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By Jeremy Glaser and Brian Colello, CPA | 07-23-2013 05:15 PM

More Good News Than Bad From Apple

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.

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.

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