Your Quarterly Apple Earnings Deep Dive

Last month, Apple (AAPL -0.81%) reported modest earnings for the third quarter, but the stock dropped 2.5% shortly after the call.

On this episode of Industry Focus: Tech, analyst Dylan Lewis and Fool contributor Evan Niu discuss the most important numbers from the call and what they mean for the company in the long term, and why the stock fell on what was a better-than-average quarter for the tech giant. Also, they examine how Apple is growing in China, how much the Samsung Note 7 fiasco might affect Apple's next few quarters, what analysts are most concerned about with the Q3 report, and more.

A full transcript follows the video.

This podcast was recorded on Oct. 28, 2016.

Dylan Lewis: This episode of Industry Focus is brought to you by Criquet. Criquet makes perfect, classic, and easy going polo shirts. For 20% off your first purchase, go to criquetshirts.com/fool and use the promo code FOOL.

Welcome to Industry Focus, the podcast the dives into a different sector of the stock market every day. It is Friday, Oct. 28. Happy birthday, mom! We're going to run through the Apple earnings report. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist, Evan Niu. Evan, how's it going?

Evan Niu: Busy week, a lot of tech stuff.

Lewis: A lot of earnings coming in.

Niu: A lot of product announcement.

Lewis: Yeah, a lot coming in from Apple. Let's talk a little bit about what they reported in terms of numbers. Maybe we'll get into some of the product discussion a little bit later on. $46.8 billion in revenue on the top line, more or less in line with expectations, down from $51.5 billion a year ago. But that is to be expected, we knew that was coming, no surprises there. EPS (earnings per share) at $1.67, which was actually slightly above what expectations were. The two big numbers that people immediately focus on, it seems like Apple delivered a pretty solid quarter.

Niu: Yeah. I think it was right on target. I don't think there was really any big upsides and downside surprises. The way I look at it, this is the most boring quarter of all the seasons, because it's right before the iPhone launched. You get a couple weeks of the new iPhone sales, but generally speaking, Q3 is just not a super exciting time for consumer electronics companies.

Lewis: You mentioned the iPhone. We might as well head in straight into the discussion on that product. The company sold 45.5 million iPhones at an ASP (average selling price) of $619. That amounts to about $28 billion in revenue, good for about 60% of Apple's top line. We've seen that trend down a little bit. I think it's stabilized in the high 50s low 60s. It isn't quite the two-thirds amount it used to be.

Niu: Yeah. On a trailing-12-month basis, it's still about 63%. It's still pretty far up there. One thing I did notice that was interesting was Apple did not disclose this whole thing about installed base related purchases that they've been doing for the past three quarters. As we talked about before, there's this effort -- in my opinion -- to shift attention away from unit sales. But they didn't do that this time, which is weird, like, are they not trying to do that anymore?

Lewis: Yeah, any time you introduce a new metric, especially a non-GAAP metric, you're shifting attention somewhere. And for them to go silent on that makes you wonder exactly what's going on there.

Niu: Yeah, it's a weird change of tune. I've been keeping track of this number, and I was expecting to plug it into my sheet, and they just didn't have it.

Lewis: One number I think a lot of people have to be pretty optimistic about is the general trend with ASP. I said $619, that's up from the previous quarter, and it seems like there's some more upside there.

Niu: Right. The main thing to remember is that the reason why it was down over the summer was because of the iPhone SE launch, which starts at $400, which was the lowest price point that Apple has ever sold an iPhone directly, even if you factor in how they bring these older models down by price point every year. The lowest they'd ever gone before was, a three-year-old iPhone would go for $450. Then they came out with the SE, which starts at $400. It was a pretty aggressive play to get smaller phones and first-time adopters, with a lower entry price. That put a meaningful impact on ASPs, which was $595 last quarter, which was the lowest it's been in about two years. They did say on the phone, they expect ASPs to climb back up to where they were last December quarter, which, for reference, was $691. So, I think we should start to see that number start to push $700 again, particularly if they can meet iPhone 7 Plus demand, which they're having a hard time doing, because the iPhone is so expensive, they can increase that price by $20 compared to last year. The 7 Plus will really push ASPs up, I think.

Lewis: And part of the justification with that incremental $20 on the price point was the camera. That was the major selling point, and that's how management pointed to that decision.

Niu: Yeah. They specifically said it was the camera. They were asked about it, and they were like, "We put a ton of Innovation into the dual-camera system." I do think that is very specifically what's the reason for that $20.

Lewis: One of the things I thought was particularly interesting with the commentary from this report was, you look at the services segment, you look at the last couple quarters, you've seen service segment revenue up 20%, and they're really touting this number. Most recently, it was $6.3 billion, which is roughly 13% of revenue. At this point, we're coming up on two full years of them breaking out services as a product segment. Looking backwards, we've seen a huge step change in the fiscal Q1 quarter. In 2015 fiscal Q4, we were at $5.1 billion. That hopped up a full billion dollars in the following quarter, fiscal Q1 2016. So, I'm really curious looking forward what that segment might look like. Theoretically, we should be in the step-change quarter. It'll be interesting to see if they can sustain that growth, or if we're going to continue to see them hum along at more or less flat sequential growth.

Niu: Yeah, services is becoming huge. Like you said, it's $6.3 billion. And if you look at the past four quarters, this is now basically a $25 billion business. That's bigger than the Mac, bigger than the iPad. It's their second-biggest business at this point, which is kind of crazy to think about, because Apple is typically not that great at services in general. Particularly because the services revenue, most of it is not coming from a subscription service like Apple Music that bills every month. That's certainly part of it. But it comes back to what we were talking about earlier, which is the whole installed base related purchases. A lot of that services revenue comes from them relying on their users buying content and apps on the App Store reliably. That's why that number is important, and I'm surprised they didn't give it. Not a whole lot of it is occurring, monthly subscription fees that you can count on every month. So, it is important, but they're doing a really good job of growing that number. It's a pretty big business now, $25 billion.

Lewis: It's huge. I think, you hit on the installed base thing, if there are any issues with them growing that installed base, it stands to reason that the services segment won't continue to grow the way that it has. That's kind of the relationship there, and that's why you always see the step change happen in fiscal Q1, because that's when they sell a ton of iPhones. You're going to see those two things move together. That's certainly something that I'm watching in the coming quarter, because they're pointing to it more and more in their conference calls. I think it's an indication of a lot of other elements of their business.

Niu: Absolutely.

Lewis: Looking forward and looking at the guidance that they provided, for the first time since physical Q1 of last year, Apple is guiding for year-over-year growth next quarter, which I think is a welcome sign for a lot of investors. The company is expecting revenue to come in somewhere between $76 billion and $78 billion. When we say year-over-year growth, fiscal Q1 last year, they posted revenue of $75.8 billion. So, it's not going to be huge, but it is positive growth.

Niu: I'll take it. (laughs) 

Lewis: Yeah, at this point, looking year-over-year declines for a little while, it's certainly a welcome trend to see. I think some people are maybe a little disappointed in this guidance, given some of the tailwinds that the business has right now at its disposal. This is something we've talked about in previous shows. One of the major competitors, the Samsung Note 7, being off the market, you would think would be a much larger catalyst for Apple than maybe they're letting on.

Niu: Yeah. They declined to give any meaningful comment on whether or not they think they'll benefit, but I think pretty clearly that they will. And now there's even reports that the Galaxy S7 Edge is catching on fire. (laughs) I don't know if you've seen it, there's not as many of them. But there were reports starting in September. That was a month ago. Again, it's not as widespread, but there are a handful of cases across the world, like in China and the Philippines with the S7 Edge -- which is one of the phones that Samsung is pushing people toward. And here's the crazy part -- one of those phone was a replacement for a Galaxy Note 7. So Samsung gives a customer and S7 Edge to replace his Note 7 that caught on fire, and the S7 Edge catches on fire! (laughs) It's just a mess.

Lewis: That's a bad brand experience there.

Niu: I think, going back to their guidance, I do think, the one thing that stood out to me as far as not so great in the guidance was the gross margin guide. The revenue guidance was fine because it'll be nice to get a little growth, even if it's not a lot. We had three consecutive quarters of negative growth up top at this point, so I think anything is nice. On the profitability side, I was surprised, too, because in the fourth quarter, Apple always enjoys a lot of operating leverage when their revenue scales up to these really high levels. Usually, you see margins expanding in a pretty meaningful way, usually to the point where you're at 40%. They're guiding to basically upwards of 38.5%. So, 50 basis points shy of what I would expect them to guide to. And, for what it's worth, last year they did 40%.

Lewis: In fairness on that 40% figure, that was also a quarter where they realized $550 million or so in a patent dispute agreement with Samsung. I think that added about 40 basis points to that margin number. I think the true margin number was like 39.6% or so.

Niu: But if you go back another year, it was still like 39.9%. It's still pretty close to 40%. And I know it doesn't sound like a lot, 50 basis points, but when you're talking about a business this big, every basis point counts. One basis point is like $7.6 million. So, multiply that by 50, and that's gross profit, coming straight down through the income statement. They've been talking a lot about commodity costs and component costs being very favorable. So, I'm wondering why that guidance wasn't stronger.

It's also possible that there are some currency effects, because they've been battling the strengthening dollar for a really long time. That's very much hurting them, because about two-thirds of revenue comes from outside the U.S. The strengthening dollar has been hurting them for many quarters. So, that could also be part of it. I think that might have been why the original market reaction was negative. If you're watching after hours, the stock jumped on the iPhone number as soon as it was released, started getting back those gains as people read through the numbers and started digesting them a little bit.

Lewis: Yeah, and we're going to hit on that in the second half of the show, also talk about a couple things that analysts are concerned about and whether they're really a cause for concern. But, before we do, I wanted to give a shout-out to our friends at criquetshirts.com. Criquet makes comfortable and sharp-looking polo shirts that perfectly mix old-school style and modern design. Criquet shirts are made with super soft 100% certified organic cotton, making them as comfortable on the 19th hole as they are on the 18th. The fit is not too baggy and not too skinny. The shirts come with removable collar stays to help keep your collar looking crisp and new. We all know the worst thing in the world is a bacon collar, and Criquet's collars don't get wrinkled or rippled. Plus, they offer free, no-hassle returns and exchanges. Criquet actually sent some shirts over to The Fool for us to check out since they were sponsoring the show. I've worn mine to the office a couple times. It's a really great shirt for that slightly dressed up casual look. I'll say, I fit in walking around The Fool in our slightly more start-up environment, and also heading out to happy hour with my friends after work. It's definitely a really versatile shirt, great all-purpose shirt. It has that modern, tailored cut to it, not boxy like some of the other polos I own, but it also doesn't feel like it's painted on, either. Just something to check out. As a special offer to our dozens of listeners, get 20% off of your first purchase by going to criquetshirts.com/fool and using the promo code FOOL. 

Evan hinted at some of the things we wanted to discuss here on the second half: some analyst concerns and the market reaction to earnings. This came up in the conference call from a couple different folks. I've seen some people worried about what's going on with the R&D spend, research and development side of Apple's expenses, and what's going on in China for them. Do you want to hit on that a little bit?

Niu: I think there are some questions about, why is R&D expenditure growth growing at this accelerated pace? Apple is really good at efficiently spending on R&D. A few years ago, it used to always be 2% to 3% of revenue range, which is tiny. A lot of other tech companies are like 10% to 15%. Google and Microsoft, that's how much they spend of their revenue on R&D. It's not as if the more you spend, the more innovative. It's not linear. It can be wasteful sometimes, if you're spending on projects that you never actually commercialize, which I think Microsoft has a tendency to do. Apple has always been really good at only really putting this money into things they know they can commercialize later on. But now, in the past few quarters, we're seeing this number rise to this 5% to 6% of sales, at the same time that revenue is slowing down, so there's a lot of questions of, "What's going on here?" The obvious answer is, they're spending money on these things for the pipeline that they won't talk about.

Lewis: Which is maddening as an investor. They're like, "Don't worry, we're spending it well, we're allocating resources great, just trust us."

Niu: "Just trust us." Yeah. There was this talk of a car, and clearly a car is incredibly expensive to develop. Who knows if they actually do it, there's all these conflicting reports on where Apple is or is not heading with this car idea. But, that is certainly, as far as expenses go, extremely expensive on the R&D front. There's things like augmented reality, virtual reality, AI. There are a lot of things Apple is certainly exploring here, but they can't talk about. So, there's a real question, I think, at this point. Yeah, we know they're spending this money, and we can probably guess on what, based not only on where Apple-specific rumors are coming from, but also where the tech industry is going. We know, everyone is working on these things. So the real question will be, can they do these things, and when they do launch them, will they be compelling, will they be better than everyone else's? Will they actually drive the business even more? And you just have to wait.

Lewis: Yeah, unfortunately it's a wait-and-see type of thing for investors. I'm not freaking out about it yet, but I think it's a good thing to monitor.

Niu: Definitely.

Lewis: What about what's going on in China?

Niu: China, there was this big thing, sales were down 30%. Last quarter, they were down 33%. The quarter before that, they were down 26%. If you just look at these year-over-year numbers, it looks really bad. But you have to realize, they're just facing tough comps, because they did so well in 2015. If you zoom out a little bit and look at their business on an annual basis, this is still a $46 billion business in China. Last year, it was a $50-plus billion business. And the year before, it was like $20-something billion. This is still very much headed in the right direction. I used to track their "Greater China" sales before they actually broke it out and exposed it in this lush detail. If you go back to fiscal 2009, I think, they did less than $1 billion in sales that year. You'd have to basically stitch these numbers together from conference call comments, which I used to do. Now they give it to you directly. But I used to dig these numbers up. I think it was $900 million in fiscal 2009. That was seven years ago.

Now they're basically $45 [billion] to $50 billion. You can't argue with the long-term trajectory of it. And there's still a lot of room to grow; this is nowhere near the end game. China is still nowhere near saturated, there's still tons of first-time smartphone buyers. The middle class is still booming. There's just a couple of tough comparisons because they did so well last year. I wouldn't worry too much. It's just this noisy, quarterly trends, quarter to quarter, it's tough to call. And yeah, there's certainly some competition coming in from these lower-end Android makers like Xiaomi and all these other local players. At the same time, I don't think there's a lot to worry about. There's still a lot of room to grow in terms of physical geographic footprint. They don't have that many stores, still, they only have about 40 stores or so. I don't think there's anything to worry about, even if these past few quarters look scary on paper.

Lewis: Yeah, if you choose to look at their numbers on a two-year comp instead of a year-over-year comp, they look pretty darn impressive, right?

Niu: Right.

Lewis: So, that's something to keep in mind. In my eyes, pretty solid quarter. They met expectations, they set guidance that put them back on to at least some sort of growth, for at least the next quarter. We had a listener tweet, and I think this is something that probably a lot of people are wondering, you say, "OK, they checked the boxes in a lot of ways. Why are they down 2.5% since they reported?" The initial reaction when you saw iPhone units was positive, and pretty much after that they've fallen off and haven't really recovered. Two-and-a-half percent is nothing to go crazy panicked over, but I think it's a valid question, and it's something a lot of people are wondering. What do you think?

Niu: I think it was just kind of in line with expectations. It's always hard to know how the market is going to react. It's not always just about with the actual consensus number is, it's also about the whispered number, which is this abstract concept of what people actually think. That's the way that analysts work. Investors talk up this whispered number, "Oh, this is what I have on my official estimates, but I think they'll probably go lower, or higher..." So, it's always hard to gauge what's actually going to happen. 2% is not a killer move in either direction. I think it was more of just a lack of being impressed, if that makes sense. We talked about the gross margin guide wasn't super great. People just have to start accepting that Apple is just not a growth machine anymore, and that's OK. But some people have trouble with that just because it's kind of boring, for it to not be a growth machine.

Lewis: Yeah. And, in fairness, this is a company that has, historically, provided relatively conservative guidance. You almost never see them miss their own guidance marks. They typically meet it or are surprised pretty comfortably. So, to show them projecting growth means they must be pretty confident that that's going to happen. They do have some nice tailwinds to support that, like I said, they have one of the biggest competitors off the market, and they also benefit this quarter from a 14-week Q1 instead of a 13-week Q1. So, that should help them out a little bit, a couple extra selling days there. But, by and large, there's nothing in this report from my end, that really changes my thesis on this company.

Niu: They do pretty much always get within their guidance. It's not like the old days, when they would put out this laughably low guidance number, a lowball that you could basically ignore. A few years ago, they changed to really be more honest, to actually give a range that they're pretty confident they'll get within. And, for the most part, they have, every quarter, more or less. I definitely take their guidance at face value these days versus the old days, when you could basically just laugh it off because it was a joke. I think maybe that's another reason why they weren't as impressed. Maybe, like you mentioned, there's an extra week in this quarter. If the revenue growth is because you get an extra week, that doesn't really inspire a lot of confidence in the business. Again, it's not like it's a terrible business. But if you're looking skeptically, you could say, "Oh, you're only going to grow because you had more days to sell in the quarter." Maybe that's another thing people were disappointed in.

Lewis: Even then, returning to a flat quarter, in my eyes, is great. We've seen this down trend for such a long time that seeing them get back to, whether it's zero or positive growth, it's pretty fantastic. Anything else before I let you go, Evan?

Niu: No, I think we covered their earnings pretty well.

Lewis: All right. Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at [email protected]. You can always tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program may have own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!