Your Quarterly Apple Earnings Deep Dive

By Markets Fool.com

Last week, Apple(NASDAQ: AAPL) reported modest earnings for the third quarter, but the stock dropped 2.5% shortly after the call.

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On this episode of Industry Focus: Tech, analyst Dylan Lewis and Fool contributor Evan Niu discuss the most important numbers from the call and what they mean for the company in the long term, and why the stock fell on what was a better-than-average quarter for the tech giant. Also, they examine how Apple is growing in China, how much the Samsung Note 7 fiasco might affect Apple's next few quarters, what analysts are most concerned about with the Q3 report, and more.

A full transcript follows the video.

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This podcast was recorded on Oct. 28, 2016.

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Dylan Lewis: This episode of Industry Focus is brought to you by Criquet. Criquet makes perfect, classic, and easy going polo shirts. For 20% off your first purchase, go to criquetshirts.com/fool and use the promo code FOOL.

Welcome to Industry Focus, the podcast the dives into a different sector of the stock market every day. It is Friday,Oct. 28. Happy birthday, mom! We'regoing to run through theAppleearningsreport. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist, Evan Niu. Evan,how's it going?

Evan Niu: Busy week, a lot of tech stuff.

Lewis: A lot of earnings coming in.

Niu: A lot of product announcement.

Lewis: Yeah,a lot coming in from Apple. Let's talk a little bit about what they reportedin terms of numbers. Maybe we'll get intosome of the product discussion a little bit later on. $46.8 billion inrevenue on the top line,more or less in line with expectations, down from $51.5 billion a year ago. But that is to be expected, we knew that was coming, no surprises there. EPS (earnings per share) at $1.67,which was actually slightly abovewhat expectations were. The twobig numbers that people immediatelyfocus on,it seems like Apple delivereda pretty solid quarter.

Niu: Yeah.I think it was right on target. I don't think there was really any big upsides and downside surprises. The way I look at it,this is the most boring quarter of all the seasons,because it's right before theiPhone launched. You get a couple weeksof the new iPhone sales, but generally speaking, Q3 is justnot a super exciting time for consumer electronics companies.

Lewis: Youmentioned the iPhone. We might as well head instraight into the discussion on thatproduct. The company sold 45.5 million iPhones at anASP (average selling price) of $619. That amounts to about $28 billion in revenue, good for about 60% of Apple's top line. We've seen that trend down a little bit. I think it'sstabilized in the high 50s low 60s. It isn't quite the two-thirds amount it used to be.

Niu: Yeah. On a trailing-12-month basis, it's still about 63%. It's still pretty far up there. One thing I did notice that was interesting was Apple did notdisclose this whole thing about installed base related purchasesthat they've been doing for the past three quarters. As we talked about before, there's this effort --in my opinion -- to shift attention away from unit sales. Butthey didn't do that this time, which is weird,like, are they not trying to do that anymore?

Lewis: Yeah, any time youintroduce a new metric, especially a non-GAAP metric, you'reshifting attention somewhere. And for them togo silent on that makes you wonderexactly what's going on there.

Niu: Yeah,it's a weird change of tune. I've been keeping track of this number, and I wasexpecting to plug it into my sheet,and they just didn't have it.

Lewis: One number I thinka lot of people have to be pretty optimistic about is the general trend with ASP. I said $619, that's up from theprevious quarter, and it seems like there's some more upside there.

Niu: Right. Themain thing to remember is that the reason why it was down over the summer wasbecause of the iPhone SE launch, which starts at $400, which was the lowest price point thatApple has ever sold an iPhone directly, even if you factor inhow they bring these older models down by price point every year. The lowest they'd ever gone before was, a three-year-old iPhone would go for $450. Then they came out with the SE, which starts at $400. It was apretty aggressive play to get smaller phones and first-time adopters,with a lower entry price. That put a meaningful impact on ASPs, which was $595 last quarter, which was the lowest it's been in about two years. They did say on the phone, they expect ASPs to climb back up to where they were lastDecember quarter, which, for reference, was $691. So,I think we should start to see that number start to push$700 again, particularly if they can meet iPhone 7 Plus demand, whichthey're having a hard time doing, because the iPhoneisso expensive, they can increase that price by $20compared to last year. The 7 Plus will really push ASPs up, I think.

Lewis: Andpart of the justification with thatincremental $20 on the price point was the camera. That was the major selling point,and that's how management pointed to that decision.

Niu: Yeah. Theyspecifically said it was the camera. They were asked about it, and they were like, "We put a ton ofInnovation into the dual-camera system." I do think that isvery specifically what's the reason for that $20.

Lewis: One ofthe things I thought was particularly interestingwith the commentary from this report was, you look at the services segment,you look at the last couple quarters, you've seenservice segment revenue up 20%, and they're really touting this number. Most recently, it was $6.3 billion,which is roughly 13% of revenue. At this point, we're coming up on two full years of them breaking out services as a product segment. Looking backwards, we've seen a huge step change in the fiscal Q1 quarter. In 2015fiscal Q4, we were at $5.1 billion. That hopped up a full billion dollarsin the following quarter, fiscal Q1 2016. So,I'm really curious looking forwardwhat that segment might look like. Theoretically, we should be in the step-change quarter. It'll be interesting to see if they can sustain that growth, or if we're going to continue to see them hum along at more or less flatsequential growth.

Niu: Yeah,services is becoming huge. Like you said, it's $6.3 billion. Andif you look at the past four quarters, this is now basically a $25 billion business. That's bigger than the Mac, bigger than the iPad. It's their second-biggestbusiness at this point,which is kind of crazy to think about, because Apple is typically not that great atservices in general. Particularly because the services revenue,most of it is not coming from a subscription service like Apple Music that bills every month. That'scertainly part of it. But it comes back to what we were talking about earlier, which is the whole installed base related purchases. A lot of that services revenue comes from them relying on their users buying content and apps on the App Store reliably. That's why that number is important,and I'm surprised they didn't give it. Not a whole lot of it is occurring, monthly subscriptionfees that you can count onevery month. So,it is important,but they're doing a really good job of growing that number. It's a pretty big business now, $25 billion.

Lewis: It's huge. I think, you hit on the installed base thing, if there are any issues with them growing that installed base, it stands to reason that the services segment won't continue to growthe way that it has.That's kind of the relationship there, and that's why you always see the step change happen infiscal Q1, because that's when they sell a ton of iPhones. You'regoing to see those two things move together. That's certainly something thatI'm watching in the coming quarter, because they'repointing to it more and more in their conference calls. I think it's an indication ofa lot of other elements of their business.

Niu: Absolutely.

Lewis: Looking forwardand looking at the guidance that they provided,for the first time since physical Q1 of last year, Apple is guiding for year-over-year growthnext quarter, which I think is a welcome sign for a lot of investors. The company isexpecting revenue to come in somewhere between $76 billion and $78 billion. When we say year-over-year growth, fiscal Q1 last year, they posted revenue of $75.8 billion. So,it's not going to be huge,but it is positive growth.

Niu: I'll take it.(laughs)

Lewis: Yeah,at this point, looking year-over-year declines fora little while,it's certainly a welcome trend to see. I think some people are maybe a little disappointed in this guidance, givensome of the tailwinds that the business has right now at its disposal. This issomething we've talked about in previous shows. One of the major competitors, theSamsungNote 7, being off the market,you would think would be a much larger catalyst for Apple than maybe they're letting on.

Niu: Yeah. They declined to giveany meaningful comment onwhether or not they think they'll benefit,but I think pretty clearly that they will. And now there's even reports thatthe Galaxy S7 Edge iscatching on fire.(laughs)I don't know if you've seen it, there's not as many of them. But there were reports startingin September. That was a month ago. Again, it's not as widespread,but there are a handful of casesacross the world, like in Chinaand the Philippines with the S7 Edge -- which isone of the phones that Samsung is pushing people toward. And here's the crazy part --one of those phone was a replacementfor a Galaxy Note 7. So Samsung gives acustomer and S7 Edge to replace his Note 7 that caught on fire, and the S7 Edge catches on fire!(laughs) It's just a mess.

Lewis: That's a bad brand experience there.

Niu: I think,going back to their guidance,I do think, the one thing that stood out to meas far as not so great in the guidance wasthe gross margin guide. The revenue guidance was fine becauseit'll be nice to get a little growth, even if it's not a lot. We had threeconsecutive quarters of negative growth up top at this point, so I think anything is nice. On theprofitability side, I was surprised, too, because in the fourth quarter, Applealways enjoys a lot of operating leverage when their revenue scales up to these really high levels. Usually, you see margins expanding in a pretty meaningful way,usually to the point where you're at 40%. They're guiding to basically upwards of 38.5%. So, 50 basis points shy of what I would expect them to guide to. And,for what it's worth, last year they did 40%.

Lewis: In fairness on that 40% figure, that was also a quarter where they realized $550 million or so in a patent disputeagreement with Samsung. I think that added about 40 basis points to that margin number. I think the true margin number was like 39.6% or so.

Niu: Butif you go back another year, it was still like 39.9%. It's still pretty close to 40%. AndI know it doesn't sound like a lot, 50 basis points,but when you're talking about a business this big, every basis point counts. One basis point is like $7.6 million. So, multiply that by 50, and that's gross profit, comingstraight down through the income statement. They've been talking a lot aboutcommodity costs and component costs being very favorable. So,I'm wondering why that guidance wasn't stronger.

It's also possible thatthere are some currency effects,because they've been battling the strengthening dollar for a really long time. That's very much hurting them,because about two-thirds of revenue comes from outside the U.S. Thestrengthening dollar has been hurting them for many quarters. So, that could also be part of it. I think that might have been why the original market reaction was negative. Ifyou're watching after hours, the stock jumpedon the iPhone numberas soon as it was released,started getting back those gains as people read through the numbers and started digesting them a little bit.

Lewis: Yeah, and we'regoing to hit on that in the second half of the show,also talk about a couple things that analysts are concerned about and whether they're really a cause for concern. But, before we do, I wanted to give a shout-out to our friends at criquetshirts.com. Criquet makes comfortable andsharp-looking polo shirts that perfectly mix old-school style and modern design. Criquet shirts are made with super soft 100% certified organic cotton, making them as comfortable on the 19th hole as they are on the 18th. The fit is not too baggy and not too skinny.The shirts come with removable collar stays to help keep your collar looking crisp and new. We all know the worst thing in the world is a bacon collar, and Criquet's collars don't get wrinkled or rippled. Plus, theyoffer free, no-hasslereturns and exchanges. Criquet actually sent some shirts over to The Fool for us to check outsince they were sponsoring the show. I've worn mine to the officea couple times. It's a really great shirt for that slightly dressed upcasual look. I'll say, I fit in walking around The Fool in our slightly more start-upenvironment, and also heading out to happy hourwith my friends after work. It's definitely a really versatile shirt, great all-purpose shirt. It has that modern, tailored cut to it, not boxy like some of the other polos I own,but it also doesn't feel like it's painted on, either. Just something to check out. As a special offer to our dozens of listeners, get 20% off of your first purchase by going to criquetshirts.com/fool and using the promo code FOOL.

Evan hinted at some of the things we wanted to discuss here on the second half: someanalyst concerns and the market reaction to earnings. Thiscame up in the conference call from a couple different folks. I've seen some people worried about what's going on with the R&D spend, research and development side of Apple's expenses, and what's going on in China for them. Do you want to hit on that a little bit?

Niu: I think there are some questions about, why is R&D expenditure growth growing at thisaccelerated pace? Apple is really good atefficiently spending on R&D. A few years ago, it used toalways be 2% to 3% of revenue range, which is tiny. A lot of other tech companies are like 10% to 15%.GoogleandMicrosoft,that's how much they spend of their revenue on R&D. It's not as if the more you spend, the more innovative. It's not linear. It can bewasteful sometimes, if you're spending on projectsthat you never actually commercialize,which I think Microsoft has a tendency to do. Apple has always been really good at only reallyputting this money into things they know they can commercialize later on. But now, in the past few quarters, we're seeing this number rise to this 5% to 6% of sales,at the same time that revenue is slowing down, so there's a lot of questions of, "What's going on here?" Theobvious answer is, they'respending money on these things for the pipeline that they won't talk about.

Lewis: Which is maddening as an investor. They're like, "Don't worry, we're spending it well, we're allocating resources great, just trust us."

Niu: "Just trust us." Yeah. There was this talk of a car, and clearly a car isincredibly expensive to develop. Who knows if they actually do it, there'sall these conflicting reports on whereApple is or is not heading with this car idea. But,that is certainly, as far as expenses go,extremely expensive on the R&D front. There's things like augmented reality, virtual reality, AI. There are a lot of things Apple is certainly exploring here, but they can't talk about. So, there's a real question, I think, at this point. Yeah, we know they're spending this money,and we can probably guess on what,based not only on where Apple-specific rumors are coming from,but also where the tech industry is going. We know,everyone is working on these things. So the real question will be, can they do these things, and when they do launch them, will they be compelling, will they be better than everyone else's? Will they actually drive the business even more? And you just have to wait.

Lewis: Yeah,unfortunately it's a wait-and-see type of thingfor investors. I'm notfreaking out about it yet,but I think it's a good thing to monitor.

Niu: Definitely.

Lewis: What aboutwhat's going on in China?

Niu: China, there was this big thing, sales were down 30%. Last quarter, they were down 33%. Thequarter before that, they were down 26%. If you just look at these year-over-year numbers, it looks really bad. But you have to realize, they're just facing tough comps, because they did so well in 2015. If you zoom out a little bit and look at their business on an annual basis, this is still a $46 billion business in China. Last year, it was a $50-plus billion business. And the year before, it was like $20-something billion. This is stillvery much headed in the right direction. I used to track their "Greater China" salesbefore they actually broke it outand exposed it in this lush detail. If you go back to fiscal 2009, I think, they did less than $1 billion in sales that year. You'd have tobasically stitch these numbers together from conference call comments, which I used to do. Now they give it to you directly. But I used to dig these numbers up. I think it was $900 million in fiscal 2009. That was seven years ago.

Now they're basically $45 [billion] to $50 billion. You can't argue with the long-term trajectory of it. And there's still a lot of room to grow; this isnowhere near the end game. China is stillnowhere near saturated, there's still tons of first-time smartphone buyers. The middle class is still booming. There's just a couple of tough comparisonsbecause they did so well last year. I wouldn't worry too much. It's just this noisy, quarterly trends, quarter to quarter, it's tough to call. And yeah, there's certainly some competition coming in from these lower-end Android makers likeXiaomi and all these other local players. At the same time, I don't think there's a lot to worry about. There's still a lot of room to grow in terms of physical geographic footprint. They don't have that many stores, still, they only have about 40 stores or so. I don't think there's anything to worry about, even if these past few quarters look scary on paper.

Lewis: Yeah, if you choose to look at theirnumbers on a two-year comp instead of a year-over-year comp,they look pretty darn impressive, right?

Niu: Right.

Lewis: So,that's something to keep in mind. In my eyes,pretty solid quarter. They met expectations, they set guidance thatput them back on toat least some sort of growth,for at least the next quarter. We had a listener tweet,and I think this is something that probably a lot of people are wondering, you say, "OK,they checked the boxes in a lot of ways. Why are they down2.5%since they reported?" Theinitial reaction when you saw iPhone units was positive,and pretty much after that they'vefallen off and haven't really recovered. Two-and-a-half percent is nothing to go crazy panicked over,but I think it's a valid question,and it's something a lot of people are wondering. What do you think?

Niu: I think it was just kind of in line with expectations. It'salways hard to know how the market is going to react. It's not always just about with the actual consensus number is, it's also about the whispered number,which is this abstract conceptof what people actually think. That's the way that analysts work. Investors talk up this whispered number, "Oh, this is what I have on my official estimates, but I think they'll probably go lower, or higher..." So,it's always hard to gauge what's actually going to happen. 2% is not a killer move in either direction. I thinkit was more of just a lack of being impressed, if that makes sense. We talked about thegross margin guide wasn't super great. People just have to start accepting that Apple is just not a growth machine anymore, and that's OK. Butsome people have trouble with that just becauseit's kind of boring, for it to not be a growth machine.

Lewis: Yeah. And, in fairness, this is a company that has, historically,provided relativelyconservative guidance. You almost never see them miss their own guidance marks. They typically meet it or aresurprised pretty comfortably. So, to showthem projecting growth means theymust be pretty confident that that's going to happen. They do have some nice tailwinds to support that, like I said, they have one of the biggestcompetitors off the market, and they also benefit this quarter from a 14-week Q1 instead of a 13-week Q1. So, that should help them out a little bit, a couple extra selling days there. But, by and large, there'snothing in this report from my end, that really changes my thesis on this company.

Niu: They dopretty much always get within their guidance. It's not like the old days, when they would put out this laughably lowguidance number, a lowball thatyou could basically ignore. A few years ago, they changed to really be more honest, toactually give a range that they're pretty confident they'll get within. And,for the most part, they have, every quarter, more or less. I definitelytake their guidance at face value these days versus the old days,when you could basically just laugh it off because it was a joke. I thinkmaybe that's another reason whythey weren't as impressed. Maybe, like you mentioned, there's an extra week in this quarter. If the revenue growth is because you get an extra week, that doesn't reallyinspire a lot of confidence in the business. Again,it's not like it's a terrible business. But if you're looking skeptically, you could say, "Oh, you're only going to grow because you had more days to sell in the quarter." Maybe that's another thing people weredisappointed in.

Lewis: Even then, returning to a flat quarter, in my eyes, is great. We've seen this down trend for such a long time that seeing them get back to, whether it's zero or positive growth, it's pretty fantastic. Anything else before I let you go, Evan?

Niu: No,I thinkwe covered their earnings pretty well.

Lewis: All right.Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. If you'relooking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program may have 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 Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Alphabet (A shares) and Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Apple. The Motley Fool owns shares of Microsoft and 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.