By Kris Rosemann
Tech giant and holding in both newsletter portfolios Apple (AAPL) reported sharp drop-offs in both its top and bottom lines in its fiscal third quarter on a year-over-year basis July 26, but its shares have surged back into triple digits ($100+) since then thanks in part to stronger than expected customer demand driving reported results past expectations. Revenue fell more than 14% in the quarter, and diluted earnings per share dropped 23% from the year-ago period as iPhone unit sell-through was down 8% from the third quarter of fiscal 2015. Though this 8% drop is not appealing on an absolute level, it is better than what the firm was expecting, and continued improvement is anticipated as we move into its fiscal fourth quarter.
Management was quick to pull out some positive trends in showcasing the resiliency of iPhone sales. The launch of the iPhone SE, a smaller 4” display version of the iPhone, in March has largely been a success, though it did provide a slight drag on the firm’s gross margin as it is priced at the lower end of the iPhone price range. Through the first few weeks of its sales, however, the iPhone SE has registered the highest percentage of sales to new iPhone customers than any other iPhone in several years. This helped drive sales to ‘switchers’ from other smartphones as a percentage of total iPhone sales to record levels, and in the first three quarters of the fiscal year, Apple has seen the highest number of absolute switchers as it has in any nine-month period. Corporate purchase intent for the iPhone has been strong as well; 75% of US corporate buyers planning to purchase smartphones in the fiscal fourth quarter plan to purchase iPhones.
Strong momentum among switchers means the iPhone SE is doing exactly what it was meant to do–that is to continue to grab market share and build the presence of Apple and its ecosystem in the consumer’s everyday life. The active installed base of iPhones grew double-digits in the fiscal third quarter on a year-over-year basis, and installed base-related purchases leapt 29% in the period. The firm’s Services business continues to grow and now accounts for 11% of its total revenue, compared with 8% as of the end of the third quarter of fiscal 2015–the business’ profit share within the company is even higher.
Multiple records were set in the Services segment in the quarter, including App Store revenue hitting its highest ever mark thanks to records in the number of transacting customers and amount spent per customer. According to App Annie, Apple’s App Store generated twice the amount of global revenue Google Play (GOOG, GOOGL) did in the June quarter. Apple Pay momentum continued to contribute to the Services segment’s growth in the quarter as well, and monthly active users of the mobile pay platform as of the end of June were several times the levels of a year ago. Apple’s leading financial partners have indicated that three out of every four contactless payments in the US are made with Apple Pay, and the US currently accounts for less than half of total transaction volume.
As a result of such growth, CEO Tim Cook stated that his management team expects its Services business to be the size of a Fortune 100 company next year–trailing twelve months revenue was $23.1 billion as of June 30. We love such potential from a higher-margin segment that is currently just over one-tenth of Apple’s total business and what it means for Apple’s strategy to be an increasingly integral part of everyday life.
Apple continues to drive growth in its ecosystem across the globe as well. Though concerns remain with the economic environment in China, not to mention some of the political tensions hindering a smooth operating environment, the firm’s installed base in the country advanced 34% in the third quarter of fiscal 2016 from the year-ago period. Switchers and first time smartphone buyers make up the majority of iPhone sales in China, and China Mobile–which boasted more than 60% market share in China’s telecom market as of the second quarter of 2015–has indicated that it has more iPhone users than any other smartphone brand on its network.
A tremendous comparable period in fiscal 2015 muddies recent results for Apple in China to a degree, but management is confident that its underlying business in the country is stronger than its financial performance implies. To that point, through the first nine months of fiscal 2016, iPhone unit sales in China were 47% higher than the same period in fiscal 2014. Apple’s presence in India continues to advance nicely, and the company reported 51% growth in iPhone sales through the first three quarters of the fiscal year. It sees huge potential in India as a growth market, and a coming roll out of a design and development accelerator specifically for Indian developers on the iOS platform is expected to play a key role in driving growth in its ecosystem in the country.
Highlights outside of the iPhone and its ecosystem exist for Apple as well. The firm reported its best quarterly growth in iPad revenue in the quarter thanks to the rollout of the 9.7” iPad Pro. Sales of the iPad Pro are being driven by commercial usage, upgrades from previous models, PC replacement, and average selling price increases. iPad now has 84% market share of tablets priced above $200 in the US, and it boasts strong purchase intent rates as well. The Apple Watch continues to be the best-selling smart watch in the world, and coming improvements in its operating system and overall capabilities are expected to drive demand not only for the physical watch but also in Apple’s growing ecosystem.
A good deal of the positive buzz surrounding Apple’s quarterly report has been focused on its potential technologies in the future. Though management would not provide a concrete number, it did indicate that research and development spending grew at a mid-20% rate in the fiscal third quarter and that “quite a bit” of that spending is going towards products and services that are not currently shipping or are derivations of something that is currently shipping. Apple is spending a lot of money on things that have yet to hit the market, as CEO Tim Cook said on the conference call, “But you can look at the growth rate and conclude that there’s a lot of stuff that we’re doing beyond the current products.”
The coming release of the iOS 10 this fall, which Apple expects to be its largest ever release of an iOS, is but one of the many products that could be eating up such significant R&D spending. Management has touted its expertise in Artificial Intelligence through the past development and implementation of Siri as well as customized recommendations and pattern recognition technologies, and customers can expect ongoing innovations in these areas.
Augmented reality has been a hot topic as of late due to the tremendous popularity of Pokémon Go, and Apple has insisted that it has been and will continue to invest in the technology. The core of its focus in this area has been to ensure that its products work well with developers’ products similar to that of Pokémon Go, in order to position itself to capture the momentum of the next big augmented reality craze.
One of the major reasons we continue to be high on Apple is due to its tremendous track record of incorporating new technology into its existing product line, enabling it to become an increasingly-important portion of the consumer’s everyday life. Such a need to be innovative makes Apple’s incredible cash position even more valuable. As of the end of the fiscal third quarter of 2016, the firm had $231.5 billion in cash, cash equivalents and marketable securities on its balance sheet, though only 7% of such cash was located in the US. Investments in and purchases of foreign entities with attractive talent and intellectual property is a likely use for a portion of its foreign cash, as we have seen with its recent $1 billion investment in Chinese ride-hailing service Didi Chuxing. Apple expects this not only to be a sound financial investment, but also sees benefits coming from the companies working together as well as the potential to learn more about the important Chinese market.
All of these developments and expectations have led Apple management to issue relatively optimistic guidance for the fourth quarter of fiscal 2016 compared to its previous two quarters. Revenue guidance of $45.5-$47.5 billion represents approximately 10% growth sequentially, near the high end for Apple’s historical estimates. Reports have surfaced that the iPhone 7 will be released September 16, near the end of the fiscal year, but management would not confirm a release date. Though such a release would provide a boost to revenue growth, the firm is expecting strong international performance in the quarter from the likes of Japan, Brazil, India, and Russia. Services revenue is also expected to continue to expand at a strong pace.
We’re big fans of Apple’s ecosystem, and the fact that its Services business revenue is growing at such a robust rate speaks to the prowess of developers to produce apps that consumers want on Apple’s platforms. This will continue to be an advantage for Apple moving forward, and we are interested to see how it continues to develop its presence in consumers’ lives through Apple TV in the living room and CarPlay in vehicles. The firm is aiming to provide users with a seamless experience across all the different aspects of daily life, which is the basis of its rapidly-growing Services business.
Nevertheless, unit sales of the iPhone more recently have not been strong by historical measures. The upcoming rollover in the product’s cycle will most certainly have the attention of investors. Accelerated upgrades surrounding the release of the iPhone 7 are expected, but management continued to guide its discussion following the quarter towards the ever-increasing usefulness of smart phones in everyday life, as opposed to something more groundbreaking. As the smart phone market matures, top-line growth via unit sales will become increasingly more difficult, in our view, but Apple has something none of its competitors do: a massive ecosystem of apps that is generating a growing, higher-margin revenue stream. Geographic expansion related to the iPhone still offers potential, of course, and Apple may have more “gadgets up its sleeve,” but the long-term future of Apple may very well be centered on an evolving extension of its current system of apps that will span beyond the user’s pocket or wrist.
We continue to include Apple in both newsletter portfolios, and while more recent performance hasn’t been great, we’re mighty pleased with the gain in shares. The firm’s share price has experienced a strong jump since the release of the fiscal third quarter report, and we continue to be high on its ability to return cash to shareholders. We’re also encouraged by management’s commentary around certain trends in its iPhone demand, its Services business, and potential future technology–it appears the market is as well! Shares of Apple yield ~2.4%.