Highlights From Apple, Inc. and Facebook's Earnings

By Markets Fool.com

Last week, tech giants Apple (NASDAQ: AAPL) and Facebook (NASDAQ: FB) reported their quarterly earnings. In this episode of Industry Focus: Tech, Motley Fool analysts Dylan Lewis and Daniel Sparks take a dive into the reports, looking at the most important numbers from each.

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Find out why investors shouldn't be worried about Apple's decrease in revenue, why year-over-year comps are so misleading for Apple as a company, how Facebook so handily beat out analyst expectations this quarter, what Apple wants to get out of its $1 billion investment in Chinese ride-hailing company Didi Chuxing, just how Facebook is positioning itself for more growth, and more.

A full transcript follows the video.

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This podcast was recorded on July 29, 2016.

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Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 29, and we're talking Apple earnings and Facebook earnings in a week of incredible tech earnings. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com senior technology specialist, Daniel Sparks. Daniel, how's it going?

Daniel Sparks: Good, thanks for having me!

Lewis: It's always a pleasure. Big week in tech earnings, a lot going on.

Sparks: For sure, it was a big week. Apple and Facebook definitely stood out.

Lewis: Yeah. Why don't we start out talking about Apple? I'm a shareholder, you're a shareholder, a lot of Fools are shareholders, a lot of people that own mutual funds wind up being shareholders whether they realize it or not because it's such a large component of the S&P 500. Apple's top line came in at $42.4 billion, which beat estimates by about $300 million. Earnings came in at $142 a share, which also beat estimates of $138. I know I was pretty happy to see that, because after the last quarterly report, I think there was some pessimism following the company in the market.

Looking at what's going on with their iPhone line, the company sold 40.4 million iPhones. Sell-through was down 8%, but that was expected. We knew that was going to be happening with where they're at in the iPhone life cycle and the product rollouts. ASP -- average selling price -- for the iPhones was $595, which is down from what we've seen in the mid-$600s with some of the other lines. Overall, the category made up about 56% of revenue.

We see sell-throughs down, revenue is down. Is this something we should be worried about, Daniel? I think no. What do you think?

Sparks: This has definitely been a trend for Apple in fiscal 2016, watching the company turn to these year-over-year declines in revenue. I think it's something we need to put into perspective [compared to] last year. Like you said, iPhone is 56% of revenue, so it's the key driver. When iPhone sales hurt, so does total revenue. And that's been the case. Lately, iPhone sales are down. During this quarter, iPhone sales were down about 15%, which also happens to be in line with the company's year-over-year decline in revenue.

But you have to put that in the context of last year. Last year was a monster upgrade cycle for Apple. The iPhone 6 was huge. The holiday quarter, which is always Apple's biggest quarter, iPhone unit sales were up about 46%. That was up from a previous record. And we're talking one of the biggest companies in the world. When you have a segment like this posting this sort of growth, it's not going to be easy to live up to that. So when you zoom out and look at iPhone [and] Apple's business on a two-year basis, you're actually still seeing revenue headed upward, and even net income headed upward. Apple's third-quarter net income of $7.8 billion was up $100 million from $7.7 billion two years ago. It's still, generally, a healthy business, but we have to put it in comparison to this monstrous year last year.

Lewis: And you talked about how, if you look at things relative to two years ago, the numbers actually look pretty rosy. I think that's how you have to look at a business that we expect to issue a major overhaul to their namesake, huge product, their flagship line, every two years. The 6S was not a huge incremental change in form factor, and they were going up against years where they had rolled out the 6+ line, which was a totally different form factor. Of course, Tim Cook has zero interest in getting into the details on what we can expect from future product launches. But based on the cadence we've seen in the past, they're almost a company you want to see a two- or three-year comp look at, rather than just a straight year-over-year. I know it's tempting for investors, but I think it's something to be mindful of.

Sparks: Right.

Lewis: So, Daniel, we talked about iPhones. Any other segments you're interested in talking about with Apple?

Sparks: I think iPad, as a product segment, and Greater China as a regional segment, are definitely interesting. The iPad segment was actually, other than services, which we'll get into in a bit, Apple's only growing product segment during the quarter, which is somewhat surprising just because generally, Apple's iPad segment has been one of its hurting product segments. But recently, we know that Apple introduced the iPad Pro. This looks like it's playing a pretty solid role in helping Apple's iPad business. When we look at the segment, we see unit sales down 9%, and revenue is up 7%. The only way for this to happen is [if] the average selling price of iPads is trending higher. The iPad Pro is definitely a very premium product for Apple. It could be said that it's cannibalizing Mac sales, but that's always been part of Apple's business -- innovate as much as possible in each product segment. In that case, it looks like it's playing a good role in iPad.

Lewis: Yeah. It's nice to see ASPs trending well for at least one of their product lines. You touched on China a little bit, do you want to give a bit more commentary there?

Sparks: Yeah. Greater China, this has historically been an area where Apple has done really well. Greater China has grown to be Apple's largest geographic segment. This has been one investors have really been honing in on to see what's going on. And it's been a huge catalyst for the company in the past. But now, we're looking at Greater China, and revenue is actually down. This is the same case as last quarter, too. Revenue was down 21%. Again, like when we're putting it in perspective of last year's awesome comparison, this is definitely the case with Greater China. Last year, year-over-year growth in Greater China was 112%.

So, you zoom out two years here, and Apple is still doing fairly well.

Lewis: When we look at some of the other ways to slice the data, I think it's worth spending a little bit of time talking about what we're seeing in the services segment. Services -- that's what comes in via the iTunes store, the App Store, Apple Pay, Apple Music, some of the App Stores associated with Apple Macs and TVs, things like that. Revenue was $6 billion for the quarter, which is up 19% year over year. This segment has quietly become 14% of Apple's revenue. Over the past year, it's contributed over $23 billion in revenue. It is the second-biggest segment on the company's books, which is pretty impressive. I think one of the reasons I love this segment as an investor is, it's a high-margin business. Delivering digital content is pretty fantastic because it's incredibly scalable, it's high-margin, and for someone that makes devices, it helps build the strength of their bread-and-butter hardware segments. It keeps those ecosystems nice and sticky, and it keeps people actively using what is in there as the operating system.

Sparks: Yeah, the services definitely is an interesting segment. I think that's why Apple is starting to see, as it becomes bigger, investors are going to care about this. That's why, I think it was in the first quarter of fiscal 2016, they introduced a new non-GAAP metric which measures the purchase value of services related to Apple's installed base. Installed base is all the active iOS devices, whether it's iPad, iPhone. This has been a really interesting metric to watch. To define it a little better for you, and why it's non-GAAP, is, it's purchases related to services, but a lot of these different sub-segments of the services segment are accounted for in different ways.

Some of them are accounted for on a gross basis, some on a net basis. App Store sales, which we all know is a huge catalyst for Apple, one of its fastest-growing areas, is actually accounted for on a net basis. The services segment has actually understated the growth for a long time, because as the App Store begins to account for a larger portion of this segment, it's not really seen as well. That's what this metric does. It adds back in the gross value of the App Store, and other different areas, where they're accounted for on a net basis, just so it's the same across the board. You have iTunes sales coming in at gross, you have App Store coming in at gross.

Anyway, this has been really interesting because the year-over-year growth in this non-GAAP metric has actually been increasing since the company introduced it. In this quarter, purchases related to services were up 29%. This is the fourth quarter in a row this year-over-year growth rate has actually accelerated. That's a pretty good rate, 29%. So yeah, as a business that looks like it's going to be a key important part to Apple's business as it matures. It's definitely good to see that growth.

Lewis: Absolutely. One of the other things I wanted to talk about a little was Apple's $1 billion investment in Didi Chuxing. This is something that came out in May. Didi, for listeners who might not know, is best described as the Uber of China. In some ways, this is an unusual position for Apple, because this is them investing $1 billion in this business, not taking a business, acquiring them, absorbing them, integrating them into products and services. Tim Cook talked about how they've been buying companies on average every 3 or 4 weeks. Those are those small players they plug into their OS or somehow work into product functionality. Didi is much more of an investment stake. And it's kind of cool to see Apple taking these shots. They have so much money to work with, there's so much capital there. I love this investment stake as an investor.

Some of the justification and some of the commentary that Tim Cook offered up in the conference call -- he said they see them as a great investment, they see them as something on the strategic side. The companies can work together. I'm guessing there's some business plans there at some points, maybe with what Apple wants to do with cars. And then, there's an opportunity to learn a little bit more about what's going on in the Chinese market, and learn it from someone who's there, and entrenched there.

In addition to there being this booming space that they now have an investment stake in, there's some nice side effects there for Apple's core business as well.

Sparks: I agree. It brings up all the active rumors about Apple and its rumored Project Titan, getting into cars. It does make investors wonder a little bit if that could have something to do with what's going on here. But of course, the iPhone itself is a really location-based device. When you're talking ride-hailing services, there's a lot of movement, a lot of mapping going on. It's interesting to speculate.

But of course, Apple makes so many acquisitions. There's many reasons. And you named some of them. A really interesting investment.

Lewis: Yeah. Daniel, we could talk about Apple all day. I still have plenty more I want to touch on. But we try to keep it tight-ish on the show. Why don't we pivot over to what happened with Facebook earlier this week? Some of the big-time numbers from them: Revenue hit $6.4 billion, which is up 59% year over year, well ahead of estimates of $6 billion. Earnings came in at $0.97 per share, which beat estimates of $0.82 per share handily. Just to give you a little idea of that revenue breakdown, 97% coming from advertising, 84% of that 97% coming from mobile. They have clearly pivoted extremely well to mobile. I know there were a lot of concerns about that a couple years ago, but everything they're doing as a business seems to be absolutely humming along.

Looking at some of the leading indicators for the business: MAUs are now up to 1.7 billion, which is 14% year-over-year growth; daily active users are also trending nicely, now at 1.1 billion. It's incredible to see them continue to grow their user base, even with the denominator the size that it is for them.

Sparks: Right. Users is always really interesting to watch with Facebook. They've done so well here. Like you said, daily active users is trending nicely, too. It actually grew on a year-over-year basis faster than monthly active users, which is helping the company to maintain a high engagement rate. Engagement rate is basically daily active users as a percentage of monthly active users. Right now, we're at 66%, which is an all-time high. It's the same as it was in the prior quarter, 66%. Still, it's been trending upward, generally. This is really impressive to think that of those 1.7 billion monthly active users, 66% of them log in on a daily basis. There's just no way to overstate the importance of this to Facebook's business, and really illustrating the sustainability of Facebook's social network.

Lewis: I know I'm guilty of that. I get a notification every day of "It's Frank's birthday, wish him well!" And I always wind up logging in and seeing what's going on. Facebook, if nothing else, is a great way to remember when it's your friends' birthdays.

A couple other business metrics I think highlight the strength of the platform, and I think they really aren't fading any time soon: Average price per ad was up 9%, and total ad impressions were up 49%. You obviously see those two numbers factoring into that great top- and bottom-line success they posted this quarter. A lot of that was driven by mobile. Another great stat: Time spent per person was up double-digit percentages year over year across not only Facebook, but Instagram and Messenger as well. So, it's not just their namesake platform that is really running with it right now. They're seeing a lot of success with pretty much all their properties.

Sparks: Yeah, for sure. I think it's been really interesting to watch the different properties. Facebook, Messenger, Groups. Groups is somewhat related to Facebook. But, over 1 billion users on these platforms, on Messenger and WhatsApp. It's really interesting to watch.

Lewis: Yeah, and Instagram is now at about 500 million monthly active users, and that just keeps climbing. I think one of the things that I love hearing updates on for what's going on in their pipeline is, management has a very clear process as to how they're going to monetize these platforms. They've talked about it in the past with Instagram, and it came up again when someone was asking about what's going on with Messenger. I think it's worth highlighting here. They focus on this three-phase approach. One is grow the user base and engagement. Two is build organic interactions between businesses and consumers. Three is build commercial opportunities. Analysts asked, "Where are we seeing Messenger right now, and where does it fall on that spectrum?" And they said Messenger is clearly in Phase II. They're looking for businesses to start reaching out to consumers in a very organic way, and make it comfortable for users to have those interactions. They'll worry about building the commercial opportunities and really monetizing it down the road.

When you hear that deliberateness, and you see the track record of them monetizing Facebook incredibly well, them starting to monetize Instagram pretty well, and now them taking the same approach to Messenger ... I know the application of the service is a little different, but the approach is so thorough and thought-out, I love it. If you're an investor -- I am not -- you have to really appreciate the fact that there have to be pretty big growth runways available on these other platforms for them. Right now, when you're seeing these revenue and earnings numbers, you have to realize, Facebook's main platform is bringing in the lion's share of those. I think you have a lot of reasons to be bullish about the company's ability to meaningfully grow their advertising business on these other platforms, particularly as they refine and iterate on this. Definitely something to be happy about.

Daniel, do you have anything to add?

Sparks: One thing on that. I do think it's really interesting, the phase one, two and three. You mentioned, historically, investors can see how that played out for Facebook. We can relate that a little bit to Messenger, where they're in phase two. For some more context on that, when we look back to Facebook, we remember that the way they went through phase two was by giving businesses in general tools on the Facebook platform to work with and begin interacting with people. We're seeing exactly that on Messenger. We're seeing businesses get new tools and ways to interact organically with users. As Facebook users, you can log in and see that play out by watching them roll out these tools that users can use to interact with businesses.

Lewis: Yeah. Even on their main flagship platform, they're still very invested in growing the small business population. It's a little tough to look quarter-to-quarter because they don't report the same numbers in every call. But six months ago, they had 50 million small businesses using Pages on Facebook. Recently, they're saying they are now at 60 million. That's an increase of 10 million in six months. That's fantastic. Of course, they're not making money on those groups; those are people that are using it for a web presence. They cited a stat, I think it was something around 30% of businesses in the U.S. don't have a website. They're hoping, at bare minimum, those businesses will port over to a Facebook page where they can grow a web presence on a very easy, quick signup basis, and build a customer base.

Where they do make money off of these is with the business advertiser pool. Six months ago, that number was at 2.5 million. Last quarter, it was at 3 million. I'm assuming that's still trending up based on the fact that small businesses creating Pages is going up, and we're seeing such excellent ROIs on the hyper-local and targeted ad options that Facebook makes available. I'm kind of curious to see when they'll mention that number again. Hopefully it's next quarter so we can get a check-in there. But that's another growth driver on a company that is already humming along and doing a great job. If you're looking for things to watch in next quarter's report, hopefully they'll provide a little update there, because that's certainly something I'm watching.

Daniel, anything on your end that you want to point out?

Sparks: A couple other areas I think are really interesting for Facebook. One is the accelerating growth. Facebook isn't just growing rapidly. I think it's worth highlighting that growth has actually accelerated. For a company achieving the growth rates it is, that's pretty wild. You look at revenue in Q2, it was up 59% year over year. Net income was up 186%. Non-GAAP earnings per share was up 94%. You look back to Q1, and you'll see revenue was up 52%. Net income was up 195%. Non-GAAP earnings per share was up 83%. Each one of these metrics actually accelerated during the quarter.

Lewis: That's pretty darn impressive.

Sparks: I guess net income didn't accelerate. But still, the fact that revenue growth accelerated from 52% to 59% year over year, it's just really wild.

Lewis: Yeah. I know when we were talking before the show and doing some of the prep, you said you wanted to mention a little bit about what's going on with operating leverage. You want to provide a little commentary there?

Sparks: Yeah, that's another interesting area. You look at this revenue growth accelerating as fast as it is, it's a really interesting narrative at the beginning of the year when Facebook management lead out its expectations for the year. They were really careful to emphasize that they were going to be spending heavily this year on its near, mid, and long-term, different things. Not all of these are going to affect the income statement, but there's a lot of overlap between some of their capital investments and things that fall on the income statement, especially as far as it comes to employee salaries and things.

So yeah, they really emphasized that they would be spending a lot. Analysts seem to take this as, "OK, Facebook is really growing fast. And generally, these fast-growing companies will have decelerating growth. So maybe this extra spending could take away some of the operating leverage, and we're going to see net income grow slower than revenue this year." But this has been totally not the case. Because revenue has been growing faster than operating income, so we've seen the company's operating profit margin increase from 31% in the year-ago quarter to 43% this quarter, and we've really seen a similar trend in recent quarters. So yeah, they are spending rapidly, like they said they were. But they're growing revenue even faster.

Lewis: I think it's part of the reason you see, what was it, a 17-18% surprise in earnings per share? It was up there. I think part of it was just, people had modeled for a lot more spending, and the revenue train just keeps chugging. It's unbelievable what's going on over there.

Sparks: It is.

Lewis: Daniel, thanks for joining us. Anything else before I let you go?

Sparks: I think that captures my take.

Lewis: Awesome. Maybe next week will check in on some of the other big tech earnings that are going to be dropping. Until next time, listeners, that does it for this episode of Industry Focus. If you have any questions or you just want to reach out and say hey, you can always shoot us an email at IndustryFocus@Fool.com. You can always tweet us @MFIndustryFocus, as well. If you're looking for more of our stuff, subscribe on iTunes, or you can check out the Fool's family of shows at Fool.com/podcasts. As always, people on the program may 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 Daniel Sparks, I'm Dylan Lewis. Thanks for listening and Fool on!

Daniel Sparks owns shares of Apple. Dylan Lewis owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Facebook. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.