On the same day Apple (AAPL) announced the purchase of Beats Electronics for $3.2 billion, Reuters reported that a Taiwanese media source stated that Apple will release the next iteration of the iPhone in August, one month earlier than expectations. The $3.2 billion purchase price of headphone maker and music-streaming service Beats is economically-neutral from our standpoint, and in the context of its massive share repurchase program and the firm’s $500 billion market capitalization, the net impact of the transaction is effectively immaterial. In any case, the deal will bolster Apple’s music offering in the face of growing competition from Pandora (P), Spotify, Rhapsody, and Google’s (GOOG) YouTube, and give it a platform to drive a streaming and subscription-based business model, where fundamentals in the music industry have been trending.
The real news of the day, however, is that unidentified sources have revealed that Apple will pull forward the release of the iPhone 6. Though we maintain a level analytical view on new product launches, we are expecting the iPhone 6 to be wildly successful. The iPhone 6 will have a larger, sapphire crystal screen, and a faster and more efficient A8 chip. The screen size of the iPhone 5s is currently 4 inches, and we think the iPhone 6’s 4.7 inch screen size (which is expected to be released in August) or 5.5/5.6 inch screen size (which is expected to be released in September) will hit the sweet spot of usability for consumers. From our research, the iPhone 5s is a bit small for many applications (both on the enterprise and consumer level), especially as workers and consumers grow more comfortable with the larger iPad in day-to-day activities.
Though there will be other features of the iPhone 6 that will attract iPhone owners to upgrade, we think the larger size will be the most important selling point. We think the iPhone 6 launch could drive an upgrade rate of 12%-14% of existing iPhone owners. Though this rate approximates peak levels, we think the iPhone 6 will have even greater success on the basis that consumers didn’t truly know the optimal usability size until the iPad proliferated. With the iPhone’s installed base of 260 million users, an upgrade rate in the mid-teens would offer a significant boost to Apple. Because the iPhone is a more portable, workable device than the iPad, we don’t think much cannibalization will happen as a result of the size adjustment. According to the Taiwanese source, Apple is expected to produce 80 million iPhone 6 handsets this year. We’re very excited about what the ‘lack of cannibalization’ means for Apple, especially as new and more powerful iPad versions hit the market.
Though profit taking may cause a slight price decline in coming weeks, we maintain our view that Apple is poised to converge to its $700+ per share fair value estimate (the 16-page report on the firm has been updated). Apple’s shares are up significantly since they were added to the Best Ideas portfolio, and the company remains one of our best ideas*.
Related Firms: CRUS, GTAT, SKUL
* A best idea in Valuentum parlance is a holding in the Best Ideas portfolio and/or the Dividend Growth portfolio. We typically add shares to the Best Ideas portfolio when they register a high rating (a 9 or 10 = a “we’d consider buying” rating) on the Valuentum Buying Index and hold them until they register a low rating (a 1 or 2 = a “we’d consider selling” rating) on the Valuentum Buying Index. We don’t add all firms that register a high score on the Valuentum Buying Index to the actively-managed portfolios due to sector weighting or overall market valuation considerations, among others. The Valuentum Dividend Cushion is a key factor behind adding companies to the Dividend Growth portfolio and is used in conjunction with a company’s annual dividend yield, its price-to-fair value ratio and Valuentum Buying Index rating.