Apple Earnings Face Cloud Of Uncertainty Over Future Catalysts

Apr.22.13 | About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) is expected to announce its Q2 FY 2013 earnings on April 23. With its stock tumbling more than 40% since the iPhone 5 was launched last year, the "iDevice" maker seems to have fallen out of favor with investors of late. A big reason for the recent downtrend has been increasing competition from rivals such as Samsung (OTC:SSNLF), which has caused the company's earnings per share to plateau recently, after years of unmitigated exponential growth.

The iPhone 5 together with the launch of the lower-margin iPad Mini did little to appease investor concerns, as gross margins took a dip last quarter despite record revenues. The margin decline set off worries that a lack of innovation has decreased Apple's gap with rivals such as Samsung and prompted customers to purchase more of its older generation devices. Little information about Apple's future products and ambiguity regarding its strategy for the emerging markets has only served to increase the uncertainty further.

It will therefore be good if Apple seeks to mitigate the aforementioned concerns about its future strategy during the Q2 earnings call. Coming off a very strong holiday quarter, there is likely to be a seasonal impact on revenues, but it will be interesting to see the extent of the decline. iPhone numbers will be especially important considering that it contributes to more than 50% of Apple's value currently, and a particularly large slowdown in the device's demand could have a big impact on the company's valuation. The fact that Apple's most important manufacturing partner, Foxconn, turned in poor sales numbers for the quarter recently, is a red flag. With PC sales having fallen this quarter, we will also be watching the iPad's performance closely. A decline in PC demand may have worked in Apple's favor, now that it has a cheaper tablet option in the iPad Mini.

Horses for Courses Approach to EMs

With earnings growth plateauing, Apple should be looking to tap the fast-growing emerging markets such as China, to grow at higher rates. Despite being only in the early stages of smartphone adoption, China has already pulled ahead of the U.S., as the world's largest smartphone market by volume. This is an incredible statistic, given that 3G penetration in China is in the low-20s currently. Considering the huge 2G subscriber base that the Chinese carriers are looking to upgrade to 3G, the potential for Apple to ride the boom is huge. This was borne out by the opening weekend sales for the iPhone 5 in China last quarter, which crossed the 2 million mark and made it Apple's best ever launch in the country.

However, Apple currently sells the iPhone through smaller two of the three carriers in the country, China Unicom and China Telecom. Without a deal with the country’s largest carrier, China Mobile, which controls almost two-thirds of the wireless market there, a vast chunk of the Chinese populace has remained out of Apple's reach. Since the iPhone 5 sports a chip that can theoretically support China Mobile's 3G network, we believe that subsidy concerns have held up discussions. (See also: "Apple's China Potential Could Be Limited By A Subsidy Compromise With China Mobile.")

Coming up with a cheaper iPhone for the emerging markets that does not compromise much on the build quality and margins, in a move similar to the iPad Mini, could help lower the per phone subsidy costs and potentially help bring carriers such as China Mobile on board. Such a move would also translate well to other emerging economies that may want the iPhone, but due to the lack of carrier subsidies, find the retail price tag too high. We will therefore be watching out for comments on this front as well. (See also: "Apple Needs A Better Emerging Markets Strategy.")

Watching iPad Mini Sales

Apart from the iPhone sales, it will be interesting to know how the company has performed on the iPad front. A recent decline in demand for PCs may have been due to tablets such as the iPad cannibalizing PC sales. Given that Apple now has the cheaper iPad Mini, unit sales are likely to be very strong this quarter. However, what investors need to look out for is the iPad Mini mix since there is a risk of cannibalization of the higher-margin iPads. Currently, we are not expecting much of an impact either way since we estimate the iPad to account for only about 12% of Apple's value. This may however change if the tablet market continues to grow exponentially in the coming years. However, Microsoft's entry into tablets with Windows 8 is a very potent threat to Apple's continued dominance in the category.

Microsoft has a widely installed PC base in place that it can leverage to pose a big threat in the young market. Moreover, it can also leverage its partnership with Nokia and other handset makers to push for an integrated experience across all devices, mobile or PCs, in order to create a viable third ecosystem. That Microsoft's two-pronged attack with the Windows Phone 8 and Windows 8 could endanger Apple's iOS ecosystem advantage, causing iPhone sales to be impacted as a result, should give Apple more reason to worry than the low-end tablet threat.

Disclosure: No positions.