Monday, January 27, 2014

Apple: Management Needs To Vision Tomorrow More Than Explain Today

On Monday, January 27th, Apple announced results for the company’s December quarter (FQ1 2014). The company reported year-over-year revenue growth of $5.65% to $57.594 billion and earnings per share of $14.50 versus $13.81 in the prior-year quarter. Net income at $13.072 billion was lower than the results in FQ1 2013 by $6 million. Earnings per share rose 5.0% due to 45.765 million fewer shares in the fully diluted share count. 

The Demise of the iPod Line
Contributing to Apple’s unimpressive revenue growth rate in the December quarter was a 54.60% year-over-year decline in iPod revenue on a 52.29% decline in unit sales. The iPod touch, which represents greater than 50% of the product line’s revenue, was last updated in September 2012. iPod sales have been subsumed by the popular iPhone line with iPod capabilities and there is declining consumer demand for specific-use digital music players. Year-over-year, iPod revenue fell by $1.17 billion dollars.

The Resurgent Macintosh
In the midst of Apple’s 30th anniversary Macintosh celebration, the product line turned in a strong 19.11% unit growth rate against a soft prior-year comparison. The 4.837 million units sold was the fourth highest quarterly unit sales total in the product line’s history and the highest unit sales performance in two years. For the quarter, the Macintosh delivered 11.10% of Apple’s reported revenue. 

Apple’s Reliance on the iPhone and iPad
No matter the strong Macintosh unit sales numbers for the quarter, Apple’s reliance on the iPhone and iPad lines for growth continued to rise in the December quarter. The graph below illustrates the fact that 76.34% of reported revenue in the quarter was sourced from iPhone and iPad sales.
iPhone and iPad Unit Sales Growth
On a combined basis, iPhone and iPad unit sales rose 9.07% in the December quarter and combined revenue rose 6.37% net of the impact of the increase in deferred revenue per unit sold.The graph below illustrates the combined unit sales for the iPhone and iPad lines over the most recent seventeen fiscal quarters. Among the challenges for Apple is the fact iPhone and iPad unit sales growth rates have begun to slow dramatically.
March Quarter Guidance
With the release of December quarter results, Apple provided a revenue guidance range of $42 billion to $44 billion. In the March quarter one-year ago, reported revenue totaled $43.603 billion. Based on guidance, Apple is suggesting the real possibility of negative recognized revenue growth year-over-year for the first time in the company’s recent history to only slightly positive revenue growth in the March quarter. 

Deferred Revenue And Its Impact On Reported Growth
In October, Apple announced an increase in deferred revenue up to $25 per iPhone and iPad sold and $40 on each Macintosh sold. In the December quarter the company’s deferred revenue balances rose $1.368 billion to $11.428 billion. Of that amount $8.357 billion will be recognized as revenue this fiscal year. While the increases in deferred revenue are a factor in Apple’s low rate of revenue growth in the December quarter and influence the forecast for possible negative reported revenue growth in the March quarter, the increases in deferred revenue per unit sold do not obfuscate or explain away Apple’s forward challenges in returning the company to strong and sustainable rates of revenue and earnings growth. 

Slowing Sales Growth, Declining Profits
In the Americas region, which accounted for 34.90% of Apple’s reported revenue in the December quarter, revenue fell 1.19% in the period. Despite 29.49% reported revenue growth in Greater China and 11.37% reported revenue growth in Japan, Apple’s performance in its largest revenue region exemplifies the company’s forward challenges. 

The addition of NTT DoCoMo as an authorized iPhone carrier last fall and the addition of China Mobile as an authorized carrier earlier this month are not enough to overcome Apple’s unit sales growth challenges in the company’s largest market. 

In the December quarter, 22.70% of each recognized revenue dollar flowed to the net income line. In the December quarter last year, 23.99% of each recognized revenue dollar flowed to the net income line. Based on management’s March quarter guidance which included a forecast of sequentially similar operating expense levels on dramatically lower sequential revenue, net income in the March quarter may fall below not only last year’s results, but the net income results from two years ago. 

Apple remains trapped in a slow revenue growth phase that began with the December quarter one year ago. Combined, the iPhone and iPad now represent more than three-quarters of the company’s revenue base and unit sales growth for both major product lines have slowed.

Moving Forward…
Apple’s revenue growth challenges will not be resolved while the company relies almost exclusively on the iPhone and iPad for growth. In this slow-growth phase, Apple needs to think again about how best to deploy the company’s idle cash. Whether that involves accelerating the completion of the already authorized $60 billion repurchase plan or the deployment of additional cash to increase the size of the plan, it’s time to act and act quickly.

It’s Time For Management To Change The Narrative
In the December quarter, iTunes/Software/Services revenue rose 19.26% to $4.397 billion and represented 7.63% of the company’s reported revenue total. It’s the company’s fastest-growing revenue segment.

There is more to Apple than the devices the company sells. There are hundreds of millions of Apple content customers around the world and hundreds of millions of customers that use Apple products every day.

Apple shrouds its product and services development plans in secrecy. In the midst of an ongoing slow-growth phase, management needs to begin a conversation with analysts, customers and the company’s shareholders as to where management sees the company two and even three years from today. That will require some disclosure, but better to outline a vision for tomorrow than keep everyone’s focus on how many iPhones, iPad and Macs the company is selling today. 

From a fundamentals standpoint, Apple continues to generate high profits. But today’s slow-growth phase needs more than an explanation. Management needs to begin a conversation with the company’s stakeholders, including customers, shareholders and eco-system partners, about what’s envisioned for tomorrow while management confronts the slow-growth reality the company faces today.

Robert Paul Leitao

Disclosure: The author is long Apple shares