AAPL Earnings Recap; iPhone Growth Accelerating

Apple reported a 4Q14 earnings beat to consensus and my estimate with strong guidance driven by iPhone sales strength. 

Few takeaways and notes:

Mac. Over the past few weeks I was noticing that the Peak Mac theory, which stated that Apple will never sell as many Macs in a single quarter as occurred in 1Q12 (5.2 million Macs), was at risk of breaking apart as my long-term 4Q15 estimate was for 5.4 million Macs. Apple ended up reporting 5.5 million Mac unit sales last quarter, representing strong 21% year-over-year (yoy) growth, and a new quarterly unit sales record. Recent price cuts and upgrades resulted in strong Mac sales to college students.  

iPad. Apple reported a 13% decline in iPad unit sales, which was in-line with my expectation.  People calling for iPad’s death will likely be disappointed though given the likelihood of a new iPad Pro model in 2015, along with the recently announced cheaper iPad mini and refreshed iPad Air 2. I still think iPad sales will pale in comparison to iPhone over time and the iPhone 6 will continue to cannibalize iPad sales, but Apple management seemed confident that there are enough niches (education and enterprise) to at least keep iPad sales from collapsing. I think it is appropriate to view iPad more like Mac, and given Mac’s respectable growth last quarter, the iPad is far from over.

iPhone.  Apple’s overall earnings per share (EPS) beat my estimate by $0.10/share on stronger iPhone sales (39.3 million vs. my 36.5 million estimate).  Management provided very bullish iPhone commentary with the expectation that iPhone will remain supply constrained through the end of the year. Apple shared other data points that reinforce iPhone momentum is accelerating from 13% yoy unit growth in 3Q14 to 16% growth last quarter to expected 30% growth in 1Q15. 

Margins. According to management, the stronger dollar will be a “significant headwind” for Apple in the near-term, but the 37.5-38.5% guidance range already reflects the FX impact. On a normalized basis, I wouldn’t be surprised if margin is closer to 40%, compared to 38.6% in 2014, on iPhone 6 strength. 

Apple Watch Disclosure.  Apple caused a minor Twitter uproar with new disclosure commentary concerning the way operating segments will be reported, including Apple Watch being lumped in with a few other products within the ”Other Products” segment.  Is Apple trying to hide something? I suspect the main reason for the classification is that Apple doesn’t want to release too much information to competitors. If Apple disclosed Apple Watch revenues and unit sales, it would be possible to obtain average selling prices (ASP) and then back into which models were selling well, thereby giving key data to both low-end and high-end watch competitors. It isn’t clear if Apple will disclose Apple Watch unit sales, such as opening weekend sales. I think it is reasonable to think if the sales are good, Apple may want to say how many units are sold without breaking out revenues. 

Guidance. Apple provided strong guidance beating my revenue estimate and consensus. Most of the beat can be attributed to iPhone, where Apple could sell upwards of 65-66 million iPhone units, which would be the strongest yoy growth (30%) in over two years. The exact sales number will depend on how many iPhones Apple can produce, but it is safe to say that iPhone’s growth is accelerating.

Apple is now trading at 13x forward EPS with net income growing 15-20% yoy. 

AAPL 4Q14 Preview. Solid Quarter; Solid Outlook

Revenue: $39.8 billion (AAPL guidance: $37-40 billion range/Consensus: $39.9 billion)

• I expect Apple’s revenue to increase 6% year-over-year.

Gross Margin: 38.0% (AAPL guidance: 37-38% range)

• I expect Apple’s margin to decrease sequentially to 38.0% from 39.4% last quarter, primarily reflecting iPhone 6 shipments. Management’s margin guidance is approximately 0-100 basis points better than the 36.9% margin reported in 4Q13.

EPS: $1.32 (Consensus: $1.31)

• I expect Apple to report 11% yoy EPS growth. I am including a 6 billion share count (implying around $5 billion of buyback - similar to last quarter).

Product Unit Sales and Commentary

Macs: 5.0 million (9% yoy growth)

• Apple has reported Mac unit sales growth over the past three quarters and I expect this trend to continue with back-to-school sales and iPad fatigue (students opting for MacBooks vs. an iPad). After a difficult 2013, the Mac line-up seems to be holding its own and the idea of “Peak Mac” (Apple will never sell as many Macs as it did in 1Q12) is starting to look a bit premature. 

iPad: 12.4 million (12% yoy decline. Consensus is closer to 13 million.)

• I expect Apple to report continued Pad unit sales declines. As I previously highlighted, the iPad is in a perilous position and I don’t see last week’s iPad refresh as having much impact on the category’s trajectory.

iPod: 1.7 million (50% yoy decline)

iPhone: 36.5 million (8% yoy growth. Consensus is closer to 37-38 million.)

• iPhone launch quarters can be a wild animal. With many moving parts, including channel dynamics, sales vs. shipped differences, and the degree of delayed purchase behavior in August and early September, the actual sales number shouldn’t be judged too harshly, but instead be included with next quarter’s results to get a better idea of overall iPhone sales trends. Similar to last year, many ordered an iPhone 6 online hours after launch only to have the phone ship in October, so it’s clear that a large number of iPhone 6 (especially the Plus) launch sales will be pushed into 1Q15. My 36.5 million iPhone unit estimate assumes 7 million units of iPhone 6 and 1 million units of iPhone 6 Plus units, along with 29 million legacy iPhone units selling at roughly a 20% slower weekly sales pace than seen in 3Q14 (2.9 million).

I expect Apple’s earnings to come in close to consensus demonstrating continued EPS growth from stronger net income and a lower share count resulting from share buyback. In terms of 1Q15 guidance, I am expecting approximately $56-60 billion of revenue (consensus is around $63 billion) and 38.0-39.0% margins (which would equate to EPS of approximately $2.25, or a 9% increase from 2014). It is important to remember that weaker iPad mini sales, as a result of stronger iPhone or iPad Air sales, will actually help Apple’s financials as the iPad mini’s lower ASP and margins weighed on Apple results. 

I exclude foreign exchange impact from results given its non-operating nature. Apple is hedged against significant foreign exchange moves, but nevertheless there may be some impact flowing for the results. 

The primary Apple story over the next few months will be the iPhone 6 rollout and corresponding implications on margins (iPhone 6 Plus running with a higher margin than iPhone 6, with both models positioned stronger than iPhone 5). 

Bendgate Is Closed

Last night Consumer Reports chimed in on Bendgate, concluding iPhones don’t bend under normal use. I think this report, coming from the consumer review site that infamously hit Apple hard with its Antennagate analysis, marks the unofficial close of this completely ridiculous witch-hunt. 

The question all along hasn’t been, “Do iPhones bend?” Of course they bend. iPhones are made of material that will eventually succumb to a certain level of applied pressure. I haven’t tried it, but if I took my heavy-duty tools and machines to my iPhone 5s, I’m sure I will be able to get something to bend. If I really wanted to, I could gather enough arm strength to do something stupid to my phone as well.  One could ask, “Why would I do such silly things?” and I would only be able to shrug my shoulders. The real question everyone should have been asking (if they were desperate to find a question to ask) is, “Do iPhones bend during normal use; walking, running, basically living your daily life?”  All of the evidence (both empirical and anecdotal) support the “no bending” claims.  Now a very select few have claimed their iPhones have become bent (although they also claim to have sat on them a lot - they aren’t sure). These same people admit the bending is hard to see at times and you need to look at it in a certain light. I’m skeptical. If these people are genuine, they can return their iPhone and get a new unit. Apple sells a lot of iPhones and if your phone is one of the very few bad apples that made it through the rigorous quality assurance tests (Apple claims only nine people reached out to them complaining of a bent iPhone), I would just consider myself lucky, exchange the phone, and move on with my life.  

Over the past week I received many jokes from Android users about Bendgate. Nearly every phone marker chimed in with their own unoriginal bending jokes, tweets, ads, and musings. Mainstream media picked the story up and ran with it.  Curiously all of these reports were missing something - evidence.  No one bothered to take a step back and think about this whole debacle for a second and actually see if their iPhones were bending. I suspect one issue is there weren’t many iPhone 6 Plus units out there in the wild to even observe possible bending. Notice how these “-gates” only take place a mere few days after launch. 

It’s 2014. We shouldn’t be surprised that we had to live through another iPhone “-gate”. These spectacles only reinforce my view that iPhone continues to hold significant global phone mindshare (which is much more important these days than market share, but that topic is for another day). Stories of iPhone’s demise have been in the news since 2007. Some have even tried to ridicule iPhone buyers, maybe one of the weirdest, and counterproductive, types of envy a competitor can possess. When you are in the lead, and running forward, competitors can only pin a target on your back and Apple seems to be wearing quite an effective shield.

It’s reassuring to know that while the world has been preoccupied with Bendgate, Apple engineers have been busy creating the product for next year’s iPhone “-gate”; iPhone 6s. 

What the Beats is Going on? Thoughts on Apple Acquiring Beats

Apple is reportedly interested in acquiring Beats for $3.2 billion. 

Here’s what I’m thinking:

1) Separate the rumored deal price from the transaction.  It’s a lot of money for Apple and in many ways focusing too much on the money will make it difficult to focus on the underlining acquisition target. 

2) What is Beats?  While everyone seems to have a different answer, to me Beats is a start-up music company that is after one thing: music mind share. Think of music and Beats comes to mind, right? No? Well give it a few more years and the growing popularity of those “obnoxiously large” headphones may change things.  Co-founded by intelligent musicians (and businessmen) who “get” music, Beats knows what it is doing and more importantly what it’s after.  Headphones, stereo equipment, music streaming service, and the list goes on. Beats wants to own music. 

3) Apple is Afraid. I suspect Apple feels threatened as its mind share for music is declining. The iPod died on behalf of its older sibling, the iPhone, and following its death, the grip Apple had on music has started to slip. Think of digital music, and Pandora or Spotify may come to mind. Beats could very well be on the same path of music stardom. This past holiday shopping season, Beats headphones were everywhere (and people were buying them in droves). Walk down the street and you could tell when someone was wearing Beats. For the first time, the white EarPod was being threatened. Who knows what things would look like in a few years. Apple would be looking to change that with this acquisition. I suspect Apple is interested in buying Beats to gain music mind share.  

4) Similar Cultures. Beats and Apple share similar cultures where passion is the ultimate driver. While there would undoubtedly be segments or pieces of Beats that Apple will shutter, Beats could very easily represent a decently sized (fewer than 200 people) division within the Apple system. Sure, this would mark a departure from the way things have been, but judging from Disney’s success, sometimes you have to let the past go and embrace the future. 

5) Let’s go back to price. I think Apple is overpaying for Beats. Recent valuations pegged the music streaming service at around $100 million with the entire company worth a reportedly $1 billion last year. While additional details may come out in the coming days I suspect Apple is overpaying to avoid others from coming in and competing over price. It’s a lot of money for any company, and regardless of how much cash Apple has in its bank account, it’s still a lot of money. To me this means Apple is serious about this bet.  

6) Lots of unanswered questions.

- Will Apple actually promote the Beats brand post acquisition? Such an idea is still hard to grasp, but maybe they would have to in order to maintain a gripe on the music mind share they are acquiring.  Is the reason Beats headphones are popular because they aren’t Apple branded?  If I had to bet I would say Apple walks a thin line introducing new Apple-branded music product, while also keeping the Beats brand around.  Such an idea is still hard to swallow though…

- Will there be a Beats brain drain (employees leave) and does it even matter?

- How will this impact future Apple products? I suspect we are going to see Apple attempt a very significant push at a true music streaming service where I can have any song, when I want it (NOT RADIO), wherever I want it…and it would be free for iOS users signed up for Apple’s new mobile payment system.  

- Will this open the floodgates to additional Apple acquisitions?  If the answer is yes, then we may be entering a new era in tech M&A as the biggest tech company in existence is officially an acquirer (I don’t think this is the case though). 

Acquiring Beats would be a new type of transaction for Apple. While there are similarities to previous acquisitions, there are just as many differences and for the first time we may be seeing Apple “doing what is right” - fighting for its survival. Apple wants to own music. 

14 hour update: After plenty of Twitter discussions and thought, the only additional comments I have include:

1) Jimmy Iovine may play a big role. If the $3.2 billion price tag holds up, it becomes obvious that Apple is paying for intangibles (branding, music industry relationships) and not current products or services.   In essence, Apple would be buying the music industry - something that Apple would not be able to do organically. Iovine has been critical of iTunes and it’s possible Apple wants him to revamp iTunes and bring the service into a new era (with the full support of the music industry).  

2) Would Apple replace the iTunes brand with Beats? Is it possible for a declining consumer electronics brand (iTunes) to turn around and regain its strength? Maybe the only way for Apple to regain its grip on music is to update its branding from iTunes to Beats (among other things).  In such a case, a $3 billion price tag doesn’t seem as crazy.