Today’s Headlines: Big Earnings Miss By Apple

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Today’s Headlines: Big Earnings Miss By Apple
May 3, 2016

Apple Earnings: Below Already Low Expectations

When it comes to earnings reports and Wall Street, low expectations are a double-edged sword. They make poor earnings numbers easier to digest, but if those low expectations aren’t met, the reaction can be severe.

In a difficult earnings quarter for many companies, Apple (NASDAQ:AAPL) had one of the worst. Adjusted Q1 earnings were expected to come in at approximately $2 a share, a poor mark by Apple standards. Reported earnings were close to that, at $1.90 per share. Year-over-year profit fell by 18%. The company’s revenue dropped 12% — to $50.6 billion — breaking a 13-year streak of quarterly revenue growth and representing the largest decline since the third quarter of 2001.

This earnings decline was attributed mainly to falling iPhone margins. Even though Apple shipped 51 million smartphones in the quarter, beating expectations, the average selling price was $625 (almost $35 below expectations). Apple is counting more on sales in price-sensitive foreign markets, where growth will be harder to sustain.

The Selloff Begins

Not surprisingly, investors were unhappy with Apple's earnings. Prior to the earnings announcement, Apple had a market value of roughly $579 billion. A pummeling during after-hours trading dropped the company's market cap by approximately $43 billion. As of this writing, Apple's market cap resides at just under $498 billion — a remarkable drop of $81 billion in the span of three days.

Trouble has been brewing for Apple stock for some time now. The day after Apple's announcement, billionaire investor Carl Icahn, who often referred to investment in Apple as a "no-brainer" in the past, announced that he had sold his entire Apple portfolio (45.8 million shares as of December 2015) back in February. Icahn cited worries about China as his primary reason. His concerns are partially about the Chinese economy, but also about Apple's relationship with the Chinese government.

Apple has vital manufacturing facilities in China, and also expects significant revenue from sales there. Yet the government can't be relied upon to keep a business-friendly stance. Earlier this month, China shut down the iTunes Movies and iBooks stores in the country thanks to fresh regulations for online publishing.

Even without governmental intrusion, Apple is facing increased competition from local smartphone makers such as Huawei, Xiaomi, and Meizu that offer similar products for a considerably lower price. According to the New York Times, the Apple cachet is now less powerful with the fickle younger, middle-class consumers in China.

Apple views India as another large growth market, but India is far more price-conscious than China. The cheapest current iPhone (the SE) in India sells for $584, while the large majority of smartphones in the country sells for $150 or less. There may not be a price point for Apple to improve upon its current 2% share of the Indian market.

In some ways, the iPhone 6 has been a blessing and a curse for Apple. It has been so popular — and represented such an improvement over earlier iterations of the device — that it has proven to be a hard act for Apple to follow. Clearly, Cupertino needs a far larger improvement in its next version to induce consumers to upgrade.

A Few Winners among Tech Stocks

Apple had plenty of company in the earnings doghouse. Tech stocks had a particularly difficult quarter, including declines by Google (NASDAQ: GOOGL), Microsoft (NASDAQ: MSFT), and Twitter (NYSE: TWTR). However, two major tech stocks defied this trend — Amazon (NASDAQ: AMZN) and Facebook (NASDAQ: FB).

Amazon blew away estimates of 58 cents per share with a $1.07 per share, and posted a significant profit — a rarity for Amazon. Sales revenue projections for 2017 are a healthy $156 billion. Meanwhile, Facebook topped an expected 62 cents per share with a 77 cent-per-share earnings report, thanks mostly to an increased foothold in the $187 billion digital advertising field. According to Pivotal Research, Facebook is expected to capture nearly half (47%) of global advertising growth on digital platforms and 43% of all advertising growth excluding China in 2016.

On Wall Street, it's all about growth — and while Apple may simply be on a down cycle between innovative products that can spur growth, that cycle scares off investors in the short term.

Where Does the Growth Come From?

The real question for Apple is what comes next. The iPad is on a declining sales path as smartphones become larger, encroaching on its niche. Even with a technological leap, the next iPhone will be hard-pressed to improve upon the sales performance of iPhone 6. Does the Apple Watch fill the gap? Early sales suggest not. Or is it Apple Pay, Apple Music, or perhaps some yet-to-be-revealed technology?

Apple certainly has the cash to buy growth, with $232 billion in cash and investments available — but at its vast size, what company could it buy to grow meaningfully? Besides, that is not Apple's style. Apple tends to acquire startups that can be integrated into their product line, or larger strategic acquisitions such as its $3 billion purchase of Beats Music and Beats Electronics.

The main upside from the Beats purchase appears to be improved curation methods for personalized stations. A recent Forbes article highlights that Apple Music appears to be focusing on distinguishing themselves from competing services such as Spotify, and succeeding in doing so. Apple Music subscriptions were one of the lone bright spots in the earnings report, with an increase from 11 million to 13 million subscribers in the past two months.

Apple Music's experience represents the alternate Apple growth path — if we didn't invent it, buy it and incorporate it into our own brand. It remains to be seen if Apple Music can be the next big driver of revenue and profits, but it has a solid chance to do so — especially with profits. The service sector doesn’t have to deal with the manufacturing costs and logistics that pose hurdles for product development.

The Takeaway

It's way too early to proclaim the demise of Apple as a growth stock. The current slide was almost inevitable from the slowdown in China and incremental improvements in the iPhone. Other product lines have not had sufficient time to plug the entire gap in growth. In the short term, growth for Apple looks rough, but Apple has had a knack for regenerating itself over the years. Even Carl Icahn noted that Apple is a great company with outstanding management and said, "I hope one day to get back into it."

That should be a reassuring sentiment to investors, whether they have abandoned Apple for now, or continue to hold its stock. Great companies tend to perform well over time, and have the capacity for reinvention.

[Editor’s Note: The editor is long on Apple]

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