The Obligatory iPhone 7 Show

iPhone 7. Image source: Apple.

Apple (AAPL -1.22%) unveiled its new iPhone 7 and iPhone 7 Plus recently, and though the company has come under a lot of heat from the media for doing away with the phone's headphone jack, the company is up a whopping 10% since.

In this week's Industry Focus: Tech, Motley Fool analysts Dylan Lewis and Evan Niu recap the highlights from the release (including some big tech-side improvements that Apple hardly emphasized). Then, they look at the pre-order numbers we have so far, why the stock is up so much, where the company seems to be heading, and what investors can take away from this exciting news.

A full transcript follows the video.

This podcast was recorded on Sept. 16, 2016.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, September 16th, and we're recapping Apple's event from last week. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's senior technology specialist Evan Niu. Evan, how's it going?

Evan Niu: Pretty good, it's iPhone day.

Lewis: iPhone day, yes. So, Apple's anticipated press event went down last week on the 7th. They are now going to actually go on sale. So people are getting their hands on the phones today. Some interesting news coming out of that. But this is the Cupertino company's latest update to the iPhone line. They're calling it the 7 and the 7 Plus. I know there's some speculation there. Given that the iPhone line accounts for about 60% of Apple's revenue, it fluctuates quarter to quarter, tech insiders and investors alike are eagerly anticipating this unveiling and see what the next-generation device looks like. So, why don't we hop right in? What does the new line offer users?

Niu: I think it's pretty modest and incremental. Every year, it's getting more and more incremental, just because smartphones are so good nowadays that it's hard to really make them that much better. The improvements a few years ago used to be so mind-blowing, that it's like, yeah, you have to upgrade if you care about it. But I'm actually skipping this year for the first time in eight years, which is weird for me, just because I don't think it's that compelling.

So far, the early indications look pretty strong, in terms of... again, the lines at the stores, you have the carriers announcing a lot of good, strong activities. There's a lot of positive sentiment right now around this device, even though it seems, in my opinion a little incremental. I don't think the improvement's all that great.

Lewis: I think one of the biggest, and probably got the most press in terms of features or changes was the removal of the headphone jack. Definitely one of the more controversial elements of the new phone. Apple decided to shift consumers toward wireless connections using Bluetooth and things like that. And, of course, they're offering $159 AirPods to help ease that pain. But, the new phones will be shipping with a Lightning port adapter that will allow people to plug in their headphones. It seemed like the removal of the headphone jack was really something that enabled them to up the processing power, improve the battery life, make some camera improvements. It was a form-factor decision that help to them juice the guts of the phone itself.

Niu: Yeah. It's just Apple's same thing of identifying that some technology standard is outdated. And the headphone jack is 100-plus years old. So, of all the standards they've killed in the past, this is one of the oldest ones. Arguably, it's kind of surprising but they haven't done it already. But every time they do this, they get a bunch of crap, and people don't like it. But the market always survives. And yeah, there's always these big ecosystems that are built around these ports of standard. But at the same time, they're the only company that does this, that pushes the industry forward in this way, because all the other companies are too afraid to make these controversial decisions. This is not a new thing for Apple. They have done this for the past four years, and every time they do it it's controversial. 

You can see both sides. Just like every other time they've done it, there's two sides. Everyone's like, "Hey, I want to still be able to use all my stuff." But then, if you look forward into the trajectory of audio connectivity, yeah, Bluetooth, like you mentioned, is getting a lot better, especially with Bluetooth low energy. It's just kind of like analog going to digital. The Lightning audio is a digital connection, versus the headphone jack, which is an analog connection. It's just one of those things that probably needs to happen eventually, and Apple is making the leap now. And there's even suggestions now, they actually just sent out a survey to their users asking if people use headphone jacks on their laptops. So they're obviously thinking about killing it on the laptop eventually, which isn't surprising. But for people's computers, there are people who plug in their home audio and computer speakers in there too, in addition to headphones. It's an even bigger ecosystem of devices that you would have to try to transition somehow, versus on a smartphone. It's just headphones, versus speakers. It's pretty big change, it's one of the bigger ones.

Lewis: Yeah. To quote Apple, "it definitely takes courage to make a decision like that." I know as someone with a nice set of Bose headphones that are not wireless...

Niu: Yeah, like these.

Lewis: Yeah. I'm going to need to use that adapter. Like I said, they will ship with the phones. One of the criticisms is that, unless you use a different type of adapter, you won't be able to charge and listen to music at the same time. Some of the other big things with this product release, they introduced water resistance. The iPhone 7 and 7 Plus can be submerged under three feet of water for 30 minutes. That's the benchmark that they're using there. Apple is not the first company to do this. Samsung pretty heavily promotes their water-resistant products. So, just an interesting thing. I know that they deal with a lot of water-damaged products, and I don't believe that water damage will be covered under warranty.

Niu: That's true. The funny thing about the waterproofing thing is that last year's iPhone was actually surprisingly waterproof. There are test videos from last year of people putting iPhones into a bowl of water for literally an hour. They time lapsed it. And it still works. They would check every 30 minutes or so. So, I think they had made a lot of progress last year, but, if you market it, people are going to do it, and if they're disappointed, you're in a hot spot. So, I think that what they did is start this process last year, didn't tell anyone about it because they didn't want to invite people to test it, even though, of course, people tested it anyway, another felt more confident with the changes they did this year with making it even more sealed. So now, they're touting it as a big thing, but it's actually something I think they started last year or maybe even the year before that.

Lewis: Yeah, I think that's a feature that's better to surprise consumers with than have them expect it and not quite deliver on it. So, that's something you can look forward to if you were thinking about upgrading. The phones also tout a longer battery life, I believe it's an extra two hours for the iPhone 7 over the iPhone 6S, and I believe it's an extra one hour over the iPhone 7 Plus over the iPhone 6S Plus. 

Niu: I think that's a big achievement, because I think most of that is coming from this A10 fusion processor with its greater efficiency. I can't remember the numbers, but I think the battery is a little bit bigger. But the majority of that gain is probably coming from efficiency gains on the power side of the processor, because they're finally doing this process or architecture that has the two powerful cores, plus the two little cores, which is similar to something ARM used to do called big.LITTLE. But, this implementation is not exactly that, this one is much more sophisticated. But the concept is, you use these low power cores when you have low power tasks, and you save a ton of energy. I think it's a huge testament to how far Apple's chip team has come. It's crazy that they've come this far, and they're now one of the most sophisticated process makers in the world. And their first proprietary chip was in 2010. So, we're talking about six years. The A4 was the first one, in 2010. And now, they're at this insane level, where they're basically... the iPhone 7 Plus is basically stronger than a MacBook Air.

Lewis: That's incredible.

Niu: In six years, they've done this. It's really mind-blowing. And they don't get much credit. It's weird, because they don't talk about this very much.

Lewis: Yeah, I think they tend to focus on the very visible features and form factor elements of the product. To give you an idea of what the performance numbers look like from generation to generation, the A10 chip is approximately 40% faster than the A9, which is what they used to power the 6S. The A10 chip is twice as fast as the A8, which powered the iPhone 6. You're definitely getting a pretty good performance boost there. That and the battery life are two of the really big elements that you might not notice right away just looking at the product, but once you start really using it, you'll start to feel it.

They're also touting some new camera systems. The 7 and the 7 Plus both support 12-megapixel cameras. But I think one of the more noticeable things as well is the base level storage. This is something that I've been expecting for a while. I was kind of thinking they might do it with the 6S. The 7 line runs 32GB, 128GB, and 256G of storage. That's up from the 16GB and 64GB and 128GB on the iPhone 6S. They've also decided to increase the storage of new 6S phones to be in line with that. So, if you're buying a new 6S, you can get it and the base level will be 32GB. I think that makes sense. I know we're moving to a lot of cloud storage, but it's nice to have some extra space on their, particularly if you're a metro commuter and you're in a lot of areas where you'll be offline. I know that I always appreciate that.

Niu: It's weird, because I was always one of the few people that actually liked the 16GB model, purely from an investing standpoint, because it's so bad for consumers that it's actually really good for investors, if that makes sense. 16GB is really so insufficient that you have to upgrade to the mid-tier 64GB at a minimum, which boosts your revenue average selling price and all this. So, from an investment standpoint, I was actually a huge fan, even though from a consumer standpoint, it's pretty bad and annoying because it's so insufficient. But now, with this 32GB, it's a harder call, because people will have to ask... before, it was like, "There's no way you could get away with 16GB, because that's just a joke." But now, with 32GB, maybe I could." You have to actually think about the decision, do you spend the extra $100 to go to 128GB, or can you actually stick with 32GB? So, I think it'll be interesting to see what happens with ASPs going forward. But, at the same time, they just introduced SE, which starts at $400, and that already puts pretty big downward pressure on ASPs in general.

Lewis: Yeah, maybe the logic there was the SE is going to fill that niche and make it a little bit easier. I know, when I got the 6S, it wasn't even a consideration. I want for the 64GB model.

Niu: Exactly, right? And you knew, Apple made another $100.

Lewis: Just to bring it around to prices, because we talked about ASP, average selling price, the iPhone 7 will start at $650, and the 7 Plus will start at $769. That's the starting point there.

Niu: That's interesting too, because they're bumping the 7 Plus by an extra $20. It used to just be $100 more, and now it's $120 more. I tend to think that the extra $20 that they're charging is related to the camera system. That camera system is expensive.

Lewis: And the iPhone 7 Plus has a two-lens camera now, whereas in the past there was just one. The 7 maintains the one-lens camera. Certainly some added features there, and a little bit of extra stuff under the hood, so to speak. So, I think that makes sense. The company predictably took some flak for its decision to ditch the headphone jack, like we talked about, and questionable use of the word "courage" throughout the presentation. But, the stock is up 10% in the last 5 days. For a company Apple's size, that's pretty noteworthy. Any time you see something like that, I think it's less to do with the product specs and more to do with what's going on with pre-order information that we've seen from a couple different outlets.

Some of the different wireless carriers announced what they were seeing in terms of pre-order activity. T-Mobile said the two new iPhones have shattered previous sales records. I believe orders are coming in at something like 4X what the iPhone 6 did. Sprint also saw very high pre-order numbers. They said orders were up 375% over the first three days of pre-order availability compared to last year. AT&T and Verizon were a bit more muted in what they were talking about related to the iPhone line, and said that pre-orders were pretty much business as usual, business as expected.

Niu: I think AT&T said at a conference the other day that they were just above expectations. Still pretty vague.

Lewis: Yeah. Some really nice color from T-Mobile and Sprint, not so much AT&T and Verizon. But, I can't say that I'm surprised we're seeing some really good pre-orders. 1. it's an iPhone, and 2. the wireless carriers, most of them, I think all four of them, have gone with the free iPhone 7 promotion. So, it's tough to parse out how much of that is what would be a full-price purchase iPhone versus a free iPhone that's coming with an upgrade and a two-year commitment to that wireless provider. So, that's the grain of salt that you need to take with any of those pre-order numbers.

Niu: Like you said, the stock has been up 10% or so over the past few days. And I think that's interesting, because it's on heavy volume. If you look at the volume activity, the gain is on in the back, there's a lot of volume. There's a lot of people coming in, it's not a light volume move. There's a lot of people that are coming into the stock on all this iPhone 7 optimism, which is kind of ironic, because there's basically this idea, there's a sentiment that iPhone 7 is going to be strong, the carrier stuff you mentioned. But the irony is, Apple has been trying really hard to shift away from focusing so much on unit sales numbers, which is also partly why I think they're not going to release their launch weekend sales for the first time in five-plus years. They've always announced launch figures every year, but this year, they said they're not going to.

Lewis: Yeah, I believe a company spokesperson said, and I'm actually taking this from an article you wrote, "These initial sales will be governed by supply, not demand, and we have decided that it is no longer a representative metric for our investors and customers."

Niu: The silly part about that is that that's been true every year.

Lewis: Yeah, that's always the case.

Niu: I don't really believe their reasoning for why they're saying it, because there has always been supply constraints. Every year it's supply constraint. That's not a new thing. So, them saying they're not going to give this number because of that, I think that's kind of a cop-out. I think it's part of the broader strategy to get people to stop focusing on unit sales, because what they want people to focus on, particularly investors, is to look at these recurring revenue sources. They've been touting all this installed base purchases and services revenue and all these things that are not tied to unit sales. They're trying to get investors to focus on those numbers instead of unit sales.

But, obviously, investors are still focused on unit sales, because when you hear all these positive storylines about the iPhone 7, they go out and buy the stock. Also, combine this with the fact that the Samsung Note 7s are exploding, that also help. So I think there's a lot of positivity around the iPhone 7, despite the fact that Apple is trying to shift the focus away from how many units they sell.

Lewis: Yeah. I think you're absolutely right. You look at the way their revenue mix is going, it's going to play out that way. Like I said earlier, the iPhone contribution to revenue was, in the past, about two-thirds. I believe it was down to about 56% as of their most recent quarter, and that's because of that rising service revenue. You also have the introduction of the Watch line, and things like that, which they updated in this most recent press event. But, yeah, the iPhone, while it's going to be the cash cow for them, I think they're making efforts to highlight other parts of the business. This recent rise that we talked about actually pushes Apple above a 13 P/E on a trailing basis for the first time in a year.

Niu: Ooh, so expensive! (laughs)

Lewis: Yeah, right? It's kind of insane. But looking at how all of this fits into where the business is going, last quarter, the company guided for revenue between $45.5 billion and $47.5 billion. And even if they dramatically beat that guidance, which, they've typically been in the high end of their guidance range or slightly above it, they will likely fall short of previous years' number for the third straight quarter. I believe last year ago quarter, the fourth fiscal quarter, they were around $51 billion, just to give you an idea of how different the guidance is there. It's tough to keep seeing this. The product is really successful. Customer satisfaction was really great. They just keep going up against these really tough comps. Eventually that's going to change, but don't expect that trajectory to be any different for the next couple quarters. I think that's one of the key things investors need to keep in mind here. You're going to probably see year-over-year declines for this quarter, next quarter, possibly even three quarters out.

Niu: I think there's a chance the iPhone 7 could, generally speaking regardless of the time... the timing for the year-over-year comps is always tricky, because it's always really dependent on when they launched the phone. In this case, they're launching the phone with two or three weeks left to the quarter. Last year, I think they had just a couple days. So, the launch timing really has a big impact on how much of that launch gets captured in which quarter. But, in general, I think there's a chance that the 7 could push the cycle up.

The sense is, iPhone unit sales have picked because they've been flat-ish, roughly, over the past year, year-over-year or whatever. But if you look, every two years, they basically pushed higher because of the cycle, this two-year design cycle of 5, 5S, 6, 6S, etc. So, the performance of the sales, at least for the past two major product cycles, they tend to go in tandem. Because if most people upgrade their phones every two years, and all the people who upgraded for the 6 are probably all going to upgrade for the 7, they had this pattern of going in pairs. Who knows if that actually plays out again this year, because the sales are so high that is hard to really grow. But I think there's a possibility, particularly with all the kinds of indications that we're seeing. But I wouldn't bet on it. I'm just saying, it's like a curveball, it's possible.

Lewis: We've talked in the past about the idea of two-year comps being a bit more relevant for Apple, because of the update cycle that they're on. I think, as you talked about before, their refreshes on the product become more incremental and less major step changes, then I start to look at them more on a year-over-year basis. To your point about releases, another important thing to remember here is, all the numbers that Apple will be reporting for fiscal Q4, calendar Q3, only two weeks of that period will have the iPhone 7 available. It will be a part of those numbers, but it will not be a major contributor. You're going to really want to look at fiscal Q1, calendar Q4, for what it's going to be doing for the financial statements. I'm sure we're going to get some commentary in the company call come fiscal Q4. But, that's something to keep in mind.

Niu: And it's weird, because this is the first time they've ever pushed a three-year design cycle. It'll be really interesting to see how that changes the performance. They've never done a three-year design cycle before. And it's also a testament to smartphones getting more mature. It's kind of like laptops. They redesign laptops every four to five years, but they would redesign their phones every two years. So now you're seeing, they feel comfortable that they can push that limit on the design side. But then, the real question is, what happens next year? Because everyone is expecting a new design next year, maybe another display, maybe no home button, maybe curb display, whatever. Then, it just throws everything out of whack, the fact that they're changing the timing of these cycles. It's going to be cool to see what happens going forward. And plus, what are they going to call it? They can't call it the 7S if they change the design altogether.

Lewis: Eventually they're going to have to ditch that naming convention, one way or another.

Niu: I've been saying they should ditch that thing for years. This is the iPhone 7. It's the 10th iPhone. And what, next year it'll be the iPhone 8, the 11th iPhone? It just makes no sense.

Lewis: Yeah. I think, to bring it back around, and what to watch for here, if the product incremental upgrades that we talked about, some of their performance changes are visible enough to people that maybe currently hold an iPhone 6, or the offers from these wireless carriers look compelling enough, I think you could see some really great numbers for fiscal Q1, which will be calendar Q4. But you won't get a report on that for quite a bit. Be wary of that, and know that any really big enthusiasm is going to come through more on the company's call than in the numbers that the company reports next quarter.

Anything else on this? That's kind of investing take away. Obviously, everything that they delivered here was what we'd been expecting from pre-launch leaks and rumors.

Niu: Yeah. Everything pretty much came in right on target with expectations, as far as the product specs and things like that. I think the Watch 2 looks OK, it's kind of the same thing, Watch 2 looks like what they should have done with the first one. I don't think many people are going to upgrade from the Watch 1 to the Watch 2. It just doesn't seem very compelling. But maybe they get more first-time adopters that were on the fence about Watch 1 and didn't do it, but now Watch 2 is more compelling, a stronger product, so maybe the people that were on the fence will jump in and go ahead and be a first-time buyer for the smartwatch. And, of course, once they do that, they're on this upgrade track, and they're going to eventually upgrade, however long, who knows.

Lewis: Yeah, you have the chance to win over those people who don't want to own a first-generation device with the Watch, basically.

Niu: Right. I think the Watch 2 does look compelling in that sense. Of course, there's no detailed results to compare to, because Apple won't give them to us. But just generally, I think, products just get better over time. Next month, they're supposed to have these new Macbook Pros, which might reinvigorate the Mac lineup. That lineup has been there for four years. So, coming out with a new thing there could really juice the Mac performance for the next few years.

Lewis: Certainly more to watch there. Listeners, you can guarantee that we will be sure to comment on it in several episodes down the road, do a little checking. Anything else before I let you go, Evan?

Niu: No, I think we covered most of it.

Lewis: Awesome. Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or you just want to reach out and say hey, you can shoot us an email at [email protected]. You can always tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!