Sunday, April 28, 2013

Apple: There And Back Again

On April 23rd, Apple released the company's results for its second fiscal quarter of 2013. Reported revenue of $43.60 billion represented a March quarter record and the third highest quarterly revenue performance in the company's stored history. However, March quarter earnings per share fell to $10.09, down 18% year-over-year. In today's article I will review Apple's March quarter performance, the recently announced cash distribution plan and the ways in which Apple is setting a firm foundation for future growth. 

Apple: There and Back Again
The graphs below illustrate Apple's recent rates of revenue and earnings per share growth compared with the quarterly rates of growth since the first quarter of FY2010.

In the March-ending period, Apple reported its slowest rate of quarterly revenue growth in years. Since the third quarter of FY2012, quarterly revenue growth has slowed to a pace last seen in FY2009 and the peak of the Great Recession. In the March quarter, Greater China, previously Apple's fastest-growing revenue region, reported only 7.54% revenue growth. That was below the 11.27% revenue growth for the company as a whole. For the current June quarter, Apple has guided to revenue of between $33.5 billion and $35.5 billion and hinted at the possibility of a negative revenue growth quarter. In the June quarter one-year ago, Apple reported revenue of $35.023 billion.

Despite the fact Apple will almost certainly report yet another successive year of record revenue, the company's performance is overshadowed by expectations of flat earnings growth this fiscal year and present-day market preoccupation with the company's massive amounts of cash.

In the March quarter, Apple reported its second consecutive negative eps growth quarter and its first negative net income growth quarter in years. In the recent December quarter, earnings per share fell 0.4% with a modest $14 million rise in net income. In the March quarter, earnings per share fell 17.9% to $10.09 from $12.30 in the prior-year period with a corresponding drop in net income of $2.075 billion. 

Apple has returned from a three-year cycle of extraordinary rates of revenue and earnings growth following the Great Recession that was fueled by strong geographic expansion, the introduction of the iPad and fast rates of growth in the global smartphone market. This is an end to a chapter, not the end of Apple's long-term growth story. 

Gross Margin By Quarter
The graph below illustrates the dramatic drop in gross margin that has occurred over the most recent four fiscal quarters. In the March quarter Apple reported gross margin of 37.50%, the company's lowest gross margin performance since the fourth quarter of FY2010. 

The fourth quarter of FY2010 was the first full quarter of sales for the iPhone 4 series handset. The change in the iPhone's form factor in 2010 similar to the change in the form factor for the iPhone 5, negatively impacted gross margin due to the high costs of equipment for the new handsets. 

Apple's gross margin reached its highest levels during the first two quarters following the release of the second handset in the iPhone 4 series. The extraordinarily high gross margin performance in the first half of FY2012 was due in large part to economies of scale achieved with two iPhone 4 series handsets in the market and the realization of fixed manufacturing costs over a higher volume of iPhone 4 series handsets produced and sold.

A partial gross margin recovery for Apple will occur following the release of the successor to the iPhone 5 handset. In the first quarter of FY2013, Apple refreshed the iPad with Retina display, released the iPad mini and announced a new line of iMac computers. The delay in delivery of new iMac computers until the March quarter (FQ2 2013) drove iMac unit sales down over 20% from the prior year's level. Simultaneous iPad and iMac line refreshes in FQ1 2013 along with the introduction of the iPad mini and a new form factor for the flagship iPhone handset will influence gross margin throughout the fiscal year. The precipitous drop in gross margin year-over-year is the primary cause of negative earnings per share growth in the December and March quarters. 

In the March quarter, Apple accrued $1.551 billion for product warranty expenses. This was a more than tripling of the amount accrued in the year-ago quarter. Changes to the company's service policies and increases in other estimated warranty costs had an adverse impact on gross margin in the period. 

Although gross margin will most likely not again reach early FY2012 levels anytime soon, gross margin recovery will begin following the release of the next iPhone 5 series handset.

iPhone and iPad Revenue
The graph below illustrates Apple's revenue from combined iPhone and iPad device sales and the percentage of reported revenue represented by the two product lines. In the year-over-year comparison, the percentage of total reported revenue from Apple's two biggest device lines remained fairly constant in the March quarter at just over 72%.

Despite a 22% year-over-year rise in combined iPhone and iPad unit sales, revenue from the two product lines inched up in the March quarter only 11% due to the popularity of the iPad mini and rising consumer demand for the lower-cost iPhone 4 series handsets.

In early FY2014, as Apple moves past the first anniversary of the introduction of the iPad mini, revenue growth for the combined product lines will track more closely with the combined rise in units sales for Apple's two most popular device lines.

The global PC market is in a state of irreversible economic decline. Although the Macintosh will remain a high revenue device line and is important for overall eco-system growth, its percentage of total revenue produced will continue to decline and will decline markedly following Apple's next big disruptive step.

From Here To There
Apple's future growth hinges as much on the increasing number of active device owners as it does on the cyclical nature of new product sales. Apple has developed a multi-device content and services platform in which the individual device lines are simultaneously independent and components of a large and growing eco-system of apps, content and services.

Apple's platform of apps, content and services provides for the emergence of new devices and the release of new and disruptive product lines over the next few years. The company's future growth will be determined more by the scope of its content, apps and services platform than it will be determined by the unit sales growth of any one of the company's current device lines. 

The closest proxy available for gauging the growth in Apple's global eco-system is the iTunes/Software/Services revenue segment. The graph below illustrates the consistent rates of growth for what is becoming an increasingly important revenue segment. In the March quarter this revenue segment delivered nearly 30% revenue growth to just under $4.114 billion and represented 9.44% of reported revenue.

The iTunes/Software/Services revenue segment will eventually surpass the Macintosh line in revenue generated each quarter and remains one of the best yardsticks to gauge the growth in the installed base of active Apple-branded device users. 

No matter the fluctuations in quarterly device sales, the iTunes/Software/Services segment continues to deliver consistent rates of revenue growth. Payments to developers have now surpassed $9 billion and the payments continue to flow at the rate of $1 billion per quarter or more.

Apple's Cash Distribution Plan
With the release of March quarter results, Apple announced the largest share repurchase program in enterprise history. By the end of calendar year 2015, Apple will return a total of $100 billion to shareholders through a combination of quarterly dividends and share repurchases. The share repurchase program will consume $60 billion of the $100 billion cash distribution plan.

In the first fiscal quarter of FY2013, Apple recognized the use of $1.950 billion for the purpose of repurchasing shares of the company's common stock. As of April 1, 2013, Apple had received and retired 4.077 million shares of common stock at a average cost of $478 per share. 

Beginning in April 2013 and ending no later than December 2015, Apple has announced  the company intends to repurchase an additional $58 billion in common stock over this thirty-three month period. Using $580 as the average price at which the company will repurchase shares by the end of 2015, the company will repurchase over this time more than 10% of the company's fully diluted share count which stood at 946.035 million shares at March 30, 2013. 

On April 23, 2013 Apple also announced the company is raising its quarterly dividend to $3.05 per share or $12.20 per share on an annual basis. This 15% dividend rise increased the yield on the shares to 2.92% at the closing price of $417.20 on April 26, 2013. 

In the company's Form 10-Q that accompanied the quarterly results, Apple reported the average yield on the company's massive holdings of cash and marketable securities was 1.06% during the first six months of the current fiscal year. 

At this time, repurchasing shares will deliver more in cash saved on the elimination of dividends paid on the repurchased shares than would be earned on the cash and marketable securities if the repurchase plan had not been put in place. 

Although a total of $60 billion in cash used for the repurchase of shares through December 2015 may seem like an aggressive share repurchase program, it's the best use of cash at this time. Even at lowered rates of revenue and earnings growth, Apple is on track to end 2015 with more cash generated from operations than the roughly $145 billion on the books at March 30, 2013. 

At the end of the second fiscal quarter, Apple had $16.481 billion in deferred tax liabilities on foreign-earned cash that had yet to be repatriated to the United States. Rather than pay the tax liability upon repatriation, Apple has announced it will borrow funds to complete the share repurchase program. Whether or not Apple uses its own cash or borrows cash for the share repurchase program is of no real consequence to the company's balance sheet. 

Although an ambitious share repurchase plan and a higher dividend yield will provide support for Apple's share price, it is revenue and net income growth that will propel the share price significantly higher.

Restoring High Rates of Growth
As the founder of the Braeburn Group, I am in constant conversation with other independent analysts about Apple and the company's growth prospects over the next several quarters. While there's talk of a larger-screen iPhone, a less expensive iPhone for emerging markets and expectations for major product refreshes over the next six months, what will drive Apple's long-term growth is the company's eco-system, expanding customer base and growth in the number of active iOS device users. 

I expect to see evidence of Apple's next disruptive step beginning with the release of iOS 7 this summer. Increasingly, the individual device lines, while distinct and different in form and function, are becoming incidental to the growth in the eco-system and Apple's future growth prospects.

I expect a return to higher gross margin following the release of the second handset in the iPhone 5 series, a strong iPhone refresh cycle in the fall along with continuing geographic and carrier expansion. In particular, I expect the addition of China Mobile and NTT DoCoMo as authorized carriers within the next 12 months. The Apple iPad line will continue to generate attractive rates of unit sales growth over the next four fiscal quarters. But returning to the higher rates of growth experienced in fiscal years 2010 to 2012 will necessitate new and disruptive product lines to enhance the eco-system and increase the flow of revenue through the company's iTunes/Software/Services platform. 

Apple's annual WWDC event set to begin on June 10th may provide clues to Apple's next big disruptive step.

Robert Paul Leitao

Disclosure: The author is long Apple shares