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Apple Reports Another Decline in iPhone Sales, Stock Rallies Anyway

Peak Apple? Probably not yet.

The Apple Inc. third quarter earnings release reported another year over year decline in earnings and revenues after the closing bell today. The company posted quarterly revenue of $42.4 billion and quarterly net income of $7.8 billion, or $1.42 per diluted share. These results compare to revenue of $49.6 billion and net income of $10.7 billion, or $1.85 per diluted share, in the year-ago quarter. Gross margin was 38% compared to 39.7% in the year-ago quarter. International sales accounted for 63% of the quarter’s revenue. 

Earnings, down 23% year over year, beat the Wall Street consensus estimate of $1.38/share by 4 cents/share. Revenues, down 14.5% year over year, beat Wall Street's consensus estimate of $42.1 billion by $300 million. Apple's results were not great, but they were not as bad as many bears had expected. The midpoint of the company's guidance for Q4 revenue came in above Wall Street's consensus estimate of $45.8 billion by $700 million. The stock is up over 7% in afterhours trading on the back of these better than expected results.

It is not all apple sauce for shareholders today, as the company reported year over year decreases in unit sales of iPhone, iPad, Macs, and other products (Apple TV, Apple Watch, Beats products, and accessories). One standout in the Q3 results was the Services segment with year over year 19% sales growth. Services is now the second largest revenue segment at Apple Inc., with Q3 revenue of $5.9 billion. This operating segment includes Internet Services, Apple Pay, and App Store.

Another interesting data point is that while iPad experienced a 9% decline in year over year unit shipments, the product segment was able to grow revenue at 7% on higher average selling prices. This is most likely attributable to customers upgrading to higher priced iPad Pros. The iPhone segment experienced the opposite phenomenon as unit sales dropped 15% year over year while revenue dropped 23% on lower average selling prices of the smartphone, likely the result of the launch of iPhone SE that ramped up during the quarter. This is the second consecutive quarter that Apple Inc. has reported year over year declines in iPhone sales and company-wide revenues. iPhone represented 56% of Apple's revenues in the quarter.

Macintosh sales only make up 12% of Apple's revenues, and were down 13% year over year. Mac appear to be slowing more rapidly than the broader PC industry. We will know more as the rest of tech companies report their quarterly results, but this is a new trend that Apple Inc. needs to address with a more compelling lineup. They have not materially updated their flagship MacBook Pro line this year, and that could provide potential upside going into the end of the year.

Apple Inc. ended the quarter with $231.5 billion in cash, down $1.5 billion from $233 billion on the balance sheet at the end of Q2.  The company's cash hoard decreased for the first time in seven quarters. The company returned over $13 billion to investors through share repurchases and dividends in the quarter, and have now completed almost $177 billion of the ongoing $250 billion capital return program. Apple’s board of directors has declared a cash dividend of $.57 per share of the Company’s common stock. The dividend is payable on August 11, 2016 to shareholders of record as of the close of business on August 8, 2016.

Why is the stock up 7% on such mediocre news? I believe that investor sentiment had gotten too negative since the company lowered their guidance earlier this year. Wall Street was positioned for another flush to 52 week lows in the share price and when the results came in the bears had to cover their shorts. I believe that we are in a period similar to 2004-6 for Apple Inc. In those days, iPod represented more than 65% of revenues and many bears claimed that we were witnessing "Peak Apple." Our own Chatty community had a discussion about this just last week.

"I'm not saying apple will go away so much as I'm saying we have hit peak apple" - bradsh, Chatty user.

Most of the media is claiming that Apple's best days are behind it as iPhone sales are slumping. Others pile on the negativity saying that the company has yet to prove they can innovate without Steve Jobs. Apple Inc. has a history of introducing a new product category as another one matures. It is easy to claim we have witnessed "Peak Apple" after 9 years of iPhone sales growth, but it may be just as misinformed of a statement as those who claimed the company was peaking when iPod demand peaked. Peak iPhone? Maybe. 

Peak Apple? I doubt it. The company is opening their brand new space ship campus next year. This was a project introduced by Steve Jobs just a few months before his passing. A project introduced in 2011 that will not be completed until 2017. This is the pace at which Apple does business. Steve Jobs began conceptualizing the iPad as early as the 1980s, prototyping began in the early 2000s, and the product ultimately launched in 2010. Apple bulls believe that there were multiple things left in the pipeline before his passing. Steve Jobs famously told Walter Isaacson that he "cracked the code" in television, and we have yet to see Apple Inc. or anyone else truly disrupt the product category.

Faith is not an investment strategy, but it is required to believe that there is material upside to Apple's stock. Investors have to believe that there is another product category that can spur revenue growth at the company. Otherwise, declining average selling prices and margins will erode Apple's profitability and ulimately lead them into a lost decade similar to the 2000s for Microsoft.

Apple is investing in new products. Research and Development expenses are at their highest level in history and there are rumors continuing to swirl about an electric vehicle project. Tim Cook praised Pokemon Go on the conference call and reaffirmed that Apple will continue to invest in AR. With the amount of cash at their disposal, I wouldn't bet against Apple right now.

2016 will undoubtedly be a forgettable year for Apple, but it remains to be seen which way the company's fortunes will bounce from this inflection point. At the end of the day, the stock trades at a discount to its peers and the S&P 500. It is one of the worst performers in the Dow Jones Industrial Average this year and revenues continue to decline. It is completely understandable to think that the company's best days are behind it, but they are generating huge cash flows from a dedicated user base.

I will continue to stay invested in the stock, which I have owned since 1997. The stock trades at 11 times forward earnings estimates and pays investors a 2.3% dividend yield to wait and see if their faith is founded in logic or just a foolish desire for one more thing.

Full Disclosure:

At the time of this article, Asif A. Khan, his family members, and his company Virtue LLC had the following positions:

Long Apple Inc. via AAPL common stock and options

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