Fat Margins Make Apple Healthy and Investors Happy

Source: http://www.flickr.com/photos/notahipster/4319949887/

Source: http://www.flickr.com/photos/notahipster/4319949887/

On January 27, Apple (NASDAQ:AAPL) reported fiscal first-quarter earnings that didn’t quite live up to Wall Street’s expectations. Never mind that revenue increased 5.7 percent to a record $57.6 billion for the quarter, beating the mean analyst estimate of $57.4 billion, and never mind that earnings increased 5 percent to $14.50 per diluted share, beating the mean analyst estimate of $14.08 per share — the first quarter was all about iPhone sales, and Apple missed the mark.

The “biggest issues with AAPL’s Dec-13 report,” wrote analysts at Piper Jaffray in a research note published shortly after earnings were released, is that “iPhone units missed Street estimates by 7% and the company implies iPhones may be close to flat y/y in March.” Sales estimates missed expectations “despite the addition of China Mobile (as well as DOCOMO and T-Mobile with no y/y comps).” Apple sold 51 million iPhones in the quarter, an all-time quarterly sales record that fell short of expectations for 55 million in sales. Actual iPhone unit sales grew 7 percent on the year compared with expectations for double-digit growth.

The miss triggered selling pressure, driving shares down 8 percent the day after earnings to about $500. In hindsight, the selling pressure may have been an overreaction, but it wasn’t totally without warrant. Apple has most of its eggs in one basket with the iPhone — the device accounted for 56.4 percent of Apple’s total revenue in its fiscal first quarter — and with so much of the business tied up in one device, the market sometimes substitutes the performance of the device for the performance of the company.

But Apple is more than the iPhone, and most investors with a long-term bullish position on the company know this. Apple has performed phenomenally well selling hardware to consumers, but that is really just icing on the cake. Apple’s business is just as much about incorporating users into its ecosystem as it is about putting devices in the hands of consumers. In fact, the two are nearly synonymous. There is really no reason to worry about slowing iPhone sales growth as long as the ecosystem continues to expand and evolve. Apple is in the business of selling iOS products, not just Apple-branded hardware.

It can be hard to like Carl Icahn, chair of Icahn Enterprises (NYSE:IEP), but he was one investor who was totally unfazed by Apple’s first-quarter earnings. As the market bid shares down 8 percent, Icahn increased his already enormous stake in the company by $500 million. With the purchase, Icahn owns at least 4.5 million shares of Apple stock, and he has been a principal advocate for increased share repurchases on Apple’s behalf.

Icahn appears to recognize that Apple is not in a position to surf market trends and respond to ephemeral Wall Street demands. The company established its empire by setting trends and establishing new categories, not by following trends and playing follow the leader. The company would violate its own brand if it yielded short-term demands.

Instead, as it has always done, Apple appears perfectly willing to wait to act until it is ready. New products will come when they are done. Apple will invest in research and development at a pace it thinks is reasonable, not at a breakneck speed meant to impress would-be investors. The board will authorize repurchases at a pace that it thinks is appropriate, not at a pace activist investors think is appropriate.

Instead of iPhone sales, the metric to watch for in the fear future could be margins. In the first quarter, Apple expanded both its gross and operating margins sequentially, which was a welcome break after some shrinkage over the past few quarters. Gross margin is still below where it was a year ago — 37.9 percent in the first quarter of fiscal 2014 compared to 38.6 percent in the year-ago period — but operating margin is about as healthy as it was for the same comparison.

Apple’s margin could continue to expand as its ecosystem expands and the iOS empire continues to evolve into a service. While it will remain important for Apple to continue to aggressively innovate on the hardware side, investors should keep in mind that Apple products also serve as a delivery mechanism for iOS.

More from Wall St. Cheat Sheet: