Cost Discipline: Apple's Potent Pathway To Profits

In Apple's third fiscal quarter ended in June, the company reported record revenue of $28.571 billion and record earnings per share (eps) of $7.79. Fueling the record eps performance was the record high 25.5% of each revenue dollar that flowed to the net income line. 

On July 24th I published an article titled Apple's Net Income Relative To Revenue Continues To Rise. In that article I reviewed the company's net income to revenue performance over the most recent eleven fiscal quarters. Today I'm continuing my analysis of Apple's quarterly results with a review of the company's operating expenses (OpEx) and the declining percentage of revenue consumed by its two components: Selling General and Administrative (GS&A) expenses and Research & Development (R&D) expenses. 

The graph below illustrates the differences in the rates of growth in revenue and operating expenses on a quarterly basis from FQ1 2010 that ended in December 2009 through FQ3 2011 that ended in June of this year. The difference in the rates of growth between revenue and operating expenses is unmistakable and the resulting benefit to net income and earnings per share is remarkable.

Operating Expenses As A Percent of Revenue

Since the beginning of FY 2009, the percentage of revenue consumed by operating expenses has declined from a high of 14.35% in FQ2 2009 to a low of 8.90% of revenue in the recent June quarter (FQ3 2011). As revenue has scaled significantly higher over the most recent eleven fiscal quarters, the falling percentage of revenue consumed by operating expenses is now delivering literally billions of additional dollars to Apple's pre-tax income line on a quarterly basis. The drop in operating expenses as a percentage of revenue can have a bigger impact on Apple's net income and earnings per share than variations in each fiscal quarter's gross margins. 

The graph below illustrates the dramatic drop in the percentage of revenue consumed by operating expenses as revenue has risen significantly over this eleven-quarter period. 

Apple's Net Income Relative To Revenue Continues To Rise

On July 19th Apple reported record revenue and earnings for the three-month period ended in late June. The third fiscal quarter's 82% revenue growth to $28.571 billion and 122% earnings per share (eps) growth to $7.79 represented surprisingly strong results due to better than expected sales of Apple iPhones and Apple iPads. 

Apple's Nine-Month Performance

For the first nine months of the fiscal year ending in late September, Apple has realized revenue growth of 78.2% to $79.979 billion and eps growth of 96.3% to $20.63. Considering the continuing "share creep" in the fully diluted share count, the company's eps performance over this nine-month period becomes even more impressive as the numbers are analyzed. 

Rising Net Income As A Percentage Of Revenue

Underpinning the exceptional rates of eps growth is the rising percentage of each revenue dollar that flows to the company's net income line. The graph below illustrates the growth in net income relative to revenue over the most recent eleven fiscal quarters. 

Apple June Quarter Results: Numbers To Watch

On April 23, 2011 I published an article titled Posts At Eventide: AAPL June Quarter Trends To Track. In that article I mentioned several factors that will impact Apple's quarterly performances through the balance of the current fiscal year and throughout FY 2012 that begins in late September.

Today I'd like to revisit each of these factors ahead of the release of Apple's June quarter results on Tuesday and following the recent rise in the company's share price. I maintain a $590 price target on AAPL. On Friday the shares set a record closing high of $364.92. However, this recent rise in the share price has only been a retracing of ground since the previous all-time closing high of $363.13 set on February 16th. 

AAPL June Quarter Estimates

For the June quarter I'm estimating a 70% rise in revenue to $26.619 billion and a 90% rise in earnings per share to $6.67. During the first six months of the current fiscal year revenue rose 76.2% and eps 83.2% over the corresponding prior-year period. 

Declining Operating Expenses As A Percentage of Revenue

Due to the influence of the Apple iPad for the first time in prior-year comparisons, I'm expecting a slight moderation in the June quarter's rate of revenue growth. However, the continuing decline in operating expenses as a percentage of revenue will favorably impact the earnings per share results. The graph below illustrates the rates of revenue growth versus the rates of growth in operating expenses for the most recent ten fiscal quarters. I expect net income to reach above 23.5% of reported revenue in the June quarter versus the 23.33% of revenue that flowed to the net income line over the first six months of the current fiscal year. I also expect operating expenses to fall below 9.5% of reported revenue in the quarter. 

Factors That Will Positively Impact Apple's Performance Moving Forward

The Global Tablet Market: I've said several times outside of the Apple iPad, a global consumer market for tablet devices does not currently exist. While iPad unit shipments in the March quarter were below the expectations of most analysts due primarily to supply constraints, the tablet market is in a nascent phase of development. The Apple iPad will remain the undisputed leader in the tablet market well into CY 2012. The market can not at this time economically support a large number of potential competitors and Apple's global retail store presence is a competitive advantage competitors simply can not match. 

I estimate iPad unit sales in the June quarter of 8 million units, representing a 157% unit sales increase over prior-year sales. Constrained supplies of the iPad 2 will have a slight impact on the quarter's unit sales outcome. Moving forward into the September and December quarters, iPad supply constraints will evaporate leading to record revenue and earnings in the September quarter and FY 2011 revenue at or above $112 billion and eps for the fiscal year at or above $27.50.

Apple's PEG Ratio Signals Share Price Gains Ahead

On Friday, Apple (AAPL) closed New York trading at 343.26, up $7.59 on the day and up  $16.91 or 5.2% on the week. Although the week's share price advance was impressive, Apple remains significantly under valued based on the company's current rates of revenue and earnings growth. In the first six months of the current fiscal year Apple's revenue has risen 76.2% and earnings per share has gained 83.2%. In contrast, since the first trading of Apple's current fiscal year on September 27, 2010, the share price has responded with only a 17.9% gain.

Last week in a post titled AAPL: The Coiled Spring I compared the median price targets for three popular equities: Amazon, Apple and Netflix and the share prices for each of these companies. Apple is trading at a price-earnings multiple of 16.35 times trailing 12-month earnings of $20.99 per share and at only 76.3% of the median Wall Street price target of $450 per share. In comparison, both Amazon and Netflix are trading at much higher price earnings multiples and at or near their respective median price targets.

Apple's PEG Ratio: More Share Price Gains Ahead

For today's post I asked Jeff Fosberg of the Apple Finance Board to adapt his popular "coiled spring" graphic to reflect not the price-earnings multiples of the above-referenced companies but the PEG ratios of the companies at Friday's closing prices. 

Simply defined, the PEG ratio represents the price-earnings multiple divided by earnings per share growth. The lower the PEG ratio, the lower the current valuation relative to rates of earnings growth. Apple's current PEG ratio is 0.63 versus 2.92 for Amazon and 1.98 for Netflix. Compared to high-flying stocks such as Amazon and Netflix, Apple is bargain priced and the company's current PEG ratio signals more share price gains ahead. Because Amazon, Apple and Netflix operate in different product and service markets, the PEG ratio is a more effective way to compare and contrast the current market valuations of the three popular equities than a comparison of price-earnings multiples alone. This comparison accentuates the deep discount to growth at which Apple currently trades.  

The AFB AAPL FQ3 Unit Sales Estimate Index

The Apple Finance Board (AFB) is home to many AAPL traders, investors and Apple product enthusiasts. Among the members of the AFB are well know independent analysts Daniel Tello (deagol), Horace Dediu (aysmco), Turley Muller and Andy Zaky. I serve as the moderator of the AFB under the DawnTreader moniker. 

The AFB AAPL FQ3 Unit Sales Estimates

Each fiscal quarter active members of the AFB are polled for their estimates of Apple's quarterly performance based on product unit sales and financial outcome. Yesterday I posted the revenue and earnings estimates of AFB members participating in the index for the three-month period ended in late June (Apple's FQ3 2011). Today I am posting the unit sales estimates that underpin the anticipated financial results. 

On average the 30 active AFB members participating in the June quarter index estimate Apple will report the following unit sales results by product line. Unit sales numbers are in thousands:

AFB Member AAPL FQ3 Unit Sales Estimate Averages:

Macs	4,330		(24.7% Unit Sales Rise)
iPods	8,335		(11.4% Unit Sales Decline)
iPhones	17,602		(110% Unit Sales Rise)
iPads	8,325		(155% Unit Sales Rise)

Notes On The Numbers:

Macintosh Unit Sales: In the first six months of the current fiscal year (September and March quarters) Macintosh unit sales have risen 25.2%. The AFB member average estimate for Mac unit sales in the June quarter is consistent with the recent unit sales growth trend. 

iPod Unit Sales: iPod unit sales have continued to decline. In the first six months of the current fiscal year iPod unit sales fell more than 10%. The mass adoption of smartphones such as the Apple iPhone with iPod functionality have reduced demand for single-use digital music players. The iPod touch, an iOS-based device, is now the largest unit sales component of the Apple iPod line. 

iPhone Unit Sales: In the March quarter iPhone unit sales rose 113% inclusive of the 155% domestic unit sales growth rate influenced by the release of the Apple iPhone on the Verizon network. In the first six months of the current fiscal year iPhone unit sales rose 99.5%. The average estimate of AFB members suggests the March quarter unit sales growth trend will continue in the June quarter.

Last year Apple significantly reduced iPhone unit shipments in the June quarter ahead of the  release of the iPhone 4, leading to favorable conditions for year-over-year unit sales gains in the June quarter this year. 

iPad Unit Sales: The June quarter is the first quarter in which prior-year iPad unit sales are available. Apple's ability to have met demand for the iPad 2 in the June quarter will have a significant impact of the quarter's unit sales results that will be released later this month.

For more information on Apple product unit sales results please see my article published on May 8th titled Apple: Ten Quarters of Product Unit Sales.

Robert Paul Leitao

Disclosure: The author is long AAPL shares

The AFB AAPL FQ3 Estimate Index

The Apple Finance Board (AFB) is home to many AAPL traders, investors and Apple product enthusiasts. Among the members of the AFB are well know independent analysts Daniel Tello (deagol), Horace Dediu (aysmco), Turley Muller and Andy Zaky. I serve as the moderator of the AFB under the DawnTreader moniker. 

AFB AAPL FQ3 Estimates

Each fiscal quarter active members of the AFB are polled for their estimates of Apple's quarterly performance based on product unit sales and financial outcome. This article highlights the anticipated financial outcome for the three-month period ended in late June (Apple's FQ3 2011). Tomorrow I will post the unit sales estimates from each index participant by product line that underpin these financial performance estimates. 

On average the 30 active AFB members participating in the June quarter index estimate Apple will report the following results for the company's third fiscal quarter:

AFB Member AAPL FQ3 Estimate Averages:

Revenue			$26,556	69.14%	(% YOY Revenue Growth)
Gross Margin			10,714	40.35%	(% of Reported Revenue)
Operating Expenses			2,542	9.57%	(% of Reported Revenue)
Pre-Tax Income			8,235	31.01%	(% of Reported Revenue)
Tax Expense			1,987	24.12%	(% of Pre-Tax Income)
Net Income			6,248	23.53%	(% of Reported Revenue)
EPS			6.66	89.61%	(% YOY EPS Growth)

All numbers in thousands except per share data.

During the first six months of the current fiscal year Apple's revenue rose 76.2% and eps rose 83.2% in year-over-year comparisons. As a group AFB members estimate the pace of revenue growth in the June quarter will have slowed slightly to 69.14%. However, the pace of eps growth is estimated to rise above the performance of the first six months of the current fiscal year to 89.61%.

Factors Impacting the June Quarter Financial Performance

The June quarter represents the first fiscal quarter in which Apple iPad sales are a factor in the prior-year performance. This factor alone will will have an impact on year-over-year revenue growth. iPad unit sales and the resulting revenue were not a factor in the prior-year financial performance comparisons in the December (FQ1) and March (FQ2) quarters.

Apple has effectively managed the growth in operating expenses relative to revenue growth. The company's ability to keep this major expense segment under 10% of reported revenue and the rate of growth of operating expenses well below the rate of growth of revenue is having a significant and positive impact on the company's earnings per share performance. AFB members are estimating the percentage of revenue that flows to the net income line will reach above 23.5%.

Robert Paul Leitao

Disclosure: The author is long AAPL shares