Just when seemingly everyone was ready to give up on Apple (NASDAQ:AAPL), it shocked everyone by soundly beating earnings expectations. The market was clearly taken by surprise, as Apple's stock jumped 7%. Apple has been challenged by several headwinds this year. Apple is in between the iPhone 6 and iPhone 7. The strong U.S. dollar is weighing on sales and profit. And, if that weren't bad enough, there are worries over slowing economic growth in China, which is a major emerging market.
It is for these reasons that Apple consistently trades for a low P/E.
Apple's persistent cheapness is certainly frustrating for investors, who are wondering if and when AAPL will ever again trade at valuation multiples on par with the broader market.
Apple's surprising earnings beat is the result of a key change in strategy, which has gone relatively unnoticed. It is transforming itself from a hardware company that can only grow with a new iPhone 6, 7, etc. to a company with recurring revenue growth. This may seem minor, but Apple's change in strategy this year will be critical to the company breaking the chains of a hardware company, and earning a higher valuation.
Apple Reinvents Itself
For the quarter, Apple earned $1.42 per share on $42.4 billion of revenue. Analysts expected $1.38 per share of earnings on $42.09 billion of sales. The biggest reason for the beat was a surprisingly strong performance of the iPhone: Apple sold 40.4 million iPhones last quarter, well ahead of the 40.02 million expected.
But how could this be? Apple's growth has slowed down this year, as the company lapped the highly successful iPhone 6, which has caused very difficult comparisons. Until the iPhone 7 is released, it was widely expected Apple would post disappointing iPhone sales totals.
The explanation for this is that Apple is actually changing strategies, and this is largely why the company beat on earnings and saw its stock price jump.
Apple CEO Tim Cook has often said that the company's goal is not to sell the most phones, but to sell the best phones. From a financial perspective, this meant focusing on high-priced phones that catered to the high end of the smartphone market. This strategy worked well for Apple, which routinely generates above-average margins. Apple has ceded market share to rivals like Samsung (OTC:SSNLF) and Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) Android-based phones, it captures the vast majority - over 90% - of profits in the smartphone industry. But while this strategy worked very well in absolute terms, it nevertheless caused Apple's growth to be completely reliant on new iterations of the iPhone.
This presents a real problem down the road, because going forward, Apple's growth rate will be dependent on penetration in new geographic markets, not just China, but perhaps more importantly India, another key emerging market with a rising middle class and a population of 1 billion. The problem for Apple, especially in India, is that consumers there are more cost-conscious than in the U.S.; people are not as willing to purchase Apple's high-priced phones relative to cheaper competing devices. This is why Apple has only around 3% market share in India.
This is why Apple released the iPhone SE, an event that did not generate much buzz in the press, but is actually a major evolution in the company's growth strategy. The iPhone SE is a lower-cost model that Apple released in March. It sells for $399 for the 16GB model, much lower than the price of a traditional iPhone.
Although Apple did not delve into specifics regarding SE model sales on the conference call, Apple CEO Tim Cook indicated that a key reason for the iPhone's better-than-expected sales figures last quarter is directly related to the iPhone SE. This quote sums up the opportunity the iPhone SE presents to the company:
Our initial sales data tells us that the iPhone SE is popular in both developed and emerging markets, and the percentage of iPhone SE sales going to customers who are new to iPhone is greater than we've seen in the first weeks of availability for other iPhones launched in the last several years.
Overall, we added millions of first-time smartphone buyers in the June quarter, and switchers accounted for the highest percentage of quarterly iPhone sales we've ever measured.
Cook also said that the sales data indicates the iPhone SE is doing particularly well in the emerging markets. The iPhone SE is doing what Apple needs. It will allow Apple to grow its market share. Even though the lower-cost iPhone will likely cause margin erosion - Apple's gross margin declined by nearly two percentage points last quarter - the stock jumped nonetheless. This is a clear indication that what the market wants from Apple is growth.
The other major change Apple is undergoing is that it is steadily building a recurring revenue stream in software. This is another way in which the company is breaking the chains of being a hardware company. Last quarter, Apple's services business grew 19% to a quarterly record of $6 billion. App Store revenue increased 37% to a new all-time high. In the past year, total services revenue has reached $23.1 billion.
This ties in with the previously mentioned strategy of pursuing market share in new markets like India. It shows the power of Apple's ecosystem. Most of Apple's services performance is from its active installed base of devices, with installed base-related purchases of $10.3 billion, up 29% year over year.
Apple: Unleashing the Power of the Ecosystem
These may seem like minor changes, but the impact from these initiatives could be greater than most realize.
When Apple released the iPhone SE, it was widely panned by analysts for threatening to erode Apple's high profit margins. The potential of the iPhone SE will be noticeable on many fronts. Not only will it increase device sales and profits overall, but it also will bring even more growth from having new customers in Apple's ecosystem. It will be seen not just in terms of device sales and profits, but also in terms of software sales.
This is evident by last quarter's impressive performance of Apple's services business, which grew 19% last quarter. The App Store had its best quarterly performance ever, generating record sales.
I've been bullish on Apple all year, based on the great potential for the iPhone SE and Apple's booming services business. It was these exact reasons why I wrote this article in May, when Carl Icahn made the announcement that he was out of Apple's stock.
Thanks to the iPhone SE and the related benefits of Apple's ecosystem, there is a good chance the company will beat expectations in future quarters, and it could result in a fairer valuation multiple going forward.
Disclaimer: This article represents the opinion of the author, who is not a licensed financial advisor. This article is intended for informational and educational purposes only, and should not be construed as investment advice to any particular individual. Readers should perform their own due diligence before making any investment decisions.
Disclosure: I am/we are 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.