A deeper dive into Apple’s quarterly earnings report

Apple shares are driving technology shares higher today in the wake of a stellar earnings report on both revenue and net income. Apple announced results for its fiscal 2018 third quarter, showing quarterly revenue up 17% from the year-ago quarter to $53.3 billion, and quarterly earnings per diluted share up 40 percent to $2.34.

Strong execution across a swathe of geographies drove the results. International sales accounted for 60% of Apple’s quarterly revenue. These results highlight how diversified and how well run Apple is. And we can expect more of the same going forward, with Apple guiding to revenue between $60 billion and $62 billion for the fiscal fourth quarter.

Nevertheless, of the FAANG stocks, I continue to see Amazon and Alphabet/Google as better positioned for future earnings growth in the TMT space. So let’s break down the numbers.

Service revenue is increasing but Apple is very dependent on the iPhone

Here’s the breakdown of Apple’s revenue numbers:

Source: Apple

I’ve highlighted the iPhone and services line items because they encapsulate the big picture for Amazon’s revenue mix. Service growth is growing rapidly. It is now up to almost 18% of total revenue. And this may be the future for a diversified Apple product mix that relies less on hardware sales.

But 56% of Apple’s revenue still comes from iPhone sales. The product mix skewed higher in the last quarter because of the iPhone X, leading to a 20% growth in revenue. But unit sales growth of 1% was weak and analyst estimates. In fact, iPhone sales growth has been weak for a great many quarters as this tweet from Charlie Bilello at Pension Partners last night shows:

Apple’s Achilles’ is this dependence on the iPhone because the natural question is: how many iPhones can Apple sell and at what price? This is especially true given the saturation of the smartphone market in the developed world. A lot of growth can come via emerging markets. But then the price point will be lower.

The tariff threat to Apple and competition from Huawei in China

Apple gets about one-fifth of its revenue from China. That makes it vulnerable to any retaliation by the Chinese government as iPhones would likely be big on the list of US products for tariffs if President Trump raises tariffs on Chinese exports to the US.

Moreover, as I wrote earlier today, Huawei has now overtaken Apple as the number two handset maker in the world. And that has caused Apple’s market share in China to decline. Moreover, both Huawei and global leader Samsung offer product at a significant discount to the iPhone, which is a very premium product in the Chinese marketplace.

Since greater China is Apple’s third largest geographic region in revenue terms, threats to growth there will hurt the bottom line.

But what about services and over-the-top media product offerings?

For me, where Apple will shine is in services. Apple’s business model basically ties its hardware sales to a whole panoply of services and devices that make up the Apple ecosystem. This includes Apple’s iCloud storage product, Apple Pay, Apple Music, its streaming music service, and other paid subscriptions. If you own an iPhone, then you are likely to use and pay for some of these services.

With $9.5 billion in service revenue last quarter, Apple is now closing in on its goal of $50 billion in annual service revenue. On the conference call, Apple CEO Tim Cook said that they are seeing double digit service revenue growth in all geographic segments. He also hinted that apple has an exciting pipeline of new services coming forward.

What I would like to see from Apple is penetration into the media space, particularly a live TV offering. Broadband connectivity makes this a compelling product. And since Apple has a tightly integrated ecosystem, it could ramp up sales very quickly. In the conference call, Cook said he expects cutting to accelerate faster than most people expect. And he also said that Apple was working on something in that space, but is just not ready to talk about it in depth yet.

Final thoughts

It was definitely a good quarter from Apple. But its 40% earnings growth was flattered by a huge stock buyback program. And even its 17% revenue growth is suspect given how it depends on the mix of sales for iPhones; I don’t expect people to buy another $1000 smartphone anytime soon unless it is demonstrably better than the iPhone X.

On the plus side though, I am expecting Apple to move into the TMT convergence space with a tightly integrated original content and live TV subscription product which will also boost Apple TV sales and ramp up Apple’s share in the highly contested home entertainment market. The benefit of Apple’s penetrating that market is the integration across hardware and service product offerings including iTunes Match music subscriptions, Apple TV console sales and digital TV subscription packages.

There are a lot of growth opportunities here. And it does sound like Apple is poised to announce some new services to keep revenue growth on track.