5s is seen as being very innovative. The new A7 processor has jumped to 64-bit processing, a move no one expected. The 5s is the first and only smartphone with a 64-bit processor.
Reuters continues (referring to:
Daniel Ernst, an analyst with Hudson Square Research, said iPhone sales show Apple still has a deep connection with its customers. "The critics have told you Apple lost its magic," he said. "Customers are telling you something very different."
On point No. 2: Google's Android has taken over the low end of the smartphone spectrum. That move has pushed the operating system to almost 80% world wide share. Even Microsoft's Windows Phone 8 has grown, moving to 4% globally. Nokia's Lumia line has been very popular.
This has not changed iPhone prices, however. The 5s was added at the same price as previous flagship models, and the 5c did not drop below the usual price of US$99 (with contract), which is something that many were looking to see. While this does not completely address falling margins, it does show that we are not seeing a pell-mell race to the bottom.
It should be noted that BOM costs of new models has risen slightly over the years, while price has remained constant. According to iSuppli, the 4s model cost about US$188 to build, but last year's iPhone 5 cost US$198. With the addition of a totally new component – the TouchID fingerprint reader – the 5s cost is still only US$199.
The real reason for dropping margins is the increasing mix of lower priced units. In July's earnings report and conference call, it was said that older iPhone models were making a higher proportion of the mix than expected. Additionally, the popularity of the iPad Mini lowered the overall margin mix. The iPhone 5c has met this challenge by using a plastic casing, saving US$42 per unit.
Apple is celebrating – and should be. The response to the new iPhone 5s is spectacular. It's clear that – in spite of what pundits and detractors say – Apple still knows how to innovate.
Additionally, we can look forward to a new iPads soon. Most likely they will include the new TouchID , but probably only on the full-sized models. This will be a strong differentiator, pulling up the ASP for that product line.
Still, there must be continued concern for margins. To me it is likely that the change in product mix has evened out to some degree. The lower-priced older products, and the iPad Mini, have begun to stabilise as a percentage of units sold.
Overall, things are looking positive. The year-long slump may be over. Factors that indicate this include:
- Apple is repurchasing
- Carl Icahn is purchasing
- New iPhones are well designed
- iPhone release was spectacular
- iOS 7 upgrade is spectacular
- Margins appear to be stabilising
Overall, the perceptions of Apple in the investment community are high. Surely, baring some unforeseen disaster, the company's stock price will soon push over the US$500 mark. I think that by the end of the year it will be at US$600, and a good end of the year quarter will send it back over US$700. (assuming Congress resolves the budget crisis!)
To get over US$700 will take a good holiday quarter. I think that we can extrapolate from the opening weekend's sales-about 80% over the iPhone 5 intro.
If we half that to plus 40% on iPhones, and figure roughly the same for iPads, but not so well for other lines, then this gives us a 24% earnings per share growth year-over-year. If we project that ahead over the trailing twelve months EPS of US$40.11 then we get almost US$50. At the new level of growth, the price-to-earnings ratio should rise somewhat to 14, and this would give us US$700.
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A version of this article, written by Malcolm Manness, originally appeared on fool.com.