Apple Q1 Numbers: Missing Explanations
by Jean-Louis Gassée
By the end of October 2018, Apple was on its way to a decent quarter. Sixty days later, $7B in revenue is missing. Tim Cook writes to his shareholders but leaves one or two key questions unanswered.
[Quickly: To confuse mere mortals, Apple’s accounting year (or fiscal year, FY) starts in October. Thus, Q1 FY 2019 runs till the end of December, 2018. Confusing, but it could be worse: HP begins its fiscal year on November 1st.]
On November 1st, 2018, Apple releases its numbers for the Q4 FY 2018 quarter ending in September. The company also provides the following guidance, a ritualistic, no warranties expressed or implied forecast for the quarter that has already started and will end two months later in December [as always edits and emphasis mine]:
• Revenue between $89B and $93B
• Gross Margin between 38% and 38.5%
• Operating Expenses between $8.7B and $8.8B
• Other Income of $300M
• Tax Rate of approximately 16.5%
Last week, on January 2nd, Apple CEO Tim Cook has so-so news for shareholders. Preliminary and approximate numbers for Q1 FY 2019 (the quarter just ended) don’t look as expected 60 days ago:
• Revenue of $84B
• Gross Margin at 38%
• Operating Expenses of $8.7B
• Other income of $550 million
• Tax rate of 16.5%
The November 1st guidance midpoint for revenue, $91B, was a reasonable expectation. In just two months, Q1 revenue shrank to $84B, a $7B fall (-8%). Management calls the newer number an estimate, but we can be less ambiguous: Aboard Tim Cook’s tight ship, the revenue number is tracked on a weekly basis and is known with high precision right when the quarter closes.
In layperson’s language, there seem to be two explanations for the $7B miss: China and the “S Factor”.
First, China. For several months, economists have warned us: The Chinese economy is slowing down. Greater China, as Apple’s calls it, represents (or represented) 18% of Apple’s revenue. 18% of $91B is $16B; cut this in half and you have a $8B miss. Higher than Apple’s projected $7B miss, but you get the idea.
Second, the S factor, exemplified by what happened between the iPhone 6, released in late 2014, and the 6S a year later. When it came out, the iPhone 6 fulfilled a previously frustrated desire for the significantly larger screens offered by Samsung and a few Chinese competitors. As a result, Apple revenue for Q1 FY 2015 (the iPhone 6 launch quarter) jumped a sizable 30% to $74.6B. iPhone revenue alone increased 57% to $51B. A year later, the iPhone 6S is released and Apple revenue is up a meager 2% to $75.9B, with iPhone revenue an anemic +1% to $51.6B. The S model isn’t different or exciting enough to move mountains of upgrades.
We see the phenomenon again in 2017. The iPhone X is a breakthrough, a visibly, neatly functional innovation. A year later, the XS iteration is seen as just that, an iteration that stretches the formula without a striking difference. (Here, I’ll insert a saying from the auto industry: When a car maker starts throwing extra words onto a model designation — the Jalopy 16S Special Sport — it’s not a good message. The product is getting old, it’s sprouting wattles and dewlaps. The analogy isn’t entirely apt for iPhones, of course, but one wonders: Would shorter model names convey a better message? iPhone 11 vs iPhone XS Max?)
Between these two explanations, China and the S Factor, we could have enough to account for the $7B miss.
Still, a few questions remain.
Let’s start with a quibble. In his January 2nd letter to shareholders, Apple’s CEO points to inexpensive battery replacements as a source of the company’s revenue shortfall. Rather than upgrade to a shiny new Phone XS or XR…
“… customers [took] advantage of significantly reduced pricing for iPhone battery replacements.”
I have a hard time believing that the $29 limited time offer had a significant impact on Apple’s numbers. Did Apple replace hundreds of thousands of batteries? I doubt it. At 100 replacements per Apple Store times 500 stores, that’s 50K happy customers and only $50M in missed new iPhone revenues. I’d have to be off by a factor of 10 — half a million iPhone battery upgrades, one thousand repairs per Apple Store — to approach a mere $500M in missed revenue.
[Update: My battery upgrade discussion above is wrong in two ways.
1. As readers pointed out, my numbers estimate might be too low.
2. And… the error might not matter. Apple had full knowledge of battery replacement numbers when issuing its Nov 1st guidance.
In his Jan 2nd letter,Tim Cook' cites battery replacement as one of the reasons for the $7B fall since Nov 1st guidance. This is logically strange, to be polite, because the influence of $29 battery replacement program was already factored in Nov 1st guidance. Ah, well… apologies for not seeing the inconsistency sooner.]
A more serious issue is Apple’s blind spot regarding China. I distinctly recall Cook telling analysts during a quarterly earnings call that, having studied the country for 30 years, he knew China. This is true and relevant. Cook’s ascension to the COO and, later, to the CEO job is due to his prowess building and managing Apple’s nonpareil Supply Chain Management (SCM) system. Imagine the thousands of parts inside an iPhone, and then picture building ten iPhones per second, 24 hours a day at the peak of the Holidays season, and shipping them to 130 countries… No question, one has to know China, the people, the culture, companies large and some small to make the SCM magic happen year after year, with only the rarest of hiccups.
With all of these strengths, how could Apple, which is more embedded than most Western companies, not see a Chinese economy slowdown that started well before the 2018 Holiday quarter? More specifically, what did Apple know and not know when they issued a guardedly optimistic Q1 revenue guidance in the $89B to $93B range on November 1st? What did they learn in the following 60 days, how much, how fast? (Unsurprisingly corporate ambulance chasers have already filed Class Action suits.)
Looking briefly at the other numbers, we see no sizable impact on Gross Margin or Operating Expenses (OPEX). Short-termers will grouse that Apple ought to cut expenses in line with the revenue shortfall. Apple execs claim their game isn’t played to a 90-day clock, that OPEX is tied to long term plans for new products and product lines — and they’re not about to tell us what those plans are.
Other Income, which bundles numbers such as the consequences of currency fluctuations, grew from $300M to a new estimate of $550M. Although the ratio is impressive (+85%), the actual amount is insignificant and is only disclosed for regulatory purposes. Let’s just ignore it for our lay purposes.
Speaking of ordinary mortals, starting with FY 2019, Apple no longer shows us detailed product numbers, units, and revenue. This will change the guessing game, one I will address in an upcoming Monday Note, mostly in an attempt to shed light on some recurrent themes, or fallacies, such as Apple’s Wall Garden or Lowering iPhone prices. As we’ll see, Apple is still a psychedelic, a creator of hallucinations.
— JLG@mondaynote.com
