Sunday, July 31, 2011

Cost Discipline: Apple's Potent Pathway To Profits

In Apple's third fiscal quarter ended in June, the company reported record revenue of $28.571 billion and record earnings per share (eps) of $7.79. Fueling the record eps performance was the record high 25.5% of each revenue dollar that flowed to the net income line. 
On July 24th I published an article titled Apple's Net Income Relative To Revenue Continues To Rise. In that article I reviewed the company's net income to revenue performance over the most recent eleven fiscal quarters. Today I'm continuing my analysis of Apple's quarterly results with a review of the company's operating expenses (OpEx) and the declining percentage of revenue consumed by its two components: Selling General and Administrative (GS&A) expenses and Research & Development (R&D) expenses. 
The graph below illustrates the differences in the rates of growth in revenue and operating expenses on a quarterly basis from FQ1 2010 that ended in December 2009 through FQ3 2011 that ended in June of this year. The difference in the rates of growth between revenue and operating expenses is unmistakable and the resulting benefit to net income and earnings per share is remarkable.

Operating Expenses As A Percent of Revenue
Since the beginning of FY 2009, the percentage of revenue consumed by operating expenses has declined from a high of 14.35% in FQ2 2009 to a low of 8.90% of revenue in the recent June quarter (FQ3 2011). As revenue has scaled significantly higher over the most recent eleven fiscal quarters, the falling percentage of revenue consumed by operating expenses is now delivering literally billions of additional dollars to Apple's pre-tax income line on a quarterly basis. The drop in operating expenses as a percentage of revenue can have a bigger impact on Apple's net income and earnings per share than variations in each fiscal quarter's gross margins. 

The graph below illustrates the dramatic drop in the percentage of revenue consumed by operating expenses as revenue has risen significantly over this eleven-quarter period. 

SG&A Expenses As A Percent of Revenue
Selling, general and administrative expenses comprise the larger of the two components of operating expenses. From a high of 10.84% of revenue consumed by SG&A activity in FQ2 2009 to a low of 6.59% of revenue consumed by SG&A activity in FQ2 2011, there's a decided and distinct trend in the percentage of revenue consumed by SG&A activity over the eleven-quarter period. SG&A expenses are influenced by many factors including the increasing number of Apple retail stores, marketing and advertising efforts and the opening of new markets for Apple products. 
The graph and table data below illustrate and detail the falling percentage of each revenue dollar consumed by SG&A expense activity and the slight seasonal influence on this major OpEx component. 




% of 
Sequential
YOY
% YOY

Quarter
SG&A
Revenue
Rise
Rise
Rise

FQ1 ’09
1,091,000,000
9.18%
92,000,000
131,000,000
13.65%

FQ2 ’09
985,000,000
10.84%
-106,000,000
99,000,000
11.17%

FQ3 ’09
1,010,000,000
10.38%
25,000,000
94,000,000
10.26%

FQ4 ’09
1,063,000,000
8.71%
53,000,000
64,000,000
6.41%

FQ1 ’10
1,288,000,000
8.21%
225,000,000
197,000,000
18.06%

FQ2 '10
1,220,000,000
7.78%
-68,000,000
235,000,000
23.86%

FQ3 ’10
1,438,000,000
9.16%
218,000,000
428,000,000
42.38%

FQ4 ’10
1,571,000,000
7.72%
133,000,000
508,000,000
47.79%

FQ1 ’11
1,896,000,000
7.09%
325,000,000
608,000,000
47.20%

FQ2 ’11
1,763,000,000
6.59%
-133,000,000
543,000,000
44.51%

FQ3 ’11
1,915,000,000
7.16%
152,000,000
477,000,000
33.17%

The graph below illustrates the rate of growth in SG&A activity has actually fallen in the first nine months of the current fiscal year. This is remarkable considering revenue has risen at the rate of 78.2% over this same three-quarter period. The company's cost discipline has kept the rates of growth in SG&A expenses far below the rates of growth in revenue. This outcome has contributed significantly to the high percentages of revenue that flow to the net income and eps lines each fiscal quarter. 
R&D Expenses As A Percent of Revenue
Apple is world renowned for thoughtful product designs and development of innovative consumer products. Apple also keeps the number of products offered to a thoughtful and deliberate minimum to reduce costs and inventory risks. Over the eleven-quarter period inclusive of final development and release of the Apple iPad, the company has continued to invest in R&D and during the first nine months of the current fiscal year R&D expenses have exceeded one-half billion dollars each quarter. 
The graph and table data below illustrate and detail the company's reported R&D expense activity for the most recent eleven fiscal quarters. Although the percentage of revenue consumed by R&D expenses continues to fall, the amounts spent on R&D have risen consistently each quarter. 



% of 
Sequential
YOY
% YOY

Quarter
R&D
Revenue
Rise
Rise
Rise

FQ1 ’09
315,000,000
2.67%
17,000,000
69,000,000
28.05%

FQ2 ’09
319,000,000
3.51%
4,000,000
46,000,000
16.85%

FQ3 ’09
341,000,000
3.50%
22,000,000
49,000,000
16.78%

FQ4 ’09
358,000,000
2.93%
17,000,000
60,000,000
20.13%

FQ1 ’10
398,000,000
2.54%
40,000,000
83,000,000
26.35%

FQ2 '10
426,000,000
3.16%
28,000,000
107,000,000
33.54%

FQ3 ’10
464,000,000
2.96%
38,000,000
123,000,000
36.07%

FQ4 ’10
494,000,000
2.43%
30,000,000
136,000,000
37.99%

FQ1 ’11
575,000,000
2.15%
81,000,000
177,000,000
44.47%

FQ2 ’11
581,000,000
2.36%
6,000,000
155,000,000
36.38%

FQ3 '11
628,000,000
2.20%
47,000,000
164,000,000
35.34%

In contrast to the decline in the rate of year-over-year growth in SG&A expenses during the first three quarters of the current fiscal year, the rate of growth in R&D expenses actually rose in the first fiscal quarter. Although Apple's frenetic rates of revenue growth this fiscal year have reduced the percentage of revenue consumed by R&D expense activity, these expenses remain well above 2% of reported revenue as Apple continues to invest in new and refreshed products and services. While Apple continues to invest heavily in R&D, its direct impact on net income and earnings per share is lessened by the impressive rates of revenue growth each quarter. 
Conclusions
Apple keeps to a practical minimum the number and array of products and services the company brings to market. This approach yields impressive benefits to the bottom line through economies of scale and lowered component acquisition and inventory management risks. The increasing number of Apple retail stores also benefit the bottom line because the stores are both sales and service centers for Apple product customers. 
Apple's ability to maintain strong cost discipline has led to impressive gains in the percentage of revenue that flows to the net income and eps lines. While revenue rose 78.2% in the first nine months of the current fiscal year, eps has risen 96.2% over the same period. Sustaining rates of revenue growth far greater than the rates of growth in operating expenses will yield superior eps outcomes for the next several quarters.

Apple's enviable gross margins and lowered effective tax rates due to the rising increasing influence of international sales combine with strong operating expense management to make cost discipline Apple's potent pathway to profits. 
Disclosure: The author is long Apple shares
Robert Paul Leitao

3 comments:

  1. Fantastic analysis. This clearly explains why Apple's profits are increasing faster than the superb revenues.

    The increased R&D in 2011 shows that Apple is going for something big in the coming years.

    ReplyDelete
  2. Due to the frenetic pace of revenue growth Apple's increasing R&D expenditures are masked when viewed as a percentage of revenue. However, R&D expenditures continue to rise in support of Apple's expanding product lines and expanding retail store presence.

    ReplyDelete
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    ReplyDelete