Highlights From Apple's and Snap's Latest Quarters

Last week, Snap (NYSE: SNAP) reported earnings, and things didn't look so hot. On the flip side, Apple (NASDAQ: AAPL) also reported, and managed to put up some incredible numbers despite the company's gargantuan size.

In episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu dive into the numbers and trends from both companies, and explain what they mean for the long term. Find out which of Snap's metrics were the most alarming and why, why Apple's inventory numbers aren't as bad as they might initially seem, what investors need to know about Apple's growth runway from here, how Snap's monetization struggles compare to the trouble Facebook (NASDAQ: FB) had shortly after it went public, and more.

A full transcript follows the video.

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This video was recorded on May 4, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, May 4th, and we're talking Snap and Apple earnings. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, it's May 4th. I guess, as a Tech show, we have an obligatory nod to May the 4th, the Star Wars movement.

Evan Niu: [laughs] It's Star Wars Day.

Lewis: It is Star Wars Day. I'm not a huge Star Wars fan, are you?

Niu: I'm kind of. My wife is big into it, just because her name is Leia, and she was named in part because of Princess Leia from Star Wars. [laughs] So, she has a special bond with Star Wars.

Lewis: Yeah. We have a lot of other writers on fool.com that are far more into it, namely Dan Kline. Maybe next year, I'll have him on the show and we can do some Star Wars, Disney stuff. Today, we're going to be talking instead about one company that you and I both love, and one company that we love to follow, that's Apple and Snap.

Why don't we start out talking about Snap? The company released earnings earlier this week. Revenue was $231 million. Wall Street was expecting $245 million. Some disappointment there. That's 54% year over year growth on the top line. Of course, on the bottom line, the company lost money, not surprising given that they're in growth mode. The narrative with this company, though, has really been user-focused, I think, specifically over the last quarter. A lot of concerns about what this redesign with their app might do to user retention and engagement. Looking at the numbers, it seems to have had an impact, Evan.

Niu: Right. Snap went public so early in its lifetime, relative to companies that go public. I think that's why investors are so focused on this user aspect, much more than most social media companies in general. Just because, their ad business is so young that it really does revolve very heavily around how the user base is responding to these types of changes. There's been a lot of controversy over this redesign. Celebrities have been bashing it, you had social media hoaxes go viral saying it's going to come back, you had online petitions, all sorts of backlash. CEO Evan Spiegel has kind of defended it, but now what we're seeing is, it's really having a very noticeable and quantifiable impact on these metrics. Daily active users came in at 191 million, which is up just 2% sequentially from the fourth quarter, which is their lowest sequential growth rate they've ever posted. So, that number speaks for itself.

Lewis: And I think, importantly, management noticed that the average in March -- this is a daily active figure -- was lower than the overall Q1 average. So, there's probably some drop-off happening there that's tied to either the redesign or some performance problems that they were running into on their Android app. If you're trying to work through exactly where the number stands and how big that drop-off was, management noted that the March average was above the 187 million daily active users that they posted as of Q4. So, they're hoping to right the ship with fixes to Android and to the tweaks and walk-backs on some of the changes that they've made in the app. But that's not a trend that you want to see, particularly for a company that was essentially pre-monetization about a year and a half ago.

Niu: Exactly. They're testing out these different versions of it. They're really still committed to this idea of separating your social content from your friends vs. professional content from media publishers. Which makes sense in some ways, but it is starting to weigh on the financials. I don't think they're going to go back to the way it was before, because they're very committed to it, they just want to tweak it and find the right balance. But, how is the user base going to respond to all these constant changes, while Snap clearly doesn't have a very clear vision on what it wants? So, they're still testing it out, but, I don't know.

Lewis: Another thing that really spooked the market was a forward-looking comment from CFO Andrew Vollero. Snap is not a company that's known for giving guidance, so when we do get anything that's forward-looking from management, I think people's ears perk up. On the call, the CFO said, "As we think about year over year revenue growth rates, we are planning for our Q2 growth rate to decelerate substantially from our Q1 levels." To help paint a picture of what growth has looked like for Snap over the past few quarters, we just said before, 54% year over year growth in Q1 of 2018. Q4, 72%. Q3 of 2017, 63%. So, for them to be saying that we're going to have a meaningful deceleration as a cue to analysts, they must be expecting a pretty decent drop, somewhere in the low 40s or perhaps even lower.

Niu: Right. I think the broader context of these relatively strong historical growth rates is, remember, as we mentioned, this ad business is so young that they're coming off of a really small base. These growth numbers look really good, but you would expect them to keep maintaining these high levels of growth -- which are, by the way, being priced into the stock, at least they were before the earnings release.

But, you have these high growth rate as you're growing off these really small bases, so some deceleration is expected. But, when they're expecting a big drop-off even when they should still be in the process of ramping, that is a pretty big concern for investors.

Lewis: And they point out that this deceleration comes as there's a lot of growth in ad impressions, which are being offset by pricing for Snap ads. I think, to a certain extent, this dynamic is bound to happen. With the switch-over from these direct-sold ads to programmatic, where you have software being used to buy ads rather than having contact and salespeople, there are a lot more fluctuations with ad prices. The flip of that is, it opens the door to a lot of new advertisers to come in. This is a move that, we've talked about in the past, Snap really had to make, especially in order to bring smaller advertisers into the fold. But this is the problem with making that switch, is that you can have some pretty big hits to your financials if you're wholly reliant on ads.

Niu: Right. And Chief Strategy Officer Imran Khan had an interesting comment, too, about, as this redesign relates to ad buyers specifically, there's been so much negative press about this redesign that he said that's probably causing some delays or pauses in purchase decisions -- which is probably true, but it's also like, you're blaming it on media. The point is, this redesign is not being well-received from the user base, and yeah, that's going to manifest in the ad business, too.

Lewis: Something that has gotten a ton of media coverage and was curiously absent from the conference call was Snap's Spectacles, the new version of their hardware product. I've read so many articles talking about this new product launch, and yet, no analyst questions about Spectacles, and nothing from management touting that they're really excited about this new product line.

Niu: Yeah, for a "camera company" [laughs] making their second-generation hardware. I think analysts realized that hardware has always been this tiny part of the business, so they're more focused on the ad business, things there. But, I was surprised that, maybe even in prepared remarks from the management, they didn't mention it. Yeah, it's a little weird, because they're trying to pin their future on their ability to pivot into camera hardware, and I think that's pretty misguided because they don't even have their core ad business down.

Besides that, the second-generation Spectacles, they're not really anything game-changing, either. There's minor improvements from the first one, and the first one was such an utter disaster and it flopped. They made this $40 million inventory charge last year. It clearly did so poorly that you would think that Snap would realize that they need a bigger overhaul of the product to make it more successful. Instead, what they did is they increased the price of it to $150 and basically just made some minor incremental small improvements -- a little bit thinner, a little bit lighter, small performance improvements, but nothing enough that really addresses why the first one failed in the first place.

Lewis: Yeah. I get that they have bigger fish to fry, but as an analyst, understanding that 10, 15 minutes into the call, a lot of the core questions have already been asked, I'm shocked that no one said, "Hey, can you talk a little bit about the inventory management that you guys are doing for the Spectacles line now that you're relaunching it? Because you did eat $40 million in charges last time around, and we'd just like to get a sense of how you're handling it this time around."

Niu: Yeah, like, did you learn anything? That's a very reasonable question to ask, even beyond detailed stuff, just, what did you learn from it, and what are you going to do next time? They're very strategic questions. I was surprised, too, they didn't really talk about it.

Lewis: Yeah. Looking broad at this business and what we learned from this conference call and this earnings release, I think so much of what Snap's management is saying sounds right at first glance. The move to programmatic was absolutely the right decision for the business, and management, to compensate for this deceleration of revenue, has talked about this narrative of, "We're not playing the pricing game to maximize short-term revenues." And that sounds like long-term thinking that we normally love. I don't know that it holds a lot of water. I think, in some ways, it's more window dressing than, maybe, how they really feel about their business.

I went back and looked at Facebook's early calls, just as a reminder of what happens when these companies go public, what is the scrutiny that they go under, and what are people focusing on. The two things I was curious with, Evan, was ad dynamics and growth rates. Generally speaking, with Facebook -- I know the monetization timeline was a little bit different for these two businesses -- ad prices were up and to the right even early on for Facebook. And there were times where they intentionally did things to lower ad prices. They lowered the price floor in some developing markets to make ad buys a little bit more accessible to advertisers. But even when they did that, the company posted overall price growth because demand was so strong in North America.

So, I think that's something to keep in mind when they're saying that this is a reflection of programmatic. Yes, it is, but if we don't find a floor for this fairly quickly, I think it's a broader reflection of how interested people are in reaching people on Snap and the ROI that they get on advertising on that platform.

Niu: Right. And another example, to your point about them saying stuff that sounds like it should be right, but in reality, isn't really what's going on, I want to point out something in their earnings slides. We've talked about their cost structure quite a bit on the show. They had this line saying, "modest capital expenditures result in stronger free cash flow conversion over time." That is technically a true statement, [laughs] but in the context of Snap, it comes off as a parody or a satire because it's just a joke. Their capital expenditures are so low because they outsource all infrastructure and cloud hosting to third-party providers, which, as we mentioned, is a really short-term strategy.

But, it was really hilarious. That line is always in their slides, but this quarter in particular, it was pretty hilarious, because their free cash flow dipped to the worst level it's ever been. And when you see that line below this chart that shows free cash flow just falling off a cliff, it's just like, "What are you even talking about?" Free cash flow is deteriorating. It was negative $268 million this quarter, and that's largely because operating cash flow is getting worse, too. Operating cash flow was negative $230 million or so, compared to about negative $150 million a year ago. So, these numbers are getting worse and worse, and then they have this line that, again, sounds right, [laughs] but when you look at the numbers, it just doesn't apply to them.

Lewis: Yeah. And I know this is a business that we've been pretty bearish on throughout the time that we've covered it. I think, to paint a somewhat rosy picture, or give the alternate side of things, going back to this Facebook example I had before, there are plenty of times early on where Facebook had year over year revenue growth decelerate quarter to quarter, and then the company found growth and reaccelerated. And that happened because they had user growth, they had growth in their ad inventory, and ad prices continued to climb. Which is to say, it's not doom and gloom for Snap, necessarily, if you're only looking at what's going on with revenue rates.

But, when the other metrics aren't also trending in the right direction, I think it doesn't look very good. The idea that user growth on a sequential basis is as low as it's ever been, that's problematic. I think, the possibility that, within the quarter, they had their lowest user counts in the most recent month is not a particularly great sign, either. And you talk about the social and pop culture elements that they have to overcome with getting advertisers on the platform, there just seems to be a lot of obstacles in front of this business right now.

Niu: Yeah. I kind of regret closing out my puts a couple of months ago.

Lewis: [laughs] Thank you for that note of transparency. [laughs] Yeah, neither of us have any active positions in Snap now, but that was the case, where you had something going on there for a little while.

Niu: I made a little bit of money. [laughs]

Lewis: We're going to talk about something that you and I both own, we're going to talk about Apple and their earnings report, on the second half of the show. Alright, Evan, on to one of our favorites. I think we've skipped a couple of quarters here and there with Apple, but this is a business that we generally love to cover for a couple different reasons. It's a fun company to talk about, it's one of the world's largest, and whether people realize it or not, almost everyone has a stake in Apple because it's such a large component of the major indices out there. Why don't we walk through what they reported on Tuesday, and some of the headline numbers?

Niu: Sure. Revenue was up 16% to about $61 billion. Net income up 25% to about $13.8 billion. Earnings per share up 30% to $2.73. You can see a disconnect there between net income and earnings per share because Apple is so aggressive on the buybacks, and a lot more of those earnings are accreting to individual shareholders on a per-share basis. We'll talk more about the buyback program later.

iPhone units were up about 3% to around 52 million. iPhone revenue was up 14% to about $38 billion. A lot of that is due to the iPhone X and its $1,000 price tag. Tim Cook did note on the call that this is the first product cycle since 2014, when they introduced the two different sizes, 6 and 6 Plus, back in 2014, this is the first product cycle since then where the most expensive iPhone has also been the most popular. So, we're seeing a lot of uplift in terms of average selling prices. That business continues to perform very well. We're seeing Apple actually reaccelerate on the top line a little bit, which is not an easy thing to do when you're talking about a company of this size.

Lewis: Yeah. You teased this a little bit. The number that stood out to me with this was $100 billion. It looks to me like Apple is going to be buying back some more shares over the next couple of years. That EPS number is probably going to continue to climb.

Niu: Right. Of course, the big thing to thank here is tax reform that was passed last year. Many people have expected that a lot of companies would use these tax savings not necessarily for stimulating the economy -- of course, some of that will be there, too -- but, a lot of companies are really allocating a lot of these tax savings toward share repurchases. Which, as investors, we like a lot.

They repurchased over $23 billion in stock last quarter, all in open market purchases, which is a big sequential spike and all thanks to this tax reform. They're expected to complete their current $210 billion authorization during the June quarter. They've spent about $200 billion or so over the past five or six years, which is kind of a mind-blowing figure in itself. And after that, they'll have about $10 billion left.

So, in the June quarter, they're going to finish that off, and then start on this brand-new program that they announced that you mentioned, the $100 billion, which is another humongous number. They're not pinning that on any specific time frame, they're just saying they're going to be fast and efficient with it. But they didn't really specify exactly when they expect to do that all by.

Lewis: And it's really kind of hard to argue with the success of the buyback program for them. If you look at Apple's stock chart, this is a company that has generally been up and to the right with few exceptions over the past five years or so, so it's not as if management has been buying back shares and then seeing the price fall dramatically, and been bad capital allocators. They very opportunistically bought back shares and done quite a service to shareholders by doing it.

Niu: Right. By all traditional valuation metrics, Apple is super cheap. It's hard to compare it against other companies because they're so large. In terms of their size, they don't have a lot of peers that are bringing this much money in as profitably as they do. But they have been very focused on buybacks. Even on the call, CFO Luca Maestri admitted that, yes, Apple is very "biased" toward the buybacks because it's so cheap and because they still think it's undervalued. So, even though they're also increasing the dividend by 16% or so --which is a nice little boost for income investors -- they're still really heavily focusing on the buyback piece, which is better to drive up earnings per share over time, as you can retire a lot more shares. And they're not just buying these back to offset dilution from ongoing compensation. They've retired so many shares over the past years that investors are really getting a tangible benefit from that.

Lewis: Looking at some of the smaller parts of the business, Evan, what's going on with wearables right now?

Niu: Wearables, the way Apple defines it, includes Apple Watch, wireless Beats and AirPods. Which is kind of, in my opinion, a dubious definition, because wireless headphones, I don't know if that's what most people think about when they think about wearables. But, for what it's worth, that's how Apple defines it. They're saying it's up almost 50%. They still don't disclose a dollar figure for it.

These products are pretty much driving almost all growth in the Other Products category. They said over 90% of growth was because of these wearables, which they also mentioned is now the size of a Fortune 300 company, which is Apple's way of saying that it's close to a $10 billion business for them. That's pretty impressive, considering the fact that they only got into wearables in 2014 starting with Apple Watch.

Lewis: That's one of my favorite things to see in Apple's conference calls, is the different ways that they refer to the scale and size of these tiny business operations, for their purposes. The idea that wearables is the size of most companies, or larger than most companies. They do the same thing very often for their Services segment. It looks like growth was very strong there, too. This is one I'm particularly happy about as a shareholder because it's a high-margin business for them.

Niu: Right. Revenue in Services was really strong last quarter, up 31% to about $9.2 billion. On a trailing 12-month basis, Services is now a $33 billion business for Apple, which is huge. And it's much more profitable than the corporate average, typically. That's being driven by, now they have 270 million paid subscriptions going through all of their digital storefronts. That means they've added over 100 million in the past year alone. It just shows you how well they're executing on growing this business after they set out this goal a year or two ago that they were really going to try to double this business. These numbers really show that they're making a lot of progress. They're on-target to hit that.

Lewis: And this becomes increasingly important for the company as we get closer and closer to smartphone saturation and, perhaps, this concern about slowing upgrade cycles for these major phones as average selling prices get larger. The fact that they can build out this nice, high-margin Services segment is a nice way for them to continue to make money off of that base.

Niu: And within Services, those subscriptions, they have Apple Music, which is now at about $40 million. They also have iCloud storage, which is technically billed as a subscription. Those are Apple's two main first-party subscriptions. So, if we say iCloud storage is probably $30 million or less, that means third-party paid subscriptions are probably over $200 million. And remember, Apple does very little for those third-party subscriptions. It gets a 30-15% cut depending on how long that subscription has been in place. They're getting a pretty nice cut on that even though they're not doing a whole lot. So, that's pretty profitable revenue, getting their cut on those subscriptions.

On top of that, there are reports that Apple is planning this premium new service since they bought Texture earlier this year, which is a digital magazine service. I think that could really build on this momentum that they're seeing. Apple News is already a very strong service and has a lot of users. If they can introduce this new premium service for news, not only do they benefit, but also all of their publishing partners will benefit, too. I think that sounds pretty promising to me.

Lewis: One thing I was a little surprised to see in this earnings release was a pretty big spike in inventory. We know Tim Cook as this guy who's a supply chain master. That was kind of his MO and his reputation coming into the CEO role. And it's something that Apple has very tightly managed for a really long time. We see that it spikes to over seven billion, the highest ever. What's going on with their inventory right now?

Niu: Tim Cook has this famous line that he considers inventory to be "fundamentally evil," just because over time, if you build so much of it, it gets written down, and it's just a mess to deal with. It's very good to have lean inventory, enough to meet demand but not too much on your books, which is why this spike was so weird.

But it's really just actually component purchases. An analyst was able to get some clarity on that. I noticed it, too, initially, when I saw the balance sheet. Basically, CFO Maestri said, "We're basically making these purchasing decisions because of current market conditions." So, they're basically pre-buying all of these different components because the components, most specifically memory, the pricing is supposed to continue going up. I mean, it's been going on for two years, and it's probably going to keep going up, so they're basically just trying to buy as much as they can now to get ahead of continued price increases later this year. As we all know, they release a ton of iPhones in the fall, and they're going to need all those components to put them in the phones.

So, very specifically, the type of inventory that we're talking about is just components. It's not unsold products on shelves, which would be a pretty big concern there, if that were the case. So, it did jump out at me, too, but that's what's going on there.

Lewis: So, this is more of a planned decision than them sitting on stuff in a warehouse.

Niu: Right, exactly. [laughs] He was like, "It'll unwind itself over time," so really nothing to be concerned about, even though the numbers look a little scary.

Lewis: One other little tidbit from the call and from the release that I think is interesting, to go back to the conversation we were having about Facebook when we talked about their earnings, we both expressed some surprise at seeing a company have forex that was accretive. Usually, when you have money that you're bringing back from overseas from foreign operations and you're bringing it to the United States, because the dollar has been so strong for such a long period of time, that winds up being a ding on your top and bottom line. That was the case with what we saw here with Apple, where they wound up taking a slight hit for that.

Niu: Right. It was kind of the opposite scenario here. Facebook doesn't really have much of a hedging program in place to accommodate for these FX movements, which is why they got this benefit as the dollar continued to weaken. Apple is much larger, and obviously has a lot more money on the line, and in general, their business is much more spread across the world in terms of their supply chain. So, they have a much bigger and more active hedging program that kind of mitigates these foreign exchange movements, both up and down.

So, they tried to do their best to mitigate these hits that they've taken while the dollar was strengthening. And now that the dollar is weakening, they're missing out on the upside because these hedges are in place. So, it was kind of a funny thing, but it's because Apple does such a good job in general. If you're a company, you just don't want the risk at all. You just want to hedge it. You're not a currency trader, you don't want to ride the swings up and down. So, they just try to hedge it to mitigate all risk, up and down. So, yeah, they didn't get to enjoy some benefit like other companies.

Lewis: Coming into this quarter, I think there were a lot of concerns surrounding Apple. There were a lot of people reading the tea leaves on what they were getting from various points in the supply chain and saying, "We're not seeing the demand that we thought we'd be seeing for these really high-priced iPhones." It seems like those concerns were overstated, to say the least.

Looking at Apple over the next year, two years, three years, what are you seeing in this business? We're both shareholders. I kind of feel like I'm sitting on my shares, that they will not be this massive growth company like they have been, perhaps, over the last five years, but that there's nothing wrong with owning them, especially if you're looking for some pretty low-risk exposure to the tech space.

Niu: Right. That's exactly how I view it, too. I don't have huge expectations in terms of capital appreciation. The income is nice. I'm not really an income investor, but I'll take it, I'll reinvest the dividends. Nothing to complain about.

But I also view them as a pretty safe play because, as we mentioned before, their valuation numbers are so low, and they make so much money, that they're not going to be super volatile. I mean, I've been overweight in Apple for many years, just because I've had it for so long, but I'm just going to hang on to it. I'm not going to have huge expectations about it jumping through the roof.

But right now, it's kind of like this race to a $1 trillion market cap, because all these tech companies are having pretty strong results. The big question is, can Apple get there first? It's only 10-11% up from here, so it's not a huge gain. But, it'll be a milestone, if and when it comes.

Lewis: Listeners, if you want any more Apple coverage, Evan is one of our best. He's written the classic earnings take, but he also has some more deep dive stuff from the call and some things that maybe aren't covered quite as much. So, if you want any of that news, just write in and we'll make sure that you get it. Evan, anything in particular you want to plug on that Apple coverage?

Niu: No, I think we're good.

Lewis: [laughs] Alright, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out The Fool's family of shows over 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. Thanks to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

Dylan Lewis owns shares of Apple, Facebook, and DIS. Evan Niu, CFA owns shares of Apple, Facebook, and DIS. The Motley Fool owns shares of and recommends Apple, Facebook, and DIS. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.