Saturday, February 22, 2014

Apple: Net Income Growth Is The Name Of The Game

Apple is a global empire with revenue results that place it among the top publicly-traded enterprises on the planet. Apple is also among the largest dividend payers in the world and management is dedicated to returning more than $100 billion in capital to shareholders over a four-year period through a combination of dividend payments and share repurchases. Apple’s brand value is arguably the highest in the world and the company’s balance sheet reflects over $140 billion in cash and equivalents net of debt despite the ongoing capital return program. 

No matter these superlatives, Apple is challenged to reverse a decline in profitability. The company is in the midst of a multi-quarter decline in net income and a cycle of lower net income per revenue dollar even as revenue rises modestly year-over-year.

Apple: Net Income Growth Is The Name Of The Game
For Apple’s first quarter of FY2014 ended December 28, 2013, management reported revenue growth of 5.7% to $57.594 billion. In the same 91-day period net income fell year-over-year by $6 million to $13.072 billion and represented 22.70% of reported revenue, below the 23.99% of net income per revenue dollar earned the year before.

This FQ1 2014 performance came on the heels of the company’s FY2013 results in which Apple’s reported revenue rose 9.2% to $170.91 billion and net income fell 11.25% to $37.037 billion. Based on Apple’s March quarter revenue guidance, which suggests the possibility of a decline in revenue year-over-year, net income in the current quarter may fall below not only last year’s results, net income is likely to come in well below the results of two years ago. 

Apple’s Net Income By Quarter
The graph below illustrates Apple’s net income has been in decline on a year-over-year basis since the March quarter (FQ2) of FY2013. Although in FQ1 2013 the company managed a meager rise in net income of $14 million, in the recent December quarter (FQ1 2014), Apple’s net income was $6 million below the results in the prior-year period and only $8 million above the results of two years ago. 

While Apple’s reported revenue has continued to rise, the company’s net income per revenue dollar has continued to fall. In the December quarter, net income represented 22.70% of revenue versus 23.99% in the prior-year quarter and 28.20% of revenue in the December quarter two years ago.

The Impact of Gross Margin
The graph below illustrates Apple’s gross margin by quarter since FQ1 2010. In the recent June quarter (FQ3 2013), Apple’s gross margin reached a multi-year low. Competitive pressures, a changing product sales mix, global and regional economic realities as well as costs of creating new manufacturing techniques have contributed to falling gross margin. At this time I believe Apple is working off the cycle of lower gross margin and I expect marginal improvement in gross margin year-over-year through the balance of the current fiscal year and through at least the first half of FY2015.

Deferred Revenue (Again)
Apple’s decision to increase the amount of revenue deferred on each iOS device and Macintosh sold will have a material impact on net income per revenue dollar and reported gross margin over the next several quarters. On a sequential basis, Apple’s deferred revenue balances rose $1.367 billion in the December quarter to $11.428 billion. Of that amount, $3.071 billion will be recognized in periods beyond the end of the current fiscal year. On a year-over-year basis, deferred revenue rose $1.216 billion in the period. While much has been written about Apple’s change in deferred revenue per unit sold, the impact on reported revenue and gross margin will gradually diminish over the next several quarters and will soon begin to have a slight beneficial impact on reported revenue and gross margin in seasonally low revenue quarters. 

Earnings Per Share Growth Versus Net Income Growth
The graph below illustrates the dramatic drop in Apple’s fully diluted share count since the September quarter (FQ4) of FY2012. As of the end of the December quarter, Apple’s fully diluted share count is slightly below the fully diluted share count of FQ1 2009. Share repurchases to-date have completely eliminated the impact of share dilution from stock-based compensation and other sources over the past four years. Due to the ongoing share repurchase program, Apple can deliver earnings per share growth in periods in which net income has diminished year-over-year. 

For example, in the recent December quarter while net income diminished year-over-year by $6 million, earnings per share rose 5.0% due to the ongoing $60 billion share repurchase program. In FY2013 net income fell 11.25% but earnings per share fell only 10.3% as the impact of fewer shares slightly mitigated the eps impact. Apple will realize a much greater gap between the company's net income performance on a year-over-year basis and the reported performance in earnings per share this fiscal year.

Apple’s massive share repurchase program will amplify the impact of rising net income on earnings per share in the latter half of the current fiscal year. Coupled with a gradual improvement in gross margin, Apple can deliver high single-digit to low double digit eps growth in the June and September quarters. Until Apple returns to positive net income growth, the benefit of the share repurchase for the share price will continue to be compromised. Share repurchases are not a substitute for underlying profit growth. However, in concert with real profit growth the share repurchases will deliver additional shareholder value. 

Apple’s Concentration of Revenue
Currently more than 75% of Apple’s reported revenue is derived from the iPhone and iPad lines. As much as Apple’s management strives with an obsessive fervor to design and deliver the best designed and highest-quality products possible, the company does not wholly control the market’s response to its products. The cost-challenged original iPhone 5 and the market’s tepid reception of the iPhone 5c indicate high rates of unit sales growth are not guaranteed despite Apple’s every effort to deliver outstanding products. 

Since the release of the Apple iPad in 2010, much of Apple revenue growth has been fueled by global growth in tablet adoption and the addition of iPhone carriers in new and established markets. The recent addition of Japan’s DoCoMo and China Mobile have extended the addressable market for Apple’s popular smartphone line by hundreds of millions of customers. But the two carriers represent the end of the parade for now in terms of major carriers adding the iPhone. 

Absent the release of new products and/or new product categories, Apple’s rates of revenue growth will be governed primarily by slowing rates of growth for both the iPhone and iPad product lines. While gross margin may improve over the next five quarters and the continuing repurchase of shares will benefit reported earnings per share, more is needed to excite investors. 

Talk of New Apple Products
There’s always chatter about new Apple products from the now-mythical iWatch to an upgraded Apple TV to an iPad “Pro” to imaginings of major product acquisitions by the company. But speculation on specific new products is outside the scope of this article. Apple’s history of innovation and major market disruption lends credence to expectations Apple will announce new products within the next year. While new products do not guarantee new product success, new products are needed to ignite faster rates of revenue growth.

Moving Forward…
The recent announcement by Apple CEO Tim Cook that the company repurchased $14 billion worth of shares following the market’s response to disappointing December quarter results and March quarter guidance buoyed the share price. But share price appreciation won’t be fueled by share repurchases alone. 

Although Apple has increased the amount of revenue deferred on each iOS device and Macintosh sold, the company will begin to see improved gross margin year-over-year through at least the March quarter of next year. High single-digit to low double-digit revenue growth over the next several quarters combined with improving gross margin will return the company to positive net income growth as early as the June quarter. However, faster rates of revenue and net income growth are contingent on products that have yet to be unveiled and there are no guarantees of new product success. 

Apple remains among the most profitable companies on the planet. The return of capital to shareholders through dividends and share repurchases will continue to buoy the share price. Nonetheless, the market has no reason to adjust the current trading range of the shares until positive net income growth returns and management displays the new product cards the company is holding. Net income growth is the name of the game for Apple. 

Robert Paul Leitao

Disclosure: The author is long Apple shares