iPhone Upgrade Cycle Risk At Apple (AAPL)

In the last fiscal year the iPhone accounted for 55.8% of Apple’s (AAPL) revenue. Now, more than ever, Apple is heavily dependent on the success of the iPhone. So what would the bear case be for Apple? With Apple’s great design team and interlocking software ecosystem (iTunes, iCloud, Apple Watch, AppleTV, etc) there is unlikely to be a mass migration away from Apple towards a better product like the exodus that led to the downfall of Research in Motion (now Blackberry). Instead, I believe the answer may be a bit more insidious and come from within.

Right now mobile users upgrade their phones about every two years. Wear and tear from life, batteries beginning to lose their ability to hold a charge, and improvements in hardware and software lead users to want to upgrade. The two year upgrade cycle on phone contracts provides a convenient timeline. However, carriers are beginning to move away from defined upgrade cycles and from subsidizing phone upgrades. T-mobile has ceased subsidizing phones and both AT&T and Verizon offer discounts to those who own their own phones.

But what happens if the upgrade cycle begins to stretch out? I wouldn’t be unheard of; the PC industry has experienced the same issues. When PCs first became widespread the demands of new software and rapid increases in the capability of hardware made frequent upgrades necessary. Now the need for frequent upgrades has slowed. In fact, I do most of my work on computers that are not any newer then 4 years old. Indeed, prior to the great recession the average age of PCs had creeped up to 6.3. Microsoft’s decision to stop support for XP has likely played a large role in driving down the average age to 5 years.

What happens if phone batteries start lasting longer or innovation in hardware and software begins to slow? How would that effect the phone upgrade cycle and more importantly how would that affect the value of Apple stock?

Let’s dig into the financials to find out and build a model to find out.

If we assume that iPhones are replaced on average every two years we can then estimate the installed base. In FY2014 Apple sold 169.2M iPhones and some of the more bullish estimates for FY2015 are predicting iPhone sales of around 235M. This would give us an estimated installed base of 404.2M iPhones at the end of FY2015.

We next need to estimate the average yearly growth of iPhone sales. Recently year over year sales have seen solid growth due to pent up demand for larger screen size phones (according to Bloomberg Intelligence). In FY2014 year over year unit growth had slowed to 12.6% but high estimates for FY2015 (235M units) have growth rebounding to about 38%. As the 6 and 6s upgrade cycle wanes growth is likely to slow. We decided to use a 15% growth rate for our model.

For the rest of Apple’s product line up we assumed low single digit growth for the iPad and Mac. We assumed the iPod continues its slide towards the end of its lifecycle and sales fall by 50%. We have iTunes, Software, and Services growing at 10% and Accessories growing at 5%. All of these values are approximately in line with Apple’s latest yearly results.

We have very little to go on when making assumptions about the Apple Watch given how new the product is. We decided to use the most bullish assumption we could find, which was an estimate by Morgan Stanley that the Apple Watch would eventually bring in $9B of revenues.

For our other assumptions regarding margins and taxes we used Apple FY2014 10-K as a guideline.

We decided to model out to FY2018 as it’s quite clear that Apple is not at risk from the phone upgrade cycle stretching out at least for another few years.

The screenshot below shows the assumptions we used for the model and as well as the output of a pro forma FY2018 income statement for Apple.

The chart below shows how we went about computing iPhone sales.

With these bullish assumptions we see that Apple stock should be worth $150 rather than its current value of around $127.

What happens if the iPhone upgrade cycle begins to get stretched out and the Apple Watch isn’t a runaway hit? In this scenario we lower the iPhone growth rate to 10%, stretch the upgrade cycle out to 3 years, and put Apple Watch revenue at $1B.

Our model now shows Apple stock as being overvalued by about $20, with its true value being around $107.

We’ve made our iPhone centric Apple valuation spreadsheet available for download at https://strubelim.com/wp-content/publicfiles/aapl_workbook.xlsx. If you own Apple stock or are thinking about buying Apple stock the spreadsheet is a helpful tool to illustrate just how vulnerable Apple is to any changes in iPhone demand. If you disagree with any of our assumptions you can change the inputs on the spreadsheet to your liking.

If iPhone demand and the mobile upgrade cycle continue at their current pace it looks like Apple stock is close to reasonably valued.