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Optimism for Apple Is Justified

Morningstar is raising its fair value estimate for Apple after iPhone 6's spectacular start.

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Apple's spectacular December-quarter results far outpaced both our expectations and Street consensus estimates. Apple’s latest wave of iPhones is not only driving upgrades from current iOS users, but is also allowing it to gain market share against Android, and even find first-time smartphone buyers worldwide. 

We're now much more optimistic about Apple’s iPhone growth in the near-term, especially as China becomes an increasingly important part of the story. Our long-term thesis remains intact. We expect Apple to build out its ecosystem, and develop switching costs to help retain the vast majority of its iOS user base over time. We will likely raise our fair value estimate to $120 per share, and we maintain Apple's narrow economic moat and positive moat trend ratings. 

December quarterly revenue of $74.6 billion raced past the high end of Apple’s prior forecast of $66.5 billion, making this revenue beat its largest in at least the last 12 quarters. All credit goes to the iPhone, whose sales of 74.5 million units surpassed even Apple’s own internal projections, representing 46% growth from the year-ago quarter. iPhone pricing also remained robust, at $687 per unit, thanks to a richer mix toward the higher-priced iPhone 6 Plus and phones sold with greater storage capacity. Similarly, gross margin expanded 190 basis points sequentially, to 39.9%. Apple achieved these stellar results despite currency headwinds from the strengthening U.S. dollar. Adjusting for currency impact, Apple's revenue would have been $3 billion higher.

Apple expects March quarterly revenue of $52 billion to $55 billion, slightly ahead of our prior expectations, and in line with Street estimates. However, this forecast is understated by about $2.2 billion due to expectations for even stronger currency headwinds. As icing on the cake, Apple expects to launch its Watch in April, leading to even stronger cash generation through 2015.

IPhone sales were spectacular across most geographies, but the most important region, by far, was China. Apple's China sales doubled from the year-ago quarter, thanks to not only robust demand for the large screen devices, but also to the fact that the iPhone 6 and 6 Plus were the first new models sold by China Mobile after Apple struck a partnership with the carrier early last year.

We've long been optimistic about Apple’s potential iPhone growth in China, but the company’s near-term results indicate that our China sales estimates simply weren’t bullish enough. In the U.S., iPhone sales shot up 44%, likely in part to wireless carrier plans that allow for faster upgrades. Furthermore, we’re encouraged that Apple’s strong iPhone unit sales weren’t a function of stuffing the retail and carrier channels with inventory. The company stated its intentions to have five to seven weeks of inventory on hand in the channel, up from prior targets of four to six weeks. We were cautious that a strong iPhone unit sales quarter could have been tied to channel replenishment rather than true end-customer demand. However, iPhone inventory remains below this new five-week target, so Apple still appears to have a decent amount of pent-up iPhone demand worldwide.

The iPhone's average selling price, or ASP, of $687 is up 8% over the year-ago quarter, and a bit stronger than our prior expectations. Given the strong U.S. dollar (especially relative to weakening currencies in key iPhone regions like Japan), we're optimistic that Apple’s iPhone ASPs are structurally higher than what was reported, so that ASP erosion may be relatively muted over time, especially if and when currency headwinds dissipate.

IPad sales disappointed once again. Here, unit sales of 21.4 million were down 18% from a year earlier, and down 15% when comparing sell-in units sold to end customers. Pricing was also mildly alarming: IPad's ASP fell 5% from the year-ago quarter. We continue to believe that Apple’s two main iPad problems revolve around longer replacement cycles for these devices than previously anticipated, as well as some cannibalization by larger iPhones and Macs. However, given the iPhone's stupendous growth, iPads made up only 12% of Apple’s revenue. This makes Apple's growth story a bit more dependent on the iPhone, and less so on the iPad, than what we might have predicted a couple of years ago.

Mac generated record revenue of $6.9 billion, as unit sales of 5.5 million Macs were up 14% from the year-ago quarter (and flat sequentially) while ASPs fell only 5% (and were up 5% sequentially, thanks to the launch of the iMac with its high-end 5k resolution display). Service revenue (including iTunes and the Apps Store) also reached an all-time high, but was consistent with our expectations given the massive growth in Apple’s iOS user base over time.

In April, Apple expects to launch the Apple Watch. This should give a boost to both revenue and earnings during the seasonally slow June quarter. Apple will likely update its capital allocation policy in the April quarter, as the firm sits on a whopping $142 billion of net cash or $24 per share (although the bulk of it is still held overseas). We wouldn’t be surprised to see another nice dividend increase and an expansion of the firm’s buyback program. We continue to approve of Apple’s measured M&A approach toward smaller, bolt-on deals, rather than a high-priced, splashy acquisition.

We expect to raise our fair value estimate to $120. We're significantly raising our near-term iPhone unit sales and ASP estimates, thanks to the exceptional growth in China, which seems poised to continue into the March quarter during the Chinese New Year. During the December quarter, iPhone revenue grew 57.5% over the year-earlier period, and we now forecast iPhone revenue for all of fiscal 2015 to advance 39% over fiscal 2014.

We've also raised our estimates for the Apple Watch launch in April 2015. We now forecast 13 million units sold in fiscal 2015 at a $500 ASP. Given Apple’s iOS user base, which we estimate at 550 million unique users and counting, we foresee millions of loyal Apple users buying watches, almost regardless of the device’s functionality, battery life, or operability. The Watch should also provide a nice incremental boost to our fiscal 2016 profitability estimates. Longer-term, we estimate that Apple may sell up to 40 million watches per year by the end of our five-year forecast period. As a product category, we estimate that Apple Watch adds an incremental $7 to our fair value estimate.

From an economic moat perspective, we continue to believe that Apple will benefit from switching costs that will keep a good portion of its user base tied to the iOS (and Mac) ecosystem for years to come. However, we wouldn't draw a direct correlation between Apple’s stellar results, and a strong, or strengthening, economic moat. Company executives have indicated that December-quarter sales to first-time smartphone buyers and prior Android users were significant. We suspect that screen size, brand image, and perhaps iOS functionality all played key roles in attracting these customers to the iPhone.

For Apple, winning new, first-time users and capturing market share certainly bode favorably, at least in the near term. However, the key to its continued business success, and to long-term cash flow generation, in our view, is Apple's ability to maintain a robust ecosystem that will generate repeat purchases by keeping these new users tied to its platform. As first-time users eventually seek to upgrade their phones, we anticipate that native apps (FaceTime, iMessage), a leading Apps Store, services (Apple Pay), and connectivity to both iOS and OS X devices (iPad, Mac, Apple TV), as well as iOS-compatible devices (CarPlay, IoT products via HomeKit) will keep most customers coming back to buy future iPhones. In turn, Apple should be able to avoid the violent swings in market share and earnings that have plagued other smartphone vendors (Nokia, BlackBerry, and more recently, Samsung) that didn’t control valuable services and software assets, rendering them unable to convert their (at-times) large user bases into repeat customers. Finally, our moat trend for Apple remains positive, as a greater number of customers are likely buying additional iOS devices that sync with their iPhones, thus making it harder for them to defect to other platforms.

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Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.