Apple (AAPL) announced a mixed set of results for Q1 FY2013 Tuesday as revenues continued their upward ascent but earnings took a dip for the first time in nearly a decade. That Apple’s growth is slowing down was evident from the fact that the y-o-y growth in revenues came in at a lowly 11% – a far cry from the nearly 60% it had posted a year ago. The decline in net profit was mostly a result of the downward slide in gross margins which came in at the low end of its guidance at 37.5 %, a big fall from the exceptionally high 47% it had posted in the same period last year.
Apart from the normal seasonality in iPhone sales, a higher sales mix of the lower-margin iPad mini was to blame for the gross margin decline. Growing demand for the iPad mini however helped Apple grab tablet market share as iPad sales declined by only about 15% sequentially even as the overall tablet market shrunk by almost 30% over the strong holiday quarter.
The iDevice maker however continues to generate tons of cash. The March quarter saw Apple generate about $12.5 billion in cash flow from operations, which was about 30% of its revenues. Increasing investor restlessness about the huge $145 billion cash hoard that has piled up at Apple finally prompted the board to approve a huge $100 billion capital return program, more than doubled the existing one. The bulk of the cash return will be done through share purchases, which we think is a good move considering the low valuation that Apple’s stock is trading at, and shows management’s faith in the stock.
Our $625 price estimate for Apple is about 55% ahead of the current market price.
Better Approach To EMs Needed
With revenues plateauing, Apple needs to tap the fast-growing emerging markets such as China. 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 in December last year, which crossed the 2 million mark and made it Apple’s best ever launch in the country.
However, Apple currently sells the iPhone through the smaller two of the three carriers in the country, China Unicom and China Telecom (CHA). Without a deal with the country’s largest carrier, China Mobile (CHL), 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 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. Apple CEO Tim Cook alluded to a fall launch of some exciting new products that the company is working on, but it is hard to say if those plans include a cheaper iPhone or not. (see Apple Needs A Better Emerging Markets Strategy)
iPad mini key to future growth as PC declines
The iPad currently accounts for less than 13% of Apple’s value currently. However, with tablets rapidly cannibalizing PC sales, this division could contribute a lot more to Apple in the coming years. The PC market is declining faster than many anticipated, with Gartner and IDC claiming that the March quarter registered the most decline in PC sales in over a decade. A big reason for the decline has been the proliferation of mobile devices, especially tablets, and Apple is looking to play the market share game here. This will not only help it preserve its first mover’s advantage but also get more users to adopt its iOS platform which can fuel the growth of its future products. The iPad mini was therefore attractively priced, and Apple said that early usage stats showed an overwhelming majority of iPad mini purchasers being first-time iPad customers.
However, Microsoft’s entry into tablets with Windows 8 is a very potent threat to Apple’s continued dominance in the tablet category. The Windows maker not only has a widely installed PC base in place but also a mobile partnership with Nokia and other handset makers which it can use 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 from Amazon and Google.
Disclosure: No positions.