It's throwback week at Industry Focus! In this tech episode, Dylan Lewis talks with former host Nathan Hamilton about the tech market's darling child, Apple (AAPL 0.49%).
First, they look at four metrics that Nathan identified last year for looking at Apple's earnings reports -- three to pay attention to, and one to ignore -- and explain why they matter and how well they held up into this year. They also discuss how the company's growth in emerging markets has shifted focus, why Apple really isn't a growth stock anymore, some important context to help make sense of this quarter's earnings report, and more.
A full transcript follows the video.
This podcast was recorded on April 29, 2016.
Dylan Lewis: We're talking Apple earnings on this throwback edition of Industry Focus.
Greetings, Fools, and welcome to Industry Focus. It's throwback week, so we're talking with some of our old hosts. I am Dylan Lewis, the tech bureau chief at Fool.com, and I am joined in studio by Nathan Hamilton. Nathan, how's it going?
Nathan Hamilton: It's going awesome. Glad to be back here.
Lewis: Yeah, it's been a little over a year since you used to be doing this show.
Hamilton: You guys haven't talked about Apple since, right? [laughs]
Lewis: Nope! We've been totally mum on the subject, we wanted to save it for you.
Hamilton: Well, that's what we'll be talking about today, right?
Lewis: Yes. So you used to be the bureau chief for Fool.com, running the tech bureau. Can you talk a little bit about what you've been doing since then?
Hamilton: After working in tech and consumer goods for Fool.com, I did a little bit of marketing on the U.S. side. More recently, in the past two to three months, I've been working on some of our international products. I'm sure a lot of the podcast listeners don't know that we're also in Canada and Australia and have small operations in Germany, and we're just getting ready to launch our product in Singapore. So the Fool brand is actually global.
Lewis: We're going global!
Hamilton: We are.
Lewis: We're taking over!
Hamilton: Helping the world invest better.
Lewis: Listeners, if you hear me at any point in the show pining for validation, it's because Nathan used to be my boss. [laughs] Look how far I've come! Hopefully he approves.
Hamilton: Yes, yes.
Lewis: So for this show, how can we not talk about Apple's earnings?
Hamilton: We can't. It's every single headline out there. I know our readers want to hear other stuff, but they also want to hear about Apple as well. I'm happy to provide some insights.
Lewis: And we love doing the deep dives.
Hamilton: Absolutely.
Lewis: For the most recent report, revenue for the quarter was $50.6 billion, which was down 13% year-over-year, and diluted EPS was $1.91, down from $2.34 a year ago. One of the reasons, in addition to the fact that I just couldn't resist talking about Apple, that I wanted to talk about Apple's earnings was, one of your last shows, you did a preview of Apple's earnings. You specifically honed in on four things. It was, I believe the title of the show was "Apple Earnings: 3 Things to Focus On, and 1 Thing to Ignore," something like that. So I thought it would be fun, given this most recent report, to revisit those four categories.
Hamilton: Did I predict Apple at $150 or anything like that?
Lewis: I don't think so. There won't be a "gotcha!" moment, don't worry. The first of those things you wanted to focus on was iPhone sales. Why don't we start there? For the most recent quarter, 51.2 million units sold. They still clock in at roughly two-thirds of their revenue, so that is the big driver for them, and probably the culprit when you look at this down year-over-year revenue growth. So what did we see with that, and what can investors make of it?
Hamilton: We were talking about it a little bit before. You almost have to look at where Apple is in the upgrade cycle and put that into context. When Apple went from the 5S to the 6, different change in form factor, everything changed, and they had blockbuster sales. I can't remember the exact numbers at the time, but I recall 40% year-over-year growth during some quarters, when the 6 came out. Where we are now, essentially the iPhone 6SE, essentially a 5 form factor with better guts to it, better processors, that was essentially on sale starting in April. It's not even reported in the most recent quarter for Apple.
You have to look at it that way. It's pretty much expected that iPhone sales will come down a little bit when there isn't a huge upgrade, and when there isn't a change in the form factor altogether. You mentioned a good point, you almost have to look at Apple in two-year cycles, and say, "OK, what's happening here?" Because, the longer-term side of it, Apple is still adding territories. They're still growing in a lot of different, important countries. The U.S., of course, isn't doing much for actual iPhone unit sales. The company is pretty much trade market share. But the longer-term story, you see a slightly upward trending trajectory for iPhones over time, but from quarter to quarter, definitely not.
Lewis: I totally agree. It's tempting to look at companies' comps year over year. But when you have this very clear product cadence of the new numerical issue, and then the new numerical issue S, and that's the year-to-year march. It is, in some ways, not really fair to compare numbers year to year. It's almost more of a two-year comp cycle.
Hamilton: Yeah. And to put that in context, it's not just a matter of, OK, things will still go great for Apple. If you look at previous iPhone releases, they did have the quarter-over-quarter growth, even in down times when there wasn't a fresh model coming out. It's not the most favorable, but I don't think it's anything, if you're looking to Apple as a somewhat safer stock to say, "I'm out of it, hit the sell button, I'm done, Apple."
Lewis: Yeah, and one other note with how particularly rough the comps they were going up against were -- they actually had a lot of supply constraints when they issued the 6 to begin with. So a lot of the demand for the 6 bled into this quarter. It was originally launched in fiscal Q1, but because of pent-up demand and supply issues, a lot of that wound up trickling into Q2. So that inflated what was already incredible demand because of the new form factors and a lot of the new things they brought to that line.
Hamilton: The great debate of Apple is whether they plan out their ... strategic ... supply shortages. Who knows? Maybe it is, there's just such high demand that they can't keep up with it. But sometimes I think, a company like Apple can't keep up with demand and predict? But, who knows? That's my theory.
Lewis: Yeah. So the second thing you mentioned in that episode a year ago, was focusing in on gross margins. A year ago, they clocked in just under 38%. Now they're around 39.4%. So it's actually a nice little uptick. But if you look quarter to quarter, the story is a little bit different. They've actually trended down. A while back, you said the days of high-40% gross margins, which is something I think they realized as recently as 2012 or so, those days are over. And I totally agree, that's just not sustainable for what they're doing right now. Is there anything you're seeing on the gross margin side, or the average selling price side?
Hamilton: On the ASP side, again, going back to the most recent release, it's not reflected in the quarter. As they mentioned on the call, and as many people are predicting, over the next few quarters, you'll probably see some pressure and some downward trends on the ASP because, as you look at the 6 SE, it is going to be a cheaper model. It's not necessarily made for U.S. markets. I'm sure people will buy it here, but really, the play is, how do we get this thing to expand in India, China, all the other developing economies, where people want the luxury of an iPhone, the high-end model, but may not be willing to pay up for it.
Lewis: Yes. And something we saw with this most recent report was, ASPs were down year over year and sequentially. In the guidance ...
Hamilton: Tough comps again!
Lewis: Tough comps again! And that'll probably continue to trend down. As you mentioned, the product mixed profile has changed dramatically with the SE, and the currency headwinds in the foreign markets are going to persist. That's not going anywhere, either.
Hamilton: Yeah. But for the currency headwinds, just look at the constant currency revenue basis. That's the true guide of what a business is doing. If you're a short-term trader, OK, sure you can look at that and put it into your model and see what it spits out and make your decision. But if you're longer-term, you just have to look at what the actual business is doing, not what currencies are doing, which is out of their control.
Lewis: Yeah. Looking forward, from the conference call, management guided for gross margin to come in somewhere between 37.5% and 38% for this upcoming quarter. Again, this will be down sequentially. I think that's very realistic, and I think that's where you're going to continue to see things. Last quarter, we talked about on the show, they actually had an above-40% gross margin, and that was a slightly inflated number, because they had about $500 million coming in via a patent dispute with Samsung. That added to the top line, and that was not the true measure of the product operations. That was just a one-off that was coming in.
Hamilton: Yeah, one time, non-recurring.
Lewis: Exactly. So don't get too used to the idea of those 40% margins. I think we'll be seeing them in the mid- to high 30s.
Hamilton: But at the same time, and we'll talk about this a little bit, the high margin businesses they do have, that, as we look at it, pretty much as I see it, en fuego. They're not super meaningful to the company ... well, to Apple. But any other company, any of those companies as a single one company, would be a huge success, but not in Apple's standards.
Lewis: And we will tease that, and make you wait until the second half of the show to get into that. One of the other big things he wanted to focus in on was the capital return program. At the time, it was a $130 billion program. It has now since ballooned to $250 billion, which is kind of crazy. Most recently, they announced, the board authorized an additional $35 billion in share repurchases, so that total is $175, the remainder, of course, going in the way of dividend payments. You are an Apple shareholder.
Hamilton: I am.
Lewis: I'm also an Apple shareholder. I love seeing these types of programs; what about you?
Hamilton: I do; it's pretty much expected at this point, because when you're generating as much cash as Apple is, even with gross margin pressures, even when the ASP is coming down, it's still a very good business to own. And, also, we'll address this as well, what the perceptions or thinking should be for Apple in the future as an investor. But it's definitely a positive. I would like a little more dividend, because right now, it's just above a 2% yield. But when you add in the fact that it's trading below 10 times earnings, for a company like Apple, at this very moment -- when I checked 10 minutes before this podcast -- it's definitely something to consider. But all together, they have to increase that capital return program overtime. I believe it extends through 2018. I'm sure in six, nine, 12 months from now, we'll see a further extension of it. But sometimes I prefer dividends over buybacks.
Lewis: Yeah. But either way, more good of the same for investors.
Hamilton: Absolutely.
Lewis: The one thing you said to ignore when you did the show was EPS in Apple's report. You said the $2.59 EPS estimate doesn't tell you anything about where the company is going to be in the next five years. This quarter, I think they delivered $1.90 per share; diluted per-share earnings was within guidance, but off analyst expectations. So I'll pose to you again -- is this something we should ignore?
Hamilton: This is my personal opinion. It's not a one-size-fits-all for everyone. I honestly, over the past year, even the most recent quarter, I could not tell you what Apple's EPS numbers were. I could tell you everything else about the business, and discuss it. But it's not anything I focus on, because, for the way I invest, it just doesn't have any relevance.
Some people out there, maybe it does make sense. Maybe they do need to focus on EPS. And maybe I'm back-tracking on my staunch stance before. But I think for the type of investing we look at in The Motley Fool, and maybe you do with your Apple shares, and the way I do with mine, it just doesn't matter at all. It's a headline number that people focus on for week-after earnings, then completely forget about and remember a week before earnings are in the next quarter.
For me, it just doesn't give any sort of indication of the business. For example, I believe their revenues were down 13% when accounting for currency fluctuations. Don't quote me on that exactly, but I believe it was right around that number. That's uncontrollable.
Lewis: Yeah, that's a macro-factor you can't do anything about.
Hamilton: Yeah. Does it tell you anything about the business? No, not necessarily. Does it tell that Apple is no longer innovative? No. Does it tell you that Apple is managing its expenses well as that currency flows down to net income? No. It doesn't tell you all the important stuff.
Taking that into account, for my purposes, I just don't focus on it. But hey, if there are people out there who do, I'd love to hear your opinions. Send me an email; I'll look it over.
Lewis: Yeah, I'm a firm believer in checking out the underlying business segments and using them as my guide. So the second half of the show, we'll get into that a little bit. Before we do, listeners, if you enjoy our podcasts, and you're interested in hearing a little bit more from the Fool, check us out at focus.fool.com. There, we have a special offer for our Stock Advisor newsletter for Industry Focus listeners.
So second half of the show. I thought it would be fun to look at some of the big differences between the Apple of today and the Apple of a year plus ago -- how the business has changed a little bit, some segments that are now a little bit more relevant than they had been in the past. Just taking stock of where things are.
Over the last 12 months, Apple's actually down 20%, which is crazy.
Hamilton: Yeah, we're not loving that, huh?
Lewis: No, especially as someone who had added to my position during that period. [laughs]
Hamilton: Did you catch the high? Or the low?
Lewis: I caught bits of both. Dollar-cost average, right? Always continue to buy, and make sure you're working down that dollar-cost average.
Hamilton: Very Foolish.
Lewis: Of course. Compared to the previous 12 months, they were up over 60%. So there was a period where it was very hard to be down on an Apple position. Obviously, the story has changed a little bit there. I think, looking at things to be very optimistic about as an investor, from this most recent report, the services segment has to be one of them. This is, of course, the segment of their business that houses App Store, Apple Music, Apple Pay, just to name a few. They revealed that this is their second-largest revenue driver, which blows my mind. I didn't realize it was getting that big, and I think a lot of people were surprised by that number. But, it provided $6 billion last quarter, which is up 20%.
One of the things that showed, I think, that there would be an increased emphasis moving forward on this is, in the conference call, they described this new non-GAAP metric. They're calling it "the purchase value of services tied to our installed base." Last quarter, that was $9.9 billion. If that's not a sexy accounting name, I don't know what is.
Hamilton: [laughs] Is that official GAAP legal language?
Lewis: No, they had to somehow curb that in.
Hamilton: It is a good metric, though. I really like that they're breaking it out.
Lewis: Yeah, so this is essentially the value of stuff their service segment is facilitating. The reason they have to create this metric is because there are a couple different accounting approaches for the different segments. Some of them run on gross accounting, and some of them run on net accounting, in terms of what actually shows up in the financial statements. So this is done to clean up all of that.
You hinted at this earlier. A couple things for investors here. One of them is, this segment operates in kind of a different margin profile than what you'd expect with the hardware business, right?
Hamilton: Absolutely. It's essentially an asset-light business, where there are high margins that are accompanying it, but you also have to put it in the context, you said it exactly there, about $6 billion worth of revenue --
Lewis: And I think it was $9.9 billion of facilitated transactions. That new non-GAAP number is $9.9, actual revenue is $6 billion.
Hamilton: Then, put that in the context of the iPhone, and you start to see how it'll actually affect the margins. It's not a huge driver. But could Apple add five to 10 of these businesses over time? Sure. Add some margins, get a couple billion out of them. That sounds hilarious, when you think about it. But it definitely is something to consider. Apple Pay, the actual gross purchase volume is up. But, put in context of the payments market as a whole, I believe Apple is around $9 billion in payment volume. PayPal, over the December quarter, not matching up exactly, was above $80 billion. There's definitely room to grow there.
And the important thing, which I think is definitely necessary to focus on is the Apple ecosystem. Tim Cook hit upon it in the call. Essentially, you hold your iPhone, it can really do everything. And what it's doing at this point is nothing, compared to what it eventually can do. It doesn't control your home, doesn't control your car, doesn't control your desktop computer, doesn't control your life and everything around you, when it comes down to it. And those are businesses that Apple very well could get into and essentially generate more revenue from the ecosystem. It's just like telecom. Once you're locked in, it's a pain in the butt to change.
Lewis: Yeah. I am an entrenched Mac user, iOS user. I love having it all in one place, I love being fully integrated. I'm going to change out of that dragging, kicking, and screaming, and I'll hate it, if I ever do.
Hamilton: You are what the financial world would call a "sticky customer."
Lewis: Yes.
Hamilton: That's exactly what Apple has within their ecosystem. There is value to it, and it seems like they're recognizing that with the new metric, just seeing what value this creates, subsequent knock-on events, and so forth. So I like that they're breaking it out. But also put it in context. If you're looking for significant growth to hit Apple, the company as a whole, from these businesses, let's wait a little bit and see.
Lewis: Yeah. It is another way to enhance the value of that 1 billion installed base that they have. It's a tack on there. Hopefully they can monetize that group a little bit more.
Hamilton: Healthcare stuff, that's something that hasn't even been tapped into at all. I don't think Apple even knows exactly what they want to do with it at this point, but there's definitely a lot of potential there.
Lewis: Another thing, this was not available when you were talking about Apple and doing the show -- the Apple Watch. [laughs] Unfortunately, we still don't know a ton about it, which is maddening. The company has been kind of infuriatingly opaque about the Apple Watch. On the most recent call, we got this: "Unit sales of Apple Watch during its first year exceeded sales of iPhone in its first year," which means they sold at least 6 million. Some analysts think it's closer to 12 million. ASPs are believed to be around $500. So this business right now looks like a $3 billion-$6 billion business. Not huge, but again, something to watch. It gets people more involved in their ecosystem.
Hamilton: By all business standards, that is a huge success. There are good things about the Apple Watch. I recall one article I recently read, where it said more than 50% of Apple Watch buyers just don't think the Watch has much value. It's important to put that into context. Is that the thinking now, and will that be the thinking two, three years from now, after they're able to iterate upon error? Maybe they add more health capabilities, controlling, I guess, Internet-of-Things sort of ideas, and controlling your home and so forth.
I think it could be a good idea, but when you have to look at it now, and what it means, I just don't think it's a huge success, even by Apple's standards. It almost feels a bit like the iPad. The iPad sales are trending down over the last one, one and a half years, during that time frame. Still generate a lot of revenue, has high enough margin where you're getting cash flow. It's going to contribute to buying back shares, it's going to contribute to investing in the company and growth. But I would like to see something a little more innovative out of it. And at this moment, I just don't see it.
Lewis: Yeah, the reception has been a little bit flat.
Hamilton: Yeah, it has.
Lewis: One of the big markets that people have been talking about for quite some time is China, and the huge market potential there. A year ago, the company posted 81% year-over-year growth in mainland China. This quarter, revenue was down 11%, or 7% in constant currency, something you like to focus on. Both of these are less than overall declines, but still not ideal for what everyone considers to be a very high-growth market for them.
Hamilton: Yeah. And, if I recall, a year ago, we were very big on it, saying, "China's a huge contributor." And it very well will be over time. That was when they were just starting to bring some big telecoms on board, expanding 4G coverage, and you sort of see the uptake when the iPhone expands to a population that didn't really have much of it before. So you get that hockey-stick growth to it. It has cooled down a little bit.
It's interesting, because, if you looked at the headlines before we record here, see Carl Icahn on the front page of Yahoo! Finance saying, "I've sold my Apple position," and one reason is that China is a concern. For example, they've shut down Apple's services, including the app store. Those are higher-margin businesses with a huge population. Apple loves their ecosystem, they have to get it out to them, but what if the app store can't do that? How do they actually get the ecosystem out and expand upon it? It's definitely something to consider.
But I think, in the grand scheme of things, it's still pretty favorable. There are a lot of favorable factors within China.
Lewis: And Tim Cook made the point here during the conference call, they're taking an 11% dip on 81% growth. That's still a very large segment. And even if it didn't grow year over year, it's still contributing for the company.
Hamilton: The shareholders want the good money. It's disappointing to me. I know we can frame it either way. It's slower growth coming out of blockbuster growth, but you're only as good as what you just did. You have to continue, and offer up growth. Otherwise, people will be questioning the future.
Lewis: If you're looking for a regional market to be excited about as an Apple investor, I think it's India, just based on the most recent call. Tim Cook, in talking about the market potential there, said, "India is where China was maybe seven or 10 years ago." For the region, iPhone sales this most recent quarter was up 56% year-over-year. That's obviously a bright spot in that report.
The retail business is a little bit different there, because you don't have these telecoms, the wireless providers, acting as a storefront for smartphone manufacturers. They have to build out their retail presence. So the challenges there are quite different. But if you're an Apple investor and you want something to put in your bull cap, that's one of the things.
Hamilton: Yeah. One thing to look for, if you pay close attention to Apple and what happened with the government in India is, a lot of American companies have had difficulties opening up brick-and-mortar establishments within India. So you kind of have to look at that to change. Over time, Wal-Mart has been able to, and some other retailers have been able to. But, it's definitely a roadblock with the government that it does slow down growth from what it could be. What they've had recently is very impressive growth, but it could be even better if things were firing on all cylinders with the government, which we know probably won't happen.
Lewis: Maybe that'll change in time.
Hamilton: Yeah. But it's interesting, when you back it up to their product strategy as a whole with the iPhone SE. Obviously, that's a play for markets like India, where there is huge competition from the likes of Xiaomi. They're hitting it hard with very good, high-quality phones, some say on par with what the iPhone offers, for a far cheaper price.
Lewis: Yeah, the price point is dramatically different.
Hamilton: Yeah. They have a really good strategy in India so far. Apple will be bumping up against them quite a bit.
Lewis: You mentioned Carl Icahn has sold his entire position in Apple. That was one of the big news items of the past week, following earnings, of course. He cited concerns of the Chinese market. One of the things he did say, though, is that the stock is still cheap on a multiples basis. So I have to ask you, what are your thoughts on the company at this point? Where do they fit in?
Hamilton: I'll give you my thoughts, but actually go back to some thinking I had maybe two years ago, when I loaded up on a few more Apple shares. I told myself, "If Apple ever dips below nine times earnings, I'm going to buy shares regardless of whether I think it's a high-growth company, or just want a dividend or some sort of income." Right now, shares are just below 10 times earnings, which, on all accounts, if you compare it to IBM, Oracle, Cisco, who are all trading for multiples above 12 times earnings, it does look pretty cheap. But you have to put it in context.
I still think -- and maybe I'll go on a little bit of a rant here -- a lot of people still think of Apple as a growth company. And I don't know if it's just looking in from the outside and not recognizing exactly what Apple is and what's happening with the business, but, it's really not, when it comes down to it. You almost have to focus on it and say, "What do I want to invest in Apple for?" How I'm looking at it at this point is, I like the dividend, I like the capital return program. I'm holding for the longer-term, when it comes down to it.
But, as you look over, OK, two to three years from now, based upon what we know at this very moment, us not being a board member, not being part of Jony Ive's design team and knowing exactly what they're working on, these game-changing products, we don't know exactly what's going to come out in the next few years. You have to look at it over that time frame and say, "OK, there's nothing that really stands out and says revenue is going to move significantly, and I'll see my share price increase by that amount." So I'm all about the dividend now.
Lewis: To your point about it not being a growth company anymore, it's very difficult to experience extreme growth when you're already at a market cap of like $500 billion.
Hamilton: Yeah. Not to say they can't do it. But lightning striking twice like the iPhone, and doing so over the next few years -- which, for many investors, that's the time frame they look at -- I don't necessarily believe that'll be the case. But maybe we'll do a throwback show two years from now, and I'm completely eating my words. It's not a hard prediction, but all the signs point in that direction.
Lewis: Yeah. And a lot of investors have done very well by buying and holding dividend-paying tech companies, DRIPing the dividends, and letting that compound over time.
Hamilton: Nothing's wrong with that, yeah. If you're into options, selling puts, selling calls, those are all strategies to grab more income, if you want to juice up that 2% yield, if it's not sexy enough for you.
Lewis: On my end --
Hamilton: Yeah, what are you doing?
Lewis: I'm still an Apple bull. Perhaps after the necessary period passes, where, we're not allowed to buy after talking about a company for a certain amount of time, I might consider adding to my position. But I'm really not going to be --
Hamilton: Sorry, let's flip the interview here. Why are you thinking to add to the position?
Lewis: I'm not freaked out about iPhone sales, and I won't be until I see what happens with the iPhone 7. I think, like we were talking about before, the two-year comp cycle is much more relevant. People know the big changes will come when the number changes on the phone. So I'm not too worried about it. If they come out with a dud on the iPhone 7, then you start to think, "OK, this is real stability."
I'm still in the same camp as you, with it being more of a moderate to low-growth company that pays a nice dividend that'll be around forever. But I think a lot of the iPhone issues and the concerns there are a little overblown. I'm also excited to see what happens with the emerging markets. I think India is a huge opportunity. I think once they refresh the iPhone 7, there should be some nice response in China, as well.
Hamilton: Wouldn't it be amazing if Apple surprises us and says, "We're not doing an iPhone 7, we're going back." They almost did with the SE, somewhat.
Lewis: Yeah, and that's a great way to meet that market. So we'll see what happens there.
Hamilton: Absolutely.
Lewis: Thank you for your time, Nathan. It's been great to have you back on the show.
Hamilton: Yeah, I love doing this stuff.
Lewis: Listeners, how are you guys feeling about Apple? Send in your opinions, we always love to hear from you. You can write in at [email protected], or you can tweet us @MFIndustryFocus. Again, we love hearing from you guys, it's always great to know the stuff you like about the show, some stuff you want to hear. As always, people on the program may have interests in the stocks they talk about -- Nathan and I both do -- and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear here on the show. For Nathan Hamilton, I am Dylan Lewis. Thanks for listening and Fool on!
