Why Apple Profits Pack Such Punch

Sure, the tech company showed strong revenue growth. But its profit potential is what really matters

Somehow, Apple's (AAPL) trips to the doghouse don't ever seem to last too long.

Just a day after investors drove its shares down almost nine bucks to $134.89, on concerns of poor iPhone sales, CEO Steve Jobs & Co. obliterated Wall Street's expectations, boosting sales 24%, to $5.41 billion, from the third quarter of last year. Even more impressive, net income soared 73%, to $818 million. In after-hours trading on July 25, investors' fervor sent shares up $13, to more than $150, more than erasing the previous day's decline.

The reasons for the change of heart had nothing to do with the iPhone. The company booked just $5 million in iPhone sales for the quarter, most of it for accessories. Rather, the Mac took a star turn. Despite rumors of soon-to-come new iMacs, Apple still increased its computer sales by 33% in the quarter. That's nearly three times the 12.5% overall PC industry growth reported by market researcher IDC (IDC) on July 18.

Apple increased its market share in the quarter to a 10-year high, says Piper Jaffray (PJC) analyst Gene Munster, although it remains at only 3% of the overall market, well behind leaders Hewlett-Packard (HPQ) and Dell (DELL). Munster thinks Apple's PC share could rise to 4% by the end of fiscal 2008.

While the products win the headlines, the more important accomplishment of the quarter may be the bottom line. Gross margins rose from 30.3% to 36.9%, an enormous increase for the PC business. The hike came thanks to low prices for components such as memory chips, and to an increase in direct sales from Apple's 185 stores and its Web site. It turns out that consumers who use these outlets, rather than traditional retail stores, buy higher-priced, more-profitable models.

What's Its Recipe?

There's also something more fundamental and more sustainable in Apple's profit growth than chip prices or product mix. The latest quarter shows that Apple is gaining leverage from its unique cupboard of technologies. While many large rivals have scores of products with little in common with each other, Apple increasingly is creating its products from the same set of ingredients. The iPhone illustrates the point: It runs the same Mac operating system software, the Safari browser, and the same iTunes music software as all of the company's computers. It also utilizes many of the same chips as the iPod. "Apple's ability to develop, launch, and support new products, using the same R&D and sales and marketing investments, creates [earnings] leverage that is substantially greater than people thought even six or twelve months ago," said Goldman Sachs (GS) analyst David Bailey in a recent interview.

What's more, the company is expert at outsourcing the rudimentary work to suppliers and manufacturing partners. "They're mainly in the business of defining architectures," says Kathleen Eisenhardt, an engineering professor at Stanford University. "We're talking about a small number of people—maybe ten—that think about how all the pieces go together. [Apple is] more the thinker bees than the worker bees, and that scales a lot better than trying to do everything yourself."

The result: Apple should be able to continue to boost profits faster than its sales growth, which may keep analysts scrambling for ways to justify higher and higher targets for Apple's share price.

"A Solid Start"

Of course, that's a double-edged sword for investors. Sky-high expectations mean the stock can plummet even on a hint of bad news. Take the iPhone. On July 24, analysts fretted when AT&T (T) said it had activated only 146,000 iPhone accounts in the two days after the product went on sale on June 29. That was well short of projections, which spanned from 300,000 to as high as 700,000.

It turns out the AT&T figure was too low. Apple sold 270,000 iPhones in those last two days of the quarter—still disappointing to many, but not enough to dampen most analysts' view. "It's a solid start," says Piper Jaffray's Munster. "It's a disappointment relative to the whisper numbers, but you've got a bunch of [PC industry] analysts who are rookies to the cell-phone space. But if you talk to any mobile phone analyst, they'd say the iPhone is off to a strong start. And none of this changes the fact that we still think Apple is going to sell 45 million iPhones in 2009."

That's partly based on Apple's plan, announced during the earnings call on July 25, to roll out the iPhone in major European countries by this year and to begin expanding into Asian markets in 2008. "The starting gun has been fired, and we've gotten off to a great start. However, our focus is not on initial sales," Apple Chief Operating Officer Tim Cook told analysts. "Our perspective is measured in years, not months. But the rewards will be huge."

Lowering the Short-Term Expectations

No doubt, the early part of this trajectory may be far less explosive than the iPhone hype may have suggested. Unlike many past Apple products, there's no multi-week wait for shoppers to get their hands on an iPhone: From Apple's online store, the iPhones can be at your door in one to two days, with free shipping, no less. The company says it plans to sell its one-millionth iPhone by the time its fourth quarter ends, on Sept. 30 (the iPod, by comparison, took seven quarters to reach that level). And rather than raise its long-term guidance, Apple stuck by its goal to sell 10 million iPhones in fiscal 2008.

One bit of anecdotal evidence: The iPhone has dropped from No. 1 on the Top Sellers list on Apple's Web site to No. 5, behind items such as the iPod nano and iTunes gift cards. "We're past the initial bubble [of sales to Mac fans and early adopters], and back in the building-the-business phase," says Munster.

Certainly, that's the message Apple seems to be trying to send with its conservative guidance for the September quarter. While the company blew away consensus earnings per share targets of 66¢ this quarter by delivering 92¢ earnings per share, it says it will only be able to deliver 65¢ in the current quarter, due to an expected increase in component prices, back-to-school promotions, and relatively mediocre revenue growth of around 19%. But given the roll the company has been on, most analysts don't put much faith in such numbers. "The guidance is really crummy, but I don't know that it even matters," says American Technology Research analyst Shaw Wu. "It was an awesome quarter."

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