Apple and The Law of Large Numbers

Apple and The Law of Large Numbers

There's been much talk about the perceived limits to Apple's continuing growth due to what's called the Law of Large Numbers. This axiom or financial rule suggests as Apple's revenue grows the chance of sustaining current rates of growth diminishes as more growth is required to maintain the same percentage of growth.

In my view applying the Law of Large Numbers to Apple at this time is a fallacious argument. It might appear valid to casual observers of the company or to those fixed on applying commonly accepted axioms in their investment strategies without regard to the  unique circumstances of a particular enterprise, but for now this axiom or financial rule does not apply to Apple. 

Here's why:

In the June quarter close to 50% of Apple's revenue was derived from products that did not exist in the market just over three years ago. In the September and December quarters, well over 50% of Apple's reported revenue will be derived from iPhone and iPad sales. At the moment there's no practical limit to the size of the market for these two products. 

The Macintosh

Apple's oldest hardware product line, the Macintosh, has sustained a roughly 33% unit sales growth rate over the past three fiscal quarters. In the June quarter operating segments exclusive of the Americas and Apple's international chain of retail stores accounted for just over 41% of unit sales. In Europe alone unit sales increased 46% over the prior year period. While Mac sales continue to grow at a pace greater than industry averages, the Mac still accounts for less than 10% of domestic PC sales and garner a much lower percentage of global market share. Although Apple's offerings in the sub-$1,000 PC market are limited to the Mac mini and nominally the MacBook, the company recorded in the June quarter the largest shipment into the educational channel  in the company's history. This occurred during a period in which public education spending remains severely constricted. 

Apple Retail Stores

At the end of the June quarter Apple had 293 retail stores open for business. During the September quarter Apple will open 24 new stores and store sales and foot traffic continue to accelerate. In the June quarter store revenue increased 73% to $2.578 billion and produced average store sales of $9 million. Foot traffic into the stores reached a record 60.5 million visitors, an increase of 57% over the prior-year period. With an increase of over 8% in the number of stores in the September quarter alone, store sales and foot traffic will continue to rise at record levels for the foreseeable future.

Management reports roughly 50% of the 677,000 Macs sold at Apple retail stores in the quarter were to customer who had never owned a Mac before.

The Apple iPad

In the June quarter and in limited release, The Apple iPad and constituent products accounted for $2.166 billion of reported revenue, representing almost 14% of Apple's reported revenue activity. The Apple iPad remains in constrained supply and even Apple's management does not have a reliable metric to gauge global demand for this currently unique device. 

In the September and December quarters the Apple iPad and constituent products should deliver between 15% and 20% of Apple's reported revenue. This is revenue from a product that was not present in the market as recently as five months ago and will deliver significant year-over-year revenue gains for the next several quarters. 

Apple's $100 Billion FY 2011

I'm working on early FY 2011 forecasts for Apple. At this time I expect Apple to realize roughly $100 billion in revenue and a corresponding $23 or more in eps for the year.

Back in May I forecast FY 2010 revenue of $65 billion. Apple will come close to that mark for the fiscal year with a $20 billion revenue fourth fiscal quarter. In the June quarter Apple grew revenue 61% versus the prior-year period due in part to the early success of the Apple iPad. Apple should at least match this rate of revenue growth in the current quarter.

In the fourth fiscal quarter of FY 2009 Apple reported revenue of $12.207 billion. What will propel revenue to gains of roughly 65% in the current quarter is the expansion of the  iPad's sales reach, continuing growth in the number of Apple retail stores and strong sales of the iPhone 4 in its first full quarter of release. 

Looking forward to fiscal year 2011, the iPad and constituent products may represent over 20% of total revenue, proving the company with a significant head start in achieving better than 50% revenue growth during the fiscal year. 

It's virtually impossible to rationally forecast 50% or better growth in revenue for next fiscal year without an associated and more than commensurate rise in the company's share price. This is due in large part to the significant discount at which the shares trade relative to current earnings and the company's growing cash position. I reiterate my expectation for AAPL to move above $400 per share by early May 2011. 

Robert Paul Leitao

AAPL 4th Fiscal Quarter Early Estimates

It's early in Apple's 4th fiscal quarter. But in reviewing the June quarter results (the first quarter incorporating iPad revenue activity) certain revenue and earnings trends have already emerged. 

Yesterday I published a primer titled Understanding Apple's Success Made Easy. I posted the content especially for readers who might not be financially inclined but are curious about Apple's continuing success. Using the June quarter results as an example, roughly $.20 of each revenue dollar flowed to Apple's bottom line. For the September quarter I expect Apple to improve ever-so-slightly on this ratio. 

My expectation is based on an impressive quarter for iPhone sales as Apple continues the global rollout of the iPhone 4 and seeks to replenish channel inventory following the June quarter drawdown. Further, the Apple iPad continues to sell extraordinarily well, and will assist in boosting revenue growth to at least the 61.2% rate experienced in the June quarter.

In the fourth fiscal quarter of 2009 Apple reported adjusted revenue (after removing the impact of deferred revenue accounting for the iPhone) of $12.207 billion. Applying the June quarter's revenue growth rate, fourth fiscal quarter revenue would reach about $19.68 billion. I expect the year-over-year revenue growth to accelerate in the September quarter above the June quarter's pace. The revenue drivers are the iPhone 4 and the Apple iPad. For now I expect the growth in Mac unit sales to remain relatively consistent with the growth rates experienced in the first nine months of the fiscal year at about 33%. As revenue scales higher, operating expenses as a percentage of revenue should decline modestly, providing for a more than proportional gain in earnings from each additional revenue dollar received. 

In the fourth fiscal quarter of 2009 Apple reported sales of 7.367 iPhone units. Although year-over-year iPhone unit sales grew 61% in the June quarter, the rate of unit sales growth in that quarter was well below the growth rates experienced in the first six months of the fiscal year. For now I expect iPhone unit shipments to grow in the September quarter at least 75% over the prior year, supply constraints being the only mitigating matter. 

My early fourth fiscal quarter estimates call for revenue of about $20 billion and eps of at least $4.30 per share. I reiterate my forecast Apple's share price will move above $400 per share by early May 2011 and should surpass $300 per share within the next several weeks.

Robert Paul Leitao

Understanding Apple's Success Made Easy

Apple is an extraordinarily successful company. I have a hard drive full of spreadsheets to document it and I spend much time each calendar quarter forecasting it. But there's an easier way to understand Apple's success than pouring over news reports, financial reports and traversing the Web on a daily basis looking for insights. 

I'll use the company's most recent quarterly performance as an example. For the three-month period that ended June 26, 2010, Apple reported revenue of $15.7 billion and net income of $3.253 billion dollars. Essentially just over $.20 of every revenue dollar flowed to the company's bottom line. This is after all costs have been paid, including income taxes. Prior to income tax expense Apple reported about $.27 of every revenue dollar flowed to the operating income line. 

In the June quarter Apple reported cost of sales (costs of the products and services sold during the quarter) totaled $9.564 billion or about 61% of each revenue dollar. Conversely, about 39% of each revenue dollar was maintained by the company to apply to other costs and reward shareholders in net profits.

Here's the simple math: Apple retains roughly 40% of each revenue dollar after covering the costs of products and services sold. Of that amount roughly 50% or 20% of each revenue dollar flows to the company's bottom line. 

How Does Apple Create Such High Profits?

Market Segmentation

Apple doesn't compete for product sales, per se. Apple competes for profits. The company carefully picks and chooses its product markets and defines which segments of these markets in which to compete. This is why Apple doesn't manufacture nor sell cheap PCs, cheap phones, etc. Apple competes in select market segments such as the $1,000+ PC market because in that segment Apple has greater pricing control and thus greater opportunities to realize higher profits.

Constituent Products and Services

Products and services such as AppleCare and MobileMe are margin expanders. They increase the yield per customer and increase the gross margin averages on products sold. Apple's focus is not on unit sales of products alone. Apple's focus is on the customer. Customer satisfaction drives sales in Apple's chosen market segments far more than the appeal of a discounted price. 

Apple consolidates revenue from iPhone-related products and services in the iPhone revenue segment. While iPhone unit sales increased 61% in the June quarter versus the prior-year period, segment revenue increased by 74%. The rising revenue relative to unit sales is influenced by revenue created from constituent products and services such as iPhone accessories. 

Content Sells Devices

Sales of the Apple iPod exploded following the opening of the iTunes music store in 2003 and the release of iTunes for Windows. Availability of content drives hardware sales. The iTunes app store is an important component of the iPhone's success. The Apple iPad, a product that set sales records at the time of release, came to market with the iTunes stores providing electronic books, music, movies and apps from the start. The iPad's early success is due in large part to the availability of content for the device. 

In the June quarter Apple reported revenue from "Other Music Related Products and Services" of $1.214 Billion, representing about 7.7% of total revenue. This revenue segment includes iTunes store sales, iPod services and Apple-branded and third-party iPod accessories. Content sells devices and devices subsequently sells more content. 

Apple Retail Stores

Apple's chain of retail stores was the fastest chain to reach $1 Billion in sales in US history. Not only are the stores successful as a retail chain, according to management 50% of Mac buyers at the retail stores are new to the platform. Although we've all seen Mac, iPhone and iPad advertisements, much more would need to be spent on advertising to support product sales absent the retail store chain. In the June quarter the retail stores were the source of 677,000 Macintosh units sold representing almost 20% of all Macintosh computers sold worldwide. 

If All This Represents A Model of Success, Why Don't Competitors Replicate It?

There's an old saying, "It took a lifetime to become an overnight success." The first Apple retail stores opened in May 2001 and the iTunes music store began operations in 2003. Both the Apple retail stores and the online iTunes stores are vital components of Apple's continuing success. Competitors can attempt to match Apple's market approach. But it would require huge investments in retail and online sales infrastructures and the ability to establish and maintain product pricing control. None of those variables come easy and nothing comes cheap. It also requires a great deal of time to establish and build on these sales assets. 

Absent the time, resources and willingness to invest in a long-term strategy to achieve Apple-style success, most competitors focus on price capitulation as a means to move units. This obviously reduces profit per revenue dollar and also reduces the competitor's ability to maintain pricing control over products.

Apple jealously guards its brand image and the company obsesses over product quality and customer satisfaction. Apple's success was not achieved overnight and can not be replicated without years of effort and billions of dollars of investment. While brand value might be considered an intangible by some, brand awareness, a reputation for quality products and strategic selection of market segments to enter are all producing tangible results for the company that will soon become the most highly-valued corporate entity in America. 

Understanding Apple's success requires only simple math. But achieving that success is the culmination of many years of effort and investment. 

Robert Paul Leitao

All Eyes On Apple

Following the close of trading in New York on Tuesday Apple will release June quarter results. While the expectations of analysts vary, Apple will report record or near-record revenue and earnings. The company will also report more than $3 per share has been added to its coffers.

Apple's share price has been under pressure due to overall market conditions, media preoccupation with the iPhone antenna non-issue and in Monday trading was pressured by the statement of CEO Steve Jobs during Friday's special event about the number of iPhone 4 handsets sold.  

None of these factors should have more than a short-term impact on the share price. The big question Tuesday evening is whether or not the June quarter results and the corresponding forward guidance from management will provide enough of a catalyst to push the share price above $300 over the next few weeks. I reiterate my expectation AAPL will cross over $400 per share by May of next year.

I'll be back later this week with an early look at September quarter expectations for Apple. 

Robert Paul Leitao

The iPhone Antenna Song

There's a smartly crafted two-minute response to the iPhone antenna issue available on YouTube from Jonathan Mann. He records and publishes a song a day. Song A Day #561: The iPhone Antenna Song puts the issue in perspective with humor and music. "If you don't want an iPhone 4, don't buy it. If you bought one and don't like, bring it back." Enough said and well said.

A well-reasoned response to the iPhone 4 antenna non-issue has also been posted by Andy Zaky. His response can be found at Bullish Cross. 




Robert Paul Leitao

AAPL June Quarter Estimates In Detail

The past month has been unbelievably busy at work leaving little time to post or even second guess my AAPL June quarter estimates. Perhaps that's a good thing. My June quarter estimates are based in part on averages and ratios sourced from Apple's most recent quarterly results. For the June quarter, ratios are slightly weighted in favor of the December quarter performance due to the anticipated record revenue from the success of the Apple iPad. 

My June quarter estimates anticipate both record revenue for Apple and record earnings per share. Although I expect record revenue, I did not scale down certain expense ratios relative to revenue as might be realized in better economic times. No doubt there are also costs related to the rollout of the Apple iPad.  Still, I maintained a gross margin estimate below that of the 2nd fiscal quarter but inline with recent trends. 

My forecast of over $16 billion in revenue is influenced by the release of the Apple iPad (obviously) and anticipated growth in iTunes store sales from the proliferation of iOS devices. The estimates are also favorably impacted by expected strong sales of "beyond the box" products and services such as MobileMe and AppleCare. Although strong revenue growth is mostly influenced by hardware device unit sales, revenue from constituent and ancillary products and services benefit gross margins.

Below are my detailed estimates for Apple's June quarter. Unit sales by product line, gross revenue, gross margin and eps calculations have been provided to Philip Elmer-DeWitt for use in his Apple 2.0 quarterly analyst comparisons:

Revenue:

$4.4288 Billion (Macs) - 3.46 million units

$5.9247 Billion (iPhone) - 9.4 million units

$1.4720 Billion (iPod) - 9.2 million units

$2.2275 Billion (iPad)

$2.3800 Billion (iTunes/Other)

$16.433 Revenue Total

$9.7776 Billion (GOGS)  - GM 40.5%

$6.6554 Billion (Gross Margin)

Expenses:

$0.4601 Billion (R&D)

$1.4379 Billion (GS&A)

$4.7574 Billion (Operating Income)

$0.0600 Billion (Other Income)

$4.8174 Billion (Income Before Taxes)

$1.3730 Billion (Provision for Taxes) - 28.5%

$3.4444 Billion (Net Income)

$3.71 Earnings Per Share

928,415,000 Fully Diluted Shares Used In Computation


Robert Paul Leitao

Apple Isn't Perfect

Apple isn't perfect.

It's about time this has been widely and publicly acknowledged. One of the things that had disturbed me for the past couple of years was the expectation of naysayers that Apple would eventually flub it in a major way. In fact, one could perceive a growing resentment of Apple's string of hit products and the company's overwhelming success.

There's a silver lining to the iPhone 4 issue and thanks to the company's highly public response, the misperception of Apple being a company that sees itself as perfect or a company that has somehow become unjustifiably arrogant can be put to rest. 

The iPhone 4 issue may become a high-profile non-issue. For those of us who expect the share price to reach or exceed $400 within twelve months a challenge of this kind couldn't have come at a better time. 

Robert Paul Leitao

Final AAPL June Quarter Estimates

My final AAPL June quarter estimates include a revision to my preliminary iPod unit sales estimate. I now estimate June quarter iPod shipments at 9.2 million units, roughly a 10% year-over-year decline.

My final estimates for the June quarter are as follows:

Revenue: $16.433 Billion

EPS: $3.71

iPhone units: 9.40 Million

iPod units:   9.20 Million

Mac units:    3.46 Million

iPad units:   3.30 Million

Gross Margin: 40.5%

Robert Paul Leitao

Preliminary AAPL June Quarter Estimates

Below are my preliminary estimates for AAPL's June quarter revenue and product unit sales. For now I'm keeping my eps estimate off the public timeline though my estimate has been sent to Philip Elmer-DeWitt for inclusion in the Apple 2.0 analyst comparatives:


Revenue: $16.337 Billion

iPhone units: 9.40 Million

iPod units:   8.60 Million

Mac units:    3.46 Million

iPad units:   3.30 Million


With the inclusion of iPad unit sales in the June quarter results, I forecast a record quarter for AAPL revenue. 




Robert Paul Leitao