Saturday, July 27, 2013

Apple: Where From Here?

On Tuesday, July 23rd, Apple announced results for the company's third fiscal quarter of  2013. The company surprised Wall Street with year-over-year iPhone unit sales growth of 20% to 31.241 million units despite a 600,000 unit reduction in global channel supply to 11.0 million units. iPhone unit sell-through in the quarter was about 31.84 million units. 

iPad unit sales were a disappointment in the period, falling year-over-year by 14.23% to 14.617 million units. Management emphasized during the quarterly conference call that reported iPad unit sales were negatively impacted by a 1.9 million unit swing in channel supply year-over-year. Meanwhile, Mac unit sales fell 6.62% to 3.754 million units. In the June quarter Apple did not refresh its MacBook Pro line, but refreshed the MacBook Air line only. One year ago both the MacBook Air and the MacBook Pro received a June quarter update. 

For the quarter, revenue rose a scant 0.86% to $35.323 billion and net income fell from $8.824 billion in the June quarter last year to $6.90 billion in the quarter ended June 29th. 

Despite the stronger than expected iPhone unit sales numbers and the fact Verizon and AT&T activated more iPhones in the June quarter than all other makes of smartphones combined, the quarter's results highlight Apple's many challenges moving forward. While revenue in the Americas region rose 12% in the June quarter, Greater China delivered a 14% decline in revenue and Apple's Retail revenue segment had a $10 million year-over-year revenue setback despite more stores open for business. 

Apple: Where From Here?
In today's article I will detail changes that are occurring in Apple's revenue flow and why the company's road to earnings recovery may take some long and winding turns.   

Apple As An Eco-System 
Apple has moved beyond the scope of being primarily a device maker. In the June quarter revenue from the company's iTunes/Software/Services revenue segment rose nearly 25% to $3.99 billion and represented 11.3% of reported revenue. The graph below illustrates the growth in what was the company's fastest growing revenue segment in the period. The fairly consistent revenue growth in the iTunes/Software/Services segment is contrasted in the graph with the seasonal revenue performance of Apple's Accessories segment that experienced a 4% revenue decline in the recent quarterly period.

Of the $3.99 billion in segment revenue, $2.4 billion was sourced from iTunes alone. Since the opening of the Apple app store, $11 billion has been paid through to developers. According to management, half of the $11 billion was earned by developers within the past 12 months. iTunes billings, separate from recognized iTunes revenue, reached $4.3 billion in the June quarter.

Although Apple's device sales are highly influenced by seasonal factors, including the company's pattern of refreshing its major device lines in the fall, the company's customer base continues to grow by the minute. Cumulative app downloads have surpassed 50 billion and the number of apps available for iOS devices is fast approaching 1 million in number. There are over 320 million iCloud users and over 240 million Game center accounts. 

The iPad and iPhone Device Lines
The graph below illustrates the combined unit sales growth for Apple's iPhone and iPad device lines. Despite the iPad line's lackluster June quarter performance, iPhone and iPad unit sales rose a combined 6.47% to 45.858 million units. Although neither the iPhone or iPad lines have been refreshed since last fall, combined unit sales growth has continued to rise on a year-over-year basis.

The combined revenue from iPhone and iPad device sales will again generate well above 70% of revenue in the first two quarters of FY2014 and following the expected fall refresh of the iPhone and iPad lines. However, the long-term trend suggests the iTunes/Software/Services segment will deliver revenue growth rates greater than the rates of growth for the combined iPhone and iPad lines on a fiscal year basis while gradually increasing the line's percentage of total reported revenue. 
The percentage of reported revenue contributed by the combined iPhone and iPad lines reached its zenith in the recent December quarter at nearly 76% following the release of the iPhone 5 and the nearly 22% drop in Mac unit sales due to iMac production delays in the quarter. In the June quarter the combined revenue from the iPhone and iPad lines actually declined by $72 million year-over-year despite the overall rise in unit sales due to the influence of the lower-priced iPad mini which debuted last fall. 

Apple's Global Performance
Although revenue in the Americas revenue region rose 12% in the quarter and revenue in Japan rose an impressive 27%, revenue in Greater China and the Rest of Asia-Pacific fell 14% and 18% respectively. In Europe, revenue fell 7.6%.

Contributing to the mixed revenue growth results in all of Apple's regional revenue segments was a big swing in global channel supply value. On a sell-through basis, Apple's revenue rose about 6% year-over-year in the June quarter. On a sequential basis, channel supply value dropped by $1 billion.

Greater China has always been a long-term investment for Apple and Tim Cook has committed to doubling the number of retail stores on China's mainland within two years. With or without an iPhone carrier deal with China Mobile, Apple is focused on overall eco-system expansion and a balanced approach to top line growth. Consequently, Apple will remain a non-participant in the low-cost smartphone and tablet markets. 

The company is preparing for the fall product refresh cycle by reducing supplies of currently shipping devices. Among Apple's biggest challenges over the next 60 days is manufacturing management. The company's balance sheet reflects a more than $900 million increase in inventories year-over year to $1.697 billion. Both finished goods inventory and components inventory contributed to the rise in reported inventories value. Apple increased inventories value while decreasing channel supplies of currently shipping products.This suggests Apple began preparations for the pending product transitions before the end of the June quarter. 

Apple's ability to meet demand outside the US for newly refreshed iPhone and iPad models will significantly impact the company's rate of revenue growth in the final four months of the calendar year, including the first fiscal quarter of FY2014 that begins on September 29th. Staggering release dates for new products because of constrained product supplies works against revenue growth and is adversely impacting the company's global revenue performance. 

On a global basis, Apple is quietly and persistently driving growth through expansion of the company's vast eco-system which includes sales of devices, content, software and services. Successfully executing on the company's eco-system development plan outlined during June's WWDC is management's primary goal. Apple's success must be measured by the increasing number of eco-system customers as well growth in the number of high-end smartphones and tablets sold. 

EPS Growth Through Share Count Reduction
Earlier this year Apple announced an expansion of the company's share repurchase program to $60 billion by the end of CY2015. As of the end of the June quarter, almost $18 billion had already been committed to the share repurchase plan including $12 billion deployed through an Accelerated Share Repurchase program (ASR). 

At the end of the June quarter, Apple reported a fully diluted share count of 924.265 million, down sequentially from 946.035 fully diluted shares reported at the end of the March quarter. 

The sequential reduction of nearly 22 million shares included the impact of almost 1.5 million shares repurchased through a prior ASR in the March quarter and delivered for retirement at the start of the June quarter, 9 million shares repurchased in open market transactions by management and a portion of the shares that will be reported as repurchased under the new ASR. The recognition of all shares repurchased under the $12 billion program will stretch into CY2014. Of the planned $60 billion in repurchases, $42.1 billion remains to be committed. 

The graph below illustrates the dramatic impact on the fully diluted share count from the reduction in shares recognized on Apple's Statement of Operations for the June quarter. 

While thirty months remain in the expanded $60 billion share repurchase program, Apple has front loaded its share repurchases to take advantage of the dramatic drop in the share price over the past ten months and is aggressively acquiring shares at today's lower share prices. 

Although a reduction in the fully diluted share count will have a dramatic impact on the company's earnings per share outcome throughout the multi-year share repurchase program and beyond, delivering strong net income growth is among the company's biggest challenges moving forward.

Apple's Path Forward
Tim Cook has stated repeatedly Apple is not in the market to sell the most devices. Apple is in the market to deliver the best devices. Moving forward, those looking at Apple purely as a device maker may be disappointed in the company's rates of units sales growth. Apple is purposely not entering the low-cost device markets. This alone will keep the company from delivering the outsized revenue growth rates realized as recently as 18 months ago. Those looking at Apple as an expanding global eco-system may be rewarded for their patience and long-term shareholders may be justified in their stubborn perseverance as the calendar moves through the fall.

The successor to the iPhone 5 and the much anticipated new lower-cost iPhone handset will deliver strong unit sales growth throughout FY2014. The updates to the MacBook Pro line expected in the next few weeks will boost Apple's PC market performance above the rate of declining unit sales for the PC industry as a whole. 

A refreshed iPad line including a lighter, thinner 9.7" model will also drive sales. As Apple passes the first anniversary of the release of the iPad mini, revenue growth for the device line will move in tandem with the rise in unit sales. Meanwhile, revenue in the iTunes/Software/Services segment will continue to rise at a better than 20% year-over-year pace. 

Apple is traveling on a long and winding road to revenue and earnings growth recovery.  The recovery will come not from outsized unit sales growth in the company's two biggest device lines. It will come from balanced growth throughout the company's global eco-system including device sales and revenue generated from iTunes, software and services. 

The massive share repurchase program will not only boost eps on its own, it will also amplify the pace of eps growth following the fall product line updates. In my next article I will illustrate the specific performance metrics beyond unit sales growth Apple must improve beginning this quarter as Apple makes Apple its biggest cash investment. 

Robert Paul Leitao

Disclosure: The author is long Apple shares