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Happy Wednesday. Today's update will be a bit more numbers-focused as we go over the impact from Samsung's Note 7 recall on Apple. Tomorrow will be Thursday Q&A, where I answer questions from Above Avalon members. If you have a question, send it my way (can reply to this email or post the question in the Above Avalon team in Slack - there is a dedicated "#thursday_qa" channel). 

Let's jump into today's update...


Estimating Samsung Note 7 Recall Impact on Apple

One consequence from the developing Samsung Galaxy Note 7 crisis is that we have additional information available for estimating the potential fallout. 

As we will see, there are a number of moving variables found in this exercise. At the same time, we are discussing a very fluid situation. Samsung's actions over the next few weeks and months may have an outsized impact on long-term product sales.

Samsung shipped 2.5M Galaxy Note 7 devices in 10 countries before they were recalled in September. That number includes phones sent to mobile carriers and customers. In the U.S., one million units made it into customers' hands. At first, Note 7 units sent to China were excluded from the recall. However, as discussed yesterday, Chinese regulators went ahead and recalled the device. The recall impacts 191,000 units in China. This means that the original Galaxy Note 7 recall includes approximately 2.7M Note 7 units around the world. 

We can use this 2.7M data point to estimate the number of customers directly impacted by the Note 7 crisis. These are customers who in one way or another have to turn in their Note 7 and choose a new device. Technically speaking, a certain number of Note 7 units likely never left mobile carriers, so I would be more comfortable saying that 2M to 2.5M customers are impacted.

Samsung claimed at the end of September that 90% of those customers participating in the original Note 7 recall opted for a Note 7 replacement (all of which have to be returned due to ongoing battery problems). At the time, about 60% of Note 7 owners turned in their device. This meant that approximately 55% of all Note 7 owners opted for another Note 7 in the first few weeks of the recall. 

My first thought in hearing those very high percentages is that a good portion of the 2M to 2.5M customers directly impacted by this Note 7 recall will likely stay with Samsung. Because these users are buying a Note 7 so close to launch, there is a good likelihood they are a bit more engaged with and loyal to the Samsung brand. These users will likely opt for a Samsung Galaxy S7 or S7 Edge. There will be some customers who will use the second Note 7 recall as an opportunity to switch brands. The iPhone 6s and 7 are the most likely products to benefit. However, I don't think the numbers are too large there (a few hundred thousand people, if that). 

The next major discussion point involves Samsung canceling the Galaxy Note 7. This is a significant development as the Note 7 was positioned as one of Samsung's flagship phones. Recent estimates pegged Galaxy Note 5 sales (there wasn't a Note 6) at about 15M units in a year. The most recent estimates I've seen assumed Samsung would be able to sell 15M to 20M Note 7 units through April 2017 - around the time the Galaxy S8 is estimated to be released. On an annual basis, we are talking 20M to 22M Note 7 unit sales (the original 2.7M Note 7 units impacted by the recall are included in this 20M to 22M range). 

Samsung cut its revenue and profit outlook earlier today for the three months ending September. The cut in revenue does support the idea that Samsung could have shipped up to 20M Note 7 units over the next four quarters. 

This presents an interesting scenario. If there is no Note 7, do we assume that the 20M to 22M customers that would have bought the phone end up with a different model? Do they stick with their current phone and wait to see if there is a Note 8 next year? In some ways, this is unchartered territory. 

My thought process is that there will likely be a combination of factors. A certain percentage of customers who may have otherwise bought a Note 7 this year will end up buying another smartphone. If these customers are current Samsung users, they may either stick with Samsung or switch brands. These users may need a new smartphone for whatever reason and won't wait to see if there is a Note 8. Other customers may hold on to their current smartphone because of the lack of a new, large screen option from Samsung. 

Relative to the overall smartphone market, Samsung actually has enjoyed OK loyalty with recent estimates pegging loyalty around 65% to 70%. For reference, Apple's industry-leading loyalty is more like 85% to 90%. While a major recall due to safety concerns puts a brand's loyalty to test, I'm hesitant to assume that Samsung will see a mass exodus of customers, at least in the near-term. All bets are off when looking out a few years. 

Putting all of these pieces together, here's how I'm thinking about the Note 7 recall impact on Apple. 

I assume approximately 17M people who would have otherwise bought a Note 7 over the next four quarters will be in the market to buy a different phone. This means there will be 3M to 5M customers that will hold on to their current smartphone because of the lack of a Note 7.

Next, I assume that the vast majority of those 17M users in the market for a smartphone are existing Samsung customers. This is where Samsung brand loyalty comes into play. Assuming approximately half of those users will remain with Samsung (less loyalty due to the recalls), this leaves us with about 9M Samsung users that are open to switching brands for a large screen phone option over the next four quarters.

The other 8M users will likely end up with a Samsung S7/S8 or S7 Edge, assuming this Note 7 recall doesn't escalate and begin to impact other Samsung phones. If that happens, all bets are off the table.

To recap: 

Note 7 would have seen 20M to 22M Note unit sales over next four quarters (estimated)
  • 9M = Will now buy a different phone from a different brand. 
  • 8M = Will now buy a different phone from Samsung. 
  • 3M to 5M = Will end up holding on to their current phone.
The 9M customers that will buy a different phone from a different brand will primarily benefit Apple. There have been quite a few people positioning the Google Pixel as a beneficiary of the Note 7 recall. I just don't see it. Apple's distribution and brand gives the iPhone the clear advantage. Huawei may end up seeing a small benefit in Europe and Asia as the other premium smartphone manufacturer (other than Samsung and Apple). 

The wild card in this exercise is how the Note 7 recall will impact the rest of Samsung's businesses. I will admit there is a chance this variable may end up being an even bigger deal than our previous Note 7 customer calculations. If a current Samsung user heads to his or her carrier store and is swayed by the sales rep to buy a different brand because of Samsung battery concerns, we could be talking a very bad day for Samsung. 

At this point, I'm confident in assuming a certain number of current Samsung users will jump ship. How many? We can assume a few hundred basis point decline in Samsung loyalty. This would total up to 10M users who may jump ship over the next few quarters (this would be up and above the normal customer churn). 

And of course, we have the impact from iPhone users deciding to stay with iOS due to the Note 7 recall. I don't think we are talking huge numbers, but it's possible it could be as high as 1M to 2M iPhone customers that stick with Apple. 

We have Apple seeing a potential 9M sales boost due directly to the Note 7 recall over the next four quarters. In an effort to remain conservative, I assume Apple will see another 5M to 8M of sales from the broader Note 7 recall fallout. These would be current Samsung users that are simply turned off by the Samsung brand because of the recall. We can then add 1M to reflect higher Apple loyalty. When combined, we are left with 15M to 18M additional iPhone sales over the next four months.

For reference, I estimate Apple will sell 200M iPhones over the next four quarters (we discussed the math behind that estimate in the daily update from August 30th, "New iPhone Estimates," - 
available here).  

It is important to reiterate that this is a fluid situation and my estimates will likely change as we see Samsung's response to the recall. If Samsung continues to make questionable decisions, it is possible for Apple to see a much larger boost. However, given what we know today, I'm more confident in remaining conservative. Regardless of the estimates and assumptions, it's clear that Apple will benefit from the Galaxy Note 7 recall and we are talking more than just a few million additional iPhones. 


Improving iPhone Growth Prospects for FY17

One consequence from the Galaxy Note 7 recall is the overall impact on iPhone unit sales growth over the next four quarters.

The probability of Apple reporting iPhone unit sales growth in 2017 continues to increase.

Back in August, we discussed my updated iPhone unit sales estimates. Even assuming a slowing iPhone upgrade rate, Apple was on track to report at least 200M iPhone unit sales in FY2017, which would represent a 5% year-over-year decline in unit sales. Apple is on track to report 210M iPhone unit sales in FY2016.

This meant that slightly better than expected iPhone 7 demand would likely throw the iPhone business back into growth in FY2017.

It's still early, but it does appear that iPhone 7 sales are coming in slightly better than Apple expected. Using the latest numbers from the iPhone supply chain, iPhone 7 shipments will end up being roughly flat with iPhone 6s shipments (we discussed this topic on September 28th -
available here). Apple's early expectations were for iPhone 7 shipments to come in below iPhone 6s. 

When reflecting this more optimistic forecast, my iPhone estimate for FY2017 would jump to something more like 215M to 220M units. 

If we then add another 15M to 18M iPhone unit sales from the Samsung recall, we are looking at iPhone unit sales in the 230M range. This would put the iPhone firmly into growth territory in FY2017 (about 10% growth in unit sales).

We will discuss my iPhone estimates in much more detail as we prepare for Apple's 4Q16 earnings.


Samsung Can't Find Note 7 Problem 

One of the first steps that a company must take when notified of a product defect or problem is to quickly enter the information gathering phase. Management must diligently investigate the problem, which involves various tasks including trying to recreate the issue(s). At the same time, the company must keep an open dialogue with customers. 

Samsung is reportedly unable to figure out why some Note 7 units are exploding.
The New York Times has the story:  

"When several Samsung Galaxy Note 7 smartphones spontaneously exploded in August, the South Korean company went into overdrive. It urged hundreds of employees to quickly diagnose the problem.  

None were able to get a phone to explode. Samsung's engineers, on a tight deadline, initially concluded the defect was caused by faulty batteries from one of the company's suppliers. Samsung, which announced a recall of the Note 7 devices in September, decided to continue shipping new Galaxy Note 7s containing batteries from a different supplier.  

The solution failed. Reports soon surfaced that some of the replacement devices were blowing up too. Company engineers went back to the drawing board, according to a person briefed on the test process who spoke on the condition of anonymity because the internal workings were confidential. As of this week, Samsung's testers were still unable to reproduce the explosions."

This was a pretty damning report for Samsung. It's a bad day when your smartphones are exploding. It's a really bad day when you don't know why your smartphones are exploding.

The NYT goes on to describe internal struggles at Samsung, including employees being told not to use email to discuss Note 7 testing for fear of lawsuits and subpoenas.

Initially, the assumption was that the Note 7 problem was a combination of faulty batteries from one supplier and design issues that led to the battery not fitting correctly into the Note 7, resulting in a short circuit. However, when Note 7 replacements began to have issues, that made it unlikely that the battery was the root cause of the problem as Samsung relied on a different battery supplier for the replacement units.

At this point, it seems like the problem is related to the overall Note 7 design - the part of the device that received many accolades from reviewers. This would signify a much bigger problem within Samsung in terms of product design. 


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