Why Apple Profits Pack Such Punch

Sure, the tech company showed strong revenue growth. But its profit potential is what really matters

by Peter Burrows

Somehow, Apple's (AAPL) trips to the doghouse don't ever seem to last too long.

Just a day after investors drove its shares down almost nine bucks to $134.89, on concerns of poor iPhone sales, CEO Steve Jobs & Co. obliterated Wall Street's expectations, boosting sales 24%, to $5.41 billion, from the third quarter of last year. Even more impressive, net income soared 73%, to $818 million. In after-hours trading on July 25, investors' fervor sent shares up $13, to more than $150, more than erasing the previous day's decline.

The reasons for the change of heart had nothing to do with the iPhone. The company booked just $5 million in iPhone sales for the quarter, most of it for accessories. Rather, the Mac took a star turn. Despite rumors of soon-to-come new iMacs, Apple still increased its computer sales by 33% in the quarter. That's nearly three times the 12.5% overall PC industry growth reported by market researcher IDC (IDC) on July 18.

Apple increased its market share in the quarter to a 10-year high, says Piper Jaffray (PJC) analyst Gene Munster, although it remains at only 3% of the overall market, well behind leaders Hewlett-Packard (HPQ) and Dell (DELL). Munster thinks Apple's PC share could rise to 4% by the end of fiscal 2008.

While the products win the headlines, the more important accomplishment of the quarter may be the bottom line. Gross margins rose from 30.3% to 36.9%, an enormous increase for the PC business. The hike came thanks to low prices for components such as memory chips, and to an increase in direct sales from Apple's 185 stores and its Web site. It turns out that consumers who use these outlets, rather than traditional retail stores, buy higher-priced, more-profitable models.

What's Its Recipe?

There's also something more fundamental and more sustainable in Apple's profit growth than chip prices or product mix. The latest quarter shows that Apple is gaining leverage from its unique cupboard of technologies. While many large rivals have scores of products with little in common with each other, Apple increasingly is creating its products from the same set of ingredients. The iPhone illustrates the point: It runs the same Mac operating system software, the Safari browser, and the same iTunes music software as all of the company's computers. It also utilizes many of the same chips as the iPod. "Apple's ability to develop, launch, and support new products, using the same R&D and sales and marketing investments, creates [earnings] leverage that is substantially greater than people thought even six or twelve months ago," said Goldman Sachs (GS) analyst David Bailey in a recent interview.

What's more, the company is expert at outsourcing the rudimentary work to suppliers and manufacturing partners. "They're mainly in the business of defining architectures," says Kathleen Eisenhardt, an engineering professor at Stanford University. "We're talking about a small number of people—maybe ten—that think about how all the pieces go together. [Apple is] more the thinker bees than the worker bees, and that scales a lot better than trying to do everything yourself."

The result: Apple should be able to continue to boost profits faster than its sales growth, which may keep analysts scrambling for ways to justify higher and higher targets for Apple's share price.