Apple's (AAPL) knockout first quarter has left investors in a daze. Some dismiss it as a burst of bottled-up demand for the new iPhone 6 and iPhone 6 Plus, its first smartphones to boast a larger screen - a major draw of rival devices. Others laud it as the renaissance of the Silicon Valley giant; a return to its glory days of consistently besting market expectations.
Two years ago, our cover feature peeled Apple open and scrutinised its core. At the time, the business was in a lull, innovation seemed lacking and margins looked a little thin. Critics questioned whether its handful of high-end products could stand out in a crowd of cheaper, similar devices. We pondered whether Apple chief Tim Cook could step out of founder Steve Jobs' shadow and spearhead a new era of growth; eventually we concluded that Apple offered an "irresistible" buying opportunity. With the shares up over four-fifths since (adjusted for a seven-for-one stock split), it appears we made the right call.
Cheering investors should keep a level head, however. We've often lamented Wall Street's myopic focus on quarterly earnings and its propensity for swift punishment, but it's equally important not to get carried away by a blockbuster performance. Certainly, some of the questions we posed have been laid to rest; Mr Cook has proven to be a worthy successor and capable leader, and Apple has held its own against fierce competitors Samsung (SMSN) and Chinese handset-maker Xiaomi. Others remain salient: can investors expect a windfall from Apple's enormous $142bn (£94.2bn) net cash pile, or will it be returned in dribs and drabs?
Let's consider what we do know. Apple continues to show a near-miraculous ability to sell record numbers of devices at ever-higher prices and margins. That not only reflects Mr Cook's command of the supply chain, but the enduring appeal of the iPhone, which accounts for over two-thirds of group revenues. Yet Apple's greatest strength - and what separates it from the competition - is its rich ecosystem of hardware, software and services, roped together by a powerful brand. It has even managed to broaden its products' appeal - without devaluing its premium offerings - by discounting older devices such as the iPhone 5s and 5c, which remain best-sellers in multiple markets.
Investors may worry that Apple's sterling performance has set it up for a fall. Where does it go from here? Similar to a marathon runner who breaks the world record, Apple must now set its own goals and push the boundaries of possibility, which can be tougher than jostling with the pack. Mr Cook has allayed shareholders' consternation with a clear game plan: expand internationally, plug the iPhone and launch new products and services.
Apple earns just under two-thirds of its revenues overseas, leaving substantial room for growth. Indeed, a recent landmark deal with carrier China Mobile drove first-quarter sales up 70 per cent in Greater China - comprising China, Hong Kong and Taiwan - to over $16bn; a 26 per cent rise in US revenues looks modest by comparison. As for the iPhone, Apple is attracting record numbers of first-time buyers and switchers from Google's (GOOG) Android platform. Moreover, less than 15 per cent of iPhone owners have upgraded to the latest devices, leaving an estimated 340m potential customers in the pipeline.
On the product front, Apple is currently rolling out its contactless payments system, Apple Pay. Around 750 banks and credit unions have signed up, along with big-name retailers such as McDonald's and Nike. Just three months after release, the majority of domestic contactless purchases are conducted on the platform, and an overseas rollout should follow soon. There's also the upcoming Apple Watch, which will mark Apple's entry into its first new product category in five years - it launched the iPad in April 2010. And Beats, the preppy headphone brand and music-streaming service it bought for $3bn in 2014, could rejuvenate its iTunes business.
Apple faces its fair share of short-term headwinds. For instance, management have warned that currency volatility and a strengthened dollar could weigh on revenue and gross margin this year. It also has work to do with the iPad - first-quarter sales were down 22 per cent for a range of reasons: fierce competition from cheaper tablets, consumers skipping a dedicated tablet in favour of a large phone or small laptop, and owners waiting longer to upgrade. Apple is working with IBM to address the enterprise market, but it doesn't foresee a short-term turnaround.
Our main concern is the aforementioned Apple Watch, due in April. Along with the usual risks of introducing a brand new device, we think Apple may have to adapt its current in-store strategy of encouraging customers to pick up and play. That could prove unwieldy for selling a pricey watch that comes in two sizes, six colours and a choice of half-a-dozen straps. Visitors will want to try it on and fiddle with its many apps and features, potentially leading to long waits and irritated customers. The watch also requires an iPhone 5 or 6 to work, limiting its user base, and reportedly needs to be charged after only a few hours of use. Most worryingly, though, it will seek to replace the traditional watch - a status symbol with a rich history that doesn't become obsolete within a year or two.
On the other hand, Apple Watch owners will be swaddled more tightly in Apple's cloud of devices, apps and services; leaving becomes a headache when one has to move mountains of music, photos and documents. It's also easy to forget the allure of Apple's brand. Morningstar analysts predict blind loyalty: "We foresee millions of loyal Apple users buying watches, almost regardless of the device's functionality, battery life or operability."
IC view: History has shown that prolific, innovative and dominant companies eventually fall into irrelevance or ignominy. Just look at Xerox in copiers or Kodak and Polaroid in photography. However, we're confident that Apple can stave off that fate for many years to come. Its outlook remains strong; analysts at Hilliard Lyons expect sales to rise a fifth to $220bn this year, and pre-tax profit to rise 22 per cent to over $65bn. Although Apple's shares have surged two-thirds in the past year to $119, strip out cash of $24 a share and they trade at an appetising 11 times broker Hilliard Lyons' forecast EPS of $8.33 for 2015. We think investors should give in to temptation and take a bite of Apple.
Apple's iPhone 6 bears fruit
Apple's first quarter was one for the history books. It sold 74.5m iPhones - a 46 per cent rise - at a higher average price of $697. That sent sales and net profit up 30 and 38 per cent respectively, to $75bn and $18bn. Furthermore, Apple widened its gross margin by 2 percentage points to 40 per cent, a two-year high. Unsurprisingly, its shares leapt about 9 per cent over the next two days.
The Silicon Valley giant expects a sharp dip in second-quarter sales to $52-$55bn, reflecting currency pressure and the absence of the holiday season. Still, that suggests it will sell 55m iPhones - the second-highest amount ever. Moreover, Chinese consumers' penchant for luxury gift-giving during Chinese new year should buoy sales in February.
Unsurprisingly, Apple's polished performance had ramifications for both its suppliers and competitors. Shares in Arm (ARM) and Imagination Technologies (IMG), which design the microchips used in iPhones and iPads, rose 2 and 3 per cent on the news. Shares in NXP Semiconductor (US:NXPI), co-inventor of the near-field communication (NFC) technology that underlies Apple Pay, and ams (Swi:AMS), whose chips boost the iPhone's NFC functions, also crept up. Moreover, Apple suppliers SK Hynix and LG Display - which specialise in microchips and LCD screens, respectively - doubled their profits last quarter. On the other hand, Apple snatched market share from Samsung's (SMSN) smartphones, contributing to declining full-year mobile sales after several years of double-digit growth. That, in turn, weighed on chipmaker Qualcomm, one of Samsung's key suppliers.
Brokers' views:
Brian Colello, Morningstar: The key to Apple's continued success is its ability to maintain a robust ecosystem. That will generate repeat purchases by keeping new users tied to its platform. We anticipate that apps, services such as Apple Pay, and connectivity to devices including iPads and Macs will keep most customers coming back to buy future iPhones. That should help Apple to avoid the violent swings in market share and earnings that have plagued other smartphone vendors such as Nokia, BlackBerry and, more recently, Samsung. They didn't control valuable services and software assets, preventing them from converting their large user bases into repeat customers.
Chris Caso, Susquehanna Financial Group: Migration to higher memory tiers and the higher-priced iPhone 6 Plus helped bump up the average selling price and margin on Apple iPhones last quarter - a trend that should persist over the next two years. We expect material costs to fall as the year progresses, which may be enough to offset currency movements. Apple will probably cut the price of the iPhone 6 when the next iPhone is released, spurring further upgrades and first-time purchases. We also look forward to an update on Apple's cash return programme in April - given the strong cash generation this quarter, we expect management will have a lot to talk about.
Walter Piecyk, BTIG Research: Apple has shown that it can deliver strong revenue and EPS growth in 2015, but its stock valuation doesn't adequately reflect that. Its current share price is justified by the growth potential of its existing products, but doesn't account for Apple Watch. Nor do we think that a raft of upgrades in 2014 precludes another in 2015; none of the US wireless operators seem to expect a material fall-off in upgrade rates this year. Therefore, we expect iPhone unit sales to grow 8.5 per cent to 209m this calendar year, and forecast 80m iPhones will be sold in the December quarter.
