The Maestri Code, Fiscal Q3 2014, Part 4: “Around the World” Operating Margin Survey, + Gross Margin Update

I’m fresh out of bad pun titles related to operating margin by revenue geography. Hey, it’s tough to generate humor from this stuff! So, lucky you. 😀

Time for another quarterly, basic-level update on the operating margins of Apple’s five revenue geographies (Americas, Europe, Greater China, Japan, and Rest of Asia Pacific – as I mentioned two quarters ago, Retail is off in its own, er, “hemisphere” for a variety of reasons). If you’re a first-time reader or would like a refresher, you can refer to my fiscal Q2 2014 update or my fiscal Q1 2014 post (introducing operating margin to the home game earnings preview) if so inclined.

Operating Margin Commentary

First, my humble home game survey of ex-Retail, per-geography operating margin. As usual, if you want to skip ahead to the gross margin chart or commentary, it’s near the end of the post.

Here’s the updated chart of Apple’s operating margins per revenue geography through Q2 2014 (the line chart) with segment revenue “in the background” as a stacked column chart. (It’s probably best you open this in a new window.)

aapltree-opmarginchart-q214-exretail

I’ve charted operating margin geography results from fiscal Q1 2011 onward (which is far back as they go for Greater China), and included segment revenue (same color, just “faded”) for context. For new readers, apologies if this looks dense – but since there’s 70 primary data points, it really just is. 1 And since the more data points, the better…it’ll only get more dense from here. 😀

Now that you’ve had a chance to look things over (the primary focus being the line chart), any takeaways from this data? Maybe there isn’t anything “definitive”, and there’s many ways to approach a data set. But here’s a few of my observations:

Japan

Japan’s operating margin continues to level off, down to 47.7% – which is still incredibly high (maybe it’s just me), and only really notable because of the steady downtrend from a staggering 58.3% two fiscal years ago. On a year-over-year basis, though, the near-200-basis-point reduction in gross margin is more than outweighed by a 26.4% increase in revenues, from about $3.14B to $3.96B. That’s a much higher percentage increase than Greater China, and actually pretty close to Greater China’s YOY revenue growth on a dollar basis ($820M vs. $1.08B). To my fuzzy recollection, Apple isn’t saying – or analysts on the conference call aren’t asking – why Japan is the only revenue geography that continues to decline in operating profitability.

On the other hand, there’s any number of plausible reasons why this is of little apparent concern to Apple or Wall Street. Maybe it’s because of iPad unit growth and Mac unit growth, both of which would “weigh down” margins. Maybe Apple’s aggressively investing in the region from a position of great strength (see revenue growth), whether it be R&D (Apple counts Sharp and Japan Display as but two of its 139 Japan-based suppliers), (ex-Retail) employee/executive compensation (payroll, share-based compensation), marketing (SG&A expense), etc. Maybe iPhone 5 and 4S are strong sellers. Heck, maybe ForEx is a factor? Anyway, I’ll keep an eye on the downtrend, but considering how well Apple’s been doing in Japan, I find it difficult to read any negatives into it just yet.

Americas

The Americas geography is now in general operating margin uptrend since Q1 2013. Despite a very modest YOY revenue increase of about 1.8%, operating margin increased by 133 basis points. Not bad for a revenue growth laggard – though generally flat smartphone sales growth amongst most of the major US carriers certainly doesn’t help.

Yes, I do believe I have enough information to back up this trend observation, despite non-full-equivalencies such as activations v. unit sold (Verizon) and fuzzy corporate-speak math (Sprint):

Verizon: 7.6M smartphone activations calendar Q1 2014 vs. 7.2M Q1 2013 – around 5.6% YOY growth, so it’s the “big winner” here

AT&T: 5.8M smartphones sold calendar Q1 2014 vs. 6.0M sold Q1 2013 – about 3.3% YOY decline

Sprint: “just under” 5M “retail” smartphone sales calendar Q1 2014 vs. “5M” Q1 2013 – call it a slight YOY decline

By the way, noticed how the Americas geography has, over several quarters, gone from least profitable to one of the more profitable revenue geographies (aside from Japan) on an operating margin basis?

Europe

The Europe geography tells a somewhat similar story to the Americas – fairly modest YOY revenue growth (4.4%), but a meaningful boost in operating margin (150 basis points). Was that due to higher overall profit mix, say declining lower-margin iPod and iPad sales YOY outweighing any margin-dilutive impact from Mac and iTunes/software/services revenue growth? (Page 28, Apple Q2 2014 10-Q) This geography has also shown the second-best sequential increase in operating margin since apparently “bottoming” in Q3 2013. One guess which revenue geography performed better.

Rest of Asia Pacific

Rest of Asia Pacific continues to be interesting. A 17% decline in revenue, from about $3.16B to $2.63B. An operating margin increase of almost 150 basis points. So, “problematic” in some ways, but not others. Overall, Rest of Asia Pacific operating margin has been holding steady and generally increasing since Q4 2012. Apple cited several factors for the revenue decline YOY, including changes in iPhone channel inventory, net unit sales declines in all major product categories except Mac, and currency weakness vs. the US dollar. Now that I’m taking a slightly closer look at the trends, it’d be nice if an analyst asked about this revenue geography in a future conference call – since it’s been the most inconsistent of the five revenue geographies from Q1 2011 onwards in terms of revenue growth. After all, “Rest of Asia Pacific” includes, among other countries Apple’s paying extra attention to, India.

Greater China

Greater China certainly seems to be on track to be the second-highest operating margin revenue geography, trending upward sharply since Q4 2013. Big-time driver of Apple’s margin and profit growth? Sure seems that way. YOY revenue growth “slowed” to about 13% from close to 30% in the December quarter, but much of that “disparity” can be explained by Apple’s addition of China as a first-stage launch country for iPhone, with the associated effects on the demand curve. China Mobile is very likely boosting revenues and operating margin in Greater China, but it may take until Q1 2015 (presumably the first full quarter of iPhone 6 availability) to better assess the impact of this mega-carrier partnership with Apple.

To wrap up, some quick thoughts on gross margin.

aapl-q3-gm-est

– My home game prediction is for Apple to report a 38% gross margin (top end of guidance). Considering what happened last quarter, that could turn out to be conservative – we’ll see.

– No big surprises as to why a sequential decline in gross margin seems like the safe bet. Major themes, as cited by Maestri, include significantly reduced revenue leverage on a sequential basis and a “less favorable” revenue mix in terms of high-margin products (which probably means iPhones). That’s just what happens with Apple’s current product release cadence – it makes Q3 Apple’s “slow quarter”. Apple’s relentlessly driving down the cost curve, as usual, will mitigate the margin decline, but per Maestri will only be a partial offset.

– On the other hand, gross margin is being guided to at least 50 basis points higher year-over-year, despite the net deferral accounting “headwind” Apple will likely face in the quarter. Combine that with projected revenue growth and you can see why Apple is guiding to the possibility of genuine net income growth for the first time since Oppenheimer introduced the current range guidance methodology.

– Looking 1-2 quarters ahead, it’ll be interesting to see whether Apple will take an “iPhone 5”-type approach to margins (read: increase relative cost/value vs. iPhone 5S and iPad mini retina gen 1, whether out of expediency, necessity or both) for iPhone 6 and any iPad mini retina redesign. Not that I have any clue myself, but based on the historical data my wild guess is that Apple probably won’t be planning on a gross margin drop anywhere near that seen from Q2 2012 to Q3 2013. We’ll just have to wait a few fiscal quarters to watch this gross margin scenario play out. Apple is expert at building to a high standard at an enviable cost, and yet Apple does have a few percent of gross margin “to give” if it so chooses. Hopefully (if you’re an AAPL bull, that is), management will give some slightly better indications of this should the new crop of iOS products prove significantly higher-cost than their predecessors.

 

Next up, to conclude the fifth quarterly installment of my AAPL home game earnings preview series: The Wall Street expectations game. 

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1  I’ve had some time to look this format over and I’m still decently happy with overall readability, though feel free to chime in if you have suggestions or comments.

 

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