Sunday, November 24, 2013

Apple’s Scenic Detour On The Road To Reported Growth

Apple’s December quarter will be the highest reported revenue quarter in the company’s history and earnings per share will reach a new high as well. During this quarterly period Apple will sell over eighty million iPhones and iPads combined while setting new records for unit sales of the company’s two most popular product lines. Despite these superlatives, Apple is taking a scenic detour on the road to reported growth. 

Long gone are the meteoric rates of growth of fiscal years 2011 and 2012. In FY2011 revenue rose 65.96% and in FY2012 revenue advanced at a 44.48% rate. In the fiscal year ended in September, Apple’s reported rate of revenue growth was a dawdling 9.20%. For the first time in years, Apple reported negative earnings per share growth in FY2013 following a 59.60% rise in eps in FY2012 and an astonishing eps growth rate of 82.64% in FY2011. 

The graphs below illustrate the company’s slowing rates of reported revenue growth and the impact of slowing rates of revenue growth on Apple’s earnings per share.

Since the third fiscal quarter of FY2012, there’s been a marked decline in Apple’s quarterly rates of revenue growth. Although the company continues to deliver record revenue each fiscal year and so far has escaped a year-over-year decline in quarterly revenue, there’s no mistaking the dramatic drop in revenue growth rates over the most recent six fiscal quarters.
Apple’s earning per share has been negatively impacted by the slowing rates of revenue growth. In each quarter of FY2013, Apple reported negative eps growth despite a continuing reduction in the number of fully diluted shares from the ongoing $60 billion share repurchase plan.

Gross Margin Matters
In an article published last month, I discussed Apple’s average selling prices by product line and Apple's declining rates of iPhone and iPad unit sales growth. Today I’m illustrating Apple’s declining gross margin. 
The influence of a dynamic unit sales mix and management’s efforts to deliver competitively priced products have led to an unmistakeable decline in gross margin on products sold. From a high of 47.37% in FQ2 2012 to a low of 36.90% in FQ3 2013, Apple’s gross margin has been on a steady decline over the last six quarters. The introduction of the lower-margin iPad mini in the fall of 2012, negative Mac unit sales growth over the most recent four fiscal quarters and more aggressive iPhone sales efforts in emerging markets have combined to reduce the company’s gross margin performance.

Net Income Per Revenue Dollar
The graph below illustrates the decline in the percentage of Apple’s revenue that has flowed to the company’s net income line over the most recent six fiscal quarters.
From a high of nearly 30% of revenue flowing to the net income line in FQ2 2012, to a low of under 20% in FQ3 2013, net income per revenue dollar has dropped dramatically. 

Much Ado About Deferred Revenue
Following Apple's September quarter conference call in late October, much has been written about Apple’s announced increase in the amount of revenue deferred on each iOS device and Macintosh sold. Apple’s decision to increase deferred revenue on each iOS device sold to as much as $25 and on each Macintosh sold to $40 will have a moderating effect on reported revenue in quarters of seasonally high revenue. As the calendar moves past the first four quarters under the new deferred revenue program, the higher deferred revenue amounts will have a slight positive impact on the reported rates of revenue growth in fiscal quarters with seasonally low revenue totals. However, eight quarters out from the change in deferred revenue per unit sold, the impact of this change will be dramatically diminished. The net impact of the deferred revenue will only be from the year-over-year increase in units sold. 

Revenue deferred is not revenue lost. The accumulated deferred revenue balance is clearly delineated on Apple’s balance sheet and represents revenue to be recognized in future quarters. No matter the influence of the recognized revenue shift to future quarters under the new deferred revenue program, absent a new major product line, Apple’s revenue growth rates will remain far below FY2011 and FY2012 rates of growth. In both of those fiscal years high year-over-year unit sales growth for the iPhone and iPad product lines drove revenue growth to unusually high levels. 

Apple And Hardware Monetization
More than a product company, Apple is a platform and an enterprise that obsesses over innovation and customer satisfaction. Management’s decision to offer no-cost OS upgrades and free distribution of select company-developed productivity and lifestyle apps evidences the renaissance of the hardware monetization model. Hardware monetization through the delivery of premium products and the free distribution of software and services is the impetus to increase the amounts of revenue deferred on devices sold. The deferred revenue per unit sold represents an estimate of the value of the products and services Apple plans to deliver to the customer over the anticipated economic life of each device sold.

The no-cost distribution of OS upgrades and company-developed apps and services is designed to increase the value proposition of the company’s hardware products and justify the company’s approach to product pricing. Apple creates and sustains customer relationships as much as the company creates and updates its popular products. Hardware monetization through software commoditization is among the company’s far-reaching goals. 

iTunes/Software/Services and Accessories
The graph below illustrates the fairly consistent growth in Apple’s iTunes/Software/Services and Accessories revenue segments. Although the free distribution of OS X upgrades and free distribution of select company-developed apps will slightly moderate the rate of software segment revenue growth in the December quarter, there’s no better proxy to represent the growth in Apple’s underlying eco-system than the revenue derived from the iTunes/Software/Services segment.
There’s a brisk market for the sales of pre-owned iPhones and iPads and the installed base of iOS-device owners grows larger by the day. As a platform and customer relationship enterprise, Apple continues to extend and expand its global economic and customer reach. 

I’ve mentioned several times in previous articles iTunes billings (inclusive of the revenue pass through to developers and content owners Apple doesn’t recognize as its own revenue) may reach $20 billion this fiscal year. While Apple chooses to moderate the current pace of reported revenue growth through revenue deferrals, the company’s global eco-system is expanding at a faster rate than the rate of reported revenue growth for the company as a whole.

Apple As A Platform
Apple’s deliberate shift in focus to the value proposition of the company’s products through high quality devices and the availability of free OS upgrades, apps and services highlights the emerging platform for the expansion of the company’s product lines. The no-cost upgrade to Mac owners of OS X Mavericks has accelerated adoption of the latest version of OS X.  The universal distribution of each iOS upgrade drives adoption to near 100% within three months of release. This strategy creates a uniform environment for apps, content and services. 

The no-cost distribution of Keynote, Numbers and Pages productivity apps along with the availability of iWork for iCloud services create a common productivity platform for Apple device owners. Additionally, through iCloud, device owners can sync iTunes-related purchases (apps, books, music, etc.) across devices. 

Apple is creating a multi-device platform upon which to not only deliver new products and services to hundreds of millions of device owners, but also a platform for new device lines. 

A Quick Note About China Mobile
As the founder of the Braeburn Group, I am in constant contact with members of our global network of independent analysts. Discussion and debate about the impact of the much-anticipated China Mobile deal for the iPhone occur within our community on a daily basis. While a China Mobile agreement will obviously boost iPhone unit sales, long-term the market for high-end smartphones will deliver slowing rates of growth. More is needed than the addition of China Mobile as an authorized carrier to move the company back into the fast lane of revenue growth.

Moving Forward
Apple’s iPhone and iPad product lines represented 70% or more of the company’s revenue in fiscal years 2012 and 2013. Consistent year-over-year unit sales growth rates of well over 20% for both product lines may now be a reality only of the past. Apple’s recent decision to increase the amounts deferred on each iOS device and Macintosh sold will add to the pressure on reported revenue growth rates in FY2014.

Moderating rates of iPhone and iPad unit sales growth will pressure gross margin and net income per revenue dollar. Absent new device lines emerging this fiscal year to drive revenue growth, Apple will continue to travel along a scenic yet slow-moving detour on the road to reported revenue growth.

Apple’s decision to distribute at no cost OS upgrades and company-developed apps while providing cross-device services such as iCloud hint at a broader and more sublime strategy than pushing iPhone and iPad unit sales. 

As of this writing the Wall Street consensus revenue estimate for Apple this fiscal year is  $184.03 billion. My current estimate for the fiscal year, exclusive of a China Mobile agreement and the introduction of new product lines, is $187.50 billion or a revenue growth rate of about 9.7% and similar to Apple's reported rate of revenue growth last fiscal year.

In my view, absent the release of a major new product line in FY2014, Apple’s revenue growth and net income will remain subdued. The company is building a platform for the delivery of cross-device services while the reach of Apple’s massive global eco-system continues to expand. 

Whether Apple continues along the scenic but slow-moving detour on the road to revenue growth or returns to the fast lane will be determined not by the company’s current device portfolio, but by the new products Apple chooses to release this fiscal year. Apple is paving the road for new products through the platform of apps and services the company is now making available to device owners for free. 

For shareholders, a China Mobile deal will be good news. It will bring the iPhone to the world’s largest carrier. But new products in FY2014 would be even better news for those with an interest in the company and in the stock. Earlier today it was confirmed Apple has acquire PrimeSense. This acquisition may provide clues as to direction Apple chooses to travel in the development of new product lines.

Robert Paul Leitao

Disclosure: The author is long Apple shares