Apple's Relief Rally

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

After Apple's second quarter earnings repor, Apple (NASDAQ: AAPL) shares staged a relief rally...as in relieved that things weren't worse.  Although the news was mixed, I found encouraging signs in Apple's bolstered R&D spending, as well as its continuing strong iPhone sales.

Expectations of a humbled Apple

It's indicative of how much market sentiment had turned against Apple that its arch rivals in mobile, Google (NASDAQ: GOOG) and Microsoft (NASDAQ: MSFT), saw moderate sell-offs after arguably stronger earnings reports.  The expectations were high at the beginning of the year that Apple would collapse before the superior might of Microsoft and its Windows 8 Phones and Tablets. 

I've been hearing numerous variations of this theme from Microsoft supporters and fans, and for some reason it was always Apple that would suffer, even though Google's Android users made a better target audience for Windows Phone. Most Android users disdain Apple's "toys" and pride themselves on being able to customize and control the Android OS in ways that iOS simply doesn't allow. 

The threat from Microsoft has so far not really materialized, as was apparent in Microsoft's earnings report.  The $900 billion write-down for Surface RT and the comparatively small sales (7.4 million) of Windows 8 Phones by Microsoft's principal Windows Phone partner, Nokia, demonstrated that Microsoft still had a lot to learn about being a mobile device maker.

While Microsoft's mobile efforts have faltered, Google has an entirely different kind of problem: how to make more money from all the Android phones and devices that have been made.  Google CEO Larry Page was happy to share with the world at the Google earnings call last week that Google had "activated" over 900 million Android devices as of Q2.  Of course, Google never talks about how many active accounts Google Play has or how many of the "activated" devices are actually still in use. 

Google had offered as of 2012 Q3 an annual "run rate" of $8 billion in revenue for mobile search, advertising and Play revenue.  Undoubtedly it's higher now, but it's unlikely to approach Apple's revenue from direct iPhone and iPad sales for the past 4 quarters: $122.2 billion. 

This doesn't include revenue from mobile devices for iTunes and the iOS App store, which I'm leaving out because Apple doesn't break out mobile revenue separately in its iTunes, Software and Services category.  This category has only existed for the past three quarters, but has made a total of $11.8 billion in revenue so far.

I'm not making these comparisons to argue that Apple has nothing to worry about from its rivals, but to point out that much of the disdain heaped on Apple has been overwrought.  As the following table shows, Google and Microsoft posted relatively strong quarters (compared to Apple) in terms of revenue growth.

<table> <tbody> <tr> <td> <p>2013 Q2 Metrics</p> </td> <td> <p>Apple</p> </td> <td> <p>Google</p> </td> <td> <p>Microsoft</p> </td> </tr> <tr> <td> <p>Total Revenue ($billions)</p> </td> <td> <p>35.32</p> </td> <td> <p>14.11</p> </td> <td> <p>19.9</p> </td> </tr> <tr> <td> <p>Revenue Y/Y % Change</p> </td> <td> <p>0.86</p> </td> <td> <p>19</p> </td> <td> <p>10.2</p> </td> </tr> <tr> <td> <p>Operating Income ($billions)</p> </td> <td> <p>9.2</p> </td> <td> <p>3.12</p> </td> <td> <p>6.07</p> </td> </tr> <tr> <td> <p>Op. Income Y/Y % Change</p> </td> <td> <p>-20.5</p> </td> <td> <p>-3.5</p> </td> <td> <p>-4.99 (exclusive of 2012 Q2</p> <p>goodwill impairment charge)</p> </td> </tr> </tbody> </table>

Apple does have to worry about competition from Microsoft and Google.  To assume otherwise would indeed be hubris, something Apple management has been unfairly accused of.

Positives, negatives, and a few surprises

The most positive news in the report was the sale of 31 million iPhones in the quarter.  According the Philip Elmer-Dewitt, the institutional consensus was for 26.57 million and the independent consensus was for 27.89.  I had gone out on a limb and predicted 30 million. 

Total revenue of $35.32 billion also came in ahead of the institutional consensus of $34.94.  I had predicted $35.2 billion. 

I was also delighted to see Research and Development (R&D) spending finally exceed 3% of revenue at 3.33% for an all-time high of $1.18 billion.  I had predicted 3.41%, but I'm not too disappointed.  The trajectory looks good for an additional increase in percent of revenue in Q3, based on Apple's guidance of $3.9-3.95 billion in operating costs.

Some of Apple's results I have mixed feelings about.  Gross margin and operating margin were both higher than I expected or wanted at 36.9% and 26% respectively.  I had expected 36% gross margin, the low end of Apple's guidance, and 24.8% operating margin (operating profit/revenue). 

I realize that lower margins would have hurt Apple's stock price in the short term.  Here my argument on behalf of lower margins is that Apple needs market share more than it needs profit.  The cash return program and Apple's new indebtedness have barely put a dent in the cash pile, which remains at about $130 billion. 

The most worrisome and surprising news in the report was the drop in iPad unit sales by 25% sequentially and 14% year over year.  I definitely didn't see that one coming and had expected 18 million unit sales.  At least I wasn't alone, as the institutional consensus was for 17.6 million units.  

The year over year percent drop is mostly attributable to the fact that the 3rd gen iPad introduced in 2012 boosted sales in Q2.  Also I think there was a disappointment factor this year that there wasn't a new iPad at what had become the accustomed time.  When a 5th gen iPad didn't appear, many customers simply decided to wait.

Other not so good trends included the sequential drop of 43% in sales revenue in Greater China (China, Hong Kong and Taiwan).  Tim Cook indicated that most of this was in Hong Kong, whereas there had been a sequential increase in China.  This points to a crying need for a low cost iPhone in order to bring the goodness of iOS to emerging markets, but it's not clear at all if this will happen.

Clearly the worst development by far was the lack of year over year revenue growth.  I can accept lower profit if Apple is growing its markets.  It's lack of growth that most concerns me.  Lack of revenue growth can be attributed to a number of things: lack of new products, lack of variety of new model iPhones, lack of lower cost iPhones and iPads. But if Apple doesn't have the new products yet, then it should be cutting prices to spur demand.  It can afford to.

Apple has indeed promised new products for the Fall, and there is even some indication that some may emerge in the third quarter.  As the Fall approaches, I'll be sifting through the rumors to see which pass the giggle test and offer my projections for Apple's new products.

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Mark Hibben owns shares of Apple. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple, Google, and Microsoft. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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