Quick Thoughts: Apple – The Glass is Only a Quarter Full

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– Apple beat modest expectations in a less than remarkable 3QFY13, with upside on revenues, EPS, and iPhone unit sales. Still sales were flat YoY and net profits were off nearly 25%.

– iPhone units were 19% above projections, but ASPs were down 5.2% QoQ. iPad units were 16% light vs. expectations and last year, clear share loss in a fast growing market.

– This is 3 straight quarters of sales deceleration and 5 quarters of falling margins. Margins dropped despite the positive mix shift toward iPhones. International sales were off hard.

– 2014 consensus expects 12% sales growth and a recovery to 37.5% gross margins. Given the current trajectory and tough competition, AAPL needs an easier target.

Apple triumphed over diminished expectations with a 3QFY13 beat, despite delivering flat sales and sharply lower earnings vs. the year ago quarter. Coming off several misses, Apple delivered a top line revenue figure that slightly beat expectations at $35.3B versus $34.9B. EPS came in at $7.47, just above the $7.28 expected but at a level not seen since September 2011. While investors cheered that Apple sold 19% more iPhones than were expected, ASPs were off 5.2% sequentially and 4.4% YoY. This price decline partially offsets the volume surprise, and highlights a market that is becoming far more price sensitive. In the quarter, Apple atypically employed aggressive price promotion with partners like Walmart and AT&T on the flagship iPhone 5 to drive volume, and likely experienced a sharp mix shift toward the lower priced iPhone 4 and 4S models.

At the same time, iPad sales are troubling. The 14.6M units sold in 3Q were 16% below expectations for 2% YoY shipment growth. Even adjusting for reductions in channel inventory, which CFO Peter Oppenheimer claimed would have resulted in a more palatable YoY 3% decrease, any decline at all is shocking in a tablet market that is still growing in the mid-double-digit range. Apple is hemorrhaging share in the market that it created, with the Android driven competition hitting the market with innovative and capable tablets at sharply lower price points. In particular, competitors, like Amazon and Google, willing to sell hardware at cost in pursuit of e-commerce, service, and advertising revenue, are a serious challenge to Apple which needs fat margins on its tablets to sustain its business model.

There are ample signs that the business model is beginning to come apart. This was the fifth consecutive quarter of declining gross margins, with guidance on the table suggesting further declines in the September quarter. Indeed, the mix shift toward the higher margin iPhones and away from the lower margin iPads OUGHT to have resulted in good margin news for 3QFY13. Sales were flat vs. the year ago quarter, a level considered disappointing even then, and decelerated for 7th quarter in the last 8. 4QFY13 guidance offers little hope for a break in the trends – the mid-point of guidance would have another 40bp sequential drop in gross margins and sales down 1.3% YoY. With vigorous competition in its core markets, and signs that the high-end smartphone market is slowing, business as usual for Apple may not be good enough to meet consensus projections that expect the company to return to double digit growth and reverse margin declines.

Apple is said to be dabbling in several other product categories aiming to replicate its historical successes with iPod, iPhone, and iPad. iTelevision speculation has been a cottage industry for at least three years, but there is little evidence to support Apple’s long awaited and purportedly game changing TV could be as big as either iPhone or iPad. At this point, a new Apple TV solution would find fierce competition – Microsoft’s Xbox One is due in 4Q13, Intel has been open about its plans to bring a game changing TV box and service to market, and Amazon and Google are reputedly negotiating content for next generation TV boxes of their own. Apple won’t have the advantage of being first to market, and could actually be late to the party. The other major new product rumor out there is the iWatch, but the potential for a connected wristwatch is likely a small fraction of the iPhone or iPad.  Apple will realistically be able to siphon only a small share of the $60B watch business whose revenues are dominated by luxury watchmakers crafting timepieces noted more for aesthetics than practical use. Moreover, once again rivals, like Sony, Google, and Microsoft are targeting the exact same concept. Waiting for the next big blockbuster category for Apple may be a fool’s errand.

Apple also faces issues expanding in international markets. Apple has primarily focused its retail operations in well developed markets. Like North America, Western Europe, and Japan. The Americas, which is comprised of mostly the US and Canada, and Japan were the only major markets reporting YoY growth. Europe, Apple’s second largest market, is undergoing economic turbulence that likely contributed to declining sales in those markets. Notable in the quarter was Apple’s -43% sequential decline in China, which was a focus area for the company. Just last year, store openings were marred with riots and violence as customers flocked in droves for the latest Apple devices. Interest may have waned for Apple with newer and cheaper home grown devices and likely impact from counterfeit iPhones and iPads. Even the rest of Asia was down almost -20% YoY and -35% sequentially. The reality is developed markets are already mature and winning in emerging markets will mean attacking growth at the expense of margins. Apple will have to come out with a lower priced phone to compete with handset makers taking advantage of growth in large markets like China, India, and Brazil. With Apple fanboy blogs ablaze with talk of such a handset for the better part of the past year, such a move would not be a surprise.

Taken in full context, the quarter was anything but good for Apple. The decline in iPad sales within the high growth tablet market is sobering and reminiscent to Apple’s early pitfalls with Mac against the PC that ushered in the Wintel era. Apple’s pace of innovation has slowed with no major product announcements since last October, and none expected until the fall. Apple may have lost the interest of consumers. Execution in markets outside the US has been difficult with the existing business model and sales haven’t just slowed, they’ve declined in YoY and sequential terms. As a result we believe 2014 consensus estimates continue to be unrealistic given the company’s trajectory of decelerating sales and declining margins. A future of downward revisions and quarterly misses does not bode well for Apple investors.

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