Monster iPhone sales drive Q2 results for Apple

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."


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.