Apple’s Q2 is a great quarter but top line growth is gone

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Last quarter, I said that Apple the China Mobile deal and the growth in China would make for a better quarter for Apple this go round. Moreover, despite the negativity we heard before the earnings report about Tim Cook, Apple is a well-run company which executes its vision quite well. There is nothing wrong at the executive leve;/ And Apple will continue to be a cash machine which holds its own in existing markets. The problem for Apple is growth. They are so big that they need massive new markets to continue growth. Some thoughts on the numbers below.

I disagree with the Jay Yarow article that says Tim Cook is blowing it and I am not even an Apple fanboy. The article suggests that Apple was a great innovative company under Steve Jobs but is now a dull, boring and slow giant under Tim Cook that can only buy back shares. Though I think Apple has not been innovative enough in its core market, it is not any different than it was under Jobs.

With the iPhone, the iPod, iTunes and the Mac, Apple has always been an incrementalist organization. The goal is to build a robust integrated software and hardware product that is simple, easy to use and stylistically cutting edge. Apple isn’t about drastically changing a product once it goes to market because all of the design work is done upfront before the product is launched. Once a product like the iPhone is launched, the company makes tweaks and incremental changes to keep it updated. But it’s not Apple’s way to then totally re-design the product. I can give you countless examples of this from the Apple AirPort Express, Time Capsule, to the Mac Mini, to the MacBook Pro and the iMac. None of these products has changed its physical design drastically. To the degree Apple innovates, it does so by releasing new product.

So the problem for innovation at Apple is a consequence of its not having broadened into large new markets that have an appreciable impact on revenue or net income. And let’s remember, Apple is acquiring a lot of new companies to take in new product. They have made 24 acquisitions in the last 18 months. So it’s clear they are not standing still. The problem is finding a new market which will meaningfully boost earnings without wasting money on large and value-destroying distracting acquisitions.

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So that’s the macro picture here: Apple will continue to execute on its core products, buy middling companies without wasting cash, and return cash to shareholders via dividends and buybacks. It remains constrained by its one company, one hardware seller, one operating system motif. Android will continue to take share as a result. So we await the next big new product.

As for earnings, the numbers were good. And Apple’s shares were up more than 7% in pre-market trading as Thursday began.

Below are the headline numbers for Q2 2014:

  • Revenue: $45.6 billion vs. $43.6 billion in Q2 2013 and $57.6 billion in Q1 2014 and forward guidance between $42 billion to $44 billion
  • Profit: $10.2 billionvs. $9.5 billion in Q2 2013 and $13.1 billion in Q1 2014
  • Gross Margin: 39.3% vs. 37.5% in Q2 2013 and forward guidance between 37 and 38%
  • EPS: $11.62 vs $10.09 in Q2 2013
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This broke the string of four quarters of profit declines and eight quarters in gross margins at Apple. As last quarter was the first annual profit decline in more than a decade, this is great news on the execution front for Apple. Notice that the EPS numbers are much higher (15% over last year) while the earnings are up much less. That’s because Apple is buying back shares. Apple boosted its dividend by 8%. That meant their cash pile dropped to $151 billion from $159 billion, the first decrease since 2011. They also instituted a 7-1 for one stock split. This was a very good quarter for Apple.

On product sales, Q2 2014 numbers came in as:

  • iPhone sales: 43.7 million vs. 37.4 million in Q2 2013 and 51 million in Q1 2014
  • iPad sales: 16.4 million vs. 19.5 million in Q2 2013 and 26 million in Q1 2014
  • Mac sales: 4.1 million vs. under 4 million in Q2 2013 and 4.8 million in Q1 2014
  • iPod sales: not even mentioned. They sold 6.0 million in Q1 2014

The iPhone numbers were very good. Everything else was mediocre to poor. The iPad numbers were especially poor and it suggests that in yet another segment, Android is taking so much share that Apple’s numbers are declining. The numbers also suggest that the tablet market is no longer a market for growth. This was the last big growth market for Apple outside of the iPhone actually. So the fact that the tablet market is declining tells you that Apple is more dependent than ever on iPhone sales. They are becoming a one-product company and that makes them vulnerable.

As with last quarter, the good news on growth is Asia, and China specifically. Apple saw a 5% increase in revenue between Q1 and Q2, versus a 20 to 30 percent dip in other regions, the usual trend for post-holiday season earnings. Looking at revenue year-on-year and the numbers are even more dramatic. Apple saw sales in China rise from $1 billion to $9.3 billion, driven in part by the China Mobile iPhone deal I mentioned last quarter as a reason to expect growth. But, the Mac also had double-digit growth and iTunes revenue more than doubled in China. So China is the big story here.

Apple is providing the following guidance for its fiscal 2014 third quarter:

  • Revenue: $36 billion to $38 billion
  • Gross margin: 37 percent to 38 percent
  • Operating expenses: $4.4 billion to $4.5 billion
  • Other income: $200 million
  • Tax rate: 26.1%

This was a great quarter for Apple. Going forward, there is much less pop in Apple shares though. And this is true in the entirety of large cap tech outside of Amazon. None of these companies – Cisco, Microsoft, Google, etc have high earnings multiples when compared to bubble valuations in new tech with Facebook, Netflix, Twitter, Tesla and the like.

The big news is that a disciplined Apple is going to repurchase $90 billion in stock, up from the $60 billion the company announced last year. And the seven-for-one stock split will begin trading on June 9th, 2014. The last time Apple split its stock was in 2005; the company also split it 2000 and 1987. SO this is a big deal too.

Apple is not a bubble stock. It is a large cap stock that has low growth and it is now valued as such. For serious froth we need to look at the new tech companies with triple-digit P/E multiples.

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