Saturday, February 28, 2015

Apple’s Success Is Based On Fundamentals

On February 27th Apple’s share price ended the month’s trading at $128.46 after achieving an all-time high of $133.60 in intra-day trading on Tuesday, February 24th. The closing price represented an 8.82% rise in the share price from the opening bell on Monday, February 2nd and a 17.70% rise in the share price since the release of December quarter results on January 27th. 

Speculation About An Apple Car
In addition to Apple’s strong December quarter performance sparked by record iPhone unit sales and iPhone revenue, speculation about the development of an Apple car has added a new and alluring element to the company’s share price action. No matter the fact if an Apple car is under serious development it would not reach the consumer market before 2020, investors are attracted to the concept of Apple entering the auto industry as a new sector for revenue and profit growth.

Apple’s March 9th Special Event
Choosing the first weekday following the seasonal change in time to announce the release date and pricing for the Apple Watch, Apple has sent out invitations for a March 9th special event. The Apple Watch is the first new product line to be released by the company since the appointment of Tim Cook as CEO. While expectations for unit sales vary widely among analysts, the Apple Watch will deliver new revenue and net income for the company. The Apple Watch will add appreciably to Apple’s revenue and earnings per share growth rates particularly in the first four fiscal quarters following release. 

FY2015 Revenue and Earnings Per Share Expectations
The Wall Street consensus revenue estimate for the fiscal year ending in September currently stands at $225.24 billion, representing anticipated year-over-year revenue growth of 22.22%. The Street’s current consensus earnings per share estimate of $8.59 represents anticipated eps growth of 33.18%.

In contrast, my current revenue target for FY2015 is $235 billion and earnings per share for the fiscal year of over $9.25. My comparatively bullish outlook, anticipating revenue growth of 28.56% and earnings per share growth in the range of 44%, is based only in part on expectations for the early success of the Apple Watch. Rising iPhone and Mac sales are integral to my revenue growth models. Apple’s net income per revenue dollar is rising quickly as the rate of revenue growth zooms beyond 20%.

Apple’s Success Is Based On Fundamentals, Not Faddishness
While an Apple car is an interesting topic for conversation and as we mark time waiting for news on the release date for the Apple Watch, management is hard at work boosting the company’s underlying financial performance.

The graph below illustrates Apple’s net income performance over the most recent twenty one fiscal quarters. The recent December quarter’s iPhone unit sales growth rate of 45.94% sparked a 37.88% rise in net income and boosted net income per revenue dollar to 24.16%.

The graph below illustrates in a more simple way Apple’s net income per revenue dollar over the same 21-quarter period. The larger-screen iPhone 6 handsets have not only boosted unit sales, the increase in the average selling price (ASP) has boosted the company’s gross margin.

The Rebound In Apple’s Gross Margin
The graph below illustrates Apple’s gross margin performance over the most recent twenty one fiscal quarters.
Since the recent nadir of 36.87% gross margin in FQ3 2013, Apple’s gross margin has rebounded to the 39.87% gross margin realized in the December quarter. Gross margin will remain above prior-year levels throughout FY2015 with the potential for year-over-year growth margin improvement through at least the March quarter of FY2016. The high ASP iPhone 6 handset series coupled with the release of the Apple Watch and rising Mac sales will combine to improve gross margin over the next several quarters. Last fiscal year Mac unit sales rose 15.7% and the double-digit unit sales growth rate continued through the recent December quarter. 

While exact pricing on the soon-to-be-released Apple Watch won’t be known until March 9th, some models will range in cost into the thousands of dollars. Overall, the Apple Watch line may assist in boosting net income per revenue dollar. 

Operating Expenses As A Percentage Of Revenue
The graph below illustrates the percentage of reported revenue consumed by operating expenses on a quarterly basis since FQ1 2010. Reaching a recent high of 11.90% of revenue in last year’s June quarter, operating expenses per revenue dollar fell to 7.37% in the December quarter.
Apple’s greater than 20% revenue growth this fiscal year and anticipated double-digit revenue growth next fiscal year will moderate the percentage of revenue consumed by operating expenses moving forward. Rapid revenue growth will reduce the percentage of revenue consumed by operating expenses for the next several quarters. 

Operating expenses are comprised of selling, general and administrative expenses and the company’s investment in R&D. The graph below illustrates Apple’s reported R&D expenditures as a percentage of revenue since FQ1 2012. Although operating expenses have risen consistently over this period, as revenue growth rates remain high, the percentage of revenue consumed by R&D expenses on a year-over-year basis will continue to fall through the first half of the next fiscal year (FY2016). 
In the December quarter, R&D expenses reached $1.895 billion. Apple’s quarterly R&D expenses represent investments in new products and services as well as the development of new processes for the company as a whole. Fast-rising revenue and high gross margin facilitate greater investments in research and development. 

Where From Here?
The current Wall Street one-year price target for Apple is just under $135. Last week’s all-time high of $133.60 pushed against this number. Although Apple’s share price ended February trading at a trailing 12-month price-earnings multiple of 17.38, Friday’s closing price represents a multiple of less than 14 times my estimated FY2015 earnings per share. During an epoch of fast-rising revenue and net income, looking back obfuscates the view of potential share price appreciation moving forward. For the fiscal year I expect net income per revenue dollar to be above 23% and the ongoing share repurchase program will continue to amplify the impact of rising net income on the company’s earnings per share.

With several analysts holding Apple price targets that are now underwater, the parade of price target revisions may continue through the March 9th Apple special event and the release of March quarter results in April.

Robert Paul Leitao

Disclosure: The author is long Apple shares