Apple's monster quarter can be explained in two words: China Mobile

This is a special Apple earnings edition post from Neil Cybart’s daily email about Apple. Neil is a former Wall Street analyst now focused on building an Apple analysis site called Above Avalon. Sign up for his daily email about Apple here.


Similar to last quarter, you need to search pretty hard to find any negatives or risks starting to appear. Quick checks with ASP, product mix, and upgrade rates all point to continued iPhone momentum through June.

There are a few things that are coming together to produce a “perfect storm” resulting in strong revenue growth with attractive margins. Apple is selling more $US650+ iPhones with 45% profit margin and fewer $US430 iPads with 25% profit margin. The end result was 25% revenue growth and more impressively, net income up 32% from last year.
There really isn’t any mistake about it. This is all due to China.

We were told for years that China was going to be huge for Apple, but we didn’t really see it play out in the financials. Everything changed last year when China Mobile, the world’s largest mobile carrier, started selling the iPhone. We are now seeing what may turn out to be the most robust growth the iPhone will see in China.

To get a clear perspective on what is happening, look at China Mobile’s customer numbers:

  • 429 million 2G: Not Apple’s target market quite yet.
  • 235 million on 3G: These customers represent the future growth of 4G for China Mobile.
  • 143 million on 4G: Apple’s primary target market.

Meanwhile, in the U.S., Verizon is the largest mobile carrier with 132 million total subscribers, and AT&T has 122 million.

China Mobile not only has more people on 4G than Verizon has altogether, but there are 5x as many subscribers in China working their way up the economic ladder to one day reach 4G.
This is why Apple is opening retail stores as fast as they can in China and why China made the initial country launch for Apple Watch. China will soon be Apple’s primary market in terms of sales. Apple’s record quarter three months ago was due to China, and now we have another record-quarter due to China.

The rest of the report

While the iPhone deserves all of the headlines, there are a few other subtopics. I think the best way of attacking this is to talk about what I think matters most first and then proceed down the importance scale.

1) Apple Watch. Management was a bit coy about Apple Watch, not really saying anything too extreme or unexpected. Luca Maestri made a comment about Watch margins coming in less than Apple’s overall margin (which is around 40%). The likely scenario is that Apple Watch Sport represented 70-75% of pre-orders. The Sport probably has a profit margin close to 30-35%.

If most of the Watches Apple sells at first has a 30-35% margin, then “Apple Watch’s margin is less than Apple’s overall margin” is pretty straightforward and simple to understand. In addition, Apple Watch Edition and the higher-priced Watch collection models haven’t shipped, and those are where all of the profit will come from. Recall our discussion about the 80-20 rule. I’m becoming increasingly confident that Apple shipped around 500-700K Apple Watches since the April 24th launch with Watch pre-orders likely around 3 million units.

2) Capital Return. Apple updated the capital return program by increasing the dividend to $US0.52/share and the repurchase authorization by $US50 billion. Not too many surprises with that. However, if you take a look at Apple’s cash flows, Apple spent less on buyback last quarter when compared to 2014. In fact, the drop-off in buyback pace was noticeable. I suspect the accelerated share repurchase (ASR) plans may be to blame here. Reported amounts may not match reported figures until you look at next quarter’s repurchase data. Even with spending $US10 billion on buyback and the dividend, Apple’s cash levels grew $US16 billion to $US193.5 billion ($US33/share).

3) R&D. Apple’s R&D expense is exploding higher, up 35% from last year. I suspect this is related to Apple Car initiatives. Luca even mentioned R&D will remain elevated and continue to increase going forward. While there is continued innovation left in iPhone, iPad, and Mac, and of course Apple Watch, I have trouble seeing how any of that adds up to the increases Apple is reporting. There is something big going on here.

4) Best Buy. Management announced that Best Buy will accept Apple Pay in all of its U.S. stores later this year. Best Buy is one of the largest MCX members. As a reminder, MCX is a consortium of retailers that have been pushing Current C, a rival to Apple Pay. This may mark a very significant development for Apple Pay. If a key MCX member accepts Apple Pay, I would expect others to follow because there is little incentive to stick with MCX, a service that has no clear value proposition for the consumer. Departures would likely spell the death of MCX and Current C. Apple Pay needs additional retailers in the U.S., and this may just may be the start of that phase. This could be a very big deal.

There were plenty of other items talked about on the call, but they are more “interesting tidbits” than anything else. My comments are italicized:

– iPhone unit sales were up 63% in emerging markets. Apple is doing well in many countries, not just China.

– iPhone sales doubled in Korea, Singapore, Taiwan, and Vietnam. Three words: large-screen iPhones.

– iPhone sales up 80%+ in Canada, Mexico, Germany, and Turkey. Even mature markets saw decent growth.

– iPhone channel inventory increased by 1 million units, putting Apple at the low end of its targeted 5-7 weeks of channel inventory. Not much channel stuffing.

– App Store revenue was up 29% year-over-year. Apple wants people to know iOS users are spending money on apps.

– 27 acquisitions in the last six quarters. Small, bolt-on acquisitions.

– 40 retail stores in Greater China by middle of next year (21 stores now). 40 is still very small compared to the potential.

– Apple extended the duration of the buyback to March 2017. Apple is buying themselves more time with buyback – they are already likely buying back as much stock as they can.

– FX impact is declining a bit (40 bps negative impact on margin after hedging this quarter vs. 100 bps last quarter). The dollar is stabilizing.

– Begin rollout of Apple Watch to new countries by late June. Apple is confident Watch supply will ramp up in May/early June.

– Payments to developers in Greater China of almost $US5 billion (half of which was in last 12 months). Not so subtle reminder to developers in Greater China that there is money to be made with iOS.

– Tim Cook: “we’re on the early stages of just major, major changes in media that are going to be really great for consumers, and I think Apple could be a part of that.” Apple’s new music and video services.

We now have two quarters of 40% EPS growth and looking at Apple’s revenue guidance which is between $US46 and $US48 billion, Apple may actually report stronger EPS growth for 3Q15 than both 1Q15 and 2Q15. Apple is telling the world that 3Q15 will be another strong quarter.
This was a special earnings edition of Neil Cybart’s daily email about Apple. You can sign up for Neil’s daily email here.

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