ISI Predicts iPhone 6 To Be 'Mother Lode' Of All Upgrade Cycles

ISI’s Apple analyst, Brian Marshall, published a report estimating that larger screen iPhones could add over $3 in EPS in the second half of calendar 2014 and that the upgrade cycle is not fully reflected in the stock price. He started his note with the widely-held view “Large-screen envy is prevalent among the iPhone installed base” and “we believe a ~5” form-factor iPhone would spark a massive upgrade cycle as well as many 'Android switchers' returning back to the iPhone.” (Note that my family and I own Apple shares and I have sold put options, which is a bullish strategy).

Marshall believes that Apple will announce two iPhones this summer with 4.7” and 5.5” screen sizes.  He estimates that in the 2011-12 timeframe about 10%-11% of iPhone owners upgraded in any given quarter and that this has fallen to 9% recently. As the chart below shows the December quarter has had the highest replacement rates since new iPhones are available then but that the upgrade rates have fallen the past two years as there is less reason to upgrade.

Apple will have sold over 500 million iPhones by the end of this quarter and Marshall estimates that approximately 260 million units (about the past seven quarters) is the current install base. At an Average Selling Price (ASP) of $600 each 1% incremental replacement rate (based on Marshall’s 260 million install base) generates $1.56 billion in revenue. With an estimated 40% gross margin (feels low to me but lets be conservative), a 26.2% tax and share count of 875 million each 1% adds $0.53 to EPS.

Marshall is estimating that the replacement rate can get back to towards its peak of 12%-14% when the iPhone 6 is available. If it gets back to 12% in both the September and December quarters I estimate it would add about $3.18 to EPS (Marshall is at $3.12 based on a higher share count of 889 million) to Apple’s calendar 2014 EPS.

If the iPhone’s gross margin is around 45% ( Morgan Stanley ’s Katy Huberty has it at 46% for fiscal 2014 and 2015) each 1% incremental replacement rate would add $0.59 and $3.55 in EPS during calendar 2014. This compares to a $4 EPS increase that Pacific Crest’s Apple analyst, Andy Hargreaves, published last week when estimating that 35% of iPhone upgrades will chose the larger screen iPhone and capture 10% of the large format Android market.

It is hard to argue that larger screen iPhones won’t increase the replacement rate. I have an iPhone 5 and have found the screen size limiting when I’m reading emails or websites. The key question is how high could the replacement rate move up to since much of the recent install base is locked in for two years.

Marshall’s calendar 2014 EPS estimate is $42.50 before any incremental iPhone upgrade assumption and would increase to about $46 if he is correct. While his timing could be a bit off (may not get a full quarters worth of upgrades in the September quarter) its affect would probably shift to the March 2015 quarter and help that years earnings (which he has not published). The Street is expecting $46.26 which probably includes some positive impact from larger screen iPhones.

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