AAPL’s Sept ’09 earnings: what they mean for the market

All or nothing

The short answer:  AAPL’s just-reported earnings mean either a lot, or nothing, depending on your perspective.

First, the nothing.

Even though the September was an exceptionally good one for AAPL, and it was joined by good overnight results from TXN and CAT, the US stock market went down yesterday.

How so?  None of the companies added anything to the picture of the global economy that has already emerged in the earnings announcements of the many companies which have already reported:

the worst of the general economic downturn is over;

consumer-oriented technology is recovering;

Asia is stronger than Europe ex the UK, which is stronger than the UK and US (for AAPL, though, international sales are strong all over).

Of the three firms, AAPL had by far the best report, filled with eye-popping numbers.  I also suspect that AAPL’s near-term prospects are better than the consensus thinks.  But it’s clear that a large part of the company’s performance comes from taking market share from competitors, not from over all economic strength.

What AAPL said

The company reported record sales of Macs and iphones during the quarter.  Sales were $9.9 billion, up 25% from $7.9 billion in the comparable quarter of 2008.  Fully diluted EPS were $1.82, 44% higher than the $.126  earned in the year-ago period.

In looking at the numbers, it’s important to distinguish between “sell in” and “sell through.”  The first is when a product leaves the factory and enters the distribution channel, much of which, in AAPL’s case is done by third parties.  Typically, a company recognizes sales revenue and profits when its manufactured products enter the distribution channel.  “Sell through,” on the other hand, is when the product is purchased by the final consumer.  Any difference between the two numbers represents changes in inventories in the warehouses of firms in the distribution chain.

The difference between sell in and sell through is most important for understanding what is happening with iPhone sales.  AAPL sold a record 7.4 million of them to phone companies during the quarter.  That was up 7% year over year.  Telcos sold 38% more iPhones to customers than in the comparable period of 2008–at a time when overall industry sales were only up 5%.  This last figure is of interest not only to show AAPL’s share gains in the phone market, but because AAPL makes much more money from sharing in subscription revenues than from handset sales.  More about this later.

Macs were also good for AAPL.  Units were up 17% year on year.  Laptops, which comprised about three quarters of sales, were up 35%.  This compares with industry growth of 9%, a healthier number than cellphone growth but again showing that AAPL is making most of its money by taking share away from competitors.  Europe ex the UK was up about 40%, Asia Pacific a little better than that.  AAPL had its best back to school sales ever.

To no one’s surprise, iPods were down, despite 100% year on year growth in the iTouch.

We have to remember that outside factors, and product introduction timing, influenced AAPL’s results in a positive way.  Recession has meant that component and transportation costs have been unusually low.  Continuing manufacturing and service issues at DELL and the failure of MSFT’s Vista have left the laptop door wide open for Macs.  In addition, the fast-selling Snow Leopard OS upgrade came out during the quarter.  And laptop and iPhone 3G shortages may have shifted sales from the June quarter into the September period.

Also, I’m not conversant enough in AAPL-speak to know for sure, but I think I heard management say (nothing like these words though) during the earnings conference call that it is pricing new products aggressively to continue to gain market share, even if margins were a bit lower than they have been historically.

These last two paragraphs might start one worrying that the September quarter marks a kind of high-water mark for earnings.  I don’t think so, however.  Despite management’s famous conservatism in giving earnings guidance, their comment that air transport costs would be unusually high in the December quarter (as AAPL pulls out all the stops to put products into the hands of retailers) suggests AAPL is expecting a blowout holiday sales season.

Why this is everything

In a booming economy, there is enough demand that no one firm can satisfy it.  So the market separates out into big winners and bigger winners.  Rather than wait a month for the product you really want to buy, you may take a competitor’s not-quite-as-good substitute that’s on the shelves today.

In a bad economy, you don’t buy.

In a slowly expanding economy, like the US had in the second half of the Seventies, products from the #1 company in an industry are almost always available, so the “overflow” sales to #2 or #3 don’t happen.  So the stock market separates into big winners and big losers in what might otherwise be a trendless, or only slowly uptrending, market.

As a stock, AAPL has already regained all the ground it lost during the recession.  Whether it outperforms from this point on or not, I think its emblematic of the formula for success in the stock market we’ll have over the next few years:  find the truly great companies.  One caveat:  I’m a died-in-the-wool growth stock investor and I’m describing growth stock Nirvana.

What’s up next for AAPL

As I mentioned above, I think the December quarter will be exceptionally good.

There’s another positive factor at play that may attract new attention to AAPL in the coming year.   It’s subscription accounting for iPhone profits.  I’m going to sketch the broad outlines of the issue here.  The actual details are mind-numbing and of interest to AAPL, me and probably no one else.  Here goes:

1.  The average selling price of an iPhone–AAPL to a telco–is about $600.  Let’s say (I’m making up these numbers, but I think they’re directionally correct) AAPL makes a profit of $35 on the hardware sale.

2.  The telco then sells the iPhone on to a consumer, who pays $200, and agrees to a 24-month contract at $125/month, or $3000 over the two years.

3.  AAPL gets a percentage of that revenue.  Let’s say it amounts to $215 (this number comes from AAPL’s press release).

4.  So AAPL’s total profit from an iPhone sale is $250.

Under accounting rules that prevailed until recently, in its income statements AAPL had to spread that $250 equally over the two-year contract term, or about $31.35 per quarter.

A recent change in accounting standards, however, allows AAPL to recognize most, if not all, of the contract revenue during the quarter when the contract is signed.  AAPL has been providing an alternate calculation of eps under the new standard, which it will adopt sometime in the coming fiscal year.  The eps number for the September quarter is $1.30 a share higher than the figure under GAAP (Generally Accepted Accounting Procedures), at $3.12.

In other words, reported earnings in the coming year could end up being close to twice what they would be on the current accounting standard.  The price earnings multiple for AAPL at today’s price might be about 15–less than that of the average stock.

You may say that the market sees through accounting changes and has already factored this one into the current AAPL price.  My experience is that markets hate subscription accounting and never give the company involved any benefit for using a very conservative way of reporting profits.

This change will, however, bring out much more clearly how highly leveraged AAPL is to the success of the iPhone.  This becomes a two-edged sword, if iPhone sales ever flag.  But my guess is that the change will at least initially bring a groundswell of new interest into AAPL.

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