Apple Inc.'s Earnings Disappointment is Overblown

Following Apple's (AAPL 0.64%) recent earnings release, the Street seemed concerned with iPhone sales and the company’s guidance for next quarter – should investors be worried or is this Apple anxiety overblown?

A full transcript follows the video.

 

Sean O'Reilly: What would you buy with $200 billion? On this tech edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly, joining you here from Fool headquarters in Alexandria, Va. To my left is the incomparable, the irreplaceable, Dylan Lewis.

Dylan Lewis: It's like a fighter's intro right there, Sean. I'm getting pumped up, getting ready to come out of my corner.

O'Reilly: You need to get your robe on? It's Apple day again. We have a lot of those.

Lewis: Apple a day.

O'Reilly: Apple a day keeps the doctor away. We're going to be healthy forever. They just reported earnings. Wall Street was somewhat disappointed. I don't know why. This company has $200 billion in cash. They beat earnings. What's the deal here?

Lewis: Face value, EPS was $1.85; estimates had come in around $1.81. They impressed there. Revenue was $49.6 billion, and analysts had been expecting $49.4 billion. You look at the two go-to stats and you think, "That's a pretty good quarter. What happened?"

O'Reilly: The stock was down as much as 10% in after-hours trading, but they rocked it. What's the problem?

Lewis: Analysts seemed a little disappointed with iPhone sales. So the company sold 47.5 million iPhones during the quarter. We're going to reference Q3 here. Their fiscal quarter doesn't line up with the traditional calendar quarter. So it's Apple's Q3; standard calendar is Q2. Analysts had expected around 49.4 million iPhones. They missed on that.

O'Reilly: I have one of them.

Lewis: They missed on that a bit. Some people are pointing to weak guidance as another possible explanation.

O'Reilly: To my mind, that's the only explanation for the slight sell-off.

Lewis: Yeah. Q4 analysts' expectations were about 51 billion, for what they provided in guidance. Apple is reporting guidance of 49 billion to 51 billion. The higher range of the guidance that they were expecting lines up with analysts' expectations. The crazy thing is, this is a company that's known for providing extremely conservative guidance. The last three quarters they've beaten guidance on revenue and gross margins -- every single quarter the last three quarters.

O'Reilly: It's like everyone was expecting it to go crazy, and when it didn't they sold their shares.

Lewis: Yeah. They were waiting for this ridiculous pop.

O'Reilly: This is not Foolish investing. We do not endorse this.

Lewis: No. I still see a fantastic company, an incredible amount of cash on hand; they've got a great product. I don't see any worries here.

O'Reilly: I compared the earnings against the forward P/E. Arguably, it's still a cheap stock.

Lewis: Yeah. On a forward P/E basis, this looks good. I think it's a big overreaction, and I think there's a couple big things to look forward to in the next coming quarters. This past quarter, ASPs were up sequentially. I think the interesting thing about that is they faced a lot of currency headwinds. So that's including the strong dollar on international sales. That's incorporating that into the average selling prices, and they were still up sequentially.

This is typically a weak quarter for them. With the expected upgrade and new products coming out in September, sales typically tend to drop off in Q3 period. For them to be up sequentially and not be discounting products, not have some of the wireless carriers giving promotions and things like that, that's obviously a good sign.

O'Reilly: OK. Were there any weaknesses that stuck out to you?

Lewis: Nothing huge. Obviously, iPod sales fell.

O'Reilly: Apple Watch.

Lewis: Yeah. That's something we can touch on a bit later, but they seemed very vocally happy about what's going on with the Apple Watch. This is something we're going to touch on in a bit, but the company's messaging was overwhelmingly positive when it comes to the Apple Watch. They indicated that it beat internal projections and that June outsold April and May. That's something that surprised a lot of people.

O'Reilly: That's actually a big deal, because there were these rumors that it would fall to 90%.

Lewis: Even the Mac line -- if you look at the PC industry and you're hearing about how there's year-over-year declines of 9% -- the Mac line was up 9%.

O'Reilly: Wow. So everybody's stopped buying PCs and they're buying Macs.

Lewis: They're bucking the trend in that category. In a lot of respects, you look at everything they're doing, and this is overwhelmingly positive. I think this is a huge market overreaction.

O'Reilly: Very good. OK. Before we move on, I want to make everybody aware of a very special offer for all of Industry Focus listeners. If you found this discussion informative, and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter started more than 10 years ago by Motley Fool co-founders Tom and David Gardner.

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Next up, we're talking about the Apple Watch.

Lewis: That seems like a natural progression if we're going to break down Apple's earnings.

O'Reilly: The secret sauce to Apple's results and everything.

Lewis: Yeah. Everyone wants to know, "How many people bought an Apple Watch? What was the average selling price of the Apple Watch?" The company made it clear they're going to be scarce on details. They think it's a competitive advantage to keep mum on these Apple Watch figures and they're going to hold onto them.

O'Reilly: It seems like this is just the human urge to grasp at what's next, because it's an open question. We have a company whose market cap is $750 billion, it's the largest publicly traded company on planet Earth, earnings are huge -- where does it go from here? How can it grow? There's naturally this question of "What's the next big product?" Everyone's like "Is it the TV? Is it the Watch?" I can't blame people. I love that Apple's being coy about it.

Lewis: One of the concerns you hear -- I think it's pretty legitimate -- how concentrated they are with iPhone sales. That's about 70% of their revenue.

O'Reilly: Arguably, they should change their name to iPhone.

Lewis: Yeah. I think people want to see some diversification among their product lines. Tough to do that, and tough to see what they're getting into here with the Apple Watch because they've been difficult. In a conference call, the message was that the Apple Watch exceeded internal expectations. Not clear whether that's units or revenue. I'm going to look for more insight in the coming quarters on that.

O'Reilly: It's fine if you didn't; did you catch what those were a couple months ago? Did they ever say. "We're hoping to sell 10 million of these"?

Lewis: They've been really cagey about that. They also said that Apple Watch's sell-through was higher than comparable launch periods for both the iPhone and the iPod.

O'Reilly: That seems so ...

Lewis: Yeah. Again, we're kind of grasping at straws here. I think the most interesting thing they mentioned was sales trends. One of the analysts had asked about whether it was a linear thing, or if there was a big drop-off; because that was a concern that a lot of people had voiced in the marketplace.

O'Reilly: The 90%?

Lewis: Yeah. They said that June sales of the watch were higher than April or May's.

O'Reilly: Wow.

Lewis: That's crazy, because I think there was a big shakeup a couple weeks ago in the market. Slice Intelligence -- a tech intelligence firm -- put out a report that indicated that June's daily sales of the Apple Watch were down 90% from the product's launch week.

O'Reilly: That's what I would have suspected, because I can think of a number of Fools here at headquarters that got the Apple Watch right when it came out, just because they're loyal Apple followers; they like the products and everything. I haven't seen anybody that I know buy it this month. I'm wondering where these sales came from. If it was because of a rollout or something in China, I don't know.

Lewis: I think you're going to expect a big surge when a product becomes available. I think upon closer glance with the study we see some limitations to their data collection. One of the things I was talking about with one of our writers was, they base this on e-receipts.

O'Reilly: I thought you were going to say they went to one store in Santa Monica, Calif.

Lewis: No. It was limited to the U.S. They based all their data on e-receipts. One of the major limitations with that is the Apple Watch wasn't available in bricks-and-mortar stores until June. So all receipts were e-receipts up until June.

O'Reilly: That's a big hole, because if I'm buying a brand-new product, sight unseen, I'm going to use it first. I'm going to go to the store. In fact, even before I bought the iPhone -- the new one -- I wanted to see how it worked and try out the new fingerprint thing and all that.

Lewis: If you're buying it from a retailer, you're probably going to get a paper receipt. You might also get it emailed to you. I think there's a limitation there. Since they don't have a regulatory body looking over their shoulder, I'm going to trust Tim Cook and Apple from the conference call when it comes to June being stronger than April and May.

Looking at some insight from some other outlets, I think 9to5Mac did a really awesome breakout following the conference call. Apple Watch falls into the "other" product category. The category was up 2.6 billion in fiscal Q3. That was up 49% from fiscal Q3 2014, where it was 1.7 billion.

O'Reilly: What else is in that category?

Lewis: iPods.

O'Reilly: OK.

Lewis: Predominantly iPods, some other services stuff as well.

O'Reilly: So it's safe to say that this is mostly watches, then?

Lewis: Yeah. It's interesting you say that. In the conference call, Tim Cook said, "The contribution from Apple Watch accounted for well over 100% of the growth of the category."

O'Reilly: Yeah.

Lewis: So the category grows roughly 1 billion, and he said it was 110% of the growth. That's the number I've seen floating around. Figure, maybe, it's $1 billion in revenue.

O'Reilly: That's all right.

Lewis: An ASP of $400 to $450, which I've seen a lot of outlets floating as their estimate. That's a ballpark of 2.5 million to 3 million units. That's the best we can get in terms of an estimate for what they've been doing this quarter.

O'Reilly: Thank you for digging that out and doing the back-of-the-envelope math there. I do think it's safe to say that Apple Watch -- unless everyone in the world buys one, it's probably not going to be the next iPhone.

Lewis: I don't think so. It could be something that is an awesome add-on to one of their existing products, and it keeps people in their ecosystem.

O'Reilly: Right, which is actually the key.

Lewis: Yeah.

O'Reilly: OK. Big question on everybody's mind because of the macroeconomic slowdown there: How is China looking for Apple?

Lewis: China is Apple's second largest market. Not surprisingly, America is No. 1, around 20 billion this past quarter. China is now 13 billion. That is 112% growth over last year.

O'Reilly: That's going to change in two years, or something.

Lewis: Yeah. Tim Cook said in the conference call, "We expect China to be our biggest market." Analysts voiced some opinions about "Is this something we should be worried about with some of the macroeconomic concerns there? Their financial market's taken a hit recently." He seemed totally unfazed. He sees a lot of opportunities in the place; he pointed to the fact that LTE penetration is only 12% in China, which is awesome.

There's a huge opportunity there if you're providing smartphones. He also pointed to a figure that McKinsey expects the middle class to grow from 14% of households in the country in 2012 up to 54% by 2022.

O'Reilly: Wow.

Lewis: There's a huge wealth effect there.

O'Reilly: Yeah, and everybody's freaking out about China's stock market, but you can believe these numbers: Their GDP just came in and it's still 7% growth, which is amazing for any other country on planet Earth.

Lewis: Yeah. I think anticipating some of this middle-class growth and people having more disposable income in the country, Apple is growing out their retail footprint there.

O'Reilly: As we all know, Apple actually just sells "cool."

Lewis: Yeah. They're luxury products, so they do very well in Asia and I think they're targeting about 40 retail stores by mid-next year. I think they're around 20 right now.

O'Reilly: Got it.

Lewis: Pretty much doubling their footprint.

O'Reilly: Cool. Very good. Well, thanks for your thoughts, Dylan.

Lewis: Always a pleasure, Sean.

O'Reilly: Have a good one.

Lewis: You, too.

O'Reilly: If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So don't buy or sell anything based solely on what you hear on this program.

For Dylan Lewis, I'm Sean O'Reilly. Thanks for listening, and Fool on!