Saturday, April 26, 2014

Apple’s Newfound Glory

On Wednesday, April 23rd, Apple triumphantly surprised the market with a return to net income growth in the March quarter following a four-quarter cycle of declining profitability. Although Apple did not set a record for March quarter net income, the company delivered record March quarter revenue and an impressive 22.40% of revenue to the net income line.

The graph below illustrates Apple’s net income performance and the percentage of revenue that has flowed to the net income line over the most recent eighteen quarters. 

On revenue of $45.646 billion, $10.223 billion flowed to the net income line. This was the fifth-highest net income performance in the company’s history and second-highest March quarter net income performance, eclipsed only by the results in the March quarter of FY2012. 

Stock Split and Expanded Share repurchase Program
With the release of March quarter results Apple also announced a 7-for-1 stock split. The likelihood Apple will be added to the Dow Jones Industrial Average (DJIA) after the completion of the stock split in early June added fuel to the immediate post-earnings share price rally. Following the release of the company’s March quarter numbers and accompanying announcements, the share price jumped from a closing price on Wednesday of $524.75 to end the trading week at $571.94. With a current market cap of over one-half trillion dollars, rising revenue, rising quarterly dividends and anticipated fiscal year revenue of over $180 billion, the addition of Apple to the well-known index is viewed as a near certainty after completion of the 7-for-1 stock split.

Apple is increasing its share repurchase program from $60 billion to $90 billion with all purchases to be completed by the end of calendar year 2015. As of the close of the March quarter, Apple had utilized $45.9 billion of the previously authorized $60 billion for repurchases.

The graph below illustrates the dramatic drop in the company’s reported fully diluted share count over the past several quarters.

Management also announced with the March quarter results the company would be returning to the debt table to borrow against the company’s massive overseas holdings of cash and marketable securities. Although Apple reports a US tax expense on all foreign-sourced earnings not permanently dedicated for use outside the US, the payments are not due until the funds are repatriated. As of March 29, 2014, Apple has $19.471 billion in deferred tax liabilities on the balance sheet and $17.0 billion in previously acquired debt for share repurchases.

Consequently, Apple’s earnings per share will rise at a significantly faster rate than the rate of underlying growth in net income. I expect Apple to surpass its all-time high on a split-adjusted basis within nine months. But new all-time highs may be on a diminished market cap than what was achieved on September 21, 2012 when the shares reached the peak price of $705.27. Apple’s ongoing share repurchases will boost the share price while dampening the rise in the company’s market capitalization.

The Return To High Gross Margin
The graph below illustrates the gradual upswing in Apple’s gross margin since the nadir of 36.87% in the June quarter last year. 

In the March quarter Apple reported an impressive gross margin of 39.32%, the highest gross margin performance since the September quarter of FY2012. The high gross margin in the March quarter was influenced by the 16.80% year-over-year rise in iPhone unit sales and the 13.54% rise in iPhone revenue. This is in contrast to the aggregate 4.69% rise in revenue for the period.

Dependence on the iPhone and iPad For Current Growth
The graph below illustrates Apple’s continuing high dependence on the Apple iPhone and iPad for revenue and net income.

Despite the year-over-year drop of 16.05% in reported iPad unit sales in the period due to channel supply adjustments and the corresponding 12.99% drop in iPad revenue, the iPhone and iPad lines combined for a 5.56% rise in revenue in the March quarter. In the period the iPhone and iPad lines represented 73.77% of recognized revenue. 

Despite the surprisingly strong March quarter performance for the company as a whole, new products and services are needed to support strong revenue and earnings growth moving forward. 

June Quarter Guidance
For the June quarter, management has offered revenue guidance of $36 billion to $38 billion and gross margin guidance of 37% to 38%. Management is also guiding to comparatively high operating expenses of between $4.4 billion and $4.5 billion. In contrast, June quarter revenue last year totaled $35.323 billion and reported operating expenses were $3.791 billion.

New Apple Products Are Coming…
In recent quarterly conference calls management has consistently stated new products will soon be introduced. Without identifying the products and services management will unveil, references have been made to the company’s rising R&D expenses as an indicator new products and services are under development. 

The graph below illustrates Apple’s rising R&D expenses and those expenses as a percentage of recognized revenue.

Apple continues to invest heavily in product development and the investment in new product development has been on the rise. Research & development and general, selling and administrative expenses are the two components of Apple’s operating expenses.

Apple’s Newfound Glory
Apple surprised the market with a strong March quarter outcome and the announcement of a pending 7-for-1 stock split. In the quarter the iPhone line delivered an impressive unit sales growth performance and through June quarter revenue and gross margin guidance management has signaled a second consecutive quarter of net income growth. Apple's multi-quarter cycle of declining profitability has come to an end.

Although Apple’s March quarter results along with the announced expansion of the share repurchase program and stock split thrilled the market, the release of new products as foretold by management and evidenced by the company’s rising R&D expenses may be the most welcomed news for shareholders this calendar year.

Tim Cook is a deliberate and determined CEO. I expect Apple to deliver on his promises of new products this calendar year and for management to begin to address the challenge of the high concentration of revenue and earnings from the company’s two most popular product lines. 

Through Apple's March quarter results released on April 23rd and management's accompanying announcements, Apple has achieved newfound glory. The pending delivery of new products and services are the next big steps in management’s efforts to generate faster rates of revenue growth and further reward the company’s long-term shareholders with sustained share price appreciation over the next several quarters.

Robert Paul Leitao

Disclosure: The author is long Apple shares