Saturday, August 17, 2013

Apple's Challenging Metric Conversion

On Friday, August 16th, Apple's share price closed above $500 for the first time since January. The recent announcement by Carl Icahn of his investment in Apple, the completion of the first big phase of the planned $60 billion share repurchase program and better than expected iPhone sales in the June quarter have combined to catapult the share price off the 52-week low of $385.10 set back in April.

From the all-time high of $705.07 reached last September to the 52-week low set in April to the closing price of $502.33 on Friday, Apple's share price has gyrated wildly over the past twelve months.

Within weeks Apple will announce its fall product refreshes for the iPhone and iPad lines. Rumors and speculation about the company's forthcoming new products are again receiving broad press coverage. The product news will come at the tail end of Apple's most challenging fiscal year in recent history.

In late October, Apple is likely to report negative net income growth for the fiscal year ending in September and a fourth consecutive quarter of tepid revenue growth. The deterioration in Apple's year-over-year profitability is due in part to the outsized revenue and earnings growth rates achieved in the prior fiscal year. In FY2012, Apple's revenue rose 44.58% and earnings per share rose 59.60%. In the first three quarters of the current fiscal year, Apple's revenue growth rate was 10.7%. Net income, a better metric than earnings per share as Apple repurchases tens of millions of shares, is down 11.89% year-over-year.

Apple's Challenging Metric Conversion
In today's article I am publishing a series of graphs that detail the recent deterioration in a select set of financial performance metrics and mention the challenges Apple faces as management strives to return the company to strong rates of revenue and earnings growth.

Apple's Revenue Growth Rates
The graph below illustrates Apple's revenue growth and revenue growth rates over the most recent fifteen fiscal quarters. 
Although the company has eked out revenue growth of 10.7% in the first nine months of the current fiscal year, due in part to a roughly $1 billion sequential drop in channel supply value in the recent June quarter, the reported revenue growth rate in the period was 0.86%. Apple is now experiencing its slowest rate of revenue growth in years and the revenue growth rate so far this fiscal year is below the 14.4% revenue growth rate realized in recession-plagued FY2009.

Apple's Earnings Per Share Performance
The graph below illustrates Apple's earnings per share and eps growth rates by quarter since FQ1 2010. 

In the first three quarters of the current fiscal year, Apple has reported negative earnings per share growth. Over this nine-month period eps has fallen 11.61% year-over-year to $31.36. The recent negative eps growth is despite fewer shares outstanding in the recent March and June quarters.  In the June quarter, Apple's $7.47 eps performance fell below the $7.79 per share earned two years prior in FQ3 2011.

Apple's Net Income Per Revenue Dollar
Causing much of the drop in earnings per share this fiscal year is a dramatic falloff in the percentage of recognized revenue reaching the net income line. The graph below illustrates the net income per revenue dollar trend over the most recent fifteen fiscal quarters. 
From a high of 29.66% of revenue reaching the net income line in FQ2 2012 to a low of 19.53% in the recent June quarter, net income has been trending down on a year-over-year basis since the June quarter of FY2012. 

Expenses Per Revenue Dollar
The graph below illustrates Apple's expenses per revenue dollar. In the recent March and June quarters, expenses per revenue dollar reached levels last seen three years ago in FY2010. The recent deterioration in net income per revenue dollar and the corresponding rise in expenses per revenue dollar are due in large part to slowing rates of revenue growth.
Gross Margin
Apple's biggest expense component is Cost of Sales. Cost of Sales represents the direct costs of revenue and is the inverse of gross margin. As Cost of Sales rise as a percentage of reported net sales, gross margin is reduced. The graph below illustrates Apple's gross margin performance on a quarterly basis since FQ1 2010. Apple's reported gross margin of 36.87% in the recent June quarter is the lowest gross margin outcome in the fifteen quarters measured in the graph.

There are many factors that have adversely impacted Apple's gross margin this fiscal year including the extraordinary $1.551 billion warranty set-aside recognized in the March quarter.  The factors also include but are not limited to the release of the lower-priced iPad mini last November, the year-over-year drop in Mac unit sales over the most recent nine months and the higher costs of producing the iPhone 5 handset versus the costs of producing the iPhone 4S handset one year ago.

Turning It All Around
Returning to faster rates of revenue growth, reversing the decline in net income growth and delivering a higher percentage of revenue to the net income line won't be easy. But it can be accomplished is a series of forward-looking steps. 

The Impact of the iPad mini
While iPad unit sales rose 28.64% in the first nine months of the current fiscal year, corresponding revenue growth was a scant 8.32%. As Apple moves past the first anniversary of the iPad mini's release in early November, the revenue growth rate from the product line will rise in tandem with the rate of growth in unit sales. 

A 1.9 million unit shift in channel supply year-over-year drove reported iPad unit sales down 14.23% in the recent June quarter. There have been no updates to the iPad line in over nine months. Consumers will pay for Apple innovation. Consumers will not pay for Apple products viewed as stale. Apple chose to forego a spring update to the iPad line and the outcome is plain to see in the line's June quarter unit sales and revenue performances.

Keeping to an annual iPad line refresh will diminish unit sales growth. A more frequent refresh schedule need not include a change of form factor but an upgrade to components. While the engineering challenges involved in delivering an iPad mini with the so-called Retina display have taken time, refreshes of the iPad line need to be more frequent. 

iPads 3 & 4 are viewed as transitional product designs. The first Retina display iPad was released in March 2012 in the iPad 3. The iPad 4 was released last fall. Consumers are waiting on a slimmer, lighter 9.7" iPad model. To boost the product line's revenue growth rates, refreshes in both the spring and fall are needed. The tablet market is not without fierce competition and Apple must address the perception of consumers the product line becomes stale six months out from each new product release.

Consumers do want a Retina display iPad mini and few will settle for anything less. The sooner Apple delivers what consumers want in the iPad mini, the sooner unit sales growth will reignite.

The Apple iPhone
The iPhone 5 suffered from engineering complexities that constrained supplies at last year's launch. Additionally, the change in form factor and the change in dock connector increased costs per unit sold. 

Speculation about a new, lower-cost iPhone 5 series handset in a polycarbonate enclosure suggests Apple is working to reduce manufacturing costs and manufacturing complexities in the pending product line refresh. 

Removing from sale all handsets with the legacy 30-pin dock connector (iPhone 4 & 4S)  and adopting the 4" display across all models will provide for uniformity on all new handsets and benefit economies of scale throughout the product line.

Cost of Sales include not only the incremental costs of each additional handset sold, but also fixed costs such as the amortization of manufacturing equipment. The more units sold and the more easily each unit can be manufactured, the higher the reported gross margin. Not all cost components represent cash out the door in the quarter the devices are sold. Apple's next flagship handset in the current iPhone 5 enclosure will deliver higher gross margin than its predecessor if Apple can deliver ample supplies of the product at launch and maintain ample supplies through the peak selling season.

As of this writing there's rampant speculation Apple is including a fingerprint sensor for added device security in the pending flagship iPhone refresh. Conspicuous innovation will drive unit sales much more than over attention to a device's enclosure. Apple views design as an art form and no one can dispute the company's global leadership in product design. Superior design, conspicuous innovation and easing the complexities of product manufacturing will deliver strong rates of unit sales growth and more attractive performance metrics such as higher gross margin beginning this fall.

Apple's outsized gross margin in the first half of last fiscal year was driven in part by the economies of scale achieved with unit volume of two iPhone 4 series handsets in the market. Innovation and product updates have costs, but economies of scale achieved with high demand for new and innovative products can and will deliver more satisfactory performance metrics. Management has been walking down gross margin expectations for the past few quarters. Although Apple will not reach the gross margin performances achieved in the first two quarters of FY2012, Apple can improve on the gross margin outcome realized in the first three quarters of the current fiscal year.

The Macintosh
Apple's Macintosh line is not immune to the economic decline of the global PC industry. To combat the industry's negative revenue and unit sales growth, Apple must continue to bring new and innovative products to market. At Apple's WWDC event in June, the company announced a radically reengineered Mac Pro line that will debut before the end of the calendar year. While views on the new Mac Pro line are mixed with many professionals decrying the loss of expandability, there's no disputing the fact Apple can and will continue to bring innovative products to market.

In the December quarter, Mac unit sales fell 22% due in part to manufacturing delays in the new line of iMacs. Today the iMac line has yet to be refreshed with the latest Intel chipsets released in late spring. In June, Apple refreshed only the MacBook Air line of portable PCs. The MacBook Pro line will be updated to Intel's Haswell chipsets at a later date. The sooner Apple delivers the new Mac Pro and processor updates to the MacBook Pro and iMac lines, the better the company can fight the declining unit sales trend.

It's All About The Eco-System
Next fiscal year iTunes billings will surpass $20 billion. Much of that revenue will be passed through to developers and content providers and not be recognized as revenue on Apple's quarterly financial statements. But iTunes billings reveals the size and scope of Apple's app and content sales economy.

Next fiscal year the entire iTunes/Software/Services segment will deliver greater than $20 billion in recognized revenue and may represent 10% or more of Apple's reported revenue total.

Over 90% of iOS device owners are currently running iOS 6. Apple will achieve a similar level of adoption with iOS 7 while providing developers with the most robust mobile platform on the planet. With all new iPhones running nothing less than the iPhone 5's A6 SOC and the new flagship iPhone running the new A7 SOC, every new iPhone sold will easily handle the latest apps while very high iOS 7 adoption will provide for a uniform platform for eco-system growth and development.

Next fiscal year the iTunes/Software/Services segment may come close to matching the revenue generated by the entire Macintosh line and may deliver five times the revenue of the fading iPod line. Boosting unit sales of all device lines will boost Apple's post-purchase revenue growth from sales of apps, software, content and services. 

iTunes/Software/Services is currently Apple's fastest growing revenue segment and is essential to the company's long-term success. Content drives unit sales as much as unit sales drives the company's overall growth. Increasing the flow of revenue through Apple's expansive global eco-system is justification for management to reduce device manufacturing complexities, moderate gross margin in favor of unit sales and deliver to developers the highest number of users possible running the latest version of iOS on the latest A series SOCs.

As the founder of the Braeburn Group, I am in contact with members of our global network of independent Apple analysts throughout the day. In general, our members are cautiously optimistic about Apple's forthcoming fall product refreshes and management's ability to return the company to strong and sustainable rates of revenue and net income growth. Although the road ahead may not be an easy path to travel, Apple's management can deliver strong revenue growth coupled with moderately higher gross margin next fiscal year. 

Apple's massive share repurchase program will buttress the share price and amplify the impact of rising net income on earnings per share. However, to move the share price well beyond Friday's closing price and capture new all-time highs, management must meet the challenge of reversing the decline in key performance metrics. For shareholders, Apple's metric conversion must begin this fall.

Robert Paul Leitao

Disclosure: The author is long Apple shares