Steady improvement in hardware gross margin, venturing into AI (Apple FY24Q1 conference call)

Apple (AAPL.O) Q1 FY2024 Earnings Report Highlights (as of December 2023) were released after the US stock market closed on February 2, 2024. The key points from the conference call are as follows:

1. $Apple(AAPL.US) Financial Highlights:

1.1 Overall Performance: Revenue & Gross Margin slightly exceeded expectations. Apple achieved a revenue of $119.6 billion in this quarter, a YoY growth of 2.1%, slightly surpassing the market consensus of $118 billion. The revenue growth was mainly driven by Apple and Services. Apple's gross margin was 45.9%, an increase of 2.9 percentage points YoY, slightly exceeding the market consensus of 45.5%. The software gross margin has remained above 70% for 10 consecutive quarters.

1.2 Apple: Growth without alpha. The global smartphone market shipments rebounded to single-digit growth this quarter, and Apple's performance in the Apple business was similar to the overall industry. Dolphin Research estimates that Apple's average selling price of smartphones in this quarter has slightly declined, mainly due to competition in the Greater China region, which directly affected product sales performance and subsequently the average selling price.

1.3 Other Hardware outside of Apple: Generally in line with expectations. Other hardware businesses such as iPad and wearables both experienced double-digit YoY declines this quarter, which were the biggest drag on the company's performance. Insufficient end demand directly affected the performance of the hardware segment.

1.4 Software Services: Setting new records. Software services generated a revenue of $23.1 billion this quarter, close to market expectations ($23.37 billion). Both the revenue and gross margin of the software business reached new highs this quarter. Software services remain the most robust part of the company, with continuous business growth. Even in a situation where hardware growth is not significant, the company's software business still achieved double-digit growth.

1.5 Overview:

2. Detailed Content of Apple's Earnings Conference Call

2.1 Executive Statements:

The day after the earnings call, Apple Vision Pro will be launched in the United States and will subsequently expand to other countries. Companies such as Walmart, Nike, Vanguard, Striker, Bloomberg, and SAP have already started utilizing and investing in Apple Vision Pro as a new platform.

Apple will continue to invest in shaping the future of technology, including artificial intelligence, and will share details of its work in this field later this year.

Apple's revenue in the first quarter was $119.6 billion, a year-on-year increase of 2%, despite being one week shorter than the previous year.

Apple achieved historic revenue records in Europe and other Asia-Pacific regions, with strong performance in emerging markets, most of which saw double-digit growth.

Apple's product revenue in the first quarter was $96.5 billion, on par with the previous year. Apple, Mac, and iPad all achieved good revenue, with Apple revenue reaching $69.7 billion, a 6% increase compared to the same period last year; Mac revenue was $7.8 billion, showing growth recovery; iPad revenue was $7 billion, a 25% decrease year-on-year.

Apple's revenue in Wearables, Home, and Accessories was $12 billion, an 11% decrease compared to the previous year, due to the timing of product releases and the impact of the 14th week of the previous year.

The number of active devices in Apple's total installed base reached a historic high, exceeding 2.2 billion, and continues to grow steadily.

In terms of services, Apple achieved a revenue record of $23.1 billion, an 11% increase year-on-year. Additionally, Apple set revenue records in advertising, cloud services, payment services, and video, with App Store revenue reaching a record $2.6 billion, a 17% increase year-on-year.

Both active accounts and paid accounts reached historic highs, with double-digit growth in paid accounts. Furthermore, our paid subscriptions have shown strong double-digit growth. The number of paid subscriptions on our platform has exceeded 1 billion, more than double that of four years ago.

Profit and expenses: a) The company's gross margin was 45.9%, an MoM increase of 70 basis points, with product gross margin at 39.4%, an MoM increase of 280 basis points, and service gross margin at 72.8%, a 190 basis point increase compared to the previous year. b) Apple's net profit in the first quarter was $33.9 billion, an increase of $3.9 billion compared to the previous year. c) Diluted earnings per share were $2.18, a 16% increase compared to the previous year, reaching a historic high. d) Apple's operating expenses in the first quarter were $14.5 billion, within the expected range, a 1% increase year-on-year.

Cash position and capital return plan: a) Apple had $173 billion in cash and marketable securities at the end of the quarter. Apple reduced commercial paper by $4 billion, resulting in net cash of $65 billion, and our goal is to achieve net cash neutrality over time. b) In this quarter, we returned nearly $27 billion to shareholders, including $3.8 billion in dividends and equivalents, and $20.5 billion through the repurchase of 112 million Apple shares. An additional 6 million shares were returned through the 19th accelerated share repurchase program. c) On February 15th, a cash dividend of $0.24 per share of common stock will be paid to shareholders.

Guidance for the next quarter: a) Apple expects the macroeconomic situation in the second quarter to not be worse than currently forecasted. b) The exchange rate is expected to have a negative impact of approximately 2% on annual revenue. c) In the second quarter of last year, due to supply shortages of the iPhone 14 Pro and 14 Pro Max, Apple replenished channel inventory and met significant pent-up demand, which increased total revenue in the second quarter of last year by nearly $5 billion. d) Total revenue for the second quarter of this year is expected to be similar to last year, excluding the impact of last year. e) The services business is expected to maintain double-digit growth similar to the first quarter of last year. f) The gross margin is expected to be between 46% and 47%. g) Operating expenses are expected to be between $14.3 billion and $14.5 billion. h) Other income and expenses (OI&E) are expected to be approximately $50 million, excluding the potential impact of market value and tax rates on minority investments.

2.1 Q&A Analyst Questions and Answers

Q: The outstanding performance in the first quarter, as well as the record gross margin, suggests that higher-margin businesses may be exceeding expectations. Can you provide more details on the drivers of the services business? And what is the forecast for services growth in the second quarter?

A: Apple's services business grew by 11% in the first quarter, reaching a record high of $23.1 billion, and set records in the Americas, Europe, and other Asian regions. The growth of the services business was strong across all categories, including cloud services, payments, video, and advertising. Additionally, the App Store and AppleCare also set records. The 11% growth rate is higher than the number we reported due to the extra week last year. The entire ecosystem performed well as both transacting and paying accounts continued to grow and reached all-time highs, and paid subscriptions continued to grow at a double-digit rate. We now have over 1 billion paid subscriptions on our platform, which is twice the number we had four years ago. Looking ahead to the second quarter, the services business will continue to grow at a similar percentage as the first quarter, with double-digit growth rates. More information on the specific performance of different service categories will be provided in three months.

Q: Can you share some specific details about the new users added in the past 12 months? Are these new users different from past new users in terms of geographic distribution, product selection, and payment trends?

A: Apple's revenue in emerging markets such as India grew by double digits, setting quarterly revenue records. Other emerging markets such as Indonesia also set quarterly records, and record sales were achieved in Latin America and the Middle East. This trend has continued in other quarters this year as well.

Q: Given the impact of the extra week in the first quarter, why is Apple not more optimistic about services growth in the second quarter? Did the price increases for certain Apple One services last winter contribute to services growth in the second quarter? A: Apple expects some negative foreign exchange impact in the second quarter, while foreign exchange remained relatively stable in the first quarter. This means that foreign exchange factors will pose some challenges to the growth of the service business in the second quarter. Compared to the first quarter, the growth of the service business in the second quarter will face some difficulties, as the base will be slightly higher.

Q: How will you support the Vision Pro developer ecosystem? Do you have any thoughts or plans regarding the upcoming AI products?

A: Apple is very excited about the opportunities for Vision Pro in the enterprise field. Apple has showcased some Vision Pro application examples from different companies, including Walmart's product promotion app, design collaboration app, on-site service app, and control center app. SAP's support for Vision Pro will bring tremendous opportunities for Apple in the enterprise. Apple has a lot of internal work going on in AI generation and will be releasing some exciting results later this year. Apple's strategy is to do first and talk later, so they will maintain this approach and announce more information at the appropriate time.

Q: How did Apple achieve revenue growth in the first quarter despite facing intensified competition in the Chinese market and longer replacement cycles for Apple products? What is your view on Apple's overall performance in the 15 cycles?

A: Apple's revenue in the first quarter grew by 6%, reaching a historic high. Apple's sales performance was strong in multiple regions around the world, especially in Europe and the Asia-Pacific region. In some emerging markets such as Latin America and the Middle East, Apple's sales performance was also outstanding. Apple's upgrade user base reached a historic high, and the global installed base of Apple devices also reached a historic high. In countries and regions such as the United States, Japan, urban China, the United Kingdom, and Australia, Apple is among the top five smartphone models. Apple 15 has a user satisfaction rate of 99%. Since the release of Apple 15, its sales performance has surpassed that of Apple 14, especially in the post-release period. The increase in Apple's upgrade user base is very exciting for Apple.

Q: How will the success of Vision Pro be measured over time? Which Apple products' adoption curve may be most similar to that of Vision Pro? Is it possible for Vision Pro to surpass products like the iPad in terms of revenue over time?

A: The success of Vision Pro will be unique to each product and cannot be directly compared to other products. Apple is very excited about Vision Pro internally and has received a lot of feedback and expectations from developers and customers. Vision Pro is being showcased in multiple Apple stores in the United States for customers to experience. Vision Pro incorporates a wealth of technology, with 5,000 patents and is built on Apple's innovation in various fields such as silicon, displays, AI, and machine learning over the years.

Q: How does Apple's performance in the Chinese market compare to other regions? What is the current situation in the Chinese market in terms of competition and demand?

A: In mainland China, Apple's sales have experienced a moderate decline year-on-year when measured in fixed currency. Despite the overall sales decline, Apple has seen an increase in the number of upgraded users in mainland China, with four out of the top six positions in urban areas. Additionally, according to IDC data, Apple is the largest smartphone brand in the Chinese market for both the full year and the first quarter. Despite the sales decline, Apple still aims to maintain growth in the Chinese market.

Q: What important updates did Apple make to the App Store after implementing DMA in Europe? Does NetApp have a significant impact on Apple's services or the overall financial statement of Apple?

A: Apple has implemented a series of updates in Europe, including offering alternative billing opportunities and opening up new NFC functionalities, which will take effect in the quarter starting in March. Apple has always prioritized privacy, security, and usability and strives to maintain a similar ecosystem as in the past. Due to regulatory compliance, Apple cannot provide maximum supply. It is difficult to predict the choices of developers and users accurately, so the implementation in the March quarter needs to be observed. These changes primarily apply to the European Union market, which accounts for approximately 7% of Apple's global App Store revenue.

Q: In the most recent quarter, Apple's product gross margin showed a significant trend. Do you think this is related to the component purchase obligations implemented a year ago? Have these obligations had a positive impact? How do you view the impact of component pricing environment on product gross margin in the future?

A: The increase in product gross margin is mainly attributed to strong sales of Apple's high-end models and the leverage effect brought by the fourth quarter, which is the largest quarter of the year. Foreign exchange rates have partially offset the positive impact on product gross margin, but overall, the increase in product gross margin is significant. In terms of services, the increase in product gross margin is also attributed to a more favorable mix. The company's overall product gross margin rate is 45.9%, a 70% increase compared to the previous quarter. Compared to the already strong results in the first quarter, the company expects the overall product gross margin rate for the next quarter to further expand to 46% to 47%.

Q: Considering that Apple's capital expenditures decreased last year, how should we consider the strength of Apple's capital expenditures as the company increases its investment in generative AI? Will the investment and expenditure in generative AI by other major tech companies affect Apple's investment strategy? A: We will never underinvest in our business and are making necessary investments in various aspects such as product development, software development, and service development. We will continue to invest in all areas of our business and maintain an appropriate level of investment.

Q: Regarding the impact of the $5 billion mentioned by Luca, is it referring to product revenue or total company revenue? Last year, some commodity costs showed deflation, but now it seems to be turning into inflation. At the same time, Apple has also made some progress in the Mac transition. Can Luca share how much room for improvement there is in Apple's product gross margin?

A: Last year, the factories for Apple 15 Pro and Pro Max were closed due to COVID-19, resulting in supply chain disruptions. As a result, there was pent-up demand for these products in the first quarter of last year, which was fulfilled in the second quarter of this year, along with channel fill. In terms of product gross margin, the company's gross margin has consistently been at a high level and has seen good expansion in recent quarters. Currently, the company expects the gross margin to be between 46% and 47%, taking into account all the ongoing factors including the commodity environment, foreign exchange situation, and the mix of products and services. The company is very satisfied with this forecast.

Q: What is the outlook for Apple's future? Will Apple continue to adhere to its consumer-centric positioning, or will it focus more on the enterprise sector in the future?

A: The company can delve into the enterprise sector while maintaining its consumer-centric approach. In the past few years, many companies' employees have been able to choose the technology that suits them best, which has brought Apple a great advantage. Many people use Mac at home and also want to use Mac in the office. The iPad has also benefited from this. Vision Pro has had over 1 million apps from the start, with over 600 specifically designed for Vision Pro. There are some of the most innovative things they have seen in the enterprise for a long time, and they believe Vision Pro has a great opportunity for success in the enterprise.

Q: Are there any specific issues facing the Americas market compared to the Chinese market? Such as the situation with US carriers? Is the sales cycle or replacement cycle lengthening? What changes need to be made to reaccelerate business in the Americas, especially Apple's business? The sales in the second quarter of last year were brought forward, and even excluding this factor, it was the weakest quarter since the COVID pandemic. Are there differences in the macroeconomic conditions in different regions? From the perspective of macro demand, are we approaching a trough? Or will this specific weakness continue for a long time?

A: For the Americas market, especially the US market, Apple's Apple business grew in the first quarter of last year and reached a record high in terms of installed base. It is difficult for Apple to measure replacement cycles at any specific point in time, as they focus more on active installed base and sales cycles. In the US market, Apple occupies the top four spots for best-selling smartphones, with a customer satisfaction rate of 99%. In the March guide, the author pointed out that the COVID year has been turbulent and volatile, and compared to previous years, the progress from December to March this year is actually stronger than those years.

Q: Last quarter, Tim still believed it was a growth market. Given the performance this quarter, has there been a change in attitude? Are there any signs that this market can recover and grow in the future?

A: Apple has a 30-year history in the Chinese market, and Tim has maintained a long-term optimistic attitude towards the Chinese market. Apple has reached a new installation base, reaching a historical high, and the growth of upgraded users in the first quarter is also satisfactory.

Q: What are your views on the idea that AI and processing on smartphones and similar devices will play a huge role in AI and AI applications? Do you think Apple can leverage this trend?

A: Apple has great opportunities in general AI and AI. We won't reveal more details for now to avoid prematurely disclosing future plans.

Risk disclosure and statement for this article: Dolphin Research Disclaimer and General Disclosure