Apple Inc.'s Transition Quarter: Soaring R&D, And Preparations For A Crucial Holiday Season

| About: Apple Inc. (AAPL)

Apple's (NASDAQ:AAPL) Q3 2013 results were released after the close of trading, and on the surface, the results provided little in the way of surprises. Revenues of $35.323 billion and EPS of $7.47 beat consensus estimates by $300 million, and 15 cents, respectively. Q4 2013 revenue guidance came in at $34-$37 billion, below a $37.1 billion consensus. However, under the surface, Apple's results provide several key insights into both the company's near-term potential, as well as its long-term corporate philosophy, both of which will manifest themselves in a crucial holiday season, one that we believe will demonstrate that innovation is alive and well at Apple. In this article, we will utilize financial statistics and managerial commentary from several sources, which we note below.

  1. Apple's Q3 2013 earnings release
  2. Apple's Q3 2013 supplemental data set
  3. Apple's Q3 2013 earnings call
  4. Apple's Q2 2013 10-Q (to compare certain items)

Breaking Down the Headline Numbers

Apple's Q3 2013 earnings contained many key elements, elements that cannot be gleamed simply by looking at Apple's headline revenue and EPS figures. Total revenue grew 1% year-over-year and fell 19% sequentially; as expected, a lack of material new products caused revenue growth to come to a halt. And EPS fell 19.85% year-over-year, driven by a 590 basis point contraction in gross margins (caused by shifts to iPad Mini, as well as other product mix changes), as well as a surge in operating expenses (more on those a bit later). Domestic revenue grew 12% year-over-year, driven by a 51% surge in iPhone sales, helping the iPhone capture 39% of the domestic smartphone market. Total iPhone sales grew by 20% to 31.2 million units; with iPhone revenue growing by 15% year-over-year, this suggests a shift to lower-priced iPhones. iPhone ASP fell to $582 in Q3 2013, down sequentially by $31. iPad ASP also fell to $437, down $12 from Q2 2013, suggesting continued shifts towards the iPad Mini. Indeed, iPad revenues fell 27% on a year-over-year basis, despite a 14% drop in units. Macintosh ASP's also fell sequentially by $75 to $1,303. However, we note that on a year-over-year basis, Mac revenue fell just 1%, despite a 7% decline in units. With global PC sales estimated to have fallen 11% in the quarter, according to CFO Peter Oppenheimer, Apple is likely to have gained market share during the quarter.

Apple's fiscal third quarter highlighted that the company's strength in advanced, non-recessionary economies is intact. Although consolidated Japanese sales fell 19% sequentially, they rose 27% on a year-over-year basis, driven by a 66% surge in iPhone sales. In Europe and Greater China, the numbers require some further analysis. European sales fell 22% sequentially and 8% on a year-over-year basis; however, CFO Peter Oppenheimer noted strong sales in both the United Kingdom (up 50% on a year-over-year basis) and Russia (iPhone activations reached a record in Russia during the quarter, despite well-publicized concerns about Apple's relationship with Russia's leading wireless carriers). In Greater China, sales fell 43% sequentially, and 14% on a year-over year basis. However, CEO Tim Cook noted that when adjusting for channel inventory, sell-through fell just 4% on a year-over-year basis, and that sales in mainland China (Greater China encompasses the mainland, Taiwan, and Hong Kong) were actually up 5% year-over-year.

Going Further: R&D and Emerging Markets Soar

The details above, which include several plus signs amidst what appears to be a sea of minuses, do not tell the whole story. Apple's operating cash flow, while down year-over-year in Q3 2013 (the paydown of nearly $5 billion in accounts payable helped lower operating cash flow to $7.828 billion from $10.189 billion a year ago), grew 4.88% in the first three quarters of fiscal 2013. Net cash and investments now stand at $129.662 billion, down from $144.687 billion in Q2 2013, reflecting the impact of nearly $18 billion in buybacks, as well as an increase in Apple's quarterly dividend. However, the figures we believe are most important are Apple's operating expenses. Amidst widespread angst about Apple's ability to innovate and create groundbreaking new products, the company continued to increase its research and development spending. In Q3 2013, R&D spending surged 34.47% to $1.178 billion, even higher than the 33.06% growth seen in Q2 2013. As we have noted time and again, Apple, unlike other technology companies [Microsoft (NASDAQ:MSFT)] does not spend money on research and development solely for the purpose of being able to claim that they invest in R&D. When Apple increases its R&D spending, there is a clear reason for doing so, even if Apple's top executives are the only people who know the true reason why. Several days ago, the Wall Street Journal broke news that Apple is testing revised iPhones and iPads with larger screen sizes, citing sources within Apple's Asian supply chain. And the company's guidance for Q4 2013 implies continued growth in operating expenses. At the midpoint of guidance, Apple is projecting operating expenses of $3.925 billion, an increase of 13.54% on a year-over-year basis. We note that Apple's SG&A expenses are growing far slower than its R&D spending (up 3.93% in Q3 2013), dampening overall expense growth, and that Q4 expense guidance implies an acceleration of consolidated operating expenses from Q3'2 11.75%, implying further growth in R&D spending. Naturally, neither CEO Tim Cook nor CFO Peter Oppenheimer shed any insight into what may be causing such a surge in R&D spending; Oppenheimer noted that Apple is "on track to have a very busy fall," and that the company will reveal more in October, when Q4 results are reported.

For much of 2013, industry observers and analysts have been trapped in what we see as fits of hysterics when it comes to Apple's emerging market presence. For many, this is seen as Apple's Achilles' heel, for the iPhone 5 is simply not competitive on price with most Android handsets in emerging markets. However, in many key emerging markets, iPhone growth has not slowed. Indian sales rose 400% year-over-year, driven by new marketing and financing programs. Sales in Poland and Turkey rose 60%, and Philippine sales rose 140%. These are all key emerging markets, and we believe that if the iPhone 4 and 4S can do well in these markets amidst a slew of competing Android devices, then a refreshed, "low-end" iPhone will likely continue the growth see by the iPhone 4 and 4S. We expect that Apple will announce a new strategy for emerging markets (be it a "low-end" iPhone or other kind of strategic overhaul) alongside a refreshed iPhone 5.

Reaffirming Apple's Corporate Philosophy

Amidst a slew of financial statistics and analyst questions related to issues such as channel inventory, product mix, and other financial questions, one exchange between CEO Tim Cook and UBS analyst Steve Milunovich stood out. After asking CFO Peter Oppenheimer whether or not the company's Q4 guidance includes any new product launches (naturally, Oppenheimer provided no answer), Milunovich pivoted, asking CEO Tim Cook the following question:

"Okay and then Tim kind of a philosophical question, but whenever you talk about what's important in the company it always comes back to great products, better, be more important than more, Wall-Street is kind of in the more business. So I just wonder kind of talk about your philosophy and if you can come up with a couple of really great products maybe they will provide enough growth, maybe they don't but you don't seem as focused on kind of financial metrics and growth projections as a lot of companies are. Maybe tie (NYSE:PH) that a little bit in your functional organizations, does that limit how many products you can actually take to market overtime?"

Cook responded by stating emphatically that Apple's focus has been, and always will be on making great products, and that if the company makes great products that customers enjoy, the financial metrics investors are looking for will come. In our view, this is perhaps the most crucial point made during Apple's Q3 earnings call. Tim Cook reiterated Apple's core philosophy of de-emphasizing financial performance in the day-to-day operations of the company. Unlike so many companies across several sectors (Microsoft chief among them; we do not intend for this article to become an Apple vs. Microsoft debate, and we note that we are long shares of Microsoft, primarily on the belief that CEO Steve Ballmer will eventually be ousted if the company's weakness in mobile and tablet markets continue), Apple has long concentrated all financial duties under CFO Peter Oppenheimer, leaving other executives and mid-level managers to focus on crafting new products and services, free of worrying about saving every penny. In our view, this is a crucial point. At a time when investor worry over Apple's prospects is growing (even if we believe that such worries are unfounded), Apple must not bend to investor concerns and make short-sighted decisions that may boost short-term EPS growth at the expense of the company's long-term prospects. Through his response, Tim Cook reiterated Steve Jobs' core vision for Apple, a vision that focused (and continues to focus) on crafting quality products, with the belief that if the company develops devices and services that customers, both consumer and enterprise, will enjoy and benefit from, then financial success will follow.


With research and development expense growth acceleration to over 34% in Q3 2013, it is clear that something is brewing in Cupertino. With a quarterly R&D run rate of well over $1 billion, we believe that Apple is crafting both updates across its entire product line, as well as a new product category. In the months to come, we believe that Apple will show investors, consumers, and industry observers that innovation is alive and well in Cupertino. Sources at Hon Hai have indicated that Apple has told the company to prepare shipping a revised iPhone in late August, and that Apple and its Asian manufacturing partners (likely including Hon Hai) are working on crafting a low-end iPhone. In our view, Apple will enter the crucial 2013 holiday shopping season with a refreshed and innovative product lineup, one that will demonstrate the company's commitment to quality, both in crafting quality products and in crafting a quality company for long-term investors to invest in.

Disclosure: I am long AAPL, MSFT. 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.