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Apple Inc. (AAPL)’s Relief Rally

After Apple (NASDAQ:AAPL)’s second quarter earnings repor, Apple Inc. (NASDAQ:AAPL) shares staged a relief rally…as in relieved that things weren’t worse.  Although the news was mixed, I found encouraging signs in Apple’s bolstered R&D spending, as well as its continuing strong iPhone sales.

Expectations of a humbled Apple

It’s indicative of how much market sentiment had turned against Apple Inc. (NASDAQ:AAPL) that its arch rivals in mobile, Google Inc (NASDAQ:GOOG) and Microsoft Corporation (NASDAQ:MSFT), saw moderate sell-offs after arguably stronger earnings reports.  The expectations were high at the beginning of the year that Apple would collapse before the superior might of Microsoft and its Windows 8 Phones and Tablets.

Apple Inc. (NASDAQ:AAPL)I’ve been hearing numerous variations of this theme from Microsoft Corporation (NASDAQ:MSFT)supporters and fans, and for some reason it was always Apple Inc. (NASDAQ:AAPL) that would suffer, even though Google Inc (NASDAQ:GOOG)’s Android users made a better target audience for Windows Phone. Most Android users disdain Apple’s “toys” and pride themselves on being able to customize and control the Android OS in ways that iOS simply doesn’t allow.

The threat from Microsoft Corporation (NASDAQ:MSFT) has so far not really materialized, as was apparent in Microsoft’s earnings report. The $900 billion write-down for Surface RT and the comparatively small sales (7.4 million) of Windows 8 Phones by Microsoft’s principal Windows Phone partner, Nokia Corporation (ADR) (NYSE:NOK), demonstrated that Microsoft still had a lot to learn about being a mobile device maker.

While Microsoft Corporation (NASDAQ:MSFT)’s mobile efforts have faltered, Google Inc (NASDAQ:GOOG) has an entirely different kind of problem: how to make more money from all the Android phones and devices that have been made.  Google CEO Larry Page was happy to share with the world at the Google earnings call last week that Google had “activated” over 900 million Android devices as of Q2.  Of course, Google never talks about how many active accounts Google Play has or how many of the “activated” devices are actually still in use.

Google Inc (NASDAQ:GOOG) had offered as of 2012 Q3 an annual “run rate” of $8 billion in revenue for mobile search, advertising and Play revenue.  Undoubtedly it’s higher now, but it’s unlikely to approach Apple Inc. (NASDAQ:AAPL)’s revenue from direct iPhone and iPad sales for the past 4 quarters: $122.2 billion.

This doesn’t include revenue from mobile devices for iTunes and the iOS App store, which I’m leaving out because Apple Inc. (NASDAQ:AAPL)doesn’t break out mobile revenue separately in its iTunes, Software and Services category.  This category has only existed for the past three quarters, but has made a total of $11.8 billion in revenue so far.

I’m not making these comparisons to argue that Apple Inc. (NASDAQ:AAPL) has nothing to worry about from its rivals, but to point out that much of the disdain heaped on Apple has been overwrought.  As the following table shows, Google Inc (NASDAQ:GOOG) and Microsoft Corporation (NASDAQ:MSFT) posted relatively strong quarters (compared to Apple) in terms of revenue growth.

2013 Q2 Metrics Apple Google Microsoft
Total Revenue ($billions) 35.32 14.11 19.9
Revenue Y/Y % Change 0.86 19 10.2
Operating Income ($billions) 9.2 3.12 6.07
Op. Income Y/Y % Change -20.5 -3.5 -4.99 (exclusive of 2012 Q2

goodwill impairment charge)

Apple Inc. (NASDAQ:AAPL) does have to worry about competition from Microsoft Corporation (NASDAQ:MSFT) and Google Inc (NASDAQ:GOOG).  To assume otherwise would indeed be hubris, something Apple management has been unfairly accused of.

Positives, negatives, and a few surprises

The most positive news in the report was the sale of 31 million iPhones in the quarter.  According the Philip Elmer-Dewitt, the institutional consensus was for 26.57 million and the independent consensus was for 27.89.  I had gone out on a limb and predicted 30 million.

Total revenue of $35.32 billion also came in ahead of the institutional consensus of $34.94.  I had predicted $35.2 billion.

I was also delighted to see Research and Development (R&D) spending finally exceed 3% of revenue at 3.33% for an all-time high of $1.18 billion.  I had predicted 3.41%, but I’m not too disappointed.  The trajectory looks good for an additional increase in percent of revenue in Q3, based on Apple’s guidance of $3.9-3.95 billion in operating costs.

Some of Apple Inc. (NASDAQ:AAPL)’s results I have mixed feelings about.  Gross margin and operating margin were both higher than I expected or wanted at 36.9% and 26% respectively.  I had expected 36% gross margin, the low end of Apple’s guidance, and 24.8% operating margin (operating profit/revenue).

I realize that lower margins would have hurt Apple Inc. (NASDAQ:AAPL)’s stock price in the short term.  Here my argument on behalf of lower margins is that Apple needs market share more than it needs profit.  The cash return program and Apple’s new indebtedness have barely put a dent in the cash pile, which remains at about $130 billion.

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