Apple’s shift into China shows the company’s masterful execution

By Edward Harrison On Jul 23, 2014

Apple’s Q3 2014 earnings report yesterday was a mixed bag in terms of actual results. But from my perspective the results show a company that continues to execute its strategy well given the onslaught from cheaper handsets using the Android operating system. Apple posted a smaller-than-expected 6% gain in quarterly revenue due to sluggish growth in saturated markets in Europe and North America. But revenue in China surged 28% despite Apple’s premium pricing. Apple’s growth days are over in developed markets. But I have been upbeat about Apple’s results because of the China strategy and this report shows that Apple’s growth has some momentum, mainly because of that market. Some figures and comments below.

As we await the new products from Apple, it bears noting that, despite steadily losing market share, Apple is still a cash machine. It has $147.5 billion in cash on its balance sheet, which equates to about $24.38 a share. And this is after a massive increase in share buybacks. The reasons are simple: Apple executes its strategic objectives well and it sells a premium product. Now, I am not saying that Apple is still a growth company. I think those days are over. What I am saying is that Apple has seen the decline in growth prospects in North America and has pivoted to China as a result. In making the transition to China, Apple has seen a huge increase in sales despite selling a premium product into a less developed market. I do question how long before the premium segment there becomes saturated. However, the execution to date has been stellar. The only real miss in recent memory was the overpriced iPad mini introduction in 2012.

Below are the headline numbers for Q3 2014:

Revenue: $37.4 billion vs. $35.3 billion in Q3 2013 and $45.6 billion in Q2 2014 and forward guidance between $36 billion to $38 billion
Profit: $7.7 billion vs. $6.9 billion in Q3 2013 and $10.2 billion in Q2 2014
Gross Margin: 39.4% vs. 36.9% in Q3 2013, 39.3% in Q2 2014 and forward guidance between 37 and 38%
EPS: $1.28 vs $1.07 in Q3 2013

Note that the EPS numbers are after they also instituted a 7-1 for one stock split. Last quarter broke the string of four quarters of year-on-year profit declines and eight quarters in gross margins at Apple. The Q1 quarter saw the first annual profit decline in more than a decade, so we can see Apple doing well with back to back increases in both profit and gross margins. Because of the dividend and buybacks, cash is shrinking. The cash pile dropped to $147 billion from $151 billion in Q2 and $159 billion in Q1, making these last two quarters the first decreases since 2011. I know the numbers were below analyst expectations. But I still feel it was a good quarter.

On product sales, Q3 2014 numbers came in as:

iPhone sales: 35.20 million vs. 31.24 million in Q3 2013 and 43.7 million in Q2 2014 and analyst expectations for 35.78 million
iPad sales: 13.27 million vs. 14.62 million in Q3 2013 and 16.4 million in Q2 2014 and analyst expectations for 14.43 million
Mac sales: 4.41 million vs. 3.75 million in Q3 2013 and 4.1 million in Q2 2014 and analyst expectations for 3.93 million
iPod sales: 2.96 million vs. 4.57 million in Q2 2014 and analyst expectations for 2.34 million. No mention was made last quarter

The iPhone numbers were very good as were the Mac numbers. IPad and iPod numbers were mediocre to poor. Like last quarter, the iPad numbers were especially poor as we saw another decline in volumes. Clearly Android is taking share. Since tablets were the last big growth market for Apple, iot is critical that Apple come up with new product. Again, as last quarter, the fact that the tablet market is declining tells you that Apple is more dependent than ever on iPhone sales. They are becoming a one-product company and that makes them very vulnerable.

We are hearing a lot about a new bigger 5.5-inch iPhone and wearable products from Apple. And while I like these products, they are not exactly innovative since other manufacturers have been in the wearables and the phablet space already. Despite the earnings increase, you have to question innovation at Apple and the companies excessive dependence on its aging iPhone line

As with the last two quarters, following the China Mobile deal, growth is dominated by China. In Q2, Apple saw a 5% increase in revenue over Q1. This time, Apple saw a 28% jump in revenue in China. So China is the big story here. In fact, I would say it’s the only story except that Apple told the FT that iPhone sales are up 55% year-on-year in BRIC countries, with Chinese iPhone sales up 48%, and iPad sales were up 51% year-on-year despite falling globally.

Apple is providing the following guidance for its fiscal 2014 third quarter:

Revenue: $37 billion to $40 billion (Wall Street expected $40 billion in guidance)
Gross margin: 37 percent to 38 percent
Operating expenses: $4.75 billion to $4.85 billion
Other income: $250 million
Tax rate: 26.1%

This was a decent quarter for Apple. Going forward, the key takeaways are these:

Growth in Europe and North America is non-existent
Tablet sales are shrinking due to Android
There is a growing market for premium-priced mobile devices in BRIC countries
Apple is returning money to shareholders rather than wasting it
The Beats acquisition is out of character, suggests wasteful acquisitions could increase
Strategic execution continues to be unparalleled

In terms of my own evolution on Apple, I am more upbeat than I had been pre-correction two years ago. I started warning about Android in late 2009, wondering aloud if Apple could stop ‘the Android menace’. The answer we now see is no as Android has taken 80% market share in handsets. My basic view was that a premium-priced producer could not hold off a slew of down-market competitors indefinitely without suffering margin or share erosion or both. Mobile users with cheapie handsets switch to Android because they are price sensitive.

When the market became saturated, Apple’s strategy would come unraveled. And this began in 2012, with me correctly predicting margin compression at Apple and finally becoming bearish on the stock after the second straight miss in October of that year. By January of last year, I was predicting outright earnings contractions at Apple, something that did occur.

A year ago, I wrote that with Apple’s earnings declining, the emphasis had to be on returning cash to shareholders. Excess cash on the balance sheet is wealth destruction. For me, this was a turning point. As I have been suggesting they do since 2011, Apple is now paying out a larger dividend. They are buying back shares. They are refraining from pie-in-the-sky acquisitions. And they are moving into the emerging markets in an disciplined and enviable way. All of this is positive.

There has been a huge run up in the stock since this time last year though. So I question whether Apple can deliver earnings increases based on a premium-device focused emerging markets strategy. The mobile handset clone wars have arrived. I think these markets will become saturated at the top end like the developed markets before them and then Apple will need new product or the bottom line will start to fall again. Let’s see what the product cycle looks like and re-visit again afterwards.