Apple Earnings Call - Music no longer a growth engine

In 2009 we'll be spending more time analysing the results of some key players in the Telco 2.0 ecosystem. Trying to give our readers a different perspective on the announcements. We start here with Apple.

In a Telco 2.0 article from earlier in January - "Apple blows a hole in the Mobile Music Landscape" - we analysed recent changes to Apple's business model around music. Our conclusion was that the mobility premium for content sales would disappear creating challenging times for mobile operators who see music as a growth opportunity. In this article we provide a Telco 2.0 examination of the state of Apple's overall business (iPhone, iPods, CPUs, Content, Retail), based on their Q4 earnings call yesterday.

In summary, it's a good time for Steve Jobs to be taking a break. Here's why:

i) Overall Company

Total Revenue up to US$10.17bn, y-o-y growth of 6%. No indication of how much is currency related. Growth in Americas only 5%. Gross Margin up significantly from US$3.3bn to US$3.5bn. However, Operating Income is stable at US$2,126.

Of course, top-line growth has been offset by R&D and sales marketing effort - which in itself is no bad thing especially going into a recession, given others will report much worse figures.

Cash generation looks really strong (although difficult to figure out) - basically Apple is sitting on a huge growing warchest of US$28bn (Total Cash US$7.2bn, Short-term securities US$18.4bn, Long-term securities US$2.5bn)

ii) iPhone

The iPhone is difficult to figure out because of the way Apple play with deferred revenue. But the headline figures are 13.7m units shipped in the Calendar year, which probably works out at around 1-1.5% of the total worldwide phone market by volume. 4.4m were shipped in the final quarter - which is below the market consensus of 5m.

Most interestingly is the deferred revenue that they are holding for the iPhone is US$7.3bn, which will be released to the P&L over the length of the contracts. With an admission that US$2.6bn was added to deferred revenue and only US$1bn released - yields an average selling price of around US$590, which more or less (with rounding errors) confirms the gossip of an average ASP of US$600 to the carriers.

A comment was made that the iPhone performs poorly in non-subsidised markets - indicating to us that at some point when demand evens out there will be a subtle shift in negotiating power between the carriers and Apple.

iii) iPods

Although all the talk was of the increase in iPod volumes (22.7m units), the fact of the matter was that iPod revenue was down 16% y-o-y (US$3.4bn vs US$4bn) - a terrible Christmas.

We're a little baffled by this as we thought people would be buying high-end iPod Touches.

But, nevertheless, it shows that future growth will come from other devices - the days of music as the growth engine for Apple are over.

Interestingly was a throwaway comment that iPod had a surge in sales in the final week of the quarter - normally a time when retail buyers are less focused on bargains and more on cures for chrimbo excesses. We read this as a clearance sale to get rid of inventory pipeline and smacks of an even worse 1Q2009 for Apple iPods.

iv) CPUs

CPUs exhibited static growth at US$3.6bn, but story here was the difference in portables (up 23%) vs desktops (down 31%). Again, we're confused here: why has Apple not moved beyond WiFi on the portables - do they not believe in AT&T capabilities in 3G and in embedding 3G cards in laptops? Or can they not see how to extract value from this?

v) Content & iPod accessories

These are up 25% y-o-y to US$1bn, which may look good prima-facie but it is hard to distinguish where the growth has come from - music, TV shows, brain-dead iPhone applications or huge-margin royalty related accessories?

The truth is that it doesn't matter as Apple reiterated that this is overall a zero margin game (although 30% at the gross level). The truth is that if this segment continues to grow whilst iPod declines - shareholder pressure will make them look at turning it into a profit centre in its own right.

vi) Retail & Distribution

Retail revenues were only up 2% to US$1.7bn, which to be frank is poor given the new store opening programme in 2008. Average revenue per store dropped from US$8.5bn to US$7m, whilst they bragged that foot-fall increased.

During the call, this analyst dropped back into a teenage '70s recessionary time-warp of buffoons frequenting record stores, just listening to stuff and buying didly-squat. Could Apple run the risk of this happening with techno-gadget addicts in the current recession?

Good news, the store programme seems on hold with only 25 new stores opening worldwide.

More interesting was the decision to go with Wal*Mart in the USA for iPhone distribution which Apple claimed was all about reaching the parts that AT&T and Apple stores can't reach. We don't have enough exposure to the USA retailing scene to verify whether this is true or not - but it is smells like a move downmarket to us.

vii) Europe

Europe had a great quarter with revenues up 12% to US$2.8bn which is 33% of non-retail revenues. With units sales up 13% - it looks like the exchange rate has balanced out between the euro and pound.

viii) Margins

Apple 'fessed up that a substantial portion of the margin beating consensus was due to component pricing, which they estimated had almost sunk to variable pricing levels. It will be hard for them to go further. Inevitably, this implies a terrible quarter for the semiconductor industry.

ix) IP infringement

It was pretty obvious on the call that Apple are going to start suing competitors and not just let people copy their designs willy-nilly. We're unsure who they are referring to, but the new Palm-Pre sounds like the best candidate - weak and reliant on Bono-driven financing. I doubt they'll go after RIM to begin with, because they probably have more experience in defending litigation than anyone else.

Anyway, litigation is a daily occurrence in the wireless industry and the law of unintended consequences may just kick-in - expect to hear counter-suits from the likes of Nokia and Qualcomm for abuse of their intellectual property.

x) Conclusions

Apple is hitting the wall - rapidly.

Even with all the deferred revenue, the iPhone cannot sustain the previous Apple growth profile.

We think they'll hunker down and perhaps drop margins to keep up volumes - especially in the CPU business.

Expansion overseas probably won't solve the underlying problems of drying up of top-end USA demand.

We're not sure what they can do in the iPod market given their huge market share - especially if there is a shift to playing music on mobile phone devices rather than having separate portable device.

However, they have a warchest full of cash and it would be simple for them to ride out the economic storms - losing something, but not as much as the competition.

Time to value Apple on cash plus a market of cash generation - rather than fantasy growth figures.

If we were being cynical, we'd say it was a good time for Steve Jobs to take a break - but we're not and wish him all the best...

Finally, some lessons and Implications for Telcos:

- Cash is King
- Everyone will be hurt in a recession, even top end consumer brands
- The grass is not necessarily greener on other people's lawns
- Making a margin in music content is going to be extremely difficult even with significant improvements in supply chain and operational efficiency

This analyst will be reviewing Nokia's results tomorrow morning, Google tomorrow night and playing catchup with eBay and IBM...

[Ed - we'll be reviewing the Device market at the 6th Telco 2.0 Executive Brainstorm on 6-7 May in Nice.]