Apple Inc. (NASDAQ:AAPL) is scheduled to release its next earnings report on Oct. 20. Analysts at Morgan Stanley are expecting the company to report shipments of about 38 million iPhones during the quarter. They have added Apple to their Best Ideas list due to under-ownership, strong demand for the iPhone 6 and 6 Plus and expansion into new product categories with the Apple Watch.

Apple Gross Margins May Drive Shares Higher

This year is different for Apple

In one report dated Oct. 14, 2014, analyst Katy Huberty and her team said this year’s product cycle may be setting Apple stock up for “significant upside.” They expect the iPhone 6 cycle to be stronger for a longer period of time.

For the last quarter, they estimate that iPhone demand was for about 37 million units, based on data from their AlphaWise Smartphone Tracker. They think “modest” inventory build will make the number of reported units match the consensus estimate of 38 million.

Apple to see a long upgrade cycle

The Morgan Stanley team also expects this year’s iPhone upgrade cycle might even last “well into 2016.” According to their market share estimates in the U.S., China and Australia, Apple has enjoyed an average of 19 points of market share gain. This implies approximately 130 million iPhone upgrades next year, even though 250 million of them own the iPhone 4S or an older model.

Two other factors in Apple’s iPhone upgrade cycle are the rollouts of Apple Pay and the Apple Watch, which works only with the iPhone 5 or newer. The analysts believe this new service and new device might convince even more iPhone users to upgrade this year compared to previous upgrade cycles.

Gross margins correlate with Apple stock movement

The analysts also think Apple could see upside to gross margins in this month’s report, noting that gross margins correlate to the company’s share performance. (Charts are courtesy Morgan Stanley)

Apple Gross Margins

The Morgan Stanley team said there are a number of factors that should expand Apple’s gross margins next year. They note that the iPhone 6 might cannibalize the iPad somewhat, but the implication for margins is positive.

For example, the bill of materials for the iPhone isn’t as high as they previously thought. They say that’s mainly because the touch screen on the iPhone 6 costs about the same as the screen on the iPhone 5S last year even though it is bigger.

They also note that the more expensive iPhone 6 Plus and the 64 gigabyte NAND mix should lift average selling prices and gross margins. Also Apple’s online services margins have surpassed the corporate average and are expanding each quarter as the App Store enjoys double digit growth.

Expectations for Apple’s guidance

The Morgan Stanley analysts believe the gross margin on the Apple Watch will skew toward the iPhone at between 40% and 50% instead of the iPad, which has a margin of 20% to 30%. They also expect Apple to raise its gross margin guidance, which has been between 37% and 38% for the last three quarters. If the company does this, they say it should be a catalyst for its stock price.

In next week’s earnings report, they also believe Apple will guide for revenue of around $63.4 billion. They see room for iPhone upside, however, in addition to average selling price and gross margins.