Saturday, December 28, 2013

Apple: It’s a Matter of What, Where and Why

For the fiscal quarter ended Saturday, December 28th, Apple will report record revenue and earnings per share. There’s no disputing the popularity of Apple’s iPhone and iPad product lines. As of today Wall Street analysts are expecting revenue of $57.31 billion and earnings per share of $14.05. This is in contrast to revenue of $54.51 billion and eps of $13.81 in the prior-year quarter. 

As the founder of the Braeburn Group, I am currently collecting December quarter estimates from our global network of independent analysts. Although management has guided to revenue in the quarter of $55 billion to $58 billion, the independents by and large are expecting a revenue performance above the upper threshold of guidance. I will be publishing the Braeburn Group Estimate Index for the quarter on Sunday, January 5th. 

However, Apple’s quarterly results are merely a static snapshot of a fast-moving enterprise object. More than a purveyor of independent device lines, Apple has become a customer relationship continuum with a global platform of inter-related products and services. 

Among the factors influencing near-term results are management’s decision to increase the amounts of device sales revenue deferred for recognition in future periods, the pace of the company’s geographic expansion and the seasonal nature of the company’s product refresh cycles. Apple’s growth is best viewed not by quarters but by fiscal years. In today’s article I will look at Apple’s growth across a variety of measures and metrics. 

Apple: It’s A Matter of What, Where and Why
The graph below illustrates Apple’s FY2013 revenue mix by product line. In the fiscal year ended in September, over 72% of the company’s reported revenue was derived from the iPhone and iPad product lines. While this concentration of revenue in two product lines for a company that reported over $170 billion in revenue might on the surface seem alarming, the concentration of revenue is emblematic of Apple’s dynamic product mix and the changing nature of the digital device markets. 

The graph below illustrates Apple’s revenue growth by product line in fiscal years 2012 and 2013. In FY2013 the rates of revenue growth in year-over-year comparisons were impacted by the release of the lower-cost iPad mini and slowing rates of growth in the high-end smartphone market. While the average selling price (ASP) for the iPhone fell from $629 in FY2012 to $607 in FY2013, the average selling price for the iPad fell from $531 to $450. 

Moving into FY2014, the reported ASP for the iPhone will be impacted as much by the recent change in deferred revenue on each iPhone sold as any other factor. Apple’s apparent ability to meet demand for the iPhone 5s more quickly than for any new iPhone release in the past will assist in stabilizing reported revenue per unit sold. 

The Retina display iPad mini, at a higher per unit price than the original, will buttress the iPad’s ASP this fiscal year. In FY2014, there will be a stronger correlation between the rates of unit sales growth and revenue growth than in the slower-growth FY2013 that ended in September.

The Macintosh line, which suffered from the late delivery of the newly-styled iMac desktop PCs in early FY2013 and a fiscal year absent a major refresh to the MacBook Pro line of portable PCs, delivered negative unit sales and revenue growth in the period. Although the Macintosh line has a diminished role in Apple’s aggregate revenue and earnings performance, the recently refreshed MacBook Pro line, resolved iMac production challenges and the completely new Mac Pro workstations will deliver positive unit sales and revenue growth in the current fiscal year.

While Apple’s current product mix (what the company currently sells) is obviously among the most important influencers of the company’s revenue and earnings performance, there are other major factors that will influence results.

Where Apple Sells Its Products
The graph below illustrates Apple’s reported revenue mix by geographic region in FY2013. Although the Americas and Europe remain Apple’s largest revenue regions, much of the company’s revenue growth in FY2014 will again depend on the revenue growth rates in Greater China and Japan. In FY2013, Greater China and Japan were the company’s fastest-growing regional revenue segments. 

Expanded distribution of the iPhone through carriers and expanded distribution of the iPad through third-party resellers diminished the rate of revenue growth for Apple’s global retail store segment. Management has publicly stated a desire to increase the percentage of iPhones sold through the company’s retail stores. 

The graph below illustrates the importance of both Greater China and Japan to the company’s overall growth performance. Although the United States and China are the only two countries delivering 10% or more of the company’s reported revenue total, Japan is fast-approaching that threshold. Japan contributed nearly 8% of the company’s revenue total in FY2013 and the addition of NTT DoCoMo, Japan’s largest cellular services provider, as an authorized iPhone reseller and carrier will materially boost the island nation’s revenue total for Apple this fiscal year. 
The graph below illustrates the percentage of revenue delivered by each of Apple’s regional revenue segments over the most recent twelve fiscal quarters. 

From 5.36% of reported revenue in FQ1 2011 to 8.92% of revenue in FQ4 2013, Japan is becoming increasingly important to Apple’s overall growth prospects. In FY2012 Greater China delivered 14.40% of Apple’s reported revenue total and 14.87% of reported revenue in FY2013. The addition of China Mobile as an authorized iPhone reseller and carrier commencing next month will boost Greater China’s percentage of total revenue for Apple this fiscal year.

Why Select Regional Revenue Growth is Essential for Higher Earnings
The graph below illustrates the percentage of revenue that has flowed to the regional operating income line over the most recent twelve fiscal quarters. 

Japan currently delivers the highest percentage of regional revenue to the regional operating income line of any of Apple’s geographic segments. The new carrier agreement with DoCoMo will benefit Apple’s revenue and earnings performance throughout FY2014. 

From a high of 49.51% of regional revenue to the regional operating income line in FQ2 2012 to a low of 30.87% in FQ4 2013, the decline in operating income per revenue dollar in the Greater China region dampened Apple’s year-over-year earnings performance despite the region’s better than 12% revenue growth rate last fiscal year.

In FQ2 2013, Apple recognized an extraordinary warranty expense accrual of $1.551 billion. Challenges with iPhone 5 production and changes to the company’s service policies, particularly in China, adversely impacted the company’s earnings results. The replacement of the original iPhone 5 with the iPhone 5c and improvements made in the design of the iPhone 5s have reduced manufacturing challenges and will benefit Apple’s gross margin this fiscal year. 

Apple As A Product Platform
The recent addition of DoCoMo as an authorized iPhone carrier, the addition of China Mobile as an authorized iPhone carrier beginning next month and the impressive across-the-board product refreshes announced last fall will boost Apple’s revenue performance in FY2014. 

Beyond the increase in iPhone unit sales through the addition of new carriers, Apple is also increasing the addressable market for iOS developers and content providers. The carrier agreement with China Mobile is made possible by the company’s 4G LTE infrastructure rollout. Not only does this benefit iPhone sales on China’s mainland, 4G LTE provides for lucrative iPad data plan sales by carriers without the burden of device sales subsidies. 

I’ve mentioned in previous articles the fast pace of Apple’s content delivery infrastructure development and my forecast that iTunes billings (inclusive of the revenue pass through to developers and content providers that Apple doesn’t recognize as its own revenue), will reach $20 billion this fiscal year. Over the next few years, Apple’s iTunes platform could reach one billion account holders as Apple continues to expand the services available to customers. 

Moving Forward…
Apple’s 9.20% rate of revenue growth in FY2013 and corresponding 10.20% decline in earnings per share was a decidedly underwhelming performance for most observers. This fiscal year will see a return to net income growth and rising earnings per share as the company expands its global base of iPhone carriers and continues to expand the addressable market for the company’s products. 

What, Where and Why
Understanding Apple’s potential for growth necessitates looking beyond the current rates of unit sales growth with an awareness of what products the company offers, where the company is creating geographic growth and why management is taking deliberate and methodical steps to increase the addressable market for the company’s products and services. 

Gone are the high-flying rates of revenue growth. However, Apple will deliver sustainable rates of low double-digit revenue growth this fiscal year while building its global platform of products and services. This fiscal year net income will rise at a rate at least commensurate with the rate of recognized revenue growth and the ongoing share repurchase program will deliver earnings per share growth at a rate greater than the rise in net income.

Robert Paul Leitao

Disclosure: The author is long Apple shares