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By Jeremy Glaser and Michael Holt, CFA | 04-24-2012 05:00 PM

Apple Has Great Quarter, But Margins Aren't Sustainable

As the tech giant expands into emerging markets with lower-priced products, profitability will likely get squeezed, says Morningstar's Michael Holt.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Apple posted another record March quarter, and I am here today with Michael Holt--he is the associate director of technology analysis here at Morningstar--to see what drove this quarter and also what growth in emerging markets could mean for Apple.

Michael, thanks for joining me.

Michael Holt: Thanks for having me.

Glaser: So let's just start off with the big numbers. What did this quarter look like for Apple? What was really driving this quarter?

Holt: It's the best March quarter ever, and it's the second-best quarter ever. With total revenue growth of 59%, they had more than 80% growth in iPhone shipments, 150% year-over-year growth in iPad shipments, and that's what's driving the quarter.

The really key metric, though, that we saw was the expansion of the gross margin up to 47%. When you take that in context with the high unit shipments, it shows that they're able to sell the premium-priced products without any issues of demand.

Glaser: So if we look sequentially, though, this quarter was down from last quarter, and the guidance for next quarter shows another sequential decline, even though their year-over-year is still growing very quickly. Is that a sign of potential weakness, that they're going to have trouble a year from now really showing this kind of impressive growth?

Holt: I think the sequential declines actually have to do more with where we're at in the product cycle. So, last quarter was a blockbuster quarter, a lot of tailwinds--you had the holiday season, you had an extra week due to the reporting calendar, and you had all this pent-up demand for the launch of the iPhone 4S.

Now coming into this quarter, some of that demand was already met, and also as you launch the third-generation iPad, you only had a couple weeks of that. So, we're kind of hitting the middle of the product cycles.

I don't see it as a problem for the long-term trajectory of Apple, so, again, the outlook for next quarter is another step down sequentially, but still strong year-over-year growth.

Glaser: So you've mentioned earlier that gross margins looked really good, and that was partly because they could sell those premium-priced products, but Apple did introduce some relatively cheaper products in the quarter with an iPad dropping a $100; with an iPhone--at least in United States--it's available for free. What impact do you think that's had in this quarter, but also longer-term, is that going to have a big impact on their emerging-market strategy?

Holt: I think the surprising thing about their strategy is, yes, they are introducing lower-price-point devices, but it hasn't impacted their financial numbers yet.

Going forward, we think it will play a bigger role, starting with next quarter and then as we look out a couple years. This is a big part of their strategy to penetrate markets on the smartphone side where there may not be carrier subsidies, and where there might be a more price-sensitive consumer, because the Android devices are stepping up their game, and becoming more competitive, and Apple may not be able to penetrate as deeply if they just go with super premium priced device.

Glaser: So is that something that over the long term is really going to squeeze margins, is going to squeeze profitability, or do you think Apple at one point will give up that growth in return for keeping the margins high?

Holt: Well, we think unit growth still has a very long runway, but absolutely this will squeeze margins in the long run.

We went from a 44% gross margin last quarter to 47% this quarter, which is amazing, but they're already forecasting for it to fall back below 42% next quarter. Now they might be setting a slightly low bar there, but when we look at the long-term trajectory, we do see margin decay, even though we have pretty optimistic assumptions about where the unit growth is going.

Glaser: Let's talk about the iPhone. I know, you've mentioned before that this is one of the most important growth drivers, if not the most important growth driver for Apple, but we heard some comments from Verizon Wireless this week that they really want to introduce Windows Mobile. They really think there needs to be a third ecosystem. AT&T is spending a lot of money promoting the new Nokia Windows device.

Do you think a lack of carrier support, or carriers really looking to wrestle back some power from Apple, is a long-term threat to the iPhone ecosystem?

Holt: It's definitely a long-term threat, but the probability of them succeeding is pretty low in the near term, because they would love to shift the power back from Apple. The problem is, Apple has already taken all the power.

So, it's in the carrier's best interest to prop up another platform, whether it's Android or whether it's Microsoft. In fact, they're better off if there are three strong platforms, or more. So, they're going to do everything they can to market those other platforms and try to chip into Apple's lead.

That being said, at the end of the day, the consumer is going to demand devices that they find compelling, so it's up to the device manufacturers for Android and Microsoft to put out compelling devices, and then the carriers will be able to shift some of the power back to themselves.

Glaser: Let's talk about valuation. Certainly, Apple shares have been under some pressure before this earnings report, ... as some investors were thinking maybe the shares were a little bit too pricey.

Does this quarter change your opinion about valuation, and do you plan on making any major changes to your model?

Holt: So, we're not planning any changes to our fair value estimate. We actually raised it before the quarter, up to $670 per share, so we still see some upside from here. It's not quite trading into the ideal entry point, but the near-term results don't change our outlook, and we still have the long-term concerns about margin compression.

Glaser: Well, Michael, I thank you so much for your thoughts.

Holt: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.

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