Apple was firing on all cylinders last quarter, reporting:
- 74M iPhones
- 21M iPads
- 5.5M Macs
- $75B of total revenue
- $24B of operating income
- 500M visitors to Apple retail stores (physical and online)
Listening to management's earnings conference call, two questions stood out. One was what many analysts were thinking: "How is it possible that a company can report such strong numbers?" The other was one that a few asked Tim Cook: "Is this sustainable?" The second question on sustainability is maybe the most important question to ask, not only for the stock, but for Apple and the iOS ecosystem. Are we at some type of peak or is this a new era at Apple? I contemplated these questions for a few hours last night. I ended up looking at Apple's product philosophy for the answer.
How Is This Possible?
Jony Ive, SVP of Design at Apple, gave a talk at the Vanity Fair New Establishment Summit in San Francisco this past October. It was a wide-ranging discussion (and I highly recommend taking a look). The question of why Apple moved back to curved edges for larger iPhones was brought up. Here was Jony's response:
Instead of shipping an iPhone with a large screen years ago just to be the first to cross an item off the feature list, Apple took a type of tick-tock approach with incremental step ups in screen size every two years, holding off on the 4.7-inch and larger screens until late 2014. The decision to wait paid off as Apple not only beat 1Q15 consensus on record iPhone sales, but reported the highest level of quarterly operating income in corporate history. The combination of pent-up demand for bigger iPhones and Apple's supply chain prowess, led to 75M iPhones being sold (up 46% year/year), well above expectations of close to 65M units, and even my 69M estimate. Heading into the quarter, the primary risk to the iPhone number was inadequate supply. Instead, having the best supply chain in the industry, under the leadership of Jeff Williams, allowed Apple to increase iPhone production to such a level as to sell the device in 130 countries within three months of launch.
The iPhone 6 and 6 Plus are increasingly looking like game changers in the smartphone industry, an industry that some declared set in stone with the iPhone destined to the top 10-15% share. iPhone unit sale growth was up 44% in the U.S. last quarter, with even stronger growth elsewhere, including 100% growth in China, Brazil, and Singapore. Countries where critics thought the iPhone would do poorly are ending up representing very attractive opportunities for Apple.
Is This Sustainable?
The iPhone is now supported by 375 carriers, representing 72% of the mobile phone subscriber base. In a rather remarkable display of Apple's growing size and power, it would likely require an additional 10M iPhones just to get iPhone channel inventory within the 5-7 week target range set by management. Tim Cook mentioned that the Android switcher rate is the highest it has been in the three previous years (likely around 15-20%) and the number of customers new to iPhone is greater with iPhone 6 and 6 Plus than any other iPhone launch. These data points serve to frame the heart of the argument surrounding iPhone sales sustainability. Having 20% of iPhone buyers come from competing platforms may be the most important figure to be taken out of Apple's earnings conference call. The iPhone 6 and 6 Plus remove the biggest feature difference that had developed in the phone market: screen size. Looking ahead, Apple will target the 100s of millions of consumers that bought Android smartphones over the past few years and will soon be looking for a new smartphone. Tim Cook also disclosed that approximately 10-15% of the iPhone user base upgraded to iPhone 6 and 6 Plus, implying the iPhone user base stands at 400-420M. Considering the average iPhone user holds onto their phones for 2-3 years, Apple expects continued momentum from iPhone upgrades through 2015.
Apple reported record revenues of $75 billion, up 30% from 1Q14, which is remarkable on a number of fronts, including the large revenue base Apple had to work off from, the overall global economic picture where any growth is considered good growth, and FX trends that have weighed on results from other multinational companies. With the Apple Watch launching in April (3Q15), Apple is on track to report 25% revenue growth for full-year 2015.
Apple's gross margin, once considered the most important piece of the puzzle to AAPL investors, continues to move higher as the iPhone makes up a larger portion of the overall business. Apple's current operating margin is approximately 41%, excluding FX impact, up from a low of 37% in 2012. Not only is Apple growing revenue by 30%, but margins are moving higher.
Management's 2Q15 guidance looks strong with revenue of $52-$55B ($55.8B expectation) and gross margins of 38.5%-39.5% (39.4% expectation), despite a 500 basis point impact on revenue and 100 basis point impact on margin from FX movements. The Chinese New Year will likely bring continued momentum for Apple product sales in 2Q15.
Exhibit 1 includes all of the major line items from Apple's income statement, compared to 1Q14 results and Above Avalon's expectations. Interestingly, research and development expense continues to remain elevated, rising 43% year-over-year to $1.9B last quarter.
Exhibit 1: Apple 1Q15 Results Compared to 1Q14 and Above Avalon Expectations
Exhibit 2 highlights Apple's product sales in 1Q15 versus 1Q14 and Above Avalon's expectations. Strong iPhone unit sales and ASP (thanks to the iPhone 6 Plus and reconfigured storage tiers) more than offset weakness in iPad and relatively in-line Mac results.
Exhibit 2: Apple 1Q15 Results Compared to 1Q14 and Above Avalon Expectations
iPad Is Finding It's Purpose. Tim Cook essentially gave guidance for the iPad in 2015 by saying he did not expect much change in iPad sales momentum. During the quarter, the company shipped 21.4M iPads, beating my 19.5M estimate, but down from 26.0M last year. iPad continues to find its proper role within the Apple ecosystem. Tim Cook announced 12 additional MobileFirst iOS apps related to the IBM partnership will be released this quarter, which will go along with the 10 apps recently released. Apple is increasingly positioning enterprise as a key market for iPad, which makes a rumored iPad Pro geared towards content creators that much more interesting. First-time buyer rates for iPad remain high with upwards of 50% of iPad sales going to new customers, including a 70% first-time buyer rate in China. iPad ASP continued to decline suggesting that the iPad mini is replacing the iPod touch as the popular entry-level price iOS device. Overall, there wasn't much in the iPad results to suggest any significant changes in my expectations.
All Eyes Are on China. In what may be the clearest signal of Apple's bullishness on China, Tim Cook mentioned Apple will have 40 stores in China by mid-2016, implying 50% store count growth in a little over a year. We are already seeing the beginning roll-out of this renewed retail focus in China with new stores in Hangzhou and Chongqing. In terms of the Apple online store (now over 350 cities), online revenues in China last quarter were more than the sum of the previous five years. Apple's recent high-profile hires from Burberry (Angela Ahrendts and Chester Chipperfield) would certainly make sense if considering China's importance to Apple and considering Burberry is in the midst of a similar retail expansion program in China.
Jeff Williams Performing at Highest Level. Apple's SVP of Operations Jeff Williams continues to position himself to be Tim Cook's successor as Apple CEO. While I don't expect any change at the top for many years, Williams is only 50 years old (Cook is 53 years old), and quarterly results like the one Apple just reported show that Williams is executing at the highest levels imaginable.
Apple's Retail Weapon. It is rather remarkable how Apple is doubling down on its retail efforts (including physical stores), while peers are either scaling back or staying out of the mix. Apple's investments in its retail operations (447 total stores, 182 of which are outside the U.S.) may be one of the most important bets the company has taken over the past 15 years. Looking ahead at the upcoming Apple Watch, having hundreds of retail locations with trained staff represents a significant competitive advantage for Apple.
Cash and Capital Management. Apple has $178 billion ($31/share) of cash and marketable securities, up $23 billion from last quarter. Apple currently has $33 billion of long-term debt and $4 billion of commercial paper (short-term debt). Management repurchased 53M shares last quarter for between $5-$6 billion (roughly in-line with expectations). Apple has approximately $16B of share buyback authorization remaining and will likely increase the buyback program, along with raising the quarterly cash dividend, in April.
Valuation: Investors Searching for Earnings Sustainability. Apple is currently trading at a 16x trailing P/E and a 12x forward P/E. Obviously, such valuation metrics (as well as more granular metrics such as price/free cash flow) would suggest the shares are undervalued given the company's growth metrics, but that has been the case for years. It is much more important to focus on investor's comfort level around Apple's EPS growth and sustainability. Unfortunately, as a consequence of the industry it operates in, Apple's earnings and growth are looked at with more skepticism than peers growing at a much slower rate. Looking ahead, the Street seems to be expecting continued strong iPhone demand and a decent Apple Watch launch. What will make investors feel more comfortable with earnings sustainability? Diversification, additional service revenue, and more clarity on how Apple product users treat ecosystem paid upgrades, such as iCloud storage). In the meantime, management will likely continue to be in the market buying back AAPL shares.
Apple is likely entering a new round of revenue growth on the heels of continued follow-through strength of iPhone 6 and 6 Plus in 2015, as well as the impact from Apple Watch revenue beginning in 3Q15, as shown in Exhibit 3.
Exhibit 3: Apple TTM Revenue (Blue = Reported, Grey = Estimated)
Apple's decision to wait to sell iPhones with large screens until the product was ready will likely go down as a turning point for iPhone. Market share gains will help position the iOS ecosystem to benefit from new services such as Apple Pay, and eventually music streaming, video, health, home, car, and other endeavors. Management often reiterates that Apple is a product company. Record 1Q15 earnings demonstrated that commitment.
This report was produced by Neil Cybart on January 28, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.