Understanding Apple's Anemic Quarter

| About: Apple Inc. (AAPL)

Apple Inc. (NASDAQ:AAPL) has grown over the last decade or so from a personal computer maker to a producer of music players, phones, tablets, set-top boxes for home-entertainment, and traditional personal computers. In connection with that transition, Apple implemented a new pricing policy that shifted the company from a premium-priced computer vendor to a mass-market manufacturer committed to competing with products at price points designed to deny price shields to competitors. Apple moved from a niche personal computer vendor to a mainstream electronics company whose market value exceeded that of any other firm on the planet.

The Run-Up and the Fall

Apple Inc. saw its share price drop from $700 to $500 over the months leading up to the most recent quarterly announcement. When Apple's "Mother of All Reports" announced an "extraordinary" 13-week holiday quarter producing $54.5 billion in revenue - and $13.1 billion of profit, or $13.87 per share - onlookers pronounced the performance a "Disappoint[ment]". Shares fell further, losing $47 billion in market cap during the announcement and more in the following days:

From its September peak, Apple shares have suffered devaluation by over a third. And no surprise: quite aside from the quarter's results, the news has not been kind. The iPhone launch was overshadowed with awful reports of parts shortages, riots, strikes, and so forth. The reports that foresaw Apple entering the low-end phone market coincided with news of huge OEM orders cuts, suggesting Apple intended building a lot fewer phones in the future.

And now the December quarter's news is in, and the market's fears appear founded: far from rebounding, the price assigned to the shares further slumped.

The Results (Pessimistically; Play to the Accompaniment of the Funeral March)

PCs. Apple sold 4.1 million Macintosh computers in the quarter, a million less than the year-ago quarter and far fewer than the flat projections Computerworld characterized as sluggish. Onlookers weren't shy about proclaiming the business segment had passed its peak. The ugly growth graphs in the last link look like Apple's business selling PCs has fallen off a cliff - much worse than its competitors. And that's saying something: Dell (NASDAQ:DELL) has done so badly as a commodity vendor for so long, and failed to make good on ambitions to transform into an IT solutions company, that Dell is now reportedly looking to avoid quarter-by-quarter public oversight of its operations by undertaking a transaction to take Dell private. Hewlett-Packard (NYSE:HPQ), which sells even more machines than Dell, isn't exactly faring well in its business, either: HP lost money in fiscal 2012 and predicted 2013 results below analyst expectations. For Apple to be so clobbered in a market that bad is just sad. Right?

Tablets. Under attack from its numerous competitors - old and new both, for Microsoft (NASDAQ:MSFT) and its Windows RT licensees first sold competing products in the December quarter - Apple suffered a drop in average-sales-price in its tablet business. Apple was proclaimed doomed to suffer declining margins in cut-throat commodity competition and die an awful death. A headline at Forbes connected the dots for those unwilling to read the details: "Apple's Margin Troubles Continue As Revenues Per iPad Tank". At 38.6%, Apple's company-wide margins were down from 44.7% in the year-ago quarter. Wham!

Music Players. Apple makes so little these days on its music players, why report it - right? But still, if there's a broad pattern, its full breadth should be explored. The recent quarter's 12.7 million iPods represent a drop of nearly 18% from last year's 15.4 million units. Engadget summed up Apple's doom meme in a line, dismissing the Mac and iPod businesses as "products [that] continued their slow descent towards ... obsolescence."

AppleTV. Apple's self-described "hobby" had trivial impact on Apple's results, as it sold but two million units over the quarter. A product with a retail price a less than a tenth of Apple's PCs and less than half their sales volume isn't a business stout enough to thwart impending doom.

The Results (More Optimistically)

PCs. Forget for a moment that this year's December quarter was a whole week shorter, and look at how many weeks of the quarter Apple was able to ship its just-announced iMac. The whole quarter would have been flat - even with the shorter week - but for the missing iMac units. Announced in October but not shipping until December, the new iMac was subject to articles dated only last month proclaiming that New iMacs Are Finally Shipping. This blip is a real result, but it doesn't mean anything about Apple's ability to sell iMacs. It is only evidence Apple's new technique to adhere LCDs to glass needed time to work out until the company's assembler partners could meet orders. Now, Apple's sales are so strong that it's facing slower shipment of 21" iMacs. The 27" iMac? Not 'till February. It'll be the June-ended quarter until we see how Apple sells its new design in a full quarter of regular availability. Apple's willingness to stick its neck out to advance design says something about its position in a world full of undifferentiated commodity boxes. Part of what it says is that Apple is targeting a discriminating customer willing to pay for something built by people who Think Different. On the tail end of what looks like an apology for a production delay, let's not forget that Apple makes more money in notebook computers than anyone on the planet.

Apple's success in expanding the consumer computing market with tablets and technologies that don't depend on software from Redmond has taken a particular toll on the competitive position of its once-nemesis Microsoft. Despite once enjoying a virtual lock on consumer computing with 95% of the market, Microsoft has been battered to 20%. Following the earnings results, some news has given some interesting color to this competition. Far from being battered by competition with Android, Apple overtook Samsung (OTC:SSNLF) as the top mobile vendor in the U.S. Not just the top smartphone vendor, mind: the top manufacturer of all mobile phones of any description. Considering the margins on Apple's smartphones, that's pretty slick stuff. So much for Samsung eating Apple's smartphone lunch. Okay, so the graphs in that article are global rather than U.S. - but Apple enjoys triple-digit growth in China, a market soon to overtake the U.S. in profitability to Apple. The smartphone war is looking pretty good, just now. And Apple is aiming to improve iPhone competitiveness internationally.

iPhones. IDC didn't expect Apple would enjoy 78% sequential growth in smartphone sales. And looking at the year-ago quarter, one can divide sales into weekly figures to get a better picture of the growth rate despite the difference in quarter-length. Last year's 37 million phones sold in the December quarter meant about 2.6 million phones per week (over 14 weeks). This year's December quarter's sales of 47.8 million phones in 13 weeks means Apple sold nearly 3.7 million iPhone units per week. That means that in its biggest business segment, Apple enjoyed 39% growth in unit sales year-over-year. Readers might want to compare that growth to the adverse depictions described elsewhere. For example, iPhone sales have been described as suffering a "stall" and "sales plateau". That, on sales rate growth of 39%. How do they print this stuff? For a product of such outstanding volume, Apple's iPhone shows shocking growth. And the growth is most concentrated where it's most effective: in Apple's biggest-growing market, where its opportunity is least bounded by a share ceiling.

Tablets. Apple's tablet business - not as old as Apple's iPhone business, and presumably in a better area of its growth curve - sold 22.9 million units, up over 48% from the 15.4 million unit performance in the year-ago quarter (which was a week longer). On a weekly basis, the sales rate grew from 1.1 million per week to 1.7 million per week. The lower average sales price about which Forbes slammed Apple? Apple just released a new model - the iPad Mini - whose whole purpose was to lower the price umbrella afforded to competitors by increasing the breadth of prices attacked by Apple in the tablet market. But, you ask - what about those dying margins? Apple is sunk, right? Actually, no. Forbes got this exactly backward. Although the iPad offers Apple half the iPhone's margins, the iPad Mini has much more outstanding margins between 40% and 55%, depending on the model. Adding the lower-priced product may have lowered ASP, but it drove margins up. Remember, Apple's margins in the quarter were under 40%; unless teardown analysis is to be disbelieved, the iPad Mini and its >45% margins are good news for Apple's margins. Apple's new 128GB iPad - clearly designed to thrash Microsoft's 128GB Surface tablet when head-to-head comparisons include a spec list - takes the top-end spot on Apple's iPad lineup, broadening the whole lineup and widening Apple's margins.

iPhones. Apple's iPhone business, where most of the company's revenues are now, grew to 47.8 million units. That's up nearly 30% from the 37 million Apple sold in the year-ago quarter. (Despite the shorter quarter.) Granted, that's not 30% across all markets. But it turns out that's a good thing: instead of depending on relatively mature markets like Europe - where growth is low, and prospects fairly capped - Apple is making huge strides in its best-growing market. China.

Retail. Apple took in over $6.4 billion in its own retail stores. Who else does that? With Apple spending money to build more of its highly-regarded storefronts around the globe - and particularly in China - look for this number to increase.

iTunes. Apple took in $2.1 billion in revenue from its iTunes store. But really, the online store has grown since it was launched as a way to ensure iPod purchasers could get music unencumbered by Apple-hostile DRM. Apple now sells movies, music, and software applications to 435 million account holders globally, raking in some $8.5 billion in the fiscal year ended in September. Apple reaches 119 countries with music and video sales, and over a hundred and fifty countries with software applications. Bloomberg noted in December that Apple's content business can be compared to the revenues of the likes of The New York Times, Simon & Schuster (which sells Isaacson's Steve Jobs biography), Warner Bros. (curating the Batman film franchise), and the largest magazine publisher in the world, Time Inc. The interesting thing about Bloomberg's comparison is that Apple doesn't just compare to each of them, it compares to all of them in the aggregate - and still comes out ahead by some $300 million in revenues over the same period.

Cash. Much has been made of Apple's cash accumulation. Cash and marketable short-term and long-term securities grew over $15 billion sequentially. Year-over-year, Apple's cash from operating activities increased to $23.4 billion - up a third from the nearly $17.6 billion generated in the (week longer) year-ago quarter. Most of the new cash was invested in marketable securities, though Apple made business acquisitions and purchased a few billion in property, plant, and equipment. Growing cash-generation by a third isn't the result of a slouch or a has-been. Growing cash-generation by a third in only a year is outstanding.

Some Thoughts

Apple's massive online business creates interesting opportunities to do disruptive things with its cash, like offer transaction-processing services to vendors who have an Apple product on the scene of a sale. Apple's Passport program, already supported in such high-traffic environments as airlines, allows electronic sales and electronic ticket-delivery. Once in the airport, you can tank up at Starbucks using passport for payment. Currently, transactions are processed using traditional credit card transaction processors on the back-end. But with Apple's tens of billions in sales, the company must be eyeing ways to improve margins on all the 99¢ transactions historically consumed in transaction fees. What would an international transaction processor be worth if it could reach into countries currently underserved by traditional credit and banking relationships? A country like China?

Apple's enormous iOS installed base - the company sold 75 million new iOS devices last quarter - gives it a special place in the game industry. Like Apple's controversial cash hoard, Apple's position in gaming has caused much ink to flow. Especially in light of Apple's founder's proclamation that he'd cracked the television problem, one expects Apple to make a more substantial effort to connect its iOS game dominion to customers' home entertainment systems. The question isn't if, but when.

And assuming Apple does nothing as described above, Apple has triple-digit growth in China and global cash generation growth exceeding 30%. Is this the profile of a company whose P/E ratio does this?

Shortly after the post-earnings plunge, observers noted that Apple's $137.1 Billion in cash and marketable securities amounted to a third of Apple's market capitalization. Backing out Apple's cash and marketable securities from the company's current market cap yields about $310 per share in market value not attributable to fungible assets unnecessary to the company's core operations. Accepting $45 as the company's per-share earnings over 2012 suggests Apple is being assigned a trailing P/E less than 7. A look at some of Apple's competitors who have profits - and thus a meaningful P/E - suggests Apple is being given especially awful treatment for a company with its sales growth:

Of course, Dell's results may be impacted by the fact it's now the object of a leveraged buyout. Hewlett-Packard can't be listed because, having losses rather than earnings, it has no meaningful P/E ratio at present. Offering Amazon (NASDAQ:AMZN) for comparison was tempting because both companies operate massive online stores - Amazon exceeds Apple's direct sales with $21B in revenue in its last quarter, but it managed under $0.1 billion in earnings on that revenue. Apple, whose stores appear to drive earnings where they open, apparently makes more on its stores than Amazon does on its. As a consequence, Amazon's P/E ratio is so astronomical that its inclusion required increasing the scale of the graph to such a point as to render every other company's graph indecipherable. Amazon was excluded not because it's not a competitor - in some markets, like e-books and downloaded films, Amazon is Apple's direct competitor - but because its outsized ratio made a mockery of the graph.

Particularly when one considers the disproportionate contribution of Apple's marketable assets to its share value and considers the P/E resulting from the valuation of the business sans cash, Apple appears especially hated by the market. Or, maybe ... maybe Apple's just misunderstood.

Conclusion

In his 1987 Letter to Shareholders of Berkshire Hathaway (NYSE:BRK.A), Warren Buffett famously quoted Benjamin Graham:

In the short run, the market is a voting machine but in the long run it is a weighing machine.

Since the iPhone 5 launch, Apple has been buffeted by bad news reports - in most cases not real bad news, just awful headlines sufficient to give the impression the news must be bad. Some stories - like the Samsung parts hike of 20% - were denied quickly and unequivocally by unquestioned authorities (in that case, Samsung executives). But the injury is done: people's hearts are influenced by things that make them nervous. So when Forbes seeks to link the new iPad Mini to a company-wide margins contraction - notwithstanding that iPad Mini reportedly increases Apple's margins - people react. And not with their intellect, but with their guts. For a view of just how shallow analysis of Apple's quarter can get, take a look at The Atlantic Wire article "Apple's Terrible, Horrible, No Good, Historically Bad Day". People see this and they vote. Many don't stop to weigh much, they just vote.

Apple has experienced a popularity shift. Apple's share prices haven't reflected an adverse change in its business performance, but an adverse mental map among market participants. Apple's business just turned in a record quarter in both revenue and profit, despite serious problems delivering products as fast as people ordered them. Executing during a technology transition is a trick, and Apple tried to do at least three: iPhone 5, iMac, and updated Retina-Display Macbooks. Availability issues in one product line might have gone unnoticed in the sea of incoming cash, but stacking them - which ultimately is unavoidable if Apple is to continue rushing technology to consumers - impacted availability enough to prevent per-share profit growth after the dilution caused by stock compensation. Apple's announced buyback hasn't been retiring shares as quickly as Apple has been printing them, a circumstance shareholders should hope will be remedied during the depressed prices currently impacting the shares.

Apple will continue experiencing subpar P/E - despite its outstanding growth in its major business segments - until Apple is seen in a different light. That may take a few quarters of consistent results. It could be triggered by optimism driven by another product's reported performance. But it won't occur within the next few weeks.

Disdain for Apple and its prospects is a common meme in headlines, and people believe headlines. The crash in sentiment on Apple wasn't driven by facts reported about Apple's actual results, but it reflects a real decline in market participants' willingness to risk capital on Apple. If they're wrong - guided by erroneous headlines or illogic, for example - then their error represents an opportunity as the market transitions over time from voting machine to weighing machine.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.