FQ1-16 Operating Cash Flow

When looking through AAPL's financial statements for its first fiscal quarter of 2016, I noticed something odd when looking at its cash flow statement. Although AAPL generated $337 million more in Net Income, it somehow generated $6.3 billion less in Operating Cash Flow. Last holiday quarter (FQ1-15), AAPL converted 45.2 cents of every revenue dollar booked during the quarter to cash. This quarter (FQ1-16), AAPL only converted 36.2 cents of every revenue dollar booked during the quarter to cash - a year-over-year drop of 20% - I would call that significant:

Source: Apple.com 10-Q Filing

So when you look at the line item details of the cash flow statement there are a few big items that swing the number in both directions, but ultimately the negatives far outweigh the positives. 

Large Gains:

• Accounts receivable, net: AAPL generated $3.9B more this holiday quarter compared to last
• Vendor non-trade receivables: AAPL generated $5.3B more this holiday quarter compared to last

Large Declines:

• Accounts payable: AAPL used $9.9B more this holiday quarter compared to last
• Other current and non-current liabilities: AAPL used $5.0B more this holiday quarter compared to last

All-in-all, these declines outweighed the gains to the tune of $6.3B. The odd thing is that these big shifts all occurred in accounts that one would consider "normal, ordinary-course, working-capital accounts". The one that baffles me the most is Accounts Payable. To see a $9.9B year-over-year decline in that account alone is pretty remarkable. I'm an accountant - I understand that balance sheets are snapshots-in-time and that there could be extenuating factors that play into an account moving significantly, but this takes "significantly" to a new level. Even if AAPL received a generous offer to pay its A/P early, that just seems like a lot of cash to move.  I've charted Operating Cash Flow as a % of Revenue for the last 13-quarters, and of all the holiday quarters, Dec-2015 (FQ1-16) was the lowest out of the past four holiday quarters:

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FQ1-16 AAPL Channel Inventory

On its FQ1-2016 Earnings' Call on Jan-16, AAPL was probed during its analyst Q&A session about its iPhone channel inventory levels. This was odd in one sense. AAPL historically has disclosed the exact amount of channel inventory it builds or draws-down during its prepared remarks. This quarter, AAPL's CFO, Luca Maestri, merely said:

"We started the quarter below our channel inventory target range and thanks to an extremely successful manufacturing ramp; we were able to exit the quarter slightly above the low end of our target range of five to seven weeks of iPhone channel inventory." [Emphasis Added]

It was only during the Q&A, where Toni Sacconaghi pressed Maestri on the actual channel inventory levels when AAPL revealed exactly how much inventory it had built during the quarter. Maestri indicated that it had an iPhone channel build of 3.3 million units during the quarter. He went on to indicate that it entered FQ1-2016 significantly short of the 5-7 week forward-looking target. The 3.3 million unit build is a significant number of units and matches the highest channel build in the product's history - it built 3.3 million units during the FQ4-2013 quarter, which coincided with the launch of the iPhone 5S / 5C. Additionally, the combined sequential builds (FQ4-15 + FQ1-16) was 5.25M units - that is the highest sequential build ever. Here is AAPL's historical iPhone channel inventory dynamics with reported (sell-in) and underlying sales (sell-through):

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Sources: Reported sales are from AAPL SEC Filings (10Qs & 10Ks); End Channel Inventory numbers are obtained from AAPL's earnings' call transcripts posted on Seeking Alpha.

Here's some food-for-thought on the channel inventory build in FQ1-2016:

• When taking into account the channel build, underlying iPhone unit sales contracted 4.3% year-over-year, vs. the reported sales growth of 0.4%. This is interesting because of a comment made by Cook during the AAPL's FQ4 earnings' call in October, once again in the Q&A portion in response to a question posed by Toni Sacconaghi about expectations for iPhone growth:

"The same – my same response applies and I think we'll do quite good in iPhone. I do believe we'll grow this quarter as we put in our guidance that when you start with a number in the low 30s in terms of the percentage of the installed base that’s upgraded that had a phone pre the iPhone 6 and 6 Plus, that number still likely to leave a lot of headroom beyond December."

Cook is often very careful with his words so the fact that he believed the company would grow sales both in the December quarter and beyond implies that the company fell short of internal expectations on iPhone sales. It also is corroborated with the fact that AAPL would have missed the low-end of its revenue guidance range (an unprecedented scenario) but-for the booking of a $548 million settlement from Samsung in its "Services" revenue - as discussed by Chuck Jones of Forbes.

• The 4.7% gap between reported sales growth (0.4%) and underlying sales growth (-4.3%) is the largest gap since FQ4-2013 when there was an 8.8% gap (reported sales growth of 25.6% vs. underlying sales growth of 16.8%).
   
• To simply analyze channel inventory builds in historical context is not exactly an accurate measurement of the product health because the channel (3rd-party points-of-sale) have expanded significantly over the past few years - specifically in China. For example, AAPL was not selling the iPhone through the world's largest wireless carrier (China Mobile) when it had the 3.3M build in FQ4-2013.
   
• However, the 5.25 million unit build that occurred between July 26, 2015 (beginning of FQ4-15) and December 26, 2015 (end of FQ1-16) is concerning. It means that AAPL has a lot of units sitting in the channel that it has already recognized revenue on that it will need to work-off during the March quarter (FQ2-16). This likely lends credence to the relatively low guidance that it provided for the March quarter and related commentary about March being a very tough compare.
   
• In short, there are a lot of eerie comparisons this time around with iPhone channel inventory between what occurred in the FQ4-13 / FQ1-14 period, which may not bode well for Street expectations and actual performance. It should be noted, however, that the all-but-confirmed launch of an updated 4" iPhone in March-2016 (dubbed the iPhone 5se) could create new dynamics that haven't been seen before. It could be the first-time ever that AAPL has had two different timed iPhone release cycles in one fiscal year (assuming they bring out an iPhone 7 / 7+ in September-2016, as-expected).

I still think there is much headroom for iPhone growth both domestically and abroad. The research firm Mixpanel put out a report recently showing that 32.2% of active iPhone users are still using a 4" screen (5 / 5S / 5C) meaning they are either not enamored with the larger 4.7" / 5.5" offerings or are still waiting to upgrade. Additionally, the enterprise uptake of iPhones has been accelerating - Cook indicated at the BoxWorks conference that AAPL's TTM enterprise sales (ending in June-2015) were $25 billion - while that includes iPads, iPhones and Macs - I would suspect that the most significant acceleration of those sales is coming from iPhone. Lastly, the Android-switch rate that Cook keeps referring to is real - and that has nothing to do with whether the current installed base has upgraded or not.

What is the iPad Pro?

The iPad Pro with Smart Keyboard and AAPL Pencil charging (not awkward-looking at all...LOL)

I know that the iPad Pro has been subject to a number of reviews since its release on November 11th - but those reviews have largely been superficial. Instead of putting something out as soon as I got it, I wanted to really use the thing for a while and test its capabilities (or lack thereof) before putting putting forth some thoughts on the new device. I think it is great for people to write about it at the launch event or even several weeks after, but I've always believed that the best reviews come after a person's been able to really use the device over a sustainable period. I also believe you have to understand the context of the user - that influences a review tremendously - somebody streaming Netflix all-day has a very different opinion than somebody actually trying to do something 'useful'.

My Profile:

I'm a consultant that travels quite a bit. I am a heavy MS Office user (Excel, PowerPoint, and Word). I read and write a ton of emails on a daily basis. I'm a tweeter. I'm a blogger.  I AM NOT a graphic designer nor a heavy photographer. I use an iPhone 6S+, but a PC for work (due to the heavy use of the MS Office Suite).  I am also not a gamer.

AAPL Adoption Patterns:

I have had every major AAPL 'device' at some point. I have never had an iMac ironically, but I've had the following:

• MacBooks: 11" & 13" MacBook Airs, 12" MacBook, 13" & 15" MacBook Pro Retina, 13" MacBook
• iPads: iPad 2, iPad 3, iPad 4, iPad Air, iPad Air 2, iPad Mini 1, iPad Mini 2 Retina
• iPhones: iPhone 3GS, iPhone 4, iPhone 4S, iPhone 5, iPhone 5C, iPhone 5S, iPhone 6, iPhone 6+, iPhone 6S+

*MICROSOFT SURFACE: I HAVE USED ONE, BUT NOT FOR A LONG PERIOD OF TIME.

My Setup:

So I'm the definition of an 'early adopter' for AAPL products (if that wasn't) - I bought the iPad Pro on the morning of its U.S. public release date - November 11, 2015.  Here's what I have:

• 128GB Space Gray with LTE (Verizon) iPad Pro
• AAPL Charcoal Gray Silicon Case
• AAPL iPad Pro Smart Keyboard
• AAPL Pencil x 2 (lost the first one)

Needless to say, I'm in about $1,350, which exceeds the price of the base new 12" MacBook w/ Retina Display. I had one and got rid of it (a whole different story for another day), but basically I felt it was an under-powered laptop with a nice screen - I expect v2 to be greatly improved. But nonetheless, on with the iPad Pro:

The Good:

• The display is amazing: You can't really appreciate such a large canvas with such high quality until you've used it for a while.  Most media content looks great on it - HD Movies, Hi-Res Photos, YouTube videos, etc. Absolutely no complaints here - I know there are some always complaining about % of RGB, color spectrum, etc...I'm not one of those people. As long as its not a completely over-saturated Samsung screen, I'm perfectly fine with the standard AAPL 326 PPI LED-backlit laminated screen (no air-gap).
   
• Speakers are great: AAPL added stereo speakers on all four corner of the iPad, as opposed to the two that are on the iPad Air 2.  They also reconfigured the internals to enhance the sound - it's a significant improvement.
   
• The AAPL Pencil is 'magical': Like I said, I'm not a graphic designer, but I still use the Pencil. I've used other stylus-type pencils before, including some pretty high-end ones from the likes of Wacom. Nothing really compares to the Apple Pencil. The latency between pressure and screen visualization is virtually zero.  I have primarily been using it with the Paper53 App. I have heard that the Pencil does have variable performance with different apps. My only gripe with the Pencil is 1) charging it is really awkward; 2) there is no logical place to store the thing (hence, I already lost one). All told, it's hard for me to believe you could buy this device without also buying the Pencil.
   
• The Smart Keyboard holds its own. I've seen a lot of reviews both on the AAPL Smart Keyboard and other 3rd party offerings. The greatest part about these keyboards is that they don't pair through bluetooth.  They pair physically through a magnetic charging port on the iPad and keyboard - this is true for both AAPL's Smart Keyboard and at least the Logitech offering - not sure about others. The 'key travel' is pretty good - I actually find it a bit better than the keyboard on the 12" MacBook.  Using it in your lap is doable albeit a bit awkward.  It folds up nicely and doubles as a Smart Cover.

The Bad:

• It's really just a 'Big iPad': Other than the Pencil, there is nothing that I am doing more of (in-terms of productivity) than on the iPad Air 2.
   
• It's not a laptop replacement. Many have claimed that they have replaced their laptops with an iPad Pro - if you're simply doing email, that's likely possible - but you could also use an iPad Air 2 for that.  I still cannot see myself building PowerPoint decks, writing long documents or even working in Excel on the Pro. I do blog on the Pro, but I was doing that on the Air 2, so once again, not sure how the Pro justifies that use-case.
   
• iOS: Either iOS needs to be 'pushed-up' or OS X needs to be 'pulled down'. It's still a mobile OS that makes it very difficult to do a lot of core productivity work. I have not been all that enamored with the split-screen mode - it's just a bit awkward to use and many apps still don't support it.  I rarely, if ever, use the feature.
   
• It's heavy. The iPad Pro (bare) weighs 1.59 lbs. The silicon case + Smart Keyboard add another 1.59 lbs. This brings the total weight with keyboard and case to 3.18 lbs. For reference, that's heavier than all of the non-Pro MacBooks: (12" MacBook is 2.03 lbs; 11" MacBook Air is 2.38 lbs; 13" MacBook Air is 2.96 lbs). It truly makes the iPad Air 2 feel like...well...'Air'.
   
• Battery life: For some reason, I am not getting great battery life out of the device. I don't have the screen brightness turned up; I don't run a lot of apps in the background.  I set it up as a new device, as opposed to restoring an iCloud backup, but still not getting great battery life.

The Final Take:

Everybody talks about this A9X chip as a modern marvel of silicon technology that outperforms Intel's Core M processors (the same one that comes in the 12" MacBook with Retina Display).  I don't do the types of things with this device to really see it.  I think it's a great device.  I use it daily, but I struggle with the question of: 'what am I doing with the iPad Pro that I couldn't do with the iPad Air 2 (other than using the Pencil occasionally)?  The hardware is there; I'm waiting for the software to catch up.  Who is this device for? Likely best suited for power users like graphic designers or gamers. If you have an iPad Air 2, not sure this is a step-up I would make right now.  As the MS Surface is still more a laptop occasionally used as a tablet; the iPad Pro is still a tablet that can occasionally be used as a laptop.  If AAPL ever put an LTE radio into a MacBook Air, I'd switch in a heartbeat - constant connectivity (especially for frequent travelers) is key, which is why I've always loved the iPads. I saw an iPad Air yesterday and I thought it was a Mini - I might be at the point where I can never return to a smaller iPad (similar to how I'd likely never be able to go back to a 4" iPhone screen after using the 5.5" 6 / 6S+ for so long).

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Apple's App Store Developer Payouts Accelerate Again (Aug-2015)

On August 6th, it was revealed that Apple's App Store saw record billings in July-2015 with $1.7 billion in sales, driven primarily by growth attributed to its revitalized smartphone lineup as well as its continued momentum in China.  Along with its record billings, Apple also revealed that it has paid a cumulative $33 billion to developers since the inception of the App Store in July-2008.  Apple provides data related to developer payouts sporadically throughout the year - the historical trend has been at least twice a year (January and June), but as seen below, there have been instances where they have provided three updates (e.g., 2013 and 2015).  I have been tracking this data as seen below:

Source: Various Press Releases and WWDC Announcements

A few points of interest:

• The $3 billion incremental payout between June-2015 and August-2015 was achieved in 59 days, leading to a per-day payout of $50.8 million.
• The $50.8 million payout is a 53.6% acceleration vs. the previous per-day payout measured when the company reported $30 billion of developer payouts at WWDC in June.  This was was highest acceleration in developer payouts seen since June-2013.
• Apple has already paid out $8 billion in 2015 alone, which aligns with the announcements made in January-2015 ($25 billion in cumulative payouts) and August-2015 ($33 billion in cumulative payouts).
• Based on the above announcements, Apple paid developers $3 billion in 2012, $8 billion in 2013, and $10 billion in 2014.  Considering that Apple has already paid out $8 billion through July-2015 and the number appears to be accelerating, it's likely that cumulative developer payouts will reach $38B+ by calendar year-end (implying $13 billion of payouts in 2015).

Here's the some things that are a bit mystifying to me:

• Very few, if any, people I know pay for apps, yet the developer payout numbers suggest that a crap-load of people are buying apps.  Since developers get 70% (roughly) of app purchase revenue, the 2014 payout of $10 billion implies $14 billion of app purchases.  As a point of reference, Netflix reported $5.5 billion of revenue in all of 2014.
• While one would logically assume that developer payout growth is a function of the iOS ecosystem growth (e.g., number of devices sold -> installed base), is that a correct assumption?  For example, if you are one of the people that buys apps and you're already in the ecosystem, you don't need to keep buying the app over-and-over as most paid apps are one-time purchases (not subscription-based).  Point being, developer payouts (which is a function of app purchases) should really be a function of incremental additions to the iOS ecosystem. 
• If you assume that developer payouts are a 'proxy' for incremental additions to the iOS ecosystem, then that ecosystem's growth continues to accelerate in markets that everybody calls "saturated".

The Curious Case of the AAPL Watch

Source: iDownloadBlog.com

For as much 'hype' as the AAPL Watch received pre-announcment, the noise has gone rather silent. As the company's perception continues to live-and-die with iPhone shipments, the AAPL Watch received very little attention on the last earnings' call.  And rightfully so - I estimate that the AAPL Watch only contributed about 3% to the company's top-line revenue ($2.4 billion). But I estimate that the $2.4 billion represented shipments of over 5 million units. 5 million units is an extraordinary number for any company not named AAPL.

I have an AAPL Watch Edition - it's a great timepiece (I also have a Panerai - mechanical watch). But what's more interesting is what I've observed about who is wearing these things.  When the AAPL Watch was unveiled in September-2014, the little that we saw of the software and capabilities made me believe it would be well-suited and popular for the upper-adolescent population (I call them the"Younger Millennials") - a generation that did not grow up wearing watches and "I thought" AAPL was now giving them a reason to do so. Due to the need for an iPhone to pair it with, I knew the AAPL Watch would not be a device for the younger-adolescent population, although it seems like kids are getting iPhones at younger-and-younger ages now. Even though AAPL touted the fashion aspect of the product, I didn't really think it would be widely adopted by professionals (35+ college-educated and sophisticated people). After all, this is a group that still does covets expensive mechanical watches and the AAPL Watch still seemed a bit too 'tech' to be worn on the wrist everyday.

Now that the product has been out for almost 10-months, I've observed some very interesting things:

• Demographic adoption: The demographic (Young Millennials) that I thought the AAPL Watch would be most popular with is virtually non-existent as buyers (and users). The demographic that I see wearing it the most is the exact demographic I thought it would be least popular with - professionals.
   
• Accretive Not Replacement: The vast majority of people that I've talked to that have AAPL Watches were not previously wearing a watch - most said that they used their phones to tell the time.
   
• Stacking the Wrist: While many have raved about the AAPL Watch as a health and fitness tool, the majority of people I talk to do not use it for that.  I'm not sure what it is - either it's too complicated and they don't want to figure out how to make it part of their 'fitness routine', or they don't think it is effective in that capacity. Strangely enough, I've seen a number of people with an AAPL Watch on one wrist and a FitBit on the other.
   
• Time is Money: Here is the irony (or maybe not). When I talk to these people about why exactly they are wearing an AAPL Watch, the one consistent answer is..."it saves me time". It allows people to determine whether a tweet, text message, email or other consistent notification is worth their time.  One person said, "I wear an AAPL Watch for one reason - I pull my phone out of my pocket 50 times per-day now, instead of 250..and for me, that's worth it." 
   
• Travelers love them: Travelers such as business professionals that are on planes each week LOVE AAPL Watches - there are more useful features on the AAPL Watch that resonate with travelers (boarding passes, hotel keys, etc.) than any other population.

But perhaps the bigger question is why the AAPL Watch does not resonate with the Young Millennial population?

• It Doesn't do the Things They Crave: This Young Millennial population I speak of loves social media - they love texting, posting, tweeting, sharing pictures, etc.  The AAPL Watch is not good for any of that. You can't take pictures, texting is somewhat awkward using voice commands...it's just not great for social media curation.

I have seen C-Suite Executives from large publicly-traded companies wearing AAPL Watches; I have seen many other business professionals (both males and females) doing the same.  I have seen Young Millennials receive AAPL Watches as gifts, open them, and are now stashed away in some drawer never to be seen again.  It's quite interesting...it's quite curious.

Analyzing AAPL's Cash

An analysis of the tremendous amount of cash flow that AAPL generated in the December-2014 quarter, a comparison of its operating cash flow (OCF) conversion rate to its competitors, and a look into what it might do next with its capital return program...read more