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Apple Earnings: Digging Through Services and Guidance

Services have become an incredibly important part of Apple's (NASDAQ: AAPL) business, which now brings in more revenue than either the Mac or the iPad. Meanwhile, Apple's guidance left a little to be desired.

In this clip from Industry Focus: Tech, Motley Fool analysts Dylan Lewis and Evan Niu, CFA, break down the results from the latest earnings release.

A full transcript follows the video.

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This podcast was recorded on Oct. 28, 2016.

Dylan Lewis: One of the things I thought was particularly interesting with the commentary from this report was, you look at the services segment, you look at the last couple quarters, you've seen service segment revenue up 20%, and they're really touting this number. Most recently, it was $6.3 billion, which is roughly 13% of revenue. At this point, we're coming up on two full years of them breaking out services as a product segment. Looking backwards, we've seen a huge step change in the fiscal Q1 quarter. In 2015 fiscal Q4, we were at $5.1 billion. That hopped up a full billion dollars in the following quarter, fiscal Q1 2016. So, I'm really curious looking forward what that segment might look like. Theoretically, we should be in the step-change quarter. It'll be interesting to see if they can sustain that growth, or if we're going to continue to see them hum along at more or less flat sequential growth.

Evan Niu: Yeah, services is becoming huge. Like you said, it's $6.3 billion. And if you look at the past four quarters, this is now basically a $25 billion business. That's bigger than the Mac, bigger than the iPad. It's their second-biggest business at this point, which is kind of crazy to think about, because Apple is typically not that great at services in general. Particularly because the services revenue, most of it is not coming from a subscription service like Apple Music that bills every month. That's certainly part of it. But it comes back to what we were talking about earlier, which is the whole installed base-related purchases. A lot of that services revenue comes from them relying on their users buying content and apps on the App Store reliably. That's why that number is important, and I'm surprised they didn't give it. Not a whole lot of it is occurring, monthly subscription fees that you can count on every month. So, it is important, but they're doing a really good job of growing that number. It's a pretty big business now, $25 billion.

Lewis: It's huge. I think, you hit on the installed base thing, if there are any issues with them growing that installed base, it stands to reason that the services segment won't continue to grow the way that it has. That's kind of the relationship there, and that's why you always see the step change happen in fiscal Q1, because that's when they sell a ton of iPhones. You're going to see those two things move together. That's certainly something that I'm watching in the coming quarter, because they're pointing to it more and more in their conference calls. I think it's an indication of a lot of other elements of their business.

Niu: Absolutely.

Lewis: Looking forward and looking at the guidance that they provided, for the first time since physical Q1 of last year, Apple is guiding for year-over-year growth next quarter, which I think is a welcome sign for a lot of investors. The company is expecting revenue to come in somewhere between $76 billion and $78 billion. When we say year-over-year growth, fiscal Q1 last year, they posted revenue of $75.8 billion. So, it's not going to be huge, but it is positive growth.

Niu: I'll take it. 

Lewis: Yeah, at this point, looking year-over-year declines for a little while, it's certainly a welcome trend to see. I think some people are maybe a little disappointed in this guidance, given some of the tailwinds that the business has right now at its disposal. This is something we've talked about in previous shows. One of the major competitors, the Samsung Note 7, being off the market, you would think would be a much larger catalyst for Apple than maybe they're letting on.

Niu: Yeah. They declined to give any meaningful comment on whether or not they think they'll benefit, but I think pretty clearly that they will. And now there's even reports that the Galaxy S7 Edge is catching on fire. I don't know if you've seen it, there's not as many of them. But there were reports starting in September. That was a month ago. Again, it's not as widespread, but there are a handful of cases across the world, like in China and the Philippines with the S7 Edge -- which is one of the phones that Samsung is pushing people toward. And here's the crazy part -- one of those phone was a replacement for a Galaxy Note 7. So Samsung gives a customer an S7 Edge to replace his Note 7 that caught on fire, and the S7 Edge catches on fire! It's just a mess.

Lewis: That's a bad brand experience there.

Niu: I think, going back to their guidance, I do think, the one thing that stood out to me as far as not so great in the guidance was the gross margin guide. The revenue guidance was fine because it'll be nice to get a little growth, even if it's not a lot. We had three consecutive quarters of negative growth up top at this point, so I think anything is nice. On the profitability side, I was surprised, too, because in the fourth quarter, Apple always enjoys a lot of operating leverage when their revenue scales up to these really high levels. Usually, you see margins expanding in a pretty meaningful way, usually to the point where you're at 40%. They're guiding to basically upwards of 38.5%. So, 50 basis points shy of what I would expect them to guide to. And, for what it's worth, last year they did 40%.

Lewis: In fairness on that 40% figure, that was also a quarter where they realized $550 million or so in a patent dispute agreement with Samsung. I think that added about 40 basis points to that margin number. I think the true margin number was like 39.6% or so.

Niu: But if you go back another year, it was still like 39.9%. It's still pretty close to 40%. And I know it doesn't sound like a lot, 50 basis points, but when you're talking about a business this big, every basis point counts. One basis point is like $7.6 million. So, multiply that by 50, and that's gross profit, coming straight down through the income statement. They've been talking a lot about commodity costs and component costs being very favorable. So, I'm wondering why that guidance wasn't stronger.

It's also possible that there are some currency effects, because they've been battling the strengthening dollar for a really long time. That's very much hurting them, because about two-thirds of revenue comes from outside the U.S. The strengthening dollar has been hurting them for many quarters. So, that could also be part of it. I think that might have been why the original market reaction was negative. If you're watching after hours, the stock jumped on the iPhone number as soon as it was released, started getting back those gains as people read through the numbers and started digesting them a little bit.

Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.