Analysis: AAPL

Tuesday evening, shortly after the closing bell, Apple (AAPL) reported a top and bottom line beat with its fiscal year 2019 first quarter earnings result. On the top line, revenues of $84.31 billion (-5% YoY, -3% when accounting for foreign exchange headwinds) outpaced expectations of $83.974 billion. On the bottom line, earnings per share of $4.18 (+7.5% YoY), an all-time record, edged out consensus of $4.17 per share.

Before digging into the release, we want to remind members of a few changed made to this quarter's release. First, management has chosen to stop disclosing unit sales, something that was met with intense pushback following the prior quarters release. However, on the other hand, management has now decided to break out gross margins (GMs) for products (which include iPhone, Mac, iPad, and Wearables, home and Accessories) and Services.

As we noted in our previous earnings release analysis (here:) we believe management's decision to reconsider the metrics they disclose is a net positive that will aid in emphasizing the shift Apple is currently going through from a hardware company to a Software/Services company. With that in mind, we want to address gross margins in the quarter.

While we were not able to compile a true "consensus" for this metric as it was, until now, unclear exactly how Apple would report the new metrics, we dug through analyst earnings preview notes and came up with the following:

  • Morgan Stanley had estimated that Street models were indicating a Services GM of ~60%, with products GM at 34-35%
  • Keybanc was modeling in a Services GM of 59%, with products at 34%
  • RBC Capital Markets had Services gross margins in the "mid-50s range," with products GM in the "mid-30s"

Based off of the estimates, which we believe to be are a fair representation of most sell-side expectations (we will know more tomorrow when we receive updated analysts notes), Apple did not disappoint, reporting a Services gross margin of 62.8% and a gross margin of 34.3% on products. On the call, CFO Luca Maestri noted that "on a sequential basis, products gross margin increased 60 basis points due to positive leverage from the holiday quarter, partially offset by higher cost structures as we launched several new products and by headwinds from foreign exchange. Services gross margin also increased 170 basis points sequentially due to favorable mix and leverage, partially offset by foreign exchange." Adding however, that "while both Products and Services gross margins improved sequentially, total company gross margin was down 30 basis points due to a different mix between Products and Services." Maestri also noted, during the Q&A portion of the call Services gross margins advanced 450 bps from the year ago period.

One last point we believe important to call out, especially as reports continue to build that Apple is looking into new paid Services streams, such as video and perhaps even gaming, on the call Maestri also noted that in prior quarters, the company would estimate and defer the value of "free services" (think apps that come pre-installed on devices such as Maps, Siri or free iCloud storage), and then amortize the estimated value and costs of these services, over time. Now in the past, this was a part of the products segment (makes sense since these Services were tied to hardware sales), however, now these free services are associated with the Services segment causing them to be "clearly significantly dilutive to the overall Services margin" according to Maestri. Why does this matter? Because it means that as more paid Services are brought into the mix and these free services become a smaller piece of the pie, the negative implications of rehousing free services under the Services segment should lessen and margins should see further upside.

We believe the results on Services margins serve to support our thesis that as Services grows, so too will profitability, perhaps even faster than those who on the sell-side who agree with this view thought, given that the highest estimate we were able to locate was in the area of 60%. This is important because not only does it back the most important aspect of our longer-term investment thesis but also because it indicates that analysts will likely need to revised their models and factor in higher margins for the Services segment. Simply put, higher than expected margins on the fastest growing segment of the company points to an upside bias in out year earnings.

Now, while we believe the gross margin profile is crucial to our longer-term thesis, we told members in our earnings preview alert (here:)  that the main concern near-term was March quarter guidance, noting that "a decline in unit sales and deceleration of Services growth are the main concerns atop investors' minds." On this front, we also want to remind members of our commentary in this morning's alert (here:) , where we called out that earnings releases this season have been met with a favorable reaction despite in some cases disappointing results or guidance (as was the case with 3M this morning), simply because investors came into the season so incredibly negative. As a result, we believe FY2Q19 revenue guidance of $55-$59 billion, which missed expectations of $58.98 billion at the midpoint, was "good enough" so to speak as it at least bracketed expectations, especially when taking into account the better than expected gross margin profile discussed above. Gross margins in the upcoming quarter we in line at 37% to 38%. Additionally, management guided for operating expenses of $8.5 to $8.6 billion, slightly above expectations, however, likely forgiven as it is well known by now that the company is investing in original content. Lastly, management expects other income of $300 million and a 17% tax rate.

Moving onto sub-segment results, iPhone sales came up a bit light at $51.98 billion (-15% YoY) versus expectations of $52.81 billion, with Maestri noting "the latest survey of U.S. consumers from 451 Research indicates customer satisfaction of 99% for iPhone XR, Xs and Xs Max combined," adding "the XR is our most popular model and it's followed by Xs Max and then the Xs." Helping to explain some of this miss, CEO Tim Cook reiterated his commentary following the company's recent pre-announcement that a combination of lower carrier subsidies and a less expensive iPhone batter replacement program led to lower than expected upgrades in the quarter.

iPad sales of $6.729 billion (+17% YoY) outpaced expectations of $6.057 with strong performance being seen for both the iPad and iPad Pro and double-digit growth being seen in 4 of 5 geographic segments. Additionally, it is worth noting that of those customers purchasing an iPad in the quarter, half were new iPad users.

Mac sales of $7.416 billion (+9% YoY), an all-time record, exceeded expectations of $7.327 billion with Maestri calling out "double-digit growth in many large markets such as the U.S., Western Europe, Central and Eastern Europe, Japan, Korea and South Asia." Similar to the iPad dynamic, half of all customers purchasing Macs in the quarter were new Mac users.

Other product revenues (which includes Wearables, Home and Accessories) also outpaced expectations, coming in at $7.308 billion (+33% YoY) versus $7.008 billion consensus, and saw record sales in all geographic segments. As a reminder, performance in this area was held back due to supply constraints for the Apple Watch and AirPods, making the beat versus estimates all the more impressive.

On the call, despite the various headwinds facing the company such as foreign exchange, China trade and supply constraints, Cook called out that the "total active installed base of devices has grown from 1.3 billion at the end of January of 2018 to 1.4 billion by the end of December, reaching a new all-time high for each of the main product categories and for all 5 of our geographic segments." Additionally, the actual global iPhone-specific installed base was disclosed for the first time this quarter and has officially "surpassed 900 million devices, up year-over-year in each of our 5 geographic segments and growing almost 75 million in the last 12 months alone." Again, we reiterate that the actual installed base which will be disclosed on a periodic basis going forward, is much more important than the number of units sold in a 90-day period because these devices (along with the iPad, Mac and Watch) are the outlet through with Services (again, much higher margins) are sold.

Looking to Services, sales of $10.875 billion (+19% YoY) edged out expectations of $10.823 billion, reaching an all-time high (even in Greater China, a region CEO Tim Cook called out as being responsible for "over 100% of our worldwide year-over-year revenue decline"). On the call, Cook noted "we not only generated our highest global Services revenue ever, but we also had all-time records across multiple categories of Services, including the App Store, Apple Pay, cloud services and our App Store search ad business, and we had a December quarter record for AppleCare. And I'm very proud to say that nearly 16 years after launching the iTunes Store, we generated our highest quarterly music revenue ever, thanks to the great popularity of Apple Music, now with over 50 million paid subscribers. The App Store wrapped up its best year ever with record holiday period results propelled by the biggest Christmas Day and Christmas week ever. Customers also spent over $322 million on New Year's Day alone, setting a new single-day record for both the number of customers and purchase volume. It was also a great holiday season for Apple Pay, with over 1.8 billion transactions in the quarter, well over twice the volume of the year-ago quarter. Merchant adoption continues to reach new milestones. Customers can now use Apple Pay with iPhone and Apple Watch at nearly 3,000 Speedway locations while all Target, Taco Bell and Jack-in-the-Box stores will be accepting Apple Pay soon. We launched Apple Pay in 3 new countries in the December quarter: Germany, Belgium and Kazakhstan and is now live in 27 markets around the world. The rollout in Germany has been a huge success, with Deutsche Bank reporting more activations for Apple Pay in 1 week then for Android in an entire year." Oh and did we mention that Cloud revenue increased over 40% from the same time last year? Bottom line, the segment is on fire.

All in, we believe that while we are not in the clear just yet, as we have yet to see a resolution on the China trade front, and a strong dollar compounded by a global growth slowdown does represent a near-term risk for all companies operating internationally, we believe this quarter's results and March quarter guidance, compounded by better than expected Services growth will effectively allow the company to reset the narrative and investors to reset their expectations. We reiterate our view that the growing installed base across all main product categories is supportive of our Services-oriented, long-term investment thesis and continue to believe that the addition of new services will result in a higher mix of recurring, higher margins revenues that will prove accretive to overall profitability.

One last point we will make, because we know the bears will jump on it tomorrow, is that while the upgrade cycle is indeed elongating (an issue brought up by analysts on the call) - with Cook explicitly stating "we do design our products to last as long as possible," we believe that it is focus on the user experience (not upgrade frequency) and an intense focus on making the best product available is something that is, and will continue to be rewarded with extreme customer loyalty, a factor that will ultimately pull users deeper into the Apple ecosystem and therefore feed Services revenues for years to come. Our rating and price target is currently under review.