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Apple's Valuation Still Compelling

Thu, 25 Oct 2012

Despite a mixed bag in the tech giant's fiscal first quarter, the firm's growing earnings power makes Apple shares attractive, says Morningstar's Brian Colello.

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Video Transcript

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Mixed bag is not how you usually describe Apple earnings, but that's how our Apple analyst Brian Colello saw them this quarter. I am here with him now to get more details.

Brian, thanks for joining me.

Brian Colello: Thanks, Jeremy.

Glaser: So, let's take a look at some of the big numbers this quarter. What did Apple report, and how did that compare to your expectations?

Colello: Sure. For the fiscal fourth quarter, for the September quarter, revenue was actually a little bit better than consensus estimates. Earnings per share were a little light. So, a little bit again mixed bag there. Looking ahead to fiscal first quarter, for the December quarter, we think they are pointing at strong revenue growth with their forecast at $52 billion in revenue. Although Apple is typically conservative, we think it will be easy for them to meet consensus estimates. It will be ahead of our estimates. We think that's going to point to a strong iPhone 5 launch, probably some decent sales of the iPad Mini, as well. So, we think that's a good revenue number.

The other bit of a disappointment, and again going back to the mixed bag, is that the EPS outlook was light. Apple hinted that gross margin for some of these products, the newer products, is going to be lower than anticipated, just higher component costs and other issues associated with launching so many new products at one time.

Glaser: Let's take a look at some of their individual product lines. First in iPhone, what trends were you seeing there?

Colello: I think iPhone for the September quarter was solid, but not spectacular, and I don't think it really would be, again with the iPhone 5 [released with] only 10 days left in the September quarter. You certainly saw a trend in the months prior of people waiting to buy the iPhone 5. So, in that regard, we think the September quarter was just fine in terms of iPhone.

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Glaser: Now, one part of the earnings that maybe was a little bit more disappointing were iPad sales. What do you think drove that that slowdown?

Colello: Exactly. And CEO Tim Cook hinted at this one at the iPad Mini launch a couple of days ago. He said that Apple just sold its 100 millionth iPad. If you back in the numbers of what they sold in prior quarters that means that it was going to come in at something lower than 16 million. It came in at 14 million. So, that was even below our revised estimates for the iPad.

What the company cited is that they had a big spike in sales in the June quarter to education and intuitions and school districts. So they think there is going to be a little bit more of a seasonal trend, a decline in the September quarter and they think that's what they saw. I wonder if you could bake in a little bit of anticipation for an iPad Mini maybe not much, but I really think that is more of a seasonal issue rather than a slowdown in iPad adoption. This is supposed to be a stronger end product. We still think it will be. We think it's a little bit of hiccup more than anything else.

Glaser: The Mac business might not get the kind of press of the iPhone than the iPad does. How important is it still to Apple, and how is it performing right now?

Colello: Sure. So, Mac is a smaller part. The iPhone has exceeded it in terms of revenue and is a bigger part of the story, but Mac sales were exceptional this quarter. The PC ecosystem has had extremely dismal results in recent quarters. A lot of companies have gotten crushed. Apple really did a great job showing strong growth, particularly in laptops and even above its own seasonal strength.

Again, I think the reason why PCs have been so disappointing lately is because the September quarter is a seasonally strong one with back-to-school season and things like that. So, for the PC industry as a whole to be down 7% is very disappointing. Apple sales showing growth is really a good sign for market share gains and really a good sign for the ecosystem in general. More people are buying iPhones and iPads. They want to kind of incorporate and benefit from the sort of iCloud and syncing across multiple devices. We think that's a good sign for Apple's Mac business and kind of strengthening those switching costs associated with the whole platform.

Glaser: Let's talk a bit about competitive pressures Apple might be facing. Certainly, there are a slew of new tablets on the market. Amazon keeps releasing new Kindles. Google is selling their own tablet, which we saw this quarter, they are putting quite a bit of marketing muscle behind that. And the Microsoft Surface is now out. Are you seeing any impact, do you think some of those slower iPad sales are from those competitive threats in that people are buying the Kindle instead, or do you think it's really just that seasonal issue?

Colello: I think it is more of the seasonal issue. Again, Amazon doesn't release Kindle Fire issues, but I think the iPad is still the dominant tablet in the market. Fourth quarter will be interesting when they release the Mini and how that will compete at the low-end of the tablets. If you think about that Kindle Fire, Amazon is essentially giving that away at cost just to drive media sales. So, that's going to be a hard proposition for Apple to compete with.

As you could tell from the iPad Mini, they are not directly competing with it anyway. They are pricing it at $329, a good premium to sort of those lower-end tablets. So, I think the competition will really ratchet up this holiday season. Again, for the September quarter, I think it is more seasonal issues, maybe anticipation before the holiday season.

And again because it's such a new product, you don't really know what seasonality is March through September, you just knew that December was going to be good for Christmas purchases and things like that. So, I think that's why September is down a little bit and maybe a little bit lower than anticipated.

Glaser: Do you think that higher price on the Mini is something that they will be able to get away with the marketplace when there are those cheaper alternatives? Apple will be able to still command that premium pricing?

Colello: I think it will be very interesting to see. When we looked at the Mini initially, we thought it was going to be about a $250 device competing more directly with those, the Kindle Fire and the Google tablet. Instead with a price at $329, for a cost conscious, for price-sensitive buyers, they may still go with those lower end tablets, and Apple may concede some of that. But I think the company will still make good margins on whatever they sell it at the $329 price point. And then Apple could get the best of both worlds, if they start selling millions of these devices at $329 and they are able to extract even more value from those customers then it could be a positive for the stock and for the company as a whole.

Glaser: The stock, after hitting an all-time high around the time of the iPhone 5 launch, has sold off considerably, what do you think about valuation. Does [Apple stock] look attractive right now?

Colello: Our fair value estimate going into earnings was $770. We plan to maintain that fair value estimate. So, we still think it's a four-star stock right now. The stock's trading at close to $600. We think Apple is a company that's going to earn close to $50 a share next year and for the next few years. So, if you think about it in terms of a 12 P/E for a very strong growth company with tons of cash on the balance sheet, we think that's a pretty compelling valuation right now.

Again, I think an important thing and some of those fears from the stock going from $700 down to $600 may have been around the iPhone 5, may have been around Apple Maps and some of those issues. If you look at Apple's [December-quarter revenue] forecast for $52 billion, I think that points to a very strong or close to a strong iPhone 5 launch. Maybe the Mini does better or maybe there is a mix issue--they don't disclose that. But I do think that points to a strong iPhone 5 launch. I think that overcomes some of those concerns. So, I do think that's a positive.

Glaser: Brian, thanks for your thoughts today.

Colello: Thanks, Jeremy.

Glaser:  For Morningstar, I am Jeremy Glaser.

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