Apple & CloudFlare Earnings Reviews

Digesting the results of a king and a disruptor.

1. Apple (AAPL) – Earnings Review

a. Demand

Apple beat revenue estimates by 0.7% & beat guidance by 0.1%. The 11.4% 3-yr revenue compounded annual growth rate (CAGR) compares to 11.0% Q/Q & 17.6% 2 quarters ago. Revenue rose by about 1.3% Y/Y on a foreign exchange neutral (FXN) basis.

Mac & iPad revenue both declined by double digits Y/Y as expected. The 34% decline in Mac was sharper than expected. As a reminder, in the Y/Y period, it enjoyed a recovery in supply chain disruptions. This meant the unleashing of pent up demand and the tough Y/Y comp. iPhone and services growth Y/Y improved vs. last quarter as expected.

b. Profitability

Apple’s 45.2% GAAP gross profit margin (GPM) was 80 basis points (bps) better than its guidance and 70 bps better than estimates. Its EBIT was ahead of both guidance and estimates by 3.3%. Finally, earnings per share (EPS) of $1.46 beat estimates by $0.07. EPS rose 13% Y/Y partially thanks to buybacks.

• Product GPM was 36.6% vs. 35.4% Q/Q and 34.6% Y/Y.

• Services GPM was 70.9% vs. 70.5% Q/Q & 70.4% Y/Y.

c. Guidance

Apple guided to roughly 0% Y/Y revenue growth next quarter. This materially missed expectations of 4.6% Y/Y growth. It’s important to note that fiscal Q1 2024 has one less week than Q1 2023. That boosted Q1-2023 revenue by 7%, but should have already been baked into estimates. What likely wasn’t fully incorporated into estimates were supply chain challenges with the iPhone 15 lineup. These issues are capping its ability to fulfill demand and will last through next quarter.

Conversely, the 45.5% GAAP GPM guidance was 200 bps better than expected thanks to mix shift towards services. Input cost efficiency gains helped too. This paved the way for EBIT guidance that was about 1% ahead of consensus. 

d. Balance Sheet

• $162 billion in cash & equivalents. Crazy.

• $111 billion in total debt.

• $77.6 billion in fiscal year 2023 buybacks vs. $89.4 billion Y/Y. Crazy again.

Share count fell by 2.7% Y/Y via continued aggressive buybacks. It initiated an additional “accelerated $5 billion buyback” this past quarter. Must be nice to be able to casually spend $5 billion on repurchases when you feel like it. That’s the luxury of its fortress balance sheet. It has the goal of being at $0 in net cash (cash - debt). It’s over $50 billion today, which gives it significantly more room to lever up the balance sheet for more buybacks.

e. Call & Release Highlights

Macro:

CEO Tim Cook unsurprisingly cited uneven macro in the September quarter. Refreshingly however, he spoke about Apple overcoming these issues rather than citing them as excuses for softness. It will continue to invest heavily in innovation which, again, is the luxury of its best in class balance sheet and massive net cash position. It doesn’t need to pull back when cost of capital rises.

Products:

iPhone revenue rose 3% Y/Y for the quarter vs. negative Y/Y growth last quarter. This represents a new quarterly record for the segment The new phone lineup is receiving nearly perfect 3rd party customer satisfaction scores. Cook spoke about the iPhone 15 Pro in a nothing but a positive light. The heating issues around the titanium frame were not discussed in prepared remarks or asked about in the Q&A. The Americas and emerging markets were the two geographic standouts that powered iPhone’s growth.

Mac’s -34% Y/Y performance was again related to difficult comps already discussed. Weak macro and “challenging market conditions” added to the softness. The demand runway here still looks promising over the longer term. Two-thirds of the young, affluent college student demographic uses Macs. Additionally, half of the buyers this quarter were brand new to the product.

As Apple debuted its new M3 chips this past week, leadership was understandably asked about how this investment is going. Cook would not explicitly say that the vertical integration is boosting margins. It’s unclear if it is. What is clear is that the pace of product innovation (thanks to this vertical integration) is far better than if it were solely utilizing 3rd party chips. He’s happier every single day” that it made this transition.

Wearables were not a big part of the discussion. Revenue shrank a bit Y/Y vs. modest Y/Y growth in the previous quarter. He talked up the previously debuted product upgrades for the new Watch lineup like the touch-less hand controls. Two-thirds of Watch buyers this quarter were brand new to the product as it becomes more ubiquitous.

Services:

Services growth of 16% Y/Y vs. 8% Y/Y last quarter was probably the highlight of this report. That makes commentary about next quarter’s services growth being “similar to this quarter” quite positive. This drove the bulk of the GPM outperformance in the guidance.

• It was a banner quarter for Apple Music subscribers. Maybe I’m not the only GenZ consumer who uses it instead of Spotify after all.

• Its first season with Major League Soccer’s league pass is “exceeding expectations.” This could make Apple more eager to bid on more live sports content in the future.

The subscriber base is well over 1 billion, engagement continues to improve as transacting accounts rose 10%+ Y/Y and retention is sky high. Product introductions like new iCloud storage tiers and more Apple TV content are building even more traction. This segment continues to thrive.

Global Backdrop & China:

Apple opened new stores in India this quarter and expanded its online store to Vietnam and Chile. India represents a fabulous growth opportunity with a business-friendly government, a massive population and a growing middle class. Revenue rose by double digits Y/Y in that country this quarter.

Interestingly, it also opened a new store in China this past week. As a review, China banned iPhones for government employees this past year. Despite that, it took market share in the country with a new iPhone revenue record there. While Cook wouldn’t say they’re trying to diversify away from Chinese supply chain reliance, they clearly are through investments in India and Vietnam. Revenue in that country missed estimates by 11% to hint at his dialogue perhaps being too rosy.

Enterprise Demand:

Starbucks is all in on Apple products. It’s investing heavily in Apple’s technology to improve its employee workflows and customer experience. It’s buying thousands of iPads to streamline order management and 10,000 Macbook Airs for its managers. GoTo (big company in Indonesia) made Macs a workplace option for the first time this quarter. 50%+ of its workforce is picking it.

f. Take

This was a very in-line quarter. Anecdotal hints about weak China demand proved to be overblown and Apple’s iconic ecosystem proved to be resilient yet again. The forward guide was light, but the reasoning was understandable. The margin expansion is impressive and the gigantic cash position leaves ample room to financially engineer more earnings growth. We sure do love those blue text bubbles… myself included.

Amazing? No. Alarming? No. Fine? Yes.

2. Cloudflare (NET) – Earnings Review

a. Demand

• Cloudflare beat revenue estimates by 1.5% and beat its guidance by 1.6%.

• Its 43.2% 3-year revenue CAGR compares to 45.7% Q/Q & 47.0% Y/Y.

• Dollar Based Net Retention Rate (DBNRR) was 116% vs. 115% Q/Q & 124% Y/Y.

b. Profitability

• Cloudflare more than doubled EBIT estimates and its same EBIT guidance.

• It beat $0.10 EPS estimates by $0.06 and its same EPS guide by $0.06.

• It nearly doubled free cash flow (FCF) estimates.

• Gross margin expanded from 75.6% to 76.7% Y/Y and was a bit better than expected.

c. Guidance

“With broadening geopolitical uncertainty and mixed macroeconomic data, the environment in which we operate remains challenging to predict. And as a result, we continue to remain prudent and cautious in our outlook for the fourth quarter.” – CFO Thomas Seifert

Cloudflare missed next quarter revenue estimates by 1.1%, beat EBIT estimates by 24.0% and beat $0.10 EPS estimates by $0.02.

It guided to $100 million in 2023 FCF which was 13.6% better than expected. The outperformance was largely due to Q3 strength.

d. Balance Sheet

• $1.6 billion in cash & equivalents.

• $1.3 billion in senior convertible notes.

• Share count rose 2.5% Y/Y.

• Headcount rose 11% Y/Y as it continues to “selectively” hire.

e. Call & Release Highlights

Generative AI:

As part of a product event this month, Cloudflare debuted Worker AI. This is a Graphics Processing Unit (GPU) inference tool. It frees developers to utilize models from the safe, secure, fully managed Cloudflare ecosystem… from anywhere. 

As a reminder, there are two key layers to model and machine learning development: Training and inference. Training educates a model and shares patterns to allow it to learn and sharpen future data/pattern surfacing. The more data a model is seasoned with, the better this training will become. Inference means asking trained models to create new insights and new patterns. It connects data dots that we didn’t even know existed. Worker AI presides in the inference category as Cloudflare thinks this is the single largest opportunity in Generative AI.

In true Cloudflare fashion, it’s focused on placing Worker AI GPUs globally by the end of 2024. This will ensure that usage of the tool and the integrated models is as low latency as possible. It has GPUs in 75 cities today and is rapidly expanding that footprint.

CEO Matt Prince is truly a visionary in my outsider opinion. Starting a full 6 years ago, Cloudflare began leaving empty slots in its servers around the world. It did this in anticipation of Worker AI GPU demand. This means it can simply plug Worker AI GPUs into its existing server infrastructure. So? GenAI proliferation will not entail hefty boosts to capital expenditures. Impressive foresight.

It’s very early in Cloudflare’s GenAI journey. All it told us about demand was that it is exceeding expectations and is up 5x month over month on a very small base. Like Microsoft, Cloudflare does intend to directly monetize some GenAI products. Its R2 product, for example, is what makes Cloudflare a connectivity cloud. It allows cloud workloads and data to be freely moved among public clouds with no tax. This use case is popular for GenAI model building and implementation. These models are voracious users of data and, again, GenAI work often spans multiple clouds. Enter Cloudflare.

The “Connectivity Cloud:”

Cloudflare is rebranding itself as the Connectivity Cloud. Why? Because its value is in “connecting people and things” expediently. Prince spoke about how hyperscalers (Azure, AWS and Google Cloud) are incentivized to gate and “hoard” data. He calls them the “captivity cloud.”

The “full potential of data is only unlocked when combined with a connectivity cloud per CEO Matthew Prince. Cloudflare is free from this conflict of interest and allows its clients to “mix and match” the best from all hyperscalers. It just cares about maximum traffic regardless of the chosen cloud(s). In a world where everyone wants to be multi-cloud, this is highly relevant. The differentiation is a core piece of Net’s value proposition, which it wanted to explicitly call out with this new classification.

Winning Big Clients:

This was a record quarter for new deals worth $500,000 or $1 million in annual revenue. While its next quarter revenue guidance was light, its results are holding up better than other related software names. Why is this? I think for similar reasons as why ServiceNow performed so well last month. Cloudflare is a platform play. It allows for significant vendor consolidation. That vendor consolidation removes disparate interfaces and enhances interoperability. That simply makes things work better.

Furthermore, cutting often 10+ 3rd party contracts allows clients to routinely save significant costs. Better and cheaper is especially popular in today’s chaotic macro environment. The need to control costs wherever possible has become far more pressing, and platform plays are outperforming point solutions as a result. The customer wins highlighted below make this point utterly clear:

• A U.S Cabinet Level agency signed a $2 million contract to displace 3 point solutions.

• A European consulting firm signed a $1.6 million contract thanks to unmatched product breadth under one ecosystem.

• Another U.S Government Agency signed a large contract for Cloudflare’s Zero Trust suite. As a reminder, zero trust constantly assumes no query, worker or endpoint is safe. It requires constant verification so an adversary cannot breach the most vulnerable part of an enterprise and move freely throughout it afterwards.

  • Gateway is an example of a zero trust product which sifts through web traffic to uncover unscrupulous activity and requests.

• A large healthcare firm signed a $1 million contract to use all Zero Trust products and its email security tool.

Go-To-Market & Macro:

Two quarters ago, Net’s underwhelming quarter was blamed on underperforming sales reps. It replaced these reps to quickly fi the issue. Pipeline closure activity is stable, sales productivity (which spiked last quarter) is stable and the new employees achieved 130% of their targets. They’re performing very well.

While macro headwinds aren’t getting worse, they’re not magically vanishing either. Clients remain focused on stretching every IT dollar as far as they can go.

Distributed Denial of Service (DDoS) Attacks:

DDoS attacks try to inundate networks with overwhelming sums of traffic to make breaching easier. The instances of these hacks are rapidly rising with state-sponsored adversaries now more readily joining the fold. This is where the scalable nature of Cloudflare, in conjunction with hyperscalers, becomes so valuable. It allows the firm to handle all of this malicious traffic without disrupting client work. This is becoming more & more needed.

f. Take

I can’t call this quarter perfect given the revenue guidance. Still, it’s nice to see the guide called “conservative” and that it coincided with better than expected profitability. Aside from that small revenue miss, this was very good.

The platform plays this earnings season are performing better than point solution software vendors. That’s a key theme. While Cloudflare may not boast the product breadth of a ServiceNow or a Salesforce in their respective software buckets, it certainly comes a lot closer than most. The team quickly fixed the sales rep issue, has quickly right-sized its cost base and is still finding brisk growth in a challenging environment. Good performance, all things considered.