$AAPL’s Greater China Profitability Remains (Unexpectedly) Great — But Why?

Beyond the FQ2 and FQ3 revenue declines, a remarkable stability hides in plain sight.

I just went over the subject of Greater China revenue without making a case, as you might normally expect from me, that Greater China will return to revenue growth for FY 2017, at least as a step “on the road to recovery”. While I happen to think that outcome will occur, I opted for an objective assessment instead.

As it so happens, an objective assessment of Greater China’s profitability-specifically, segment operating margin- does support a firm conclusion, for the time being anyway, that the revenue geography comprising (mainland) China, Hong Kong and Taiwan remains a stalwart profit center for Apple.

The extent to which this holds true is really quite impressive.

In case the font’s a little small on that chart, this is a two-y-axis presentation. I know, a bit cluttered, but it also allows for simultaneous display of data, which I find very useful in this case.

The blue column chart, measured by the left y-axis, is Greater China GAAP quarterly revenues (including Retail revenue) from FQ1 2012 to the present- quarterly data doesn’t go back any farther.

The green line chart, measured by the right y-axis, is Greater China operating margin.[1] Apparently, Apple, whether due to a relatively weaker dollar, exceptionally high margins and revenue mix on iPhone 4S, perhaps both, had ridiculous margins peaking around mid-FY 2012, though it’s since moderated from those highs. As far as Greater China’s concerned, operating margin didn’t level out until FQ3 2013 (shortly before the release of iPhone 5S), stabilizing in the 28% range.

What followed is a remarkable upward trend, with iPhone leading the way of course, but also an impressive Retail expansion (11 stores around May 2013; 41 as of today). Generally speaking, increasing revenue leverage tends to have a very positive impact on operating margin provided cost discipline is there, and Greater China has been no exception, surging over the 35% operating margin mark at the end of FQ1 2015…the quarter of the now-infamous iPhone 6 launch.

Since FQ3 2013, Greater China operating margin strongly correlated (trend-wise, anyway) with revenue. Quarterly revenue improves, so does segment margin. Revenue drops due to seasonality, the same happens with segment margin. As we all know, since FQ1 2016, something worse than seasonality has been happening to Greater China revenue.

Suddenly, Apple “fell on hard times”, with Tim Cook citing challenges in the Chinese economy (which was actually showing its fair share of slowdown warning signs even during the iPhone 6 sales nova in 2015). In retrospect, the reason why Apple never cited the Chinese economy as a headwind until 2016 was likely because their own sales data wasn’t showing any issues at all. FY 2015 resulted in an absolute banner year for Greater China, 84% year-on-year revenue growth and the very first time the revenue geography brought in more than $50B in annual sales.

So, regardless of whether Apple’s failure to execute its business model on some level (you know, because Apple’s always doomed) somehow exacerbated the current problem, Apple nonetheless faced the awkward situation of explaining to Wall Street why stratospheric growth rates throughout FY 2015 had, for FQ2 and FQ3 2016 at least, gone retrograde at -26% and -33% year-on-year growth, respectively.

What Apple doesn’t have to “make excuses for”, however, is its Greater China profitability during this revenue downturn. Here’s a numerical representation of the most recent seven Greater China operating margin data points, and the FQ3 2016 statistics are nothing short of stunning:

No need to refresh your browser/app. I’ve triple-checked the 10-Q filing, and it is indeed the case that despite

— continued (really, increased) weakness for the yuan vs. the US dollar,

— and a massive GAAP-impacting $3.6B channel inventory reduction (primarily iPhone), mostly affecting the Greater China sales channel,[2]

Greater China operating margin managed to sequentially improve by a single basis point.[3]

So, how is essentially unchanged operating margin possible, given a substantial reduction in high-margin iPhone sales, “made worse” by the introduction of the so-called “low-margin” iPhone SE?

There’s no single reason, but here’s the two most likely ones.

First, Apple’s exhibiting exceptional cost discipline and improvement. Apple gets better at cost control/efficiency each passing year, one can safely assume- and cost-containment efforts have paid off in the current strong foreign exchange headwind environment. Semi-related to this is the clearly popular iPhone SE. Because it’s a savvy assemblage of iPhone 5 (chassis/display/front camera), 5S (first-gen Touch ID/first-gen multi-color temperature flash), 6 (Apple Pay/NFC/802.11ac wireless/LTE banding) and 6S (A9 SoC + M9 co-processor, rear camera) components, Apple can drive down the cost curve for multiple iPhone generation components with a single device. In fact, Maestri specifically noted during the call that iPhone SE, contrary to common concern, “did not have a particularly large” dilutive impact on gross margin.

Second and most significant: Apple has an exceptionally rich mix of high-margin revenue in Greater China. Specifically: A high-margin revenue mix ex-iPhone.

Where to find this margin reserve? Here’s a rather blatant-for-Apple hint courtesy of Luca Maestri:

<FQ3 earnings call podcast, 18:10>: “…for the first nine months of our fiscal year, Services has increased from 8% of our total revenue a year ago to 11% this year, and it represents an even higher percentage of our profitability.”

Yes, the revenue category that includes the once-humble break-even iTunes Music Store and once-nascent break-even App Store is now a Microsoft-esque non-hardware business segment driving profitability above the corporate average.

As I noted in my previous post, in the last two years, Apple has rung up nearly $105B in revenue in Greater China — with a very large portion of those sales to new iPhone customers. So while these iPhone owners may not upgrade “for a while”, they most certainly will, as Apple’s Services growth trends show, buy apps, iCloud services, AppleCare plans and Apple Music subscriptions. (Don’t worry about those “banned” iTunes Movies and iBooks…they accounted for less than $1 million in revenue per Tim Cook.)

So even when unit sales are cooling, the China iPhone user installed base (which grew 34% year-on-year <FQ3 earnings call podcast, 6:40>) continues to grow and spend apace. And since so many millions of customers were added in just the past 7–8 fiscal quarters (a “mere” $60B in revenue could easily translate to around 90M iPhones sold), there’s a separate, “invisible” demand curve, irrespective of hardware seasonality, demonstrating the strong health of the “Apple ecosystem” in this revenue geography.

There’s simply no other way to explain how Apple can maintain the impressive, trailing-only-Japan operating margins it does on so much less revenue leverage than recent blockbuster quarters.

All of this data taken together, in my home gamer’s opinion, proves that Apple continues to be ascendant in Greater China…

…and that if nothing else, Apple is more than capable of “biding its time”, quite profitably, until the apparently quite satisfied and still-growing installed base in Greater China is ready for their next smartphone. Which will be, much more likely than not, another iPhone.

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Footnotes

[1] As defined by Apple, segment operating income (geographically speaking) includes: “net sales to third parties, related cost of sales and operating expenses directly attributable to the segment.” In addition, “[a]dvertising expenses are generally included in the geographic segment in which the expenditures are incurred.” <AAPL FQ3 2016 10-Q filing, page 22>

Segment operating income excludes several items, such as R&D spend, corporate marketing expenses, “certain” share-based compensation expense, income tax (which is superfluous, because…well…operating income after all), and “other separately managed” SG&A costs. These excluded expenses aren’t insignificant, but aside from R&D, which is a corporate-wide type of expense anyway, “excluded expenses” don’t account for a particularly sizable portion of operating income. Three-fourths of the way through FY 2016, non-R&D-excluded operating expense accounts for a $3.2B reconciliation to a $58.9B segment operating income total. [AAPL FQ3 2016 10-Q filing, page 22]

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[2] Apple’s FQ3 2016 earnings podcast, still available for a bit longer at: https://itunes.apple.com/us/podcast/q3-fy16-apple-quarterly-earnings/id74942331?

<About 1:55> (Regarding the drawdown of mostly iPhone channel inventory)

Tim Cook: “We…[reduced] channel inventory by about $3.6 billion, significantly more than the the $2 billion inventory reduction we’d expected… iPhone accounted for the vast majority of the channel inventory reduction.”

<7:00> (Most of this channel inventory reduction was in the Greater China revenue geography)

Tim Cook: “By far, the largest portion of our global channel inventory reduction was in Greater China, so our underlying business there is stronger than our results imply.”

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[3] Apparently, Apple’s gotten some measure better at optimizing margin even when the scale isn’t there, as this quick comparative sample of other similar-revenue quarters demonstrates: