Apple Beats on Q2 Earnings; Splits Shares - Analyst Blog

Shares of Apple Inc. AAPL jumped approximately 8.0% ($41.40) in after-hours trading on the heels of a better-than-expected second-quarter result, additional share buyback of $30.0 billion, higher dividend payout and a surprising 7:1 stock split.

Apple reported earnings of $11.62 per share, which surpassed the Zacks Consensus Estimate by $1.41 (13.8%). Revenues also comprehensively beat the Zacks Consensus Estimate for revenues of $43.67 billion.

Although the unusual spilt is a pure psychological move to make the stock more attractive and affordable to investors, the higher share buyback program and dividend payment seems to appease activist investors in absence of an innovative product.

Nevertheless, the strong results particularly from the flagship iPhone will provide Apple management some additional time to come up with a new innovation. Apple's solid third-quarter revenue guidance will also help in this regard.  

Quarter Details - Revenues

Revenues increased 4.7% year over year to $45.65 billion, higher than the company's guided range of $42.00 to $44.00 billion. iPhone unit sales increased 17.0% year over year to 43.71 million. Revenues climbed 14.0% from the year-ago quarter to $26.06 billion.

Apple experienced strong iPhone sales in the BRIC (Brazil, Russia, China and India) countries during the quarter. Sales were also higher in developed countries like the U.S., the U.K., Japan, Canada, Germany and France.

Apple's partnership with China Mobile CHL positively impacted results in Greater China, where iPhone revenues grew in double digits (28.0%) on a year-over-year basis. iPhone sales in Japan jumped 50.0% from the year-ago quarter. Sales more than doubled in India and Vietnam due to strong enterprise adoption.

Revenues from iTunes/Software/Services improved 11.0% year over year to $4.57 billion, primarily due to 24.0% growth in billings ($5.2 billion) from the year-ago quarter. Software & services revenues increased 14.0% on a year-over-year basis.

Cumulative App downloads were 70 billion and the App store generated 85.0% more revenues on a global basis compared with Google Play, per research firm App Annie. Accessories increased 3.0% from the year-ago quarter to $1.42 billion.

Apple shipped 4.14 million Macintosh in the reported quarter, up 5.0% from the year-ago quarter. Revenues increased 1.0% year over year to $5.52 billion. The strong growth in unit sales was due to robust performance from MacBook Pro and MacBook Air.

However, the most disappointing performance came from iPad. iPad unit sales declined 16.0% year over year to 16.35 million. Revenues were down 13.0% from the year-ago quarter to $7.61 billion in the quarter. Although, Apple cited smaller inventory and tough year-over-year comparisons as the primary culprit behind the decline, we believe that intensifying competition from low-priced tablets also negatively impacted sales.

However, enterprise adoption of iPad remains encouraging as companies such as FedEx FDX and Eli Lilly LLY continue to deploy thousands of iPad to run their day-today operations.

iPod unit sales and revenues continued to decline year over year. Apple sold 2.76 million iPods (down 51.0% year over year) and earned $0.5 billion (down 52.0% year over year) in the quarter.

Retail revenues in the quarter remained almost flat on a year-over-year basis to $5.22 billion. The company opened its first stores in Brazil and Turkey during the quarter.

Greater China revenues increased 13.0% year over year, while Rest of Asia-Pacific decreased 17.0% from the year-ago quarter. Japan, Americas and Europe grew 26.0%, 2.0% and 4.0%, respectively, on a year-over-year basis.

Margins

Gross margin expanded 180 basis points (bps) from the year-ago quarter and surpassed management's guided range of 37.0% to 38.0%. The gross margin expansion primarily resulted from favorable product mix in the quarter.

Operating expenses, as a percentage of revenues, increased 80 bps on a year-over-year basis. The year-over-year rise was due to higher research & development expense (up 50 bps) in the second quarter. Selling, general & administrative expense increased 30 bps from the year-ago quarter.

Operating margin expanded 100 bps from the year-ago quarter due to higher revenues and gross margin base. Net income was $10.22 billion or $11.62 per share compared with $9.55 billion or $10.09 in the year-ago quarter.

Balance Sheet and Cash Flow

Apple's balance sheet remains strong with cash and investments of $150.6 billion at the end of the second quarter compared with $158.8 billion in the previous quarter. Long-term debt was $16.96 billion at the end of the quarter. Cash flow from operating activities was $36.2 billion in the reported quarter.

Guidance

For the second quarter of fiscal 2014, Apple forecasts revenues to be in the range of $36.0 to $38.0 billion. The mid-point of the guided range is much better than the $35.32 billion reported in the year-ago third quarter. Currently, the Zacks Consensus Estimate is pegged at $38.76 billion.

Gross margin is expected to be in the range of 37.0% to 38.0%, while operating expenses are projected to be within $4.4 to $4.5 billion. Other income/ (expense) is forecasted to be $200.0 million while the tax rate is likely to be 26.1%.

Expanded Capital Return Program

Apple expanded the size of its overall capital return program from previously announced $100.0 billion to $130.0 billion. Apple's board of directors expanded the size of share buyback program by another $30.0 billion to $90.0 billion. The company also increased quarterly dividend payout by 8.0% to $3.29 per share.

Apple also announced a 7:1 stock split that will occur in June this year.

Our Take

Despite Apple's impressive second-quarter results, the lack of a new gadget will remain the primary headwind for the rest of 2014. The company is expected to announce a new product in the second half of this fiscal, which will be a game changer in our view.

Apple's growing market share in the BRIC and emerging markets is a major positive. Although iPad reported a dismal quarter, its growing adoption in enterprises and education sector is a significant growth catalyst. Moreover, the availability of Microsoft Office on iPad will further boost sales, going forward.

The partnership with China Mobile will help Apple in the near term. We believe that Apple's rumored upcoming large screen iPhones will get good response in China, which will further boost top line in the second half of 2014.

Apple continues to face significant competition from Asian handset makers such as Samsung and Lenovo's acquisition of Motorola will further intensify competition in China. This will further hurt its average selling price ASP, in turn negatively affecting gross margin.

Despite contraction in PC market, Apple's Macintosh continues to maintain its stable market share, which is a significant positive. We believe that frequent operating system updates and free upgrades will drive Mac user base, going forward.   

Additionally, the expanded capital return program is a significant positive for Apple. However, the company will use debt to complete the share buyback program, which can hurt profitability through higher interest expense.

Moreover, the ongoing litigation issues with Samsung and the e-Book pricing case will remain an overhang on the stock in the near term.

Currently, Apple has a Zacks Rank #3 (Hold).