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How Apple Beat Estimates

By Evan Niu, CFA – May 9, 2020 at 1:55PM

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How Apple navigated the pandemic and beat revenue estimates in this disruptive environment.

In this episode of Industry Focus: Tech, Dylan Lewis and Motley Fool senior technology specialist, Evan Niu, go through some earnings reports of tech stocks. They chat about a streaming service and how it's retaining and growing its customer base, and maximizing revenue through different avenues. Apple (AAPL 2.56%) posts strong results despite global supply chain disruptions. Learn how companies are navigating this environment and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 1, 2020.

Dylan Lewis: It's Friday, May 1, and we are talking about tech earnings. I'm your host, Dylan Lewis, and I'm joined by's Evan Niu. Evan, what's going on over in Colorado, man?

Evan Niu: I have big plans this weekend to stay home and do nothing. Play some old video games; hang out with the kids.

Lewis: [laughs] Yeah, it's kind of like a Pinky and the Brain-type world, right? Where it's like, what are we doing? The same thing we always do. [laughs]

Niu: Yes. Do nothing. [laughs] Stay home. Be safe.

Lewis: Yeah, I have a Zoom movie screening with some friends, I've been in like a weekly cadence doing Friday and Saturday nights where we'll watch a cool movie and then get on and talk about it afterwards. So, that's my plan for Saturday, going to be watching The Last Black Man in San Francisco, which I'm excited about, haven't seen that yet. But you just got to, kind of, find fun ways to mix things up and make it feel like it's actually Friday and Saturday.

Niu: Yeah, I think my daughter has some similar type thing, like, a remote birthday party thing where they're going to watch something together. I forget what app they're using, but, yeah, that's -- you know, especially for kids, they need their social outlets.

Lewis: Yeah. And I mean, the streaming services have been huge beneficiaries of all of this: if there are beneficiaries of this, what we're dealing with in terms of the pandemic. Zoom, also a company that has come up quite a bit as someone who's really thriving and on full display with all of this.

We're going to be talking today about another company that probably belongs in that conversation but hasn't gotten quite as much press, and that is Spotify, Evan. So, I think that so much of the focus has been on the video streamers, but the reality is people are also spending a lot of time listening to music and hanging out at home.

Niu: Yeah. So, Spotify reported first quarter earnings this week and a lot of the commentary that they described about what they're seeing on the platform is, kind of, what you'd expect. So, people are shifting a lot of their music consumption patterns quite a bit in light of the crisis and all the stay-at-home order. You know, people aren't really commuting anymore, they're not really spending so much time in the car, but you're spending a lot more time at home.

So, Spotify, for example, has for many years worked really hard to grow up this broad portfolio of partners where they're available on basically any device you can imagine. So, they're seeing a big uptick in usage from people streaming from their smart TV's, from game consoles, listen in the car, listen on their phones, But overall, yeah, I mean, if you're stuck at home and you're tired of watching Netflix, you can stream some audio content like music or podcasts.

Lewis: Yeah. The thing that really stuck out to me when we were going through the earnings and the shareholder letter was, you know, [laughs] this quote from management saying, the routines are changing, every day now looks like the weekend. Which is kind of a call back to [laughs] how we opened up this show, Evan.

Niu: Yeah, I mean, time is just blurring together. [laughs] Days are all just blurring together. So, everyone is stuck at home and you're going to be listening to stuff in a different routine than you would under normal circumstances.

Lewis: Yeah, those company surveys that got sent around to saying that in the U.S. 40% of consumers are listening to more music to manage stress. I think everyone is just, kind of, looking for distractions. And you know, if you're already a Spotify member, you're already paying for it, you might as well enjoy it as much as you can. You know, if you're going to be around the house, play some music and hopefully relax a little bit.

Of course, in addition to the commentary about what's going on with the business and how they're handling everything with COVID, we got some numbers when they released their earnings results.

Niu: So, revenue in the first quarter increased 22% to €1.8 billion, which is just about $2 billion in U.S. dollars. And now, premium subscribers have grown to 130 million, which was higher than what most people expected but was in line with Spotify's guidance. So, it was basically the high-end of their guidance to what they expected.

And as usual, we're seeing the Family plan really continue to drive subscriptions and Spotify has been testing -- for the past five years they've been testing this new plan called the Premium Duo plan, which is basically for, you know, if you're two people, live together. And let's say, you don't have kids or something or don't have kids that use Spotify, it's a cheaper version of a Family plan, because the regular Family plan is for six people, but this one's for two. So, they're just continuing to test new product ideas, new service tiers, just to see what kind of sticks.

Lewis: Yeah. And folks that have heard us talk about this company before might remember that as we see some of this experimentation, this is the kind of thing that will affect the Average Revenue Per User. You know, we think about where they were a couple years ago, when it was primarily an individually focused plan, they're moving more and more to these collaborative plans, these Family plans, this Duo plan for people who live together, and all of those things have an impact on the actual amount of money they're collecting per user.

Niu: Right. So, that's a big reason why ARPU has been declining over the past few years, but they've also mentioned -- the flipside is that those plans have much higher retention, helps lower churn, those customers tend to be just stickier, more loyal. So, to them it's worth any sacrifice in ARPU.

For example, if the Premium Family plan is $15 for six accounts, so you divide that out that, obviously, comes out to a pretty low, whereas this Premium Duo plan is, like, $12.50 for two accounts, so the average there is a little bit higher. So, they can certainly help mitigate some of that downside.

Lewis: Yeah, I'll be moving in with my girlfriend at the end of this month. And you know, I think moving in is one step, but going on to the Spotify Duo plan, that's a real serious commitment. I don't know. Sharing playlists, all that kind of stuff, I don't know if I want to give her that creative control --

Niu: Netflix account. [laughs]

Lewis: We already have a good situation right now. I've got Netflix, she has Hulu, I've got Prime, we're checking all the boxes. We just need someone with Disney+ and then we're good.

Yeah, so as you might expect with a business that has some exposure to advertising, there is a little bit of a hit here for Spotify, but thankfully, it is not a big one, because for the most part people are paying for the service, that's where most of the money is coming from.

Niu: Right. So, the coronavirus has kind of hurt ad spending across the board, across many industries, and we've seen that play out in varying degrees with other companies that have been reporting recently. So, their ad business has been hurt a little bit. But, yeah, to your point, ads are, like, 10% of the business. So, the bulk of this business, which is subscriptions, remains very healthy. But that being said, ad-supported monthly active users have now grown to 163 million. So, there's still a pretty large user base that really enjoys that free tier.

Lewis: Yeah. And in addition to the ad part of the business, I mean, they are getting a little bit in some of the geographies where COVID was particularly strong and where it was particularly impactful for the populations. And that's specifically Italy and Spain, where they saw some consumption decline and I think they saw some daily active user decline as well. But I think, all-in-all, given the circumstances, the business is doing pretty well.

Niu: Right. So, what they've seen is, as those countries that have been hit really hard start to, kind of, recover and improve and make progress with fighting the disease, they've seen a kind of a similar bounce back in engagement as people kind of need to listen to music again.

Lewis: [laughs] A couple of other numbers that stuck out to us. We saw some updates on gross margin, got a little bit of an update as well on the long-term plan with podcast. Evan, you want to dive into that.

Niu: So, gross margin was at the high end of the guidance, was at 25.5%, which they said was due to core royalty component mix, which on the call, they actually elaborated a little bit, it's actually not benefiting from this [noncommittal] shift toward podcasting, but actually just kind of mix shift within the subscription base of, like, the mix of Family versus Individual versus Premium.

And operating expenses were up, Spotify continued to invest in R&D and things like that. So, the operating expenses actually came in below the guidance, because if you think about some of the production halts [...] content they're saving a little bit of money there, and they're also slowing their hiring plans for this year due to all the kind of macroeconomic uncertainties here.

Lewis: Yeah. And I think that podcasts are such an interesting part of this business, because as we've talked about in the past episodes that we've done, this is something that really could dramatically change the cost profile for this company and give them something that they control rather than having to pay licensing fees. So, they have to put the money out upfront maybe for the production of these shows but then they are able to enjoy spreading that fixed cost out over more usage and not having it tie into some of the licensing agreements that they have in place.

So, that's certainly one of the big levers to watch. The other one I think is, their ad ambitions, which I don't know if we got nearly as much color on, but it seems as though the podcast stuff is moving along as much as it can.

Niu: Right. So, they said that podcast consumption is growing at triple digits, probably coming off a small base, but you know, still a good datapoint and useful for investors. And they said that nearly 20% of users are now listening to podcasts, which, that's a pretty high proportion of people that are at least engaging to some extent. And they did also make a change to how they're speaking of the podcast costs that you're mentioning, they're tweaking how they're handling some of the accounting of it. So, basically they previously, up till now, have been allocating all revenue and cost associated with podcasts, kind of, between both Premium and the Free segments, but now they're basically saying, "Now, we're going to shift all of it to the ad side," so all the podcasts revenue, all the podcasts costs are all going to be allocated into the ad-supported Free tier.

Doesn't impact the overall gross margins that they report, but they're kind of shifting around. So, I think that actually might even suggest that, you know -- we've talked about their ambitions when it comes to podcast advertising. And that could just be a sign that, hey, they really are going to make that their focus when it comes to monetization.

Lewis: Yeah, that's an interesting point, Evan, because when that acquisition happened with The Ringer and when they made some of these other podcasts-related acquisitions, you know, one of the thoughts was, OK, are they going to create this really robust suite of, kind of, membership-only podcasts? You know are they going to go with the Netflix model where you have to pay us in order to access this original content, or are you going to make it available for free but maybe make it ad-free for your members? And that's certainly something that a lot of people were sensitive to because they were acquiring existing shows. And so, these were shows that had fan bases already, that were highly engaged. So, in addition to everything they were going to launch, now you wonder what's going to happen in terms of listener behavior. It seems as though they are going to go with a primarily freemium model and make most of it available; there might be something behind the paywall, but not much.

Niu: Right. Overall, they have also said that the podcast engagement is really helping drive conversion toward paid users too. So, I think all-told, these types of content and different monetization models, they all kind of feed into each other, you know, they're all pretty highly complementary. So, I think that all parts of this business are really all working well together overall.

Lewis: And we managed to see Spotify even eke out some income. [laughs] Not something that we're too used to. They did do it a couple of quarters ago, but I think that was related to an investment stake that they had, but a very, very small net income to show for this quarter. That's not really the focus of this business at this time.

Niu: Right. So, they had €1 million, [laughs] that's the cool one, which translates to $1.1 million. When you divide it out, it actually turns into a net loss per share of €0.2, and that's just because their diluted net loss figure incorporates some fair value losses on some warrants, which is not too important. But they were able to technically be profitable.

Lewis: [laughs] Yeah. And, I mean, that's not the concern that most people have at this point. You know, if you're buying shares of Spotify, you're doing it because of the long-term growth story, you're not doing it because of short-term profitability.

Niu: Right. And looking forward, they also have some pretty nice guidance. They expect total premium subscribers in the second quarter to reach 133 million to 138 million and total users starting to approach 300 million. So, that should translate to revenue roughly flat, about €1.8 billion or so, which is about $2 billion.

Lewis: In addition to talking Spotify today, this is kind of coincidental, but we'll be talking about their chief rival as well, at least in the music streaming space, and that's Apple. Their earnings came out yesterday, so we had to scramble a little bit to get on top of these. But I think it's a pretty solid quarter for everything that's going on in the world, Evan.

Niu: Yeah, I mean of all the companies that are -- some are certainly more vulnerable to COVID than others, and some are more resilient. And Apple really proved that its business can really withstand. I mean, Apple's business is so massive and it's all over the world that they're a little more stable in that sense as this crisis hits countries to different degrees.

Lewis: Yeah. I mean, for them, they had to make some pretty interesting decisions about what they were going to do with their retail operations. Obviously, it's a super-disruptive thing for their supply chain. But looking at the numbers, the company eked-out revenue growth. They posted a total of just over $58 billion, which was ahead of estimates of $55 billion. You go down to the bottom-line, net income of just over $11 billion, which was slightly down from $11.5 billion the year prior, but ahead of estimates.

So, I think with everything going on, and, you know, they had done some signposting saying that this was going to be a disruptive thing, you have to be pretty happy about this as a shareholder. Now, you start diving into some of the segments they had, iPhone revenue growth was struggling a little bit, but thankfully, services came in and bailed them out.

Niu: Right. So, services hit a new record of $13.3 billion. Yeah, I think that it was pretty interesting to hear them talk about how this crisis has impacted them or more specifically, how they've been able to, kind of, manage it, because the impact actually hasn't been as bad as you would think for a company that has their supply chain so concentrated in China.

They said there was a period of a few weeks where it got really bad, and then the shutdowns really hurt production and demand, obviously, has been hurt. But they were able to bounce back pretty quickly. And I think at the end of March, they said that they were already at typical levels of production, which is pretty impressive to overcome a shock this big, at least on the supply side, within just a matter of weeks. So, it was, you know, probably three, four, five weeks, and now they're basically back to where they were. So, now the question shifts to how is demand being impacted in all these other markets that are struggling to deal with this virus.

Lewis: Yeah, and if I'm not mistaken, I think their retail operations in China are open again. And I think they have maybe one retail operation in Korea that's open right now too, but they were able to reopen those locations, which is a little surprising, given everything that's going on in the world. But I think that maybe that portion of their business rebound a little bit faster than people were expecting it to.

Niu: Yeah. So, retail, definitely, in China has been reopened, as other countries around the world just are dealing with this in different ways, they're kind of looking out at the local level and trying to reopen stores. And that obviously hurts their retail business, but they actually include online orders with retail, so all the people staying homes just buying, ordering stuff from home are still being, kind of, included in what they consider retail.

Lewis: And I think that all of this is kind of a case in point for why the services business is so compelling for them. The idea that you can totally sidestep physical goods and physical distribution of those goods with retail locations and instead deliver digital products to your existing installed base, not only is it high margin, but it's something that doesn't really have to deal with any supply chain disruptions. And for something that is so dependent on global supply chain that's pretty appealing.

Niu: Right. And that actually, there is an interesting dynamic happening as the mix shifts from products to services this quarter, because over the holidays, obviously, people buy tons of hardware products to give for gifts over the holidays and what have you. But then, when you come off of the fourth quarter, you have this seasonal loss of leverage on the products side of it. So, gross margin on the products actually fell 4%, nearly full 4%, but the services side grew and kind of made up for it. And the net result was that gross margin was about flat sequentially, which is actually pretty impressive when you're talking about coming off losing so much leverage over the holidays. So, they're really pushing full steam ahead with the services business, and they now have 515 million paid subscriptions, which is up 35 million during the quarter, which is acceleration because they've been doing 30 million a quarter for over two years. So, now we're seeing that growth rate in the subscriptions finally tick higher a little bit as they've been introducing more and more first-party services, like, Apple Arcade, Apple TV+, plus third-party subscriptions. You know, that business is just really booming.

Lewis: And, of course, we also got a little bit of an update on what's going on with the capital return program. And there's an only with this update on the buybacks, but I think it's still a pretty staggering number, Evan.

Niu: Yeah, so they added $50 billion to their share repurchase authorization, which most analysts thought they're going to do more, just because the valuations are pretty good and they still have all this cash. So, people thought that was a little bit lower than expected, but at the same time, Apple pointed out that they still have $40 billion left on the current authorization. So, you add $50 billion, that brings them to a total available of $90 billion, which is plenty.

And for reference, the last two years, they did $75 billion and then $100 billion. So, they're pulling back a little bit, but they still got plenty of authorization to work through. And they update the program every year, so basically $90 billion will probably be plenty to last them for next year.

Lewis: One of the things that I think is kind of interesting, as we're seeing all these businesses navigate the pandemic and how disruptive it is for their operations is that, you know, you have these capital return programs, these buybacks and these dividend programs that people have gotten very used to, especially in the case of Apple. And then you also have the more short-term staffing considerations that these companies have to make. And I think it would be easy to look at a $50 billion share authorization and say, well, what are you guys doing for your employees?

And Apple is actually one of the companies, I think, that has navigated this pretty well. They, to my knowledge, have not really furloughed anybody. There was some guidance that Tim Cook offered in mid-March, talking about how they were going to be closing a lot of their retail stores. And I think they continue to pay people, the quote that I have from that statement is, "they will continue to receive pay in alignment with business and usual operations," referring to their hourly employees. So, I think that they were able to, kind of, successfully do a little bit of both. And maybe that's something that they have the privilege of, because they have so much cash. But this is very different from the narrative that we saw with Disney, where Disney was saying, [laughs] "We're furloughing a ton of our employees." Bob Iger decided he's going to put his salary on pause, but no issues with them maintaining their dividend program. It's interesting to see the calculus that these companies are making.

Niu: Yeah, it's getting pretty political too with some of these criticism, because you know, if you're a company that's struggling during this crisis and you're getting this big bailout from the government, but you've been buying back your stock all these years and now that's the reason why you don't have enough cash to survive [laughs] without a bailout and you can't pay your people, then, yeah, I think there's a lot of criticism around that. But, yeah, to your point, Apple is just, they're different and they're lucky because they just have so much money that they can do all of it, like, they can pay their employees, they can do right by the employees, they can offer a good paid sick leave policies, they can pay the retail workers that are not even going to work, they can still give back $50 billion [laughs] to shareholders, they can still invest heavily in R&D, they can still ... and they still have money left over after that.

So, just having that much money, I think, gives them a pass when it comes to some of these criticisms, because it's not as if Apple is going to need a government bailout. [laughs] It has more money than the government.

Lewis: [laughs] But, you know, even if they had less cash on the balance sheet and they had to start making some hard choices, as a shareholder, I would be OK with them saying, we're suspending the dividend for a year. And they're not a dividend aristocrat, that's not why people are buying the stock. And actually, the same is true for Disney, that Disney is not a dividend aristocrat. And the yields are like, I think, Disney's is like sub 2%, I think Apple is in the same territory.

So, I will say it's going to be really interesting to watch how companies handle that because Apple seems to be doing a really great job of having their cake and eating it too. And they're in a position of luxury to be able to do that, but I wonder if more businesses will look at the ire that Disney got because they decided to prioritize more shareholder-friendly things and less employee-friendly things, and maybe decide that it's better to suspend their dividend and keep their employees on staff.

Niu: Yeah, I mean, it's a really tricky thing to navigate when it comes to the perception of these things, because, yeah, there's a lot of pushback for these giant corporations. And I think there's a little bit of a populist movement going on with, like, people criticizing, yeah. With the amount of job losses that we're seeing, and then if the company prioritizes their corporate capital structure and their shareholders over just individual people, I think that's kind of a really hard thing to navigate when it comes to the messaging and the optics of it all.

Lewis: Yeah. And I think, to some extent, we're a little guilty of praising buybacks, you know. I think that we look at something that, if a company thinks that they are undervalued and they are in it for the long-term and they're trying to reduce their share count and do more than just offset dilution, that's something that we tend to look at as a good thing if we're looking to hold these shares for 10 plus years. And I think, if you look at Apple's track record, it's been fantastic, they have just been up into the right with their share price. And so pretty much every buyback decision they've made, [laughs] almost every share they've bought back has been accretive to shareholders. But I do wonder how all of this will impact our perception of that and certainly the public's perception of that, because if you have these businesses getting bailed out, who instead bought back a lot of shares, you start to wonder about the capital allocation decisions that they're making, and whether there should be some more strings attached to that kind of thing?

Niu: Right, exactly. And I think one of the bailout programs does put a string attached where, if you're getting government money, you can't buyback your stock for a certain period of time. But, yeah, I think it's on a case-by-case basis, you got to look at this company and say, "Were they being responsible?" Because the big issues now that these companies have maybe gone a little bit too far with some of the buybacks, if they can't afford it, and also still have the cash to do all these other things. So, I think that's, kind of, where these criticisms are really valid in some cases, but in others, like, Apple, they have so much cash they can do whatever.

But if a company has been doing a little bit too much, which you know is going to be an objective argument, then I think that there's some validity there.

Lewis: Yeah. And I think that this could start to enter the consciousness of SRI investing or ESG investing; however you want to label it. You know, people intentionally looking for companies that are going above and beyond and really taking care of employees, it might be something where people look back at how companies handled this period and say, well, you're prioritizing shareholders over employees and maybe that's something that I don't want in my portfolio. So, TBD, but I do think it's telling to look at how management teams are handling this period.

Niu: Yeah, I mean, it's a crazy time to think how people make these tough decisions. We'll definitely say a lot about them.

Lewis: We're going to end today's show on a light note, because that got a little heavy there, Evan. We were talking about how we were doing some smoking on last week's show. I was talking about how I did some smoked chicken legs, and I know Austin is a regular meat smoker and likes to get out in the backyard and do that. And I just want to give a shout-out to one of our listeners, Tom, who wrote in with a maple smoked salmon recipe and a smoked lamb chops recipe. And I am pretty excited to give one of these a shot, particularly, the smoked lamb chops, because the hidden ingredient here is a quarter cup of oyster sauce, which I think is super-interesting, I've never seen anything like that before.

Austin, have you ever run into anything like that when you're looking at smoker recipes?

Austin Morgan: I have not. I'm not a big lamb chop guy. But I definitely would try the maple salmon. That sounds really good. I got a Memphis-style dry rub rib recipe coming your way, Tom.

Lewis: [laughs] I love it. And we love hearing about how people are spending time with family and doing stuff at home during the self-imposed quarantine or the stay-at-home orders. So, if you have anything fun to share, please write in. I'd love to share it with people. I think people are just kind of looking for fun stories. And it sounds like Austin will be going and doing the maple smoked salmon. I might hop in and try out the smoked lamb chop recipe, because that sounds pretty awesome. Might have some good weather, see if I can find lamb chops in the store. Tom, I'm on it and I will let you know how it goes.

Evan, thanks so much for hopping on today's episode, man. I hope you have a nice weekend. I hope it's eventful, rather than uneventful. [laughs]

Niu: Yeah, you too, man.

Lewis: Listeners that's going to do it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, shoot us an email over at [email protected] or you can tweet us @MFIndustryFocus. In addition, to show stuff, just a great spot to send us recipes if that's what you're into. And if you want more stuff, subscribe on iTunes or wherever you get your podcasts.

As always, people on the program may own companies discussed on the show -- I own Apple; I think Evan owns Apple and Spotify -- 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.

Thanks to Austin Morgan for all his work behind the glass today.

It's Friday. You know what that means. We're playing things out with Checks and Balances by full-time Fool Burke Ingraffia. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

Austin Morgan owns shares of Netflix. Dylan Lewis owns shares of Apple and Walt Disney. Evan Niu, CFA owns shares of Apple, Netflix, and Walt Disney. The Motley Fool owns shares of and recommends Apple, Netflix, Walt Disney, and Zoom Video Communications and recommends the following options: long January 2021 $60 calls on Walt Disney, short May 2020 $120 calls on Zoom Video Communications, and short July 2020 $115 calls on Walt Disney. The Motley Fool has a disclosure policy.

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