Major Cannibalization Concerns At Apple

Oct.26.12 | About: Apple Inc. (AAPL)

Best Ideas portfolio holding Apple (NASDAQ:AAPL) reported another fantastic quarter Thursday afternoon. The tech giant saw revenues surge 27% year-over-year to $35.9 billion, a touch higher than consensus estimates. Earnings increased 23% year-over-year to $8.67 per share, a few cents weaker than consensus expectations, but negatively impacted by a $50 million loss from other income versus a forecasted gain of $150 million. Apple generated $50 billion in operating cash flow during the fiscal year.

Guidance, not surprisingly, was lackluster. The firm establishes notoriously low expectations and is assuming earnings of $11.75 per share on $52 billion in revenue during its first quarter in fiscal 2013. Margins are expected to be lower thanks to the introduction of the iPad Mini, as well as supply chain issues with iPhone 5 - which still isn't widely available. For the fourth quarter, margins slipped 20 basis points to 40%, which is still a phenomenal figure. Sales at Apple Stores increased 18% to $4.2 billion, reflecting the firm's ability to cut Best Buy (NYSE:BBY) and other retailers out of the supply chain.

Speaking of the iPad Mini, we're not the biggest fans of the product, given its potential for cannibalizing sales of iPad 4. We think people, particularly in the US, love Apple products and prefer to own them for a bevy of reasons (sleek factor, service, etc.). However, given the smaller, more portable size, we think people could ditch the full-size iPad and opt for the Mini, much like what occurred with the iPod Nano taking share from the iPod. We're also not crazy about the tiers of iPad pricing. Apple stopped selling "The New" iPad (iPad 3), which has been replaced by iPad 4. However, iPad 2 remains available for $100 less, which could also cannibalize sales of the full-size iPad. Ultimately, we remain confident in CEO Tim Cook and the rest of the management team, so we won't worry too much about the issue. Sales of the iPad grew 26% year-over-year on a unit basis, so we figure Apple thinks the segment needs a kick-start.

On the iPhone front, the company sold 26.9 million units, driving revenue of $17.1 billion, increases of 58% and 56%, respectively. 26.9 million is an incredible number, especially given the anticipation of the iPhone 5 and the enormous amount of customers waiting for the release. The Samsung Galaxy S3 has been dubbed the latest iPhone killer - but so were the Palm Pre, Nokia Lumia, BlackBerry Torch, DROID, and the Nexus. In other words, we're not at all worried, and we continue to expect fantastic sales from the product.

iMac, which receives little attention compared to the rest of the company, continues to steal PC market share. Units increased 1% year-over-year, while revenue increased 6%. This may not be the growth we're accustomed to in the other units, but the numbers look strong in light of falling PC shipments worldwide. The company introduced a few new computer products on the iPad Mini release day, and we're confident that the segment will be able to outpace the growth of the PC market.

Overall, the earnings "miss" didn't bother us at all, especially when we consider the excitement surrounding iPhone 5 and the iPad Mini going into the holiday season. Though margins may be negatively impacted by the stronger dollar and costs associated with new product rollouts, the company should post strong results in the next quarter, and it continues to sit on a hoard of cash at over $120 billion. We're interested to see how the iPad situation plays out, but we continue to hold shares in the portfolio of our Best Ideas Newsletter, which we deliver to members monthly, and think considerable valuation upside remains. Excluding cash, the company trades at less than 10 times our fiscal year 2013 earnings estimates. Please click here (pdf) to download our 16-page report on Apple.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: AAPL is included in the portfolio of our Best Ideas Newsletter.