Apple – a 4th quarter unlike others and a year impacted by Covid

A different Q4 than others

Apple recorded around $64.7 billion in revenue, a tad higher than they did in the same period last year, and gross margin of 38.2%, 50 basis points higher than Q4 FY2019. Operating income came in at $14.8 billion due to an increase in Operating Expenses. While the increase in revenue is modest, the underlying story between this quarter and Q4 FY 2019 is very different. First of all, we are still in the middle of the pandemic which forces changes in consumer behavior. Students or office workers may spend more on hardware to aid remote working or learning. Consumers may increase consumption of digital content and services more while in isolation for a long time. Secondly, Covid-19 also forced Apple to close some of its stores; which might have adversely impacted sales. Thirdly, Apple didn’t have a new iPhone like it did with iPhone 11 last year; which is a significant element to keep in mind while comparing the two fourth quarters. About 2 weeks of sale for a highly anticipated like a new iPhone is a big deal. Apple executives gave some color on it:

 While COVID-19 and social distancing measures impacted store operations in a significant manner, demand for iPhone remained very strong. In fact, through mid-September, customer demand for our current product lineup grew double digits and was well above our expectations – Luca Maestri

If you look at China and look at last quarters — I’ll talk about both last quarter and this quarter a bit. Last quarter, what we saw was our non-iPhone business was up strong double digit for the full quarter. And then if you look at iPhone and you look at it in 2 parts: one, pre-mid-September, which is pre the point at which the previous year we would have launched iPhones, that, that period of time, which was the bulk of the quarter, iPhone was growing from a customer demand point of view. And of course, the — not shipping new iPhones for the last 2 weeks of September makes that number in the aggregate a negative.  – Tim Cook

Source: Apple Q4 FY 2020 Earning Call

While I understand the story here; folks didn’t want to buy a new phone in the last two weeks of September until after iPhone 12 came out, I wonder why both Tim and Luca kept emphasizing the growth of iPhone in terms of demand, not sale. Perhaps, I am being too paranoid, but I wonder if that specific call-out implied there is a difference in demand and sale or, in other words, there is a supply constraint.

Because of the reasons given above, it’s not easy to draw a conclusion on the two fourth quarters. It’s unclear how much the factors canceled out one another, but I have a feeling that not having a new iPhone for 2 weeks is the larger force at play here. Hence, I think it’s positive for Apple to exceed the sale last year without an iPhone. But what made up the absence of the new iPhones and a bit more?

Even though iPhone sale dropped by 21% in Q4 FY2020, non-iPhone sale grew by 30% with an excellent performance from Mac, which reached an all time high revenue of $9 billion and 29% growth, and iPad, which grew by 46% YoY. According to Apple, Mac grew by double digits in every geographic segment and notched all-time revenue records in Americas and Asia Pacific. Meanwhile, iPad had the best September quarter in 8 years in spite of supply restrictions and also saw double digits from every segment like Mac. Additionally, Services had a nice quarter as well with $14.5 billion, up 16% from the same period last year with all time records in App Store, cloud services, Music, advertising, payment services and AppleCare.

Source: Apple

In terms of geographic segments, all segments, except China, grew year over year. The absence of a new iPhone, like Tim Cook said, impacted sales in China more than other regions as last year, iPhone made up a higher percentage of sales in China than in other regions. Another reason, according to Tim as well, is a drawdown from the channel side. However, Apple is very bullish on the prospect of iPhone 12 in China because of 5G’s popularity and the fact that Apple is arguably the only major phone manufacturer without a 5G-enabled phone.

On the subscription side, Apple reported 585 million paid subscriptions in total, a sequential increase of 35 million from the previous quarter. For the last 3 years, that has been a sequential increase from one quarter to another. At this rate, it won’t be an issue for the Cupertino-based company to reach its goal of 600 million subscriptions by the end of the calendar year 2020. With the introduction of Apple One on Thursday and the imminent advent of Apple Fitness+, it’ll be interesting to see how they will impact the subscription base. There is no doubt that it will go up, but how fast it will reach the 1 billion mark remains to be seen. My guess is 3-4 years, at the earliest.

Source: Disclosures from Apple

How did Apple perform after a year full of challenges?

Apple spent at least half of the last fiscal year in the middle of a once-in-a-lifetime pandemic that brought both headwinds and tailwinds. On one hand, there was more demand for iPad & Mac to enable remote working as well as for possibly Apple TV+, Games and Music. On the other, there were supply constraints and forced store closings. Given all the ramifications of Covid-19 and the absence of a new flagship iPhone, Apple still managed to pull in $274 billion in revenue in FY2020, up 6% from last year. Gross margin increased by 50 basis points to 38.2%, due to a bigger percentage of revenue from Services. Operating margin dropped slightly by 40 basis points to 24.14% because of higher expenses. Next year, my expectation is that gross margin will decrease marginally while operating margin will remain flat because 1/ the new iPhone 12s will be available for order; which will bring a lower gross margin than Services and 2/ the new subscription bundles should also adversely impact gross margin.

Looking at Apple’s segment breakdown, iPhone sale unsurprisingly decreased by 3% YoY while non-Phone sale (Mac, iPad and Wearables) rose by 16%. Individually, Mac grew by 11%, a substantial step-up from 2% YoY growth last year, while iPad grew also by 11% and Wearables by 25%. Apple gave a bit more color on the performance:

  • Mac sale increased due to primarily higher sale of Mac Book Pro
  • iPad sale grew due to “higher net sales of 10-inch versions of iPad, iPad Air and iPad Pro”
  • Wearables sale grew “due primarily to higher net sales of AirPods and Apple Watch”. Because this segment also includes Apple TV, Homepod, iPod touch, Beats products and Accessories (like keyboard, Magic Mouse or cables), this disclosure means that last year wasn’t particularly a good year for Apple TV and Homepod. It’ll be interesting to see how the new Homepod Mini will perform in the future.

The changes in Services really caught my attention. Services brought in almost $54 billion in FY2020, up 16% YoY, “due primarily to higher net sales from the App Store, advertising and cloud services”. The color given by Apple this year differed a bit from last year’s when the increase in Services sale came mainly from App Store, Licensing and Apple Care. The difference, I suspect, came more from the impact of Covid-19 which forced some store closings and hurt AppleCare, than from an increase in demand for iCloud. When comparing the language Apple used to describe their Services segment, two points stood out for me

202020192018
Services’ main components– Advertising
– AppleCare
– Cloud Services (iCloud)
– Digital Content
– Payment Services (Apple Pay, Apple Card)
– Advertising
– Apple Care
– iCloud
– Digital Content
– Other services (Apple Arcade, Apple News+, Apple Pay, Apple Card)
– Digital Content and Services (which doesn’t include any language on licensing)
– iCloud
– Apple Care
– Apple Pay
How Apple broke down Services in their Business segment included in Annual Reports in 2018, 2019 and 2020
  • Advertising, which may include the deal with Google, was called out more prominently in 2019 and 2020. Perhaps, it’s because the payment from Google is substantial enough for it to have its own section
  • The new Payment Services now has its own section which I suspect will be the case moving forward. Tim Cook already said it’s an area of great interest to Apple, though they haven’t made public any more updates on either Apple Pay or Apple Card for a while

From the geographic segment perspective, 2020 was a good year for Americas, Asia Pacific and Europe as those segment booked all-time records while Japan stayed largely flat for the past three years and China had the lowest revenue since at least 2015. In fact, China’s revenue as % of total revenue came down from 20% in 2018 to less than 15% in 2020 while Europe was responsible for one fourth of Apple’s total revenue, up from 23% in 2018. With the new 5G-enabled iPhone 12 that suits Chinese consumers well, this segment’s revenue may likely increase considerably in the upcoming fiscal year.

In terms of operating margin, Japan led the way consistently at 43% while Americas, the biggest market for Apple, lagged behind other segments. China’s operating segment has been steadily improving and has now the second highest operating margin, behind only Japan. Because Apple didn’t give any explanation on the difference in operating margin across segments, I suspect that the reason why Americas’ is low is because of introductory offers from services such as Apple TV+, Apple Card, including sign-up bonuses, investment in content and installment plans for purchases with Apple Card, which is available to only consumers in America.

From a market distribution standpoint, Apple has been steadily increasing its direct share, growing it from 28% in 2017 to 34% of total revenue in 2020. I would imagine that a direct sale through its stores and website carry a higher gross margin than through a 3rd-party supplier. However, given that Apple didn’t particularly offer enough information and that Apple has 0% interest payment plan in America for customers with Apple Card through its stores and website, it’s challenging to gauge the specific impact of this transition. Nonetheless, because America’s operating margin and the company’s stayed largely flat, the more emphasis on direct channels may mean more in terms of customer relationships than in margin.

All in all, here are my take-aways from looking at Apple’s latest 10Q and 10K

  • Non-iPhone businesses have a bright outlook. Mac and iPad booked a strong 4th quarter, are well-liked and with a high probability, will continue to enjoy the tailwind of remote working trend. Wearables will continue to grow. I love my Apple Watch and Airpods Pro and anyone I know who bought these products says the same thing. The fact that Wearables is now the size of a Fortune 130 company after only 5 years on the market is incredible. The thing with Apple is that they tend to have a knack for offering incremental improvements that work well for consumers while keeping the prices largely on the same level. Because of that, I have confidence that Wearables will continue to grow in the near future.
  • iPhone is no longer responsible for half of Apple’s revenue like it used to in the past. Regardless, it’s still a popular phone. Just look at how people follow closely every announcement, from hardware to software, and how folks share their homescreen designs with iOS14, something that Android has had for a long time. Because I live in the US where 5G infrastructure isn’t really well built, it’s hard to see how iPhone 12 will sell. Personally, I wouldn’t buy iPhone 12. There is not enough motivation to upgrade from 11 to 12. Even Apple executives were pretty guarded when it came to giving colors on the new phones. On the other hand, iPhone 12 may become a hit in China, especially with the 5G infrastructure they have over there.
  • Services is now bigger than Mac and iPad combined and grew at a clip of 16% in the last two years. The key drivers of that growth look set to remain strong in the near future: 1/ Apple Care, which rides along with Apple’s popular products, 2/ App Store & iCloud and 3/ Advertising which seems to be made up largely of the deal with Google. Even though that deal is under scrutiny, it’s unclear whether Apple will lose that lucrative advertising money. Even if it does, there will be other browsers ready to jump in, albeit at a lower value. The breadth of Apple’s services keeps growing with Apple One and Apple Fitness+, and presence in more geographical markets. Hence, I expect Services to keep growing at 15-16% a year in the next two years.

Disclaimer: I own Apple stocks in my personal portfolio.

iPhone sale slowed down, iPad and Services impressed

Highlights from the press release and earning call

  • iPhone sale down by 17% YoY. Mac had a great quarter with a YoY increase of 21%. Mac had a 5% revenue decline compared to last year
  • Half of the Mac customers during the quarter were new to Mac and the active installed base of Macs reached a new all-time high
  • 75% of the Watch customers never owned a Watch before
  • Apple Pay transaction volume more than doubled year-over-year and on track to reach 10 billion transactions this calendar year. Apple Pay is now available in 30 markets and will be live in 40 markets by the end of the year. New York’s MTA system will begin their rollout in early summer.
  • 390 million paid subscriptions at the end of March, an increase of 30 million in the last quarter alone.
  • “As we mentioned in January, we’ve been working on an initiative to make it simple to trade in our — trade in a phone in our store, finance the purchase over time and get help transferring data from the old phone to the new phone. As part of this initiative, we rolled out new trade-in and financing programs in the U.S., China, the U.K., Spain, Italy and Australia. The results had been striking. Across our stores, we had an all-time record response to our trade-in programs and with more than 4 times the trade-in volume of our March quarter a year ago.”
  • All-time services revenue records in four of our five geographic segments. Services accounted for 20% of March quarter revenue and about one-third of gross profit dollars.
  • “In fact, the number of paid third-party subscriptions increased by over 40% compared to last year in each of our geographic segments. And across all third-party subscription apps, the largest accounted for only 0.3% of our total Services revenue.”
  • Wearables business grew close to 50%
  • Total cash, plus marketable securities: $225 billion. Total Debt: $113 billion
  • App Store search ad business: up around 70% over the previous year and expanding into new geographies
  • An additional $75 billion for share repurchases is authorized

Note: In the following chart, Other Products refers to Wearables, Home and Accessories . I tried to update the historical figures as much as possible, but there might be some discrepancies to the latest ones.

Revenue in Q2 2019 is down by 5% YoY

iPhones and Mac disappoint while the other segments impress year over year

iPhone and Mac’s makeup of Apple’s total revenue continued to decline. Services and Wearables/Home/Accessories become increasingly more significant

Revenue from Greater China as % of the total revenue continues to slide while Americas’ share went up this quarter

Both Gross and Net Margin decline year over year

QuarterGrossMarginNetMarginR&D/RevSG&A/Rev
Q2 201439.32%22.40%3.12%6.42%
Q2 201540.78%23.39%3.31%5.96%
Q2 201639.40%20.80%4.97%6.77%
Q2 201738.93%20.85%5.25%7.03%
Q2 201838.31%22.61%5.53%6.79%
Q2 201937.61%19.93%6.81%7.68%

Dividend growth decreased compared to last year

My thoughts

Though revenue went down compared to last year, it’s not that bad in my opinion. It is almost on the same level as Q2 2015 when iPhones made up 70% of the total revenue. Services, iPad and Wearables seem to be able to make up, at least for now, some of the lost revenue from iPhones. The continued drop of Gross Margin is concerning and so is the almost 3% decline in net margin.

As customers prefer keeping and using their phones longer and Apple is losing ground in China, a major market for the iPhones, I think the iPhone share in the revenue pie will become smaller while Services will be more important to the company’s health. Tim Cook wasted no time on emphasizing that this is the best quarter for Services as it made up 20% of the total revenue and 1/3 of the total gross profit. Much time was spent on a whole range of services. I look forward to seeing the remaining two quarters of the year and the first of the next year after many services announced last month debut.

I actually prefer the trade-in initiative to lowering the prices as the initiative will likely not dilute the brand value as much as price cuts, especially for a luxury brand such as Apple. It’s promising to see the response to the new trade-in program.

While it’s interesting to see a significant growth in the App Store search ad, I am concerned about what it would do the image of a privacy-focused brand such as Apple. Ads and privacy don’t actually go hand-in-hand.

Disclaimer: I owned Apple stocks. This post is a practice exercise and stems from my curiosity. It’s not intended to be investment advice or anything of the sort. I am not that good lol.

Sources:

https://www.apple.com/newsroom/pdfs/Q2%20FY19%20Consolidated%20Financial%20Statements.pdf

https://investor.apple.com/investor-relations/financial-information/dividend-history/default.aspx

https://seekingalpha.com/article/4258275-apple-inc-aapl-ceo-tim-cook-q2-2019-results-earnings-call-transcript?part=single

Apple’s strategic switch

Disclaimer: I do own a few Apple stocks, but it’s nothing major and this post is just to share my observation of Apple. As a fan of business strategy, I have been a fan of the company and interested in how it performs amid the concerns after the letter to shareholders on 2nd January 2019.

Yesterday, Apple announced their Q1 earnings. A few notable points from their announcement and earning call:

  • Apple no longer reports units sold across their business segments
  • Overall, Apple recorded $84.3 billion, down 5% year over year
  • Products gross margin was 34.3% and Services gross margin was 62.8%.
  • iPhone revenue dropped by 15% year over year
  • Services revenue in Q1 was $10.9 billion, a 19% YoY increase. Service revenue grew from $8 billion in calendar 2010 to $41 billion in calendar 2018, allegedly on pace to reach $50 billion in 2020
  • Mac revenue was up 9% while iPad revenue was up 17%
  • Wearables, home and accessories revenue grew by 33% to $1.8 billion
  • There are 50 million paid Apple Music subscribers, up from 40 million reported in June 2018
  • Apple reported a base of 900 million installed iPhones, out of 1.4 billion active devices in total from Apple
  • There are 360 million paid subscriptions across Services portfolio, an increase of 120 million versus a year ago.
  • This quarter saw 1.8 billion transactions through Apple Pay, twice the volume recorded in the same quarter a year ago
  • In Germany, there are more Apple Pay activations in one week than for Android in one year
  • “Revenue from cloud services continues to grow rapidly with year-over-year revenue up over 40% in the December quarter. And readership of Apple News set a new record with over 85 million monthly active users in the three countries where we’ve launched the United States, the U.K., and Australia”.
  • Ending Q1 2019, Apple cash stands at $244 billion while net cash is at $130 billion

I am a big believer in the notion that business models need to be adapted to the changes in the business environment. No business model could be effective while staying still over the years, especially in the fast-changing world that we live in today. Apple should be no exception and from the numbers reported, it seems to me that they are making changes.  

For years, the bulk of Apple’s business has come from hardware which is differentiated by its exclusive software, especially in the case of iPhone. iPhone revenue has made up approximately 60% of Apple’s turnover. However, the luxury smartphone market has reached the maturation point. iPhone unit sale growth has been either minimal or flat for quarters. Greater China market, which makes up 20% of their iPhone revenue, has boasted challenges to Apple, particularly in 2018. Their iOS isn’t as appealing to Chinese users as it is to users in other parts of the world while competitors such as Huawei and Xiaomi offer alternatives with more or less same features at a lower price. The macroeconomic conditions in China and the trade war aren’t helpful either.

The growth in iPhone revenue has come largely from the price hike which lengthens the upgrade cycle and puts a limit on how much Apple can reach out to potential users. Not everyone can afford those pricey phones. Lowering the prices isn’t the solution. Firstly, Apple is a luxury brand. Lowering prices may leave significant damages to its brand power. Secondly, cheaper phones will require substantial changes to its operations, including supply chain, distribution and Sales & Marketing.

All the signs point to the fact that too much dependence on iPhone is no longer sustainable for Apple moving forward. Enter Services.

Services has been a bright spot amid concerns over iPhone revenue for the past 2 or 3 years, growing at a 20% annual clip. Put that in perspective, their Services revenue this quarter alone is $10.9 billion, almost equal to Netflix’s revenue in 3 quarters in 2018 while Facebook Q3 revenue was about $13 billion. Instead of making money from devices, Apple is betting on users keeping devices longer and paying consistently and more for services. And why not? If the users tend to hold on to devices longer, it makes sense to generate more money from their activities. Plus, margin from Services is substantially higher than that of Products.

And they have been doing a good job. Apple Pay transactions reached 1.8 billion this quarter, 100% YoY increase. Revenue from cloud went up by 40%. The number of paid subscriptions grew by 50% year over year and Apple Music has added 10 million users, reaching the 50 million mark and achieving a 25% growth, since June 2018.

As of June 2017, developers earned $70 billion from App store since its launch in 2008. As of January 2019, the figure went up to $120 billion. Moreover, we are about to see their investment in original content as their streaming service is reportedly going to be live this April.

In summary, Apple seems to be heading to the right direction strategically in my opinion, given the changes in the environment they are operating in. I think the following guidance in the next few quarters will continuously be lower than analyst expectations as the reduction in iPhone revenue may not be sufficiently offset by the growth in Services yet. There is a chance that Apple won’t have the same revenue level as they had at the peak of iPhone-dominated era.

Nonetheless, I think the company is far from the demise alleged by some after a letter to shareholders on 2nd January 2019. They generated $84 billion in revenue and almost $20 billion in net income in 90 days! Instead, the change to be a Services company may be better for the company’s health.