Sunday, October 17, 2010

Apple: Do You See What I See?

Apple: Do You See What I See?
On Monday afternoon Apple releases the company's September quarter results and results for the 2010 fiscal year that ended with the quarter. Yesterday Philip Elmer-DeWitt posted the comprehensive analyst estimates on Apple 2.0. I'm honored to be among the independent analysts selected for the quarterly analyst comparison.
Apple's quarterly results are essentially a static snapshot of a dynamic company that's growing at an astoundingly fast pace for an enterprise of its size. For the first nine months of fiscal year 2010 Apple's revenue has risen 46.2% and earnings per share have grown 66.8% over the prior-year period. Most likely Apple's September quarter revenue and eps growth performance will exceed the results of the first three quarters of the fiscal year.
Apple's Revenue Source Expansion
Even before the September quarter results are released we should already be looking beyond those numbers. I've mentioned before more than 50% of Apple's revenue in the September quarter and more than 50% of revenue in fiscal year 2011 will be derived from products that did not exist in the marketplace as recently as three and one-half years ago. Fully 25% of Apple's FY 2011 revenue will be derived from a product that's been in the market for less than eight months as of this writing. According to IDC September quarter estimates, Apple has regained the #3 spot among domestic PC vendors and has now secured a 10.6% share of the US market. In fiscal year 2010 Apple's iPod line of products will actually report out an increase in revenue despite a drop in unit sales due to the popularity of the iPod touch. It's easy to see why people would become enamored with the company's quarterly results. But there's more to the story than these 91-day snapshots of performance.
When I look at Apple, I don't see a company that develops popular products. I see a management team that is focused on revolutionizing the way we use technology to better our lives and better the world around us. Excellent quarterly results are one component of management's mission.
Top Line Management and Bottom Line Growth
Apple's results aren't produced by a bottom line-only approach to management. Obviously decisions must be made based on the economic viability of products. But Apple's bottom line growth comes primarily from top line growth. Without growth in revenue, Apple's bottom line growth can not be sustained nor improved. Cost management has amplified Apple's earnings from revenue growth, but cost management has not been the primary driver of Apple's superb earnings performance. There's a difference between cost management and efforts at outright cost containment. Management understands costs must rise to support growth in revenue.
Apple and R&D
Over the past several quarters Apple has invested about 3% of revenue in research and development. As revenue has risen so has the company's investment in R&D. These expenses lead to future products. Management has chosen smartly to increase its investment in future product development  as revenue from current products provides the resources. In other words, Apple is investing in new products at a rate proportional to the success of its current products. R&D as a percentage of revenue has not been scaled back for the sake of bottom line growth.

Selling, General and Administrative Expenses
Apple's SG&A expenses have scaled almost proportionally with revenue over the past seven quarters. But as revenue has risen dramatically during the period, the reduction of SG&A expenses relative to revenue has added to the company's bottom line performance. For the seven-quarter period ending June 26, 2010, SG&A expenses averaged 9.4% of reported revenue. For the three-quarter period ending the same day, SG&A expenses averaged 8.8% of reported revenue. The difference in SG&A expenses as a percentage of revenue becomes significant in an era of 40% or greater growth in top line performance.
Apple is an an era of extraordinary revenue growth and product line expansion. The company is also expanding its retail store presence and the depth and scope of the iTunes stores. Necessarily SG&A expenses must rise with revenue. Guiding costs is a sublime art. Excessive cost controls can hinder rather than support top line growth. Management has chosen not to make this mistake. 
Apple's Gross Margins
For both the seven-quarter and three-quarter periods, Apple's average gross margins remained virtually unchanged at about 40%. In June management cautioned due to aggressive pricing on new products and higher product build costs, gross margins at least in the near-term may be reduced. We'll know more following the September quarter results whether or not management's forecast of gross margin reduction has become reality.
Unique to Apple's iOS-based products (currently the Apple iPhone, Apple iPad and the Apple iPod touch) are the prospects of recurring revenue generation from sales of apps, games, electronic books and other digital content. Management is willing to guide gross margins lower for the benefit of unit sales, market share growth and growth in revenue from the sales of products accessories and digital content. In FY 2011, revenue from these sources will contribute materially to both top line growth and bottom line performance. Management is willing to adjust its monetization matrix for the benefit of long-term revenue and earnings growth.
The Bottom Line
Apple's bottom line growth is wholly dependent on top line growth. In the current fiscal year more than 60% of revenue will be sourced from products released within the past ten years and more than 50% of revenue will be sourced from products released with the last four years. The company is guiding costs to support revenue expansion and continues to invest in new product development. Management is willing to adjust product pricing for the benefit of market share growth and development of recurring revenue sources generated by after-purchase sales of content for the company's newest products. 
Apple's Quarterly results are merely a static snapshot of a dynamic company that will experience 50% top line growth for a second consecutive fiscal year. This top line growth will achieve unprecedented growth in earnings per share.
I reiterate my forecast of AAPL reaching $400 per share by early May 2011 and $450 per share by early November 2011

Robert Paul Leitao


  1. Your contributions to understanding the phenom that is Apple continues to be significant. Thanks!