Quick Thoughts: AAPL & MSFT June Quarter Results – The Song Remains the Same

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–          AAPL’s 3QFY14 was mixed, with sales 1.5% below consensus but EPS 4% above on impressive 39.4% GMs. iPhones were in-line with strong expectations, but iPads were down YoY – again!

–          A revenue miss, 6% growth, the fast erosion of iPad sales, and tepid 4QFY14 guidance might have ordinarily spooked investors, but iPhone 6/iWatch hype has most looking ahead to Dec.

–          MSFT beat topline expectations by 1.7%, with 10% YoY organic growth driven by strong enterprise sales. EPS would have beaten by $0.06 without one-time Nokia and other charges.

–          More Nokia write downs and the costs of the upcoming layoffs will hit future quarters, but a 147% YoY increase in cloud sales, now 11%+ of total, speaks to MSFT’s real growth potential.

With the rise of the mobile/cloud era of computing, the nature of the Apple/Microsoft rivalry has changed dramatically. New rivalries with the likes of Samsung, Google and Amazon Web Services have pushed the traditional “Mac vs. PC” battles to the back burner. Still, with the two erstwhile enemies reporting on the same night, it’s an opportunity to engage in the nostalgia of comparing the two companies again.

Both companies’ results had a little bit of hair on them. Apple crushed its EPS bogie by 5 cents, juicing those earnings with 39.4% gross margins, 140bp higher than analyst expectations and the highest level since 4QFY12. However, and it’s a big however, Apple revenues were $600M below expectations at $37.4B, with disappointments in both iPad and iPhone sales not mitigated by the upside surprise in Mac revenues. Guidance for next quarter was weak, suggesting more of the same in September and pushing all of the chips on the Holiday quarter and the hotly anticipated debuts of the iPhone 6 and the iWatch. Microsoft, on the other hand, handily beat revenue expectations, with $23.4B versus the $23.0B expected, but fell short on earnings, delivering $0.55 in EPS versus the $0.60 consensus due to initial write downs associated with the acquisition of Nokia’s handset business. Absent the Nokia charges and some other one-time items, Microsoft could have beaten by $0.06.

Most likely, investors won’t care about Apple’s sales miss or Microsoft’s Nokia-induced indigestion. With new iPhones and the mythical iWatch likely to hit the shelves in October, eyes are ahead to the Holiday quarter. Rumors of gargantuan build orders and indicators of pre-sale interest will be enough to keep the stock going, almost no matter what happened this quarter or will happen in the next. Similarly, Microsoft will be choking on Nokia and the costs of its 18,000 employee force reduction over the next few quarters, but investors love a good downsizing, particularly while the company is posting impressive metrics for its forward going businesses, such as an additional 1M Office 365 subs added in the quarter, a $4.4B cloud run rate on 147% YoY growth, and 11% growth in commercial Windows licenses after the XP sunset. The market appears ready to give CEO Satya Nadella room to deliver on his bold vision of a cloud focused Microsoft. Now for the details:

Despite missing the top line, Apple delivered 6% YoY growth in what is typically a weak seasonal quarter, what with Apple fanboys holding their wallets tight in anticipation of being the first to get those new products after they are announced in the fall. Regionally, sales growth was driven by China, Europe, and Asia/Pacific ex-Japan with YoY revenue growth of 27.9%, 6.3%, and 5.6% respectively. Consumers in those markets have had limited availability of Apple products in the past and are less likely to follow the company’s product cycles. Meanwhile, other operating segments including Americas, Japan, and the retail business were flat. Japan, which has the highest levels of iPhone penetration in the past, saw an increase in taxes, which affected demand. In terms of products, iPhone revenue grew nearly 13% YoY, while ASPs were off from last year and the previous quarter suggesting a mix shift in favor of the lower priced 4S. High margin products like Mac and iTunes were also up north of 12%, with the lower margin iPad taking a hit with revenue down nearly -8%, the second quarter in a row with Apple’s bellwether tablet line declining in sales. This deterioration in Apple’s second most important product franchise has to be a bit troubling for even the most dedicated bull. With competitive Android tablets with comparative performance and dramatically lower prices flooding the market, and without carrier subsidies to cushion the premium, iPad is hemorrhaging market share and doubling the pressure on the iPhone 6 and iWatch to return the company to real growth.

Still, the mix shift enabled the company to deliver its highest gross margins in two years as it reaps the benefit of the tail end of its product cycles. Apple rarely puts active products on sale – other than Black Friday promotions and education pricing, it charges the same price for products from the day of release to 10-12 months afterward. Over the same time, component prices tend to come down and the company becomes operationally better at executing on a product leading to lower build costs and higher margins. Apple’s margins of 39.4% beat consensus by 150 basis points despite lower than expected iPhone and iPad sales.

Unsurprisingly, CEO Tim Cook and CFO Luca Maestri had little to say about the new products expected for the fall, other than to note that the rumors are causing purchase delays for iPhone customers. This is undoubtedly true, and if the hype around the big screen iPhone 6 models is accurate, these products may also pull some future demand forward once they finally launch. I have been a bit skeptical about long-term demand expectations for the iWatch (see http://live.ssrllc.com/2014/07/july-10-2014-apple-and-google-on-your-wrist-and-in-your-car/), but I expect a high price point, say $400 or more, and do not doubt that there will be lines of early adopters at Apple Stores to buy the first new product category from the company in four years. All of this points toward a big 1QFY15, and investors seem to be more than willing to put up with a couple of unexciting quarters along the way.

On to Microsoft – this quarter was extraordinary, with vibrant growth and strong profitability from most of its businesses. The major exception was the newly acquired Nokia mobile phone business, which delivered losses and hit EPS with more than $0.06 of one-time items. Excluding this, and other exceptional charges, Microsoft could have delivered $0.66 vs. the $0.60 consensus, avoiding the lurid headlines of a $0.05 EPS shortfall. Everything else was more than fine. Devices & Consumer, which books Windows OEM revenue saw the OS up 3% despite weakness in Consumer PC sales, while Microsoft Office consumer package revenue (ex-Office 365) was up 21%. Consumer cloud Office performance was even more impressive. Microsoft added 1M new consumer Office 365 subs during the quarter, bringing the total to 5.6M subs paying $100 annually for the service. This was driven, in part, by the availability of Office 365 on the iPad, which was made available in Nadella’s first few weeks as CEO.

Nadella is in the midst of focusing the company squarely on the cloud and was explicit during the call about engaging in greater discipline when it comes to devices. The Computing and Gaming Hardware division, which includes Surface and Xbox, may look different in coming quarters as Nadella aligns the unit with his “productivity and platform” vision. Nadella may have already begun to exercise this discipline as the earnings release hinted towards a Surface “form factor” being killed off, likely the rumored mini. With some $409M in Surface sales for the quarter, it’s likely the company sold between 600-800K units, and still a far cry from Apple’s 13.2M iPad unit sales. Nadella seems committed to the beefier and PC-priced Surface 3, and the version is likely to stay, but members of the Surface RT team have undoubtedly been polishing their resumes.

A lot more resume polishing is underway in the former Nokia, now called Phone Hardware. This unit will see half of its employees let go – more than two thirds of the 18,000 planned layoffs will come from here. Microsoft will phase out all of the non-Windows devices, including the Asha product line that has accounted for 84% of recent Nokia shipments. The focus will be squarely on the Windows Phone platform and leveraging the Microsoft brand to grow platform penetration in the lesser developed markets where Nokia has thrived for years.

Nadella also chimed in during the call to also clarify his thinking about Xbox. Some analysts have called on Microsoft to spin off this business, but he is NOT going to do that – full stop. Xbox remains Microsoft’s major play for the home, and Xbox Live is a considerable scale driver for the company’s distributed cloud data center infrastructure. He IS going to close down the Xbox Entertainment Studio, which had previously had a mandate to develop original video content, a la Netflix’s “Orange is the New Black”. Nadella wants to make the Xbox unit leaner, and to rely on third party partners for content rather than push into a “Hollywood” role that seems ill fitting with the Microsoft culture. All of this seems sensible to me.

Now to the meat. Microsoft’s core commercial segment results were notable – enterprise sales grew 11%, driven by the cloud business Nadella that helped to build. Commercial Windows licensing revenue (separate from OEM revenue captured in D&C Licensing) was also up 11%, spurred by the XP sunset, though Commercial Office licensing was weak growing only 4%. This of course excludes enterprise Office 365 which is counted in the Commercial Cloud Services segment that was up by 147%. With this cloud business now reaching a run rate of $4.4B and, perhaps, gaining a bit of ground on Amazon’s AWS, there is little wonder Nadella is repositioning the company for cloud opportunities. The radical changes announced over the last few weeks are necessary for the company to move away from its old bureaucratic mold and address the TMT paradigm shift. While additional write downs, to cover the downsizing and other Nokia miscellanea in coming quarters, are likely, investors seem willing to look past them – and past Nadella’s rambling communiqués as well. After more than a decade in the wilderness, the cloud is making Microsoft a growth story again.

For our full research notes, please visit our published research site.

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