Apple (NASDAQ:AAPL) reported EPS of $1.28 per share, beating the consensus analyst estimate of $1.23, and growing earnings by over 19% from FY Q3 2013 of $1.07. On the other hand, revenue missed slightly consensus estimate of about $38BN, coming in at $37.4BN, though this still is record revenue for the fiscal third quarter. Year-on-year revenue grew in the quarter by 6% from $35.3BN in FY Q3 2013.
Despite the revenue miss, the company was able to deliver an impressive earnings beat because of much stronger-than-expected gross margin. Specifically, gross margin expanded to 39.4% compared to the guidance range of 37% to 38% provided a quarter ago, and 36.9% gross margin delivered in FY Q3 2013. In my opinion, the gross margin strength was the main driver of the positive stock price performance following the earnings report, because it further undermined the thesis that some bears hold about the "structural decline" in Apple's gross margin over the long term.
Selected Key Takeaways
Of particular interest to me is the strong performance of Mac product line in the quarter, up 18% in a flat-to-down overall PC market, implying meaningful market share gains. The results appear to support, in broad terms, the direction and conclusions regarding the Mac product line I outlined in my earlier article attempting to map out the Mac's future revenue and EPS contribution.
I wanted to comment on two previously widely-publicized criticisms of Apple in the media and investment community, which I think is important in the context of appreciating how potentially misunderstood this company can be.
Many readers likely recall pessimistic outlooks and views of Apple's gross margin being in "structural decline," ever since the company's gross margin showed its first sign of deceleration in FY Q3 2012. Many investors started modeling declining margins long into the future. Instead, we saw margins bottoming in FY Q3 2013, and subsequently embarking on a steady recovery, culminating into cumulative recovery of 250 bps from the trough to the current quarter.
Need I remind readers of multiple commentaries and views expressed in the media and investment community of the iPhone 5C being a flop? It looks like iPhone 5C was selling very well, as per the conference call. This is also reflected in the reduced iPhone ASPs for the quarter, which makes the higher gross margin in the quarter even more impressive. In other words, Apple just showed us that the average price of its products may decline and gross margin can still expand at the same time.
I was particularly impressed with iPhone unit sales volume, given what must have been strong delays prior to larger-screen iPhone 6 release. My view is that purchase delays prior to a larger-screen iPhone must be meaningfully larger than during previous instances for two reasons. First, large-screen smartphones' penetration exploded over the past several years, and Apple customers up to now had no opportunity to purchase one. Second, large-screen phones are most popular in Asia and countries outside of the US, where Apple now has a much higher percentage of volume coming in than previously. See more details on iPhone quarterly performance in the Product Line Review section below.
I did not like the second consecutive decline in iPad volumes. I think this is an issue that requires very close monitoring. The IBM deal may help, but the trend is clearly concerning for this product category thus far. See more details on iPad quarterly performance in the Product Line Review section below.
Product Line Review
iPhone unit sales showed strong growth year-on-year of 13% to 35.2MM from 31.2MM in FY Q3 2013. Analyst consensus estimates appear to have been about 35.8MM units, so there could be a slight miss here. That said, it appears that analysts and the company are treating iPhone unit volume as a success. I also tend to fall in that camp, given what are likely very significant purchase delays in anticipation of the iPhone 6. A 13% unit volume growth is very impressive, in that context. iPhone ASP declined to $561 from $581 a year ago, and decreased from $596 sequentially. The decline in ASP was partly attributable to a strong performance of the iPhone 5C. The management referred to a "mid-tier" iPhone segment doing well on the conference call, which refers to the 5C.
iPad unit sales declined by 8% year-on-year, from 14.6MM units in FY Q3 2013 to 13.2MM units in the current quarter. The unit volume also missed analyst consensus of about 14.4MM units. It is a strong deceleration, and is already the second consecutive quarter with worsening iPad sales. iPad ASP increased to $443 in the quarter from $436 the same period last year, but declined sequentially from $465. The volume declines are very concerning to me, as they point to a meaningful market share loss.
The Mac, on the other hand, delivered strong unit growth of 18% year-on-year, from about 3.7MM units in FY Q3 2013 to 4.4MM units in the current quarter. The strong showing of the Mac product line was partly attributable to a great response to new, better-performing MacBook Airs. Mac ASP declined year-on-year to $1,255 from $1,303 in FY Q3 2013, and decreased from $1,334 on a sequential basis. Likely a larger proportion of MacBook Airs in the quarter contributed to the ASP decline. Interestingly, Mac revenue came close to the iPad sales level in the quarter.
iTunes/Software/Services revenue grew 12% year-on-year to $4.5BN from about $4BN in FY Q3 2013. On the conference call, management mentioned that total billings for the quarter were up by 25% y-o-y and reached an all-time quarterly high of $5.4BN, driven by strong performance in the app store.
Revenue outlook for FY Q4 2014 appears to have come in short of expectations. Specifically, the company expects $37BN to $40BN revenue and gross margin of 37% to 38%. The street was looking for revenue of about $40BN. Having listened to the earnings call, my feeling is that some may have been disappointed that the company did not increase the margin guidance range, given the very strong margin performance in the current quarter. In my opinion, there are too many moving parts, such as uncertainty related to a new product launch, strengthening of the US dollar, commodity prices, and other factors that led the management to be cautious with guidance.
I view this as a relatively successful quarter. Gross margin performance was the biggest positive, followed by strong performance by Mac and iPhone product lines. The iPad is an area of concern, and we just have to wait and see whether the company will be able re-ignite growth. Overall, adjusting the stock price for net cash of about $133BN (133/5.98=22.2 net cash per share), the company appears to be still attractively priced, in my opinion, trading at approximately 12x FY 2014 consensus earnings estimate of $6.33 per share.
Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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