Monday, October 28, 2013

Apple’s Think Different Approach To Quarterly Math

On October 28, 2013, Apple announced quarterly results for the period ended September 28, 2013. For the quarter, Apple announced revenue of $37.472 billion and earnings per share of $8.26 on 909.131 million fully diluted shares in the count. Net income was precisely 20% of reported revenue in the period. 

What surprised the market was Apple’s very conservative guidance for the December quarter. Although the quarter will most likely represent the highest revenue, net income and earning per share quarter in the company’s history, management has guided to revenue of between $55 billion and $58 billion and gross between 36.5% and 37.5%. The top end of revenue guidance suggests a 6.4% year-over-year revenue gain and the gross margin guidance range suggests a deterioration in the company’s year-over-year gross margin performance. In the year-ago quarter, Apple reported gross margin of 38.63%.

In the challenging fiscal year ended in late September, Apple reported revenue growth of 9.2% to nearly $171 billion. iPhone unit sales in the fiscal year rose 20.16% to 150.257 million units and iPad unit sales rose 21.82% to 71.033 million units. At this time, there’s little reason to expect the unit sales growth performance from the company’s two most popular product lines to fall below the FY2013 rates of growth. But with all things Apple, there’s much more to the story.

iPhone and iPad Unit Sales
The graph below illustrates the combined unit sales of the iPhone and iPad lines over the most recent sixteen fiscal quarters, including iPhone unit sales in the quarters immediately preceding the original iPad’s release in the spring of 2010.

In each quarter of the sixteen quarters there has been year-over-year unit sales growth of no less than the recent September quarter’s 6.47% rate of growth. In the December quarter one year ago, combined iPhone and iPad unit sales rose 34.63% to 70.649 million units. 

The graph below illustrates combined iPhone and iPad unit sales by fiscal year. 

In the fiscal year ended in September, combined iPhone and iPad unit sales reached 221.29 million units on a 20.90% rate of unit sales growth. Still, Apple has guided to no more than 6.4% revenue growth in the current December quarter. 

Product Line ASPs
The graph below illustrates average selling prices for each of Apple’s major product lines since the first quarter of FY2011. 

The recent fall in Macintosh ASPs is due primarily to the 16-month period between MacBook Pro refreshes. The line was updated in June 2012. This year, the update occurred in October. The recent decline in iPhone ASPs can be attributed to a change in the sales mix as Apple has become more aggressive on pricing in emerging markets such as India. The often mentioned decline in iPad ASPs since FQ4 2012 was caused by the emergence of the iPad mini. 

Unit Sales Growth Rates
The graph below illustrates the year-over-year unit sales growth rates of Apple’s major product lines over this same 12-quarter period. The extraordinarily high unit sales growth rates Apple realized with the iPhone and iPad lines in the first half of FY2012 created very challenging prior-year comparisons by which to measure growth in the fiscal year ended in September.

Deferred Revenue
As of September 28, 2013, Apple’s balance sheet reflects deferred revenue liabilities of $10.06 billion. This is inclusive of the deferred revenue on sales of Macs and iOS devices. This revenue is recognized over the two-year anticipated economic life of each iOS device sold and over the 4-year anticipated economic life of each Macintosh sold. The revenue is deferred due to the implied right of the owners of Macs and iOS-based devices to receive free software updates and services from Apple.

During the September quarter conference call with analysts, Peter Oppenheimer, Apple’s CFO, indicated the company is increasing the deferred revenue on each iOS device sold to as much as $25 and to $40 on each Macintosh sold. According to management, this will result in a sequential increase in deferred revenue of about $900 million in the December quarter. The deferrals are a dollar-for-dollar reduction to the recognized revenue on each device sold and a dollar-for-dollar reduction in the recognized revenue per device for the quarterly gross margin computation. The reduction in recognized revenue on each iOS device and Mac sold is partially offset by the straight line recognition of revenue deferred in prior quarters. Still, while Apple picks up the cash on the amounts deferred, revenue is reduced and a corresponding liability established until the deferred revenue is recognized according to the schedule previously mentioned. 

Moving Forward
In reviewing the unit sales trends for the iPhone, iPad and Mac product lines, it’s challenging to model a scenario in which revenue for the December quarter will come within Apple’s given range. Simply put, I consider guidance on the quarter to be conservative. 

Last year, Apple was unable to deliver the newly-styled iMac in time for the holiday quarter. Combined with MacBook Pros that were refreshed in June of that calendar year, Mac unit sales fell more than 20% year-over-year. This year, the MacBook Pro line was updated in October and Apple has resolved its manufacturing problems with the new iMac’s design. I expect single-digit unit sales growth for the Mac line in the December quarter and a modest increase in the line's ASP.

The iPad mini was released in November 2012. The popularity of Apple’s smaller and lower-priced iPad sparked unit sales growth, but it also reduced average selling prices for the line. Consumers have been waiting since last spring for the new iPad mini with Retina display that will begin to ship next month. Although management stated supplies of the new mini may be constrained through the holiday quarter, the new 9.7” model in a lighter and thinner enclosure will also boost unit sales. Even with a slight increase in the deferral of revenue on each iPad sold, unit sales will be strong in the December quarter and average selling prices may see an improvement year-over-year. I expect double-digit unit sales growth for the iPad line in the December quarter. Apple has increased the price on the new iPad mini with Retina display over the price of the original iPad mini. Pricing for the mini with Retina display begins at $399.

Apple surprised the market when the company announced in September the sale of 9 million iPhone handsets in the first weekend of availability for the new 5c and 5s handsets. For the September quarter, iPhone unit sales rose 25.9% to 33.797 million units, inclusive of the rise in global channel supply of 3.3 million units or a total ending inventory of 14.3 million units. Management stated the ending inventory was below the company’s target range on a look forward basis. I expect iPhone unit sales growth in the December quarter to exceed 20%. The addition of DoCoMo as an authorized carrier will be a factor in the strong iPhone unit sales results. DoCoMo is the largest carrier in what is now Apple’s fastest-growing revenue region. 

Overall, based on unit sales trends and despite the increase in deferred revenue per unit sold, I expect December quarter revenue to reach or exceed $60 billion. Apple does “Think Different” in the company’s approach to quarterly math and the December quarter outcome is apt to be a bit more impressive than management currently suggests.

Robert Paul Leitao

Disclosure: The author is long Apple shares