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A Case for Apple – Elgin Group

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A Case for Apple – Elgin Group

Apple is out of favour. This is a classic reaction, where analysts will become bullish at the top of the market and tell their audience to sell far too late to avert a disaster. Following the recent unveiling of Apple’s new mobile phones, most analysts were disappointed because they felt that the expected cheaper phone (the one Apple calls 5C) is not cheap enough to attract a significant new segment of buyers – thus the negativity.

These analysts seem to have completely glossed over Apple’s new agreement with NTT DoCoMo, Japan’s largest wireless carrier. They also seem to be completely oblivious to the obvious: that Apple has just received Chinese certification to sell its phones on China Mobile’s network, the largest in China. These are significant developments that may result in a significant increase of Apple’s revenue for the phone, let alone its other related devices.

Seeking Alpha has recently posted an article analyzing the impact on EPS of these developments. A number of conclusions can be derived as a result of Apple’s recent agreement with T-Mobile in the US. Let’s have a look:

Results of T-Mobile Agreement
On April 12 2013, T-Mobile started selling the iPhone. Since that date, the iPhone has represented 29% of T-Mobile’s smartphone sales, with sales of 903,000 units during Q2 2013. This compares with the 100,000 iPhones per month that T-Mobile was activating prior to officially selling the iPhone. Thus the availability of the iPhone in company stores with carrier subsidies increased iPhone sales to T-Mobile customers by approximately 200%.
While iPhone sales at T-Mobile are still significantly below the 40% share that Apple has in the US, it represents a marked increase from the approximately 10% share that Apple had at T-Mobile prior to the agreement.

NTT DoCoMo Expectations
Japan’s NTT DoCoMo will finally start carrying the iPhone 5S and iPhone 5C on September 20. NTT DoCoMo is Japan’s largest wireless carrier with a 48% market share and it sold 16 million smartphones in the year ending March 2013.
NTT DoCoMo previously mentioned that it wanted the iPhone to represent no more than 30% of its smartphone sales. Assuming that NTT DoCoMo’s smartphone sales increase to 19 million units over the next 12 months, iPhone sales at that target level would be 5.7 million units. If 10% of NTT DoCoMo smartphone users were currently unlocked iPhones (similar to T-Mobile), then the incremental effect of adding NTT DoCoMo as a carrier partner would be additional 3.8-million iPhone units per year. We are going to assume a $300 gross margin per iPhone sale at NTT DoCoMo since it is likely to primarily sell the iPhone 5S.
Incremental iPhone Sales at NTT DoCoMo              3.8 million
Gross Margin per iPhone                                       $300
Incremental Gross Margin                                     $1.14 billion
Income Tax                                                          $296 million
Incremental Net Income                                        $844 million
Shares Outstanding After Repurchase Plan*            836.1 million
Incremental EPS                                                   $1.01

However, more recent news indicated that NTT DoCoMo might have promised Apple that it would target 40% of smartphone sales for the iPhone. In this case, incremental iPhone sales would be 5.7 million and the net effect on EPS would be $1.51.
The iPhone’s market share in Japan is similar to the US at nearly 40%, so both 30% and 40% appear to be reasonable targets for the iPhone at NTT DoCoMo depending on how the carrier promotes the iPhone.

China Mobile Expectations
China Mobile is China’s largest carrier, representing 65% of the Chinese market. It also accounts for approximately 80% of Chinese high-end subscribers (defined as paying at least $16 per month for mobile phone services) according to Morgan Stanley. In October 2011, there were 10 million iPhones on China Mobile’s network, and this had increased to 15 million by March 2012. This is an activation run rate of 1 million per month. The iPhone only had 8% market share

among high-end subscribers at China Mobile versus 20% at China Unicom, which was Apple’s first carrier partner in China. A similar increase in sales would push Apple’s sales at China Mobile to 2.5 million per month, an incremental gain of 18 million units over the full year. We are going to assume a lower $200 gross margin per iPhone sale at China Mobile due to the possibility that Apple needed to give a better deal to China Mobile as well as the likelihood that lower priced iPhones such as the iPhone 4 will make up a significant proportion of sales.
Incremental iPhone Sales at China Mobile 18 million
Gross Margin per iPhone                                        $200
Incremental Gross Margin                                      $3.6 billion
Income Tax                                                           $936 million
Incremental Net Income                                         $2.664 billion
Shares Outstanding After Repurchase Plan*             836.1 million
Incremental EPS                                                    $3.19

Effect on Valuation
The combined impact of the two new carrier partners would be to sell an additional 21.8 million iPhones, a 15% increase on trailing 12-month iPhone unit sales. As well, EPS would increase by $4.20, which is a 10% increase over our previous low-end projections of $42.67 for FY 2.
At a valuation impact of 8x EPS, these new deals would serve to boost Apple’s price floor by $33.60, from $467 to $500.60. The impact of the NTT DoCoMo deal is roughly $8, while the impact of the China Mobile deal would be around $26.
Incremental EPS from NTT DoCoMo                        $1.01
Incremental EPS from China Mobile                        $3.19
Total Incremental EPS                                           $4.20
Effect on Share Price at 8x EPS                              $33.60
Prior Share Price Floor                                          $467
New Share Price Floor                                           $500.60

The focus has recently been on how Apple’s lower priced iPhone 5C model is priced at too high a level to significantly expand its addressable market. However, limited attention has been paid to how carrier deals with NTT DoCoMo and likely China Mobile can significantly expand the iPhone’s addressable market. The deals will give Apple increased access to the 48% of the Japanese market and the 80% of the high-end Chinese market controlled by these carriers. Past data from T-Mobile suggests that these carrier deals can increase iPhone activations at those carriers by 200% over their prior activation rate from unlocked iPhones only.
The impact of the two deals should boost EPS by $4.20. While the China Mobile deal has not been announced yet, the regulatory approval for iPhone use on China Mobile’s network suggests that there is a high probability of this occurring very soon.
The above discussion proves one thing without a doubt: Apple’s share price, at its current levels, represents a bargain going forward. No one can tell with certainty where the stock will be tomorrow, next week, or next month. But we believe that with an investment horizon of 2-3 years, return on investment will be significant.

Elgin Group LLC
Neuhofstrasse 8
6340, Baar
Tel: +41 41 760 5442
Fax: 41 41 761 9225
Email: [email protected]
Elgin Group Website click HERE

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