Monster iPhone sales drive Q2 results for Apple

Apple Q2 2014: Wow, were we wrong!

Last night I was all set to review another boring Apple quarter. Many stock followers thought the numbers would arrive in line with guidance (and Street expectations), and that there wouldn't be too much exciting stuff happen on the call.

Wow. Were we wrong.

This morning AAPL stock is up about $40 per share, or almost 8% and people are suddenly optimistic again, acting as if they've just realized Apple isn't dead in the water.

So what happened? Apple had monster iPhone numbers and strong gross margin leading to a big earnings beat. That's the good news in a nutshell. But let's go over a few numbers:

Revenue was $45.6 billion, much stronger than the Street's expectations for $43.6 billion. Keep in mind this revenue number represented year over year growth of only 4% (more on this later). Earnings per share was $11.62, up a much stronger 15% year over year. The earnings strength was driven by a better than expected gross margin of 39.3% compared to 37.7% estimates by analysts.

iPhone sales were the star of the quarter. Apple sold 43.7 million of them, up 17% year over year. This was a huge beat compared to the 37.7 million units analysts expected them to sell. But iPad sales were disappointing at 16.35 million, down 16% year over year but not down nearly as much once you listen to Tim Cook's explanation.

Before we get into a discussion on the quarter, let's just stop and consider that Apple set another record for a non-holiday quarter. Apple is growing earnings faster than revenue, and the investment community loves the results. So I thought I'd introduce this great summary of analyst commentary from Fortune. My favourite comment (sarcasm) comes from JP Morgan who wrote that the quarter was "A Beat and Not as Weak as Expected". Really? That's a lot like watching Avatar set box office records and claiming the movie was "Didn't perform that badly."

Hilarious.

Let's talk about the iPhone. A big part of the Apple story is its rapid growth in many emerging markets. During the Q2 conference call Tim Cook shared a few useful metrics to put this growth in perspective. For the first half of fiscal 2014 versus the year-ago period, Apple posted growth of 61% in Brazil, 97% in Russia, 56% in Turkey, 55% in India, and a whopping 262% in Vietnam.

These numbers demonstrate the success Apple is having by offering its iPhone 4s for sale in these markets. Even though the iPhone 4s is something most of us in first world countries would consider an "old" phone, it's still highly capable and beautifully crafted, and gives these customers access to the wonderful Apple ecosystem.

Tim Cook also said that 85% of people buying an iPhone 4S were first time iPhone customers, and the majority of these people, 62% of buyers, were also switching away from Android. Assuming these statistics are valid, I think they are meaningful. And there's something about Wall Street analysts that matters here. They're very focused on what is happening at home in the US market. It's natural. It's easy. So they don't spend that much time thinking about the rest of that big world out there. Yet Apple is clearly doing very well.

Now let's touch on the iPad, which was a disappointment to Wall Street. As I said earlier, unit sales were actually down 16% year over year. On the surface you'd think there must be some kind of problem, right?

Let's dig a bit deeper before we decide. Apple recognizes revenue on sell-in to the channel, but the metric that really matters is sell-through to end customers. Last year Apple sold a lot more into the channel versus out of the channel because of inventory build. If we just look at sell through, the company says it sold 17.5 million units to end customers in Q2 of this year. Last year's comparable number was 18 million. So the iPad business still declined, but the more meaningful sell-through number points to less than a 3% decline.

So why is the iPad business shrinking even if it's only a slight number? Part of the explanation revolves around the iPad mini, which was in backlog status at the end of last year, so Apple was filling orders in the March quarter. This year that did not happen, so it hurts the year over year comparison.

Beyond that, Tim Cook explained to investors that the iPad has been Apple's fastest selling product of all time, with Apple selling twice as many iPads versus iPhones in the first 4 years after launch, and 7 times as many iPods in the comparable post-launch period. Apple still believes (and I agree) that the tablet market will go on to exceed the size of the PC market. There is still a lot of growth to come. Apple says customer intention data points to 2 out of 3 future tablet buyers planning to buy an iPad. So while I'd like to see immediate year over year growth also, I'll be patient. I think the iPad is doing just fine.

Getting away from numbers, Apple did say it feels very good about future products. They sounded even more confident about it, in my opinion. They didn't talk specifics, but then again they never do. However to give you a sense of the size of the Apple platform, consider that the company has 800 million iTunes account holders. Most of those accounts have credit cards attached to them.

That's huge. Apple is huge. I can't wait for what comes next. And while we wait, shareholders are being rewarded with an increased dividend ($3.29 per quarter), and Apple feels so strongly about its shares being undervalued that it now plans to buy back more stock. Finally, to put the stock price in a range that is more affordable to smaller investors, they are splitting the stock 7:1. As a reminder, a stock split does not in any way affect value. One old share is carved up into 7 new shares, and it's exactly the same as taking a large piece of pizza and cutting it up in to many smaller slices.

Most investors who care about the long term performance of a stock should pay no attention to this.

Chris Umiastowski

Chris was a sell side financial analyst covering the tech sector for over 10 years. He left the industry to enjoy a change in lifestyle as an entrepreneur, consultant, and technology writer.

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Apple Q2 2014: Wow, were we wrong!

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Nice to see a rational look at the results as opposed to lots of the flying ordure promulgated by people who seem to prefer another platform to Apple. :)

Wholeheartedly agree. Was an avid Android user up until Feb 2013 then bought an iPhone5 and now 5S for work purposes and haven't looked back. And was just reading an article about the inflating of the Google+ userbase...pretty much over the robot war on Apple...pretty pathetic!!

I was reading something earlier this morning regarding Google's Vic Gundotra's resignation and how behind they still are the 8 ball.

On ABC News last night with Dianne Sawyer it was announced that what this All meant was across the board Apple was up 16% for that quarter - One of the highest it has been in years.

Great piece, I always enjoy logic and reason.

Also, "Tim Cook also said that 85% of people buying an iPhone 4S were first time iPhone customers, and the majority of these people, 62% of buyers, were also switching away from Android."

Yup, I have witnessed this on the same scale Mr. Cook mentions. People who bought low end Android devices feel burned by the poor experience and are getting the iPhone 4S as their second smart phone.

Wow, this is funny, you are saying that the old iPhone 4s is getting better traction than the new top of the line Android devices??, that's too funny, just wait till iPhone 6 is here Android must be crapping their pants.

Sent from the iMore App

It makes sense. Their low end Android was free or $.99. It was a brick that they could basically play candy crush on and watch the screen catch up to their typing 20 seconds later. So the contract is up and they have the option of the $.99 iPhone 4S. It's a pretty sweet phone for someone who isn't a heavy app user but wants to get a few things done and play candy crush without the crushing experience of lag and phone crashes. If I were a user of a crap ass Android I'd do the same thing. I actually have done that, but after having to use Android because my carrier at the time didn't have the iPhone. It doesn't seem like the worst way to get into a smart phone.

Your description of Android sounds exactly like my old Samsung phone, ha ha. I got the iPhone 5 in April 2013 after my carrier got the iPhone and never looked back.

I'm thrilled with the coming stock split in early June. I, like many, have wished they had invested in Apple at the time of the iPod unveiling. Of course, hindsight is 20:20. Today, with stock prices at over $500 and likely creeping up to $600 by the time June rolls around makes it unlikely to be able to by much stock. If you wanted to invest $3000 between now and June you'd likely be buying only 5 stock options. With the 1/7 split, that pre-split price of $600/share makes it $86/share. That means when you buy $3000 in stock you're getting 35 shares instead of 5.

And that makes it very exciting for the average/small/personal investor who missed the opportunity 12 years ago, and who are bullish on Apple. If you bought $3000 worth of stock in 2001 when the iPod first hit the market, the stock price was $15/share. That's 200 shares. With the 2:1 stock split in Feb of 2007, today you now have 400 shares at the current price of $566. Or $226,400.

See my next post. While I am happy to see people thinking about investing money for their future, there is absolutely NO difference in owning 5 shares pre-split or 35 shares post split. None. If you buy the 5 shares today they will become 35 shares. Or you wait and just buy 35 shares. Nothing changes at all.

Would you rather have 10 dimes or 1 dollar?

If the stock rises 200 % you have no more money either way!

The one way a split can help is with emotion, what I call "perceived upside". Humans believe that an $80 stock has a greater probability to double than a $560 stock. If enough humans believe in the potential for gains, they are more likely to be realized. One could say that a stocks P/E ratio measures sentiment, and it's been very clear that AAPL has been suffering in this area. While mathematically meaningless, I've long been a proponent of a stock split for Apple.

Correction. The stock split was in 2005, and the stock price after the iPod release was closer to $20/share. But even still, that's 300 shares worth $169,800 at today's stock price.

Next you'll start telling traders to stop referring to bid and offer prices. Then tell coders to stop referring to APIs for their apps. You're hilarious.

Good summary Chris!
I will partially argue with one point, "They're very focused on what is happening at home in the US market. It's natural". It surely is natural, but it's also not consistent. At other times Wall Street is clearly looking beyond the U.S. when they start quoting stats on iOS vs. Android marketshare. The no margin devices in the emerging markets heavily sway marketshare but have nothing to do with earnings. Yet, we see these numbers again and again. What I think we really have is confirmation bias -- they recognize and echo numbers that confirm their own thesis as opposed to objectively assessing them on their own merits.

I will add, that it was great to hear Tim jump in front of the iPad numbers and talk so much about the future. This is the first time I've heard him basically commit to yearly dividend increases. Previously capital allocation strategies would merely be reviewed yearly but this time we got a stronger view of the future.

Regarding iPad, Tim had provided a warning in the previous earnings call about the inventory delta, yet I was still surprised by the number. I had modelled iPad at over 19 million and was surprised by the difference because I thought I had accounted for the drawdown and seasonal change sufficiently. It will be very interesting to watch iPad next quarter and iPhone as a major new product release looms.