Best Ideas Newsletter portfolio holding Apple (NASDAQ:AAPL) posted strong third quarter results and solidified our view that the iPhone is far from dead. Revenue increased 1% year-over-year to $35.3 billion, exceeding consensus estimates. Earnings per share were also better than the consensus had anticipated, falling 20% year-over-year to $7.47 per share. Year-to-date, free cash flow remains terrific at $37.5 billion or roughly 28% of total revenue.
Image Source: AAPL 3Q FY13 Earnings Report
Apple's most important product, the iPhone, did phenomenally well as the firm sold 31.2 million units compared to the consensus estimate of 26.2 million. Remember how media pundits have claimed repeatedly that people only want Samsung Galaxies? We've made the argument several times that the bearish sentiment around iPhones was misplaced and even baffling, so we're pleased to see our opinion vindicated. Though AT&T (NYSE:T) wouldn't give specifics on iPhone numbers, management mentioned that they sold more than last year (3.7 million units; 73% of all smartphones). The iPhone accounted for more than 50% of volume at Verizon (NYSE:VZ) where the iPhone went up against several new smartphones without a new iPhone hitting the market.
Although average selling prices (NASDAQ:ASPS) were down to $587 from $608 during the same period a year ago, we aren't worried about long-term margins just yet. We think emerging markets are becoming a larger portion of the revenue mix, and these consumers tend to opt for lower-priced iPhone 4 options. As emerging-market consumers gather more wealth and familiarity with iOS and the Apple ecosystem, we believe the odds of more premium purchases increases. At the moment, penetration in emerging markets is crucial.
A lot of fuss has been made about the weaker-than-anticipated iPad number, which came in at 14.6 million units compared to a consensus estimate of 17.8 million. We do not believe the issue is related to competition, particularly in the United States ,where we know Apple has a commanding lead. Rather, we think the shelf life on iPads is better than iPhones, so unless we witness a differentiated product refresh, iPad sales growth could continue to suffer. Still, CFO Peter Oppenheimer explained why the number this quarter was particularly weak, saying on the conference call:
"We built 1.2 million units of iPad channel inventory in the June quarter last year whereas we reduced channel inventory by 700,000 units in the June quarter this year. Factoring in this 1.9 million unit channel inventory swing, iPad unit sales were down 3% year-over-year. We exited the quarter with about 4.1 million units of iPad channel inventory…"
We'll pay close attention to the iPad going forward, but the product has shown incredible resiliency as we see the prices of competition such as Amazon's Kindle Fire (NASDAQ:AMZN) and Barnes & Noble's Nook (NYSE:BKS) slashed consistently.
Mac unit sales declined 7% year-over-year, but revenue fell just 1%. Sequentially, units declined 5% and revenue declined 10%. However, this deterioration is completely reasonable, in our view. Obviously, the broader PC market is under pressure and all participants are struggling. Yet, we think it is much more important that the lower-priced MacBook Air was recently refreshed, while savvy Mac buyers know a MacBook Pro update is likely around the corner. Thus, we think consumers are delaying purchases of higher-priced items and flocking towards the lower-priced Air. This trend should reverse itself in the first quarter of fiscal year 2014.
Speaking of the October quarter, CEO Tim Cook hinted that several new products are on the way. We think it's safe to say the MacBook Pro with new Intel (NASDAQ:INTC) processors and the iPhone 5S are a safe bet, but new form factors (iWatch?) or different phone sizes could also be in store. The several hints at a "big October" lead us to believe Apple has a wonderful new product up its sleeves.
On the cost side, we're seeing clear pressure on margins, as gross margins for the quarter declined 590 basis points year-over-year to 36.9%. The introduction of the iPad Mini, iPhone prices in foreign markets, and lower iPod sales are all contributing factors. New product rollouts are generally not positive for gross margins, so we do not anticipate much margin upside going forward.
As for guidance, the firm anticipates fourth quarter revenue of $34 billion to $37 billion, gross margins of 36%-37%, and operating expenses of $3.9 billion to $3.95 billion. Though top and bottom-line guidance is generally below consensus estimates, we aren't disappointed, particularly after hearing about potential new product releases.
Many thought this would be the quarter to break Apple, but we have long held the belief that the negativity surrounding Apple was nothing more than noise. The firm remains the pre-eminent smartphone manufacturer in the world, and Cook's hints regarding new product leave us excited about Apple's fiscal year 2014. Shares of the tech giant continue to look inexpensive, and we continue to be comfortable holding the name in the portfolio of our Best Ideas Newsletter.
Additional disclosure: AAPL and INTC are included in our actively-managed portfolios.