Saturday, March 29, 2014

Apple Is Walking Up The Down Staircase

Over the past eight fiscal years Apple’s revenue has risen 1,127% from $13.931 billion in FY2005 to $170.910 billion in FY2013. Over this same eight-year period, Apple’s earnings per share has risen 2,457% from $1.55 to $39.63. The graphs below illustrate the story.

Since the migration of Apple’s Macintosh line of personal computers to Intel microprocessors in 2005 through the release of the iPhone and iPad product lines, Apple’s revenue growth performance has been phenomenal. From a peak revenue growth rate of 66% in FY2011 to a low of 9.2% revenue growth in the fiscal year ended in September, the company’s revenue growth performance over the past eight years places Apple among the highest revenue generating enterprises on the planet. Apple has become a global economic empire with roughly two-thirds of annual revenue generated outside the United States.

Despite a 10.3% drop in earnings per share in Apple’s most recent fiscal year, the company’s fast rate of revenue growth over the past eight years combined with high gross margin have propelled earnings per share on an annual basis to greater than 25 times the company’s FY2005 results.

Apple’s Revenue and Earnings Growth Performances Today
Following 66% revenue growth in FY2011 and 45% revenue growth in FY2012, Apple’s rate of revenue growth decelerated dramatically to just over a 9% rate last fiscal year. In the first quarter of FY2014 ended in December, Apple’s revenue growth rate continued to decelerate to a 5.7% pace. Management’s March quarter guidance suggests slow to no revenue growth in the quarter ended March 29, 2014. 

The graph above illustrates Apple’s decelerating revenue growth rates on a quarterly basis since the second quarter of FY2012. 

In all four quarters of FY2013, Apple realized negative earnings per share growth. However, the ongoing $60 billion share repurchase program pushed the earnings per share growth rate in the recent December quarter (FQ1 2014) to a positive 5% growth rate despite a slight decline in net income year-over-year. Based on management’s March quarter revenue guidance, earnings per share in the quarter may again turn negative despite the unprecedented share repurchase plan now in place. 

That Was Then, This Is Now
Beginning with the June quarter, Apple’s cycle of declining net income is at an end. The graph below illustrates the percentage of each revenue dollar consumed by the company’s major cost centers and the recent reduction in the percentage of each revenue dollar that flowed to the net income line.

There’s obviously a direct correlation between the rates of revenue growth and the rates of net income growth. As the graph below illustrates, Apple’s operating expenses per revenue dollar trended higher as the rates of revenue growth declined. 

Further, the company’s gross margin has declined since reaching a peak of nearly 48% in the March quarter of FY2012. 

While the company’s March quarter results will prove to be less than impressive, the turnaround of the company’s organic earnings performance is about to begin, albeit slowly.

Apple Is Now Walking Up The Down Staircase
Apple’s seemingly unreal rates of revenue growth from FY2010 through FY2012 were due in part to the release of the iPad product line in April 2010, the addition of Verizon Wireless as an authorized carrier in February 2011 and the mass consumer migration from feature phones to smartphones that occurred over the three-year period. 

Apple’s decline in earnings per share in FY2013 was influenced by the company’s very strong prior-year performance. Although Apple reported 9.2% revenue growth in the period, the drop in gross margin year-over-year produced negative net income growth and a decline in earnings per share. 

However, the cycle of declining earnings and earnings per share ends with the close of the March quarter. For the March quarter management had forecast an adjustment to iPad channel supply which may reduce reported iPad unit sales below the number of units sold through to end users in the period. In addition, China Unicom and China Telecom participated in the initial rollout of Apple’s current iPhone line. Previously, the two carriers released new iPhone handsets in the March quarter. Combined, these factors will have a significant impact on March quarter revenue results.

June Quarter Outlook
In the June quarter one-year ago, Apple reported a paltry 0.9% revenue growth rate and a 19% decline in earnings per share. In that quarter Apple reported a 1.9 million unit swing in iPad channel supply. Apple also realized a $1 billion sequential decline in iPhone channel inventory in the period. This year Apple planned for a material iPad channel adjustment in the March quarter. 

The original iPhone 5, which was replaced by the iPhone 5C last fall, incurred high warranty costs. These costs contributed to the extraordinary $1.551 billion warranty set-aside in the March quarter one-year ago. Gross margin will move higher year-over-year for the balance of the current fiscal year as Apple realizes higher gross margin on iPhones sold and as the impact of the new deferred revenue schedule on reported revenue gradually lessens beginning with the June quarter. Apple will return to net income growth in the June quarter.

Moving Forward
On a year-over-year basis, Apple will now confront less challenging prior-year comparisons against which to measure revenue and net income growth. The ongoing share repurchase program will amplify the impact of organic net income growth on earnings per share. Through at least the March quarter of FY2015, Apple will deliver consistent net income growth on a quarterly basis. Beginning in the June quarter this year, the cycle of negative net income growth is over. 

Revenue Growth Catalysts
The addition of China Mobile and NTT DoCoMo as authorized iPhone carriers will positively impact revenue growth throughout the balance of the fiscal year. This fall, China Mobile will participate in the initial launch of the next flagship iPhone handset. This will contribute to stronger rates of revenue growth following the launch of the next iPhone handsets.

While much speculation continues about Apple’s plans for new products, with the start of the June quarter, Apple’s cycle of negative net income growth has come to end with or without new product lines. 

Nonetheless, as the graphs in this article illustrate, on a forward-looking basis fast rates of revenue and net income growth are dependent on the successful release of new and currently unannounced new products. Apple is an episodic enterprise.  Revenue growth rates and organic net income growth will be challenged in fiscal years absent the delivery of new products.

Apple As An Eco-System
The graph below illustrates the quarterly growth in Apple’s iTunes/Software/Services revenue segment. No matter Apple’s decision to offer free upgrades of OS X and iOS to device owners and the distribution of Keynote, Numbers and Pages without cost, the revenue segment has continued to deliver impressive rates of revenue growth.

The iTunes/Software/Services revenue segment is the best practical proxy for gauging the growth in Apple’s underlying eco-system and the expansion of the company’s active global customer base. 

Apple’s recent decision to replace the iPad 2 in the product line with an updated version of the iPad 4 suggests management is seeking to not only raise the value proposition of the the iPad line, all shipping iPads now offer the lightning connector and LTE on cellular-equipped models. Additionally, the release of a 8GB version of the iPhone 5C suggests Apple is seeking to sell more 4G/LTE equipped iPhones. While the iPhone 4S remains Apple’s entry-level model in developed markets, the company is moving to enhance its LTE offerings to consumers and increase the likelihood of rich, post-purchase revenue streams through expanded device usage on a per customer basis.

There are no credible reasons to expect Apple to return to greater than 10% revenue growth on a sustained basis prior to the release of new product lines and enhanced services offerings. However, Apple has begun to reverse the recent cycle of negative net income growth. Apple is now walking up the down staircase of negative net income growth and is at the beginning of a cycle of improved earnings results ahead of the new products Tim Cook has promised for this calendar year. 

Robert Paul Leitao

Disclosure: The author is long Apple shares