Apple: Short-Term Challenges, Long-Term Optimism

Jun.27.13 | About: Apple Inc. (AAPL)

Apple Inc. (AAPL) has seen better days during the last six months. Apple's business operating performance momentum has slowed down relative to the heady growth rates it achieved from 1997 to 2012. Apple reported Q2 2013 revenue of $43.6B and quarterly profit of $9.55B, or $10.09 EPS. Apple's shares bottomed out a week before it released results, increased by 15% in the month after it released results and then promptly ceded its gains. Although Apple's Q3 2013 guidance calls for stable revenue year-over-year, its gross margin is expected to decline by 6% due to the increased proportion of sales from iPads and iPad Minis, which carry lower gross margins than the iPhone. At least its total return has been within the S&P 500 since April 19th (the Friday before it released its results

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Source: Morningstar Direct

The iPhone continues to be Apple's best-selling product. Revenue from the iPhone increased 3% to $23B on a year-over-year basis. Units sold increased by 7% to 37.4M, which was adequate in light of the challenging macroeconomic environment as well as the success Apple enjoyed with its iPhone 4S product line last year. This certainly outshined the revenues and units sold by Nokia (NOK) and BlackBerry (NASDAQ:BBRY), even though we previously wrote about how those companies have lower wholesale and retail costs associated with phones from those two vendors. While Apple's share price has certainly pulled back by 43% since its September 21st peak of $705.07, Apple's iPhone sales volumes are much stronger than what BBRY and Nokia have enjoyed at each firm's respective peak. We expect recent price cuts on the iPhone 5 to help stimulate demand ahead of the projected 5S launch.

Although share prices for Nokia and BBRY have generated rapid growth since the summer of 2012, Apple's iPhone sales volumes have still increased in the last quarter on a year-over-year basis unlike BBRY and Nokia. This was even though Nokia released two brand new flagship phones in the last 10 months. According to mobile carrier executives, the iPhone has lower churn than other smartphones sold by the carriers. Apple's iPhone sales through the big three U.S. carriers [AT&T (NYSE:T), Verizon (VZN) and Sprint (NYSE:S)] in the recent quarter eclipsed the number of BlackBerry smartphones sold worldwide, as well as the number of Nokia smartphone devices sold worldwide. But what Nokia Nation should be embarrassed about is that Apple's iPhone sales at AT&T as well as its iPhones sales at Verizon significantly exceeded Nokia's Lumia sales worldwide.

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Source: MRQ Reports from Apple, Nokia, Research in Motion, AT&T, Verizon and Sprint

The iPad also saw strong growth during the quarter. On a year-over-year basis, iPads sold increased by 65% and revenues from the iPad increased by40%. We believed that Research in Motion (BBRY) should be embarrassed that Apple's iPad revenues in the first quarter of Calendar Year 2012 exceeded BBRY's total company revenues for that period and low and behold, iPad did it again for the second quarter, the third quarter and in the all-important holiday quarter. We projected that Apple's quarterly revenue from the iTunes Stores and related music products would exceed BBRY's consolidated quarterly revenue and lo and behold our prediction has now become a consistent recurrence as revenue from the iTunes, Software and Services segment has exceeded BBRY's recent quarterly revenues. Even though BBRY finally released its BlackBerry 10 smartphone device earlier in the year, we are not expecting BBRY's revenues to approach the levels generated by the iPhone or the iPad.

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Sources: Apple and BBRY earnings releases

Performance of the iPod and Mac product lines has been significantly more downbeat. Unit sales of the Mac Desktops and Portables collectively declined by 2% but product revenue increased by 7% versus the comparable quarter last year. We were especially disappointed in the Mac product line's performance because it had generated strong performance in FY 2012 versus Dell (DELL) and Hewlett-Packard (HPQ). Apple introduced the first Macintosh desktop computer 29 years ago this day and it introduced the new 13-inch MacBook Pro Retina display as well as its new iMacs in October. Apple's management projected in October that it was significantly constrained with respect to the new iMacs and were only able to ship them for the final month of the December quarter. IDC estimates that the global personal computer market contracted by 14% during the March quarter. AAPL experienced strong year-over-year growth in desktop sales following the December quarter launch of its stunning new iMacs, offset by a decline in portable sales given a weaker personal computer market overall. AAPL ended the quarter within its four to five-week target range in Mac channel inventory.

The iPod is also a bit dated when you consider its capabilities versus the iPad and iPhone and it shows as unit sales declined by 27% and product revenues declined by 20% Year-over-Year. So far, the new iPod products have not helped this product line get its groove back. We don't see Apple giving up on the iPod considering it has a 70% market share in the U.S. for MP3 players as of March. The iPod continued to be the top selling MP3 player in most countries Apple's management tracks based on the latest data published by GFK. We also believe that it's a great tool to preserve the strong growth rates achieved by the iTunes product. The iTunes platform generated $4.1B in revenue during the quarter, up from $3.2B in the prior year period.

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Source: Apple's Most Recent Quarterly Report

On a geographic basis, all the regions saw strong revenue. Even though Europe is still ailing from the sovereign debt crisis, it almost generated 11.3% year-over-year revenue growth. Apple broke out Greater Chinese results from its Asian Pacific region and Greater China (Hong Kong, Taiwan and Communist China) generated over 7.5% year-over-year revenue growth in Q2 2013 after generating 67.4% YoY growth in Q1 2013. If only China Mobile and Apple can come to a sales agreement like Nokia did, Apple would be unstoppable in China.

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Source: Apple's Most Recent Quarterly Report

Cash Flows from Operations were $35.9B and capital investments including acquisitions were $5.1B, resulting in free cash flows of $30.8B for the quarter. Apple opened 1 new store and ended the quarter with 402 retail locations. About 38% of its retail store base (151 stores) is outside the US. Apple expects to open about 30 new stores in total in fiscal 2013 and to complete at least 20 store remodels. With an average of 401 stores open in the March quarter, average revenue per store was $13.1 million, compared to $12.2 million in the year ago quarter. Retail segment income was $1.1 billion. Apple hosted 91 million visitors to its stores during the quarter compared to 85 million in the year-ago quarter. Based on Ron Johnson's struggles at J.C. Penney (NYSE:JCP), we think that he should realize that he never should have left Apple Retail and we think that Ron Johnson should have resigned gracefully from JCP and begged for his old job back running Apple Retail.

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Sources: Apple's Most Recent Earnings Call and Our Most Recent Report on Apple Stores

Apple also has $144.7B in cash and marketable securities ($102B attributed to overseas entities) representing over 38.8% of Apple's Market cap. Apple paid a $2.65/share dividend payment on August 16th, which was its first dividend in 17 years and it recently increased the dividend by 15% to $3.05/share. Apple officially began its $10B repurchase program in FY 2013 and repurchased $1.95B shares. Apple was originally planning to return $45B in cash to shareholders from 2013-2015 and we were mollified that Apple boosted that figure to $100B in order to establish a firmer floor on its share price.

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Source: Morningstar Direct

In conclusion while we are never happy to see companies in our portfolio miss revenue estimates and to give downbeat forecasts, we believe that investors shouldn't count Apple out. We believe that those few investors who have been short Apple and long Nokia or BBRY will be well served by winding up that trade because Apple's shares have been through the worst that the market could throw at it. Apple has made a number of recent missteps however it has taken steps to fix the problems in order to avoid suffering the fate of Research in Motion and BlackBerry. Now that Apple is trading at a price that is lower than its prior year levels and within 3% of its 52-week low, we believe that this provides investors a solid buying opportunity.

Disclosure: I am long S, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.