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More Good News Than Bad From Apple

Tue, 23 Jul 2013

Solid iPhone sales and aggressive share repurchases outweighed iPad weakness and a China slowdown in Apple's fiscal third quarter, says Morningstar's Brian Colello.

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Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Brain Colello, our senior equity analyst who covers Apple, to check in on the tech company's third-quarter earnings.

Brian, thanks for joining me.

Brian Colello: Thanks for having me.

Glaser: So let's get your quick take on the results and how they compared with your expectations.

Colello: A solid third quarter from Apple. Revenue was a little bit higher than Wall Street estimates, and at the high end of [Apple's forecast] range. There was good gross margin reports and solid earnings per share. The highlight was iPhone unit sales. They sold over 31 million units. I think the Street was looking for 27 million. We were in about that range, as well. So there were very good unit sales of the iPhone, particularly in emerging markets, but also developed markets, too. They mentioned that the U.S. sales were up 50% year-over-year, the U.K. was up 50%, and Japan was up 60%. So there's been some fear that the high-end of the smartphone market is plateauing, that growth is plateauing. Apple's results indicate that that's still going pretty well.

The only downer within the earnings for the third quarter was iPad unit sales were a bit below what we expect. Now there were some inventory adjustments in there, but I think you saw a reflection of the fact that a year ago. You had the iPad 3 come out in the March quarter, so there were still strong sales in June. You haven't had a new iPad refresh or an iPad mini refresh in nine months. So I think that weighed on the iPad a little bit. But overall a very good third quarter.

The fourth-quarter forecast was a bit disappointing in our view, but we think that's due to timing. If they had given a brighter quarter, I think it would indicate that a new iPhone is coming a little bit sooner in the quarter. With the outlook they've given now, I think that implies that similar to last year if we get a new iPhone in the September quarter, it probably comes in the last few days and maybe gives an uplift to the entire quarter. The gross margin forecast was actually pretty decent for the fourth quarter. Not much of a dip there. But as far as revenue being a little lighter than consensus estimates and what we would have thought, again, this is due to timing, so it's not a major concern. But that's kind of the downside.

Maybe the biggest news of all was the company's aggressive stock buyback. They took out $17 billion of debt last quarter in order to bring cash back into the U.S. to use for dividend buybacks. They bought back $16 billion of stock in the quarter. So, with the stock languishing in that $400 range, they were aggressive buyers and that debt has been put to good use, particularly because we think the stock is still attractively valued. We think it was a good use of capital and a good move. So I think so are the big positives.

Glaser: So let's dive into iPhone a little bit. You mentioned that the high-end market looks like it hasn't totally plateaued, but the average sales price had come down pretty considerably. Do you think this is kind of a permanent shift with the emerging-markets consumer maybe buying one- or two-generations-old iPhones, or do you think it's just a product cycle issue?

Colello: Sure, and I'll go back to even six months and nine months prior, where one of the concerning things with Apple and probably part of the stock slide is the fact that you had a less favorable product mix in general, that maybe 60% of sales used to come from the premium phone, so like the iPhone 5, with maybe 40% coming from older models, like the 4S and the 4. For the past couple of quarters you've seen a 50/50 split. So you're seeing a less favorable product mix that way, and part of that is selling into emerging markets. But you're certainly seeing demand for the older, cheaper phones a little bit in developed markets, but certainly in emerging markets, as well. That's a trend we think is going to continue over time. We think iPhone prices really have nowhere to go but down, but we think that's more than reflected in the stock price at this point. We think it's inevitable based on just competition in the smartphone industry and the shift to emerging markets. You're going to get greater growth in emerging markets than developed. Those will all weigh on prices.

Now that said, I think in the developed markets, there is still growth there. There's still room for smartphone penetration in the U.S. I think there's still growth in Western Europe and Japan and other places in developed markets. Average selling prices did slide. They were down 5% sequentially this quarter. But again, once you remember that as iPhone products age, as they get older and older, and now we were on a nine-month iPhone, the customers who will be buying a phone, even the new phone isn't the cutting-edge, so more and more customers gravitate to those older models. So the 5% decline this quarter was a little sharper of a decline than what we expected, but not overly drastic, nothing overly alarming. We think once they launch new products, ASPs come back up, maybe not to where they were a year ago, but from where they are today. And then you get another slide again until the next product kind of raises it back up. But the trend is down. That will weigh on gross margins. Gross margins we expect to be down, but we think that is more than reflected in the stock price at this point.

Glaser: So then how is that affecting margins for the entire company?

Colello: Well, gross margin was at 36.9%; I think it was 37.5% the prior quarter. And actually they had a warranty accrual, so it would've been 39% in the March quarter. So, gross margins are down, and again, iPhone pricing is a big part of that. IPad pricing is another part of that. The launch of the mini is a bit lower-margin than iPads in general, and then iPads are even lower than the iPhone. So as iPads become a bigger piece of the Apple pie, you're going to get gross margin compression that way, as well. So you have several headwinds to gross margins, and again, we think Apple's corporate gross margins will decline over time. But again, we think the market is much too pessimistic on the degree of those declines at this point.

Glaser: So in your forecast, you don't necessarily think margins will get back to maybe where they were a couple of years ago. But do you expect to see kind of a precipitous fall as maybe lower-cost iPhones come out or emerging markets become a bigger part of the story?

Colello: Exactly. I think Apple's gross margins, I think five years out we get down to something like 32%. We're at about 37% today. You will get an uplift, again, when new products come out, especially the high-end customer, the early adopter. They buy not just a 16-gig iPhone sold for $650, but the 32- and the 64-gig model that's very margin-accretive. So you will get a nice gross margin bump when new products come out. But again, the general trend is down. So, we think the benefit of new products will help offset all of those other headwinds.

Glaser: There were some hints in the conference call that there were some new products coming in the fall. Do you think that Apple in order to really kind of get that revenue growth going again can get by, by just kind of updating its current line, or do they need to move into new categories like watches or TVs or whatever they might be cooking up? Do those need to be successful in order to kind of get the company back to those growth levels that the people had come to expect?

Colello: Our valuation, we think Apple's stock, even with the runup after hours in the market, we still think the stock is attractively valued. That is really based on iPhone and iPad. I think the iPhone is still by far the biggest part of the story because it has the highest volumes and the highest gross margin product, other than maybe some of the services. That should be the main focus for investors in terms of how is this business doing. Just refreshes of products 5S, 6, 7, going in the future, we think that's the biggest driver for growth. The iPad, we think, will be a very strong growth driver just on the revenue standpoint as they're additive devices, as they gain share from PCs. So, really we value the business based on iPhone and iPad.

Now, I recognize that the thought of innovation needs to come from an Apple TV or a watch, and if you think about where the stock price has been and investor concerns, some of that is whether Apple has lost its touch and lost its innovation. We don't think so. We recognize that others and bears may have thought so, but maybe those are the products, if nothing else, maybe are a change of sentiment. Maybe a very cool iWatch we don't think does as much for profitability, but we think it gets Apple back on track in terms of being thought of as an innovative company.

Personally, we think a watch would be interesting in terms of switching costs and Apple's narrow moat in terms of keeping people tied to the iPhone, the iPad platform. If I own an iPhone and I buy a $200, $300 watch that syncs with it, I'm going to be much less likely to switch to an Android phone later on. That's where I think the iWatch gets most interesting; not necessarily from a revenue and EPS standpoint, but how many more people can stay within that Apple ecosystem. To me, that's where the watch, I think, gets really interesting.

Glaser: So a notable geography that didn't perform so well in the quarter was China. Why has Apple had so much trouble breaking into that market?

Colello: Well, actually they've done a very good job breaking into the market. It was just weak this quarter, and they actually cite macroeconomic concerns as much as anything. So, on a sequential basis, if you look back to March, March is their Chinese New Year season, yet strong sales were there. Obviously, you are going to see a decline from March to June. But on a year-over-year basis, mainland China held up OK. But you had some inventory adjustments that weighed on revenue there. It sounded like Hong Kong was down a little bit. So I think there were macroeconomic concerns. At least that's what was cited on the earnings call. It's very hard to say.

China is a very important market for Apple. I think eventually they'll strike a deal with China Mobile in order to get much stronger volume growth. That's probably one of, if not the biggest drivers for iPhone unit growth over the next few years because they're really only selling to half of China's customer base today. So a China Mobile deal will be huge when that happens down the line, but certainly we've seen some near-term weakness. There was great growth in other geographies; India was up 400% year over year, but with China being a bit of a soft spot right now, it remains to be seen how macro factors play into how Apple can sell there in the near term.

Glaser: Then finally you talked earlier about some of these capital-allocation decisions and the money being spent on share repurchases. Do you think that this will kind of silence the critics on the capital-allocation front, or do you think Apple still has more room to buy back more shares or to increase its dividend.

Colello: Well, both. I think it was a good capita-allocation decision. I think it alleviated some investor concerns. I think some of those concerns were raised around that March/April time frame because you didn't have a new product cycle. So with the stock falling off the way it did sitting in the $400 range, we knew that there weren't going to be any new products to talk about for a little while. So what else do we talk about? If you are a value investor, you'd like to get paid while you wait, and so I think that's caused a lot of those capital-allocation concerns and raised the issues. So the $17 billion in debt that they issued to bring more cash back onshore, the dividend raise, and the big buyback announcement, we think we're definitely positives for the stock.

Now we get to the June quarter, and they basically bought back all of that stock. We see that as a very encouraging sign that the stock is cheap in the $400 range. We agree with it, but we think that is a good capital-allocation move. They have room probably to the extent that they can issue more debt. The $17 billion debt issuance was one of the largest in U.S. corporate history. I'm not sure how much more debt they can issue, whether there can be $50 billion or $60 billion in bonds in the market. Apple has enough cash offshore to collateralize it. So to the extent they want to do it, they can do it. It's a matter of what sort of rates can they get, especially with interest rates going up a little bit, what sort of rates can they get, what sort of investor interest can they get to issue more debt in order to bring more cash back into the U.S. in order to buy back more stock.

Glaser: So it sounds like more good news than bad this quarter.

Colello: I would say so, yes.

Glaser: Brian, thanks so much for talking with me today.

Colello: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.

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