Sunday, May 30, 2010

AAPL Earnings and the Value of Rising Revenue

It's a seemingly obvious axiom the greater a company's revenue, the greater its earnings. But this outcome isn't guaranteed. Witness Dell's margin and profit collapse in the consumer PC business. While increasing revenue can and perhaps should lead to rising profits, in a competitive global economy for the sales of goods and services managing operating costs and the costs of products and services are as important as growing revenue.
In the PC and digital device markets product prices remain under pressure. Particular to the PC market, the emergence of the netbook has further pressured prices. Price capitulation for the sake of revenue growth can be a disastrous temptation. In the lower-cost PC market, Acer alone is adept at squeezing profits from razor-thin margins.
In the smartphone market margins have been pressured by promotional giveaways to boost market share and by service providers seeking to combat the popularity of the Apple iPhone. RIM's earnings have been impacted by this promotional activity.  What may be a quick commoditization of the Android handset market will also pressure profits for smartphone market participants. 
I've said many times Apple doesn't sell products. Apple crafts customer relationships and those relationships sell Apple products. Each customer product purchase increases the value of the relationship to Apple and the customer and the customer relationship transcends the value of each individual Apple product purchase transaction. It's why Apple has avoided price capitulation as a means to increase revenue. Apple has historically high gross margins on its hardware products sold. This is due in part to the value of the customer relationships and the transcendent value of that relationship in the minds of customers relative to product price. At the center of Apple's success crafting customer relationships are the company's retail stores. 
The release of the Apple iPad even at aggressive price points maintains relatively high gross margins while the pricing on the product is a competitive defense against potential competitor market intrusion. Though the Apple iPad may not deliver the average 40%+ gross margins Apple has recently experienced at the start, there are other factors positively impacting the iPad's revenue profitability. 
Apple's investment per revenue dollar in research and development has remained relatively constant and hovers around three percent. This is despite a consistent increase in research and development expenditures in support of new products. In year-over-year comparisons, for the first six months of this fiscal year Apple's SG&A (selling, general and administrative) expenditures relative to revenue have dropped slightly suggesting these costs will progressively consume less of each revenue dollar as revenue rises and especially as the Apple iPad boosts revenue significantly over the next several quarters. SG&A expenses are now comprising less than ten cents of each revenue dollar. 
The Apple retail stores are essential to Apple's customer relationship development. They also decrease the expenditures otherwise needed for product advertising and marketing. The operating costs of the stores are mitigated by the retail margin on products sold (Apple products and third-party products offered for sale) and have been proven to increase Apple product sales in the geographic areas surrounding the stores. The stores are also the primary means to introduce Macintosh computers to new customers. Because the retail margin on products sold supports store operations, advertising and marketing costs per revenue dollar will decrease as revenue scales higher. 
One of the challenges in accurately forecasting Apple's earnings per share as revenue rises at a torrid pace is determining the marginal profit value of each additional revenue dollar.  Due to Apple's strong customer relationships, the growth in Apple retail store locations and the company's ability to avoid price capitulation to increase revenue, each additional revenue dollar has a greater incremental contribution to operating income. 
While much attention has been focused on Apple's gross margin ratios and recent decline in tax liability per net income dollar, little attention has been paid to the decline in operating expenses per revenue dollar and the resulting increase in operating income.
In Apple's case rising revenue creates more than a proportional increase in earnings. It's why the rate of Apple's earnings per share growth will continue to exceed the rate of revenue growth and why the Apple iPad and its strong revenue contributions may be the catalyst for three consecutive quarters of record earnings results even if at introduction gross margins on the product are slightly below recent averages for the company. 

Robert Paul Leitao

No comments:

Post a Comment