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Is Apple's Growth Hitting a Limit?

Jeremy Glaser
Brian Colello, CPA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Apple posted a good quarter, but provided an ugly forecast. I'm here with senior equity analyst Brian Colello to take a closer look.

Brian, thanks for joining me.

Brian Colello: Thanks for having me.

Glaser: Let's start with the quarter. What did the company report? Was it roughly in line with your expectations?

Colello: Looking at the fiscal first quarter for December--which is a very important one, because it's a holiday season--Apple actually posted good results. The revenue range was $55 billion to $58 billion. They were just shy of the high-end of that. EPS of $14.50 was ahead of the company's forecast, ahead of Street estimates, so very good results there--good gross margin guidance.

iPhone units were slightly less than expected, but only by a million or so--wasn't too bad. The real strength was iPad and Mac. iPad units were ahead of expectations. I think there was strong growth in China. They mentioned that in mainland China iPad sales doubled year-over-year. So, there was a little bit of negative mix shift, but the strong unit growth more than overcame that.

Macs were solid, especially in a bad PC environment. iPods were a little weak, and that weighed on it a bit. But overall a very good December quarter.

Glaser: If the quarter looked like it was either in line or better than some expectations, the stock got hammered after hours on their guidance. What are they expecting? Why do you think it was so much lower than the market was hoping for?

Colello: The revenue guidance was for $42 billion to $44 billion. I think the Street was looking for something over $46 billion. We were actually a little higher than that. There were such strong hopes for the China Mobile deal and the partnership, and some growth there, on top of a lot of other factors.

Apple usually sees a decline in the March quarter, but with the China Mobile deal coming on, we would have thought that slide would be a little less than anticipated. It's actually a little more than anticipated.

A couple of things are going on. It looks like embedded in that guidance is iPhone units somewhere in mid-to-high 30 million unit range; that's identical to a year ago. So if you think about the fact that now you have a China Mobile deal, which is getting started--they discussed that on the call--but still, I think there were expectations there would be more of an initial ramp there. You have a new deal with NTT DoCoMo that went into [effect in] December, and that helped. We would have all expected, I think, stronger iPhone growth.

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They said that there's some inventory adjustments that make the numbers a little less comparable. So, if you're looking at sales to end-customers, they'll still see growth. But again, I think because they have the new carrier deals, that's not a surprise to anybody. It should have been a bit better than that.

Given the strong initial weekend sales--we saw 9 million that initial weekend of the 5s and the 5c launch around the world--I think all investors were looking for brighter expectations for these new products and not such a sharp fall-off.

Glaser: Is any of this an inventory supply issue, or is it an end-demand issue?

Colello: Well, it's a bit of both. The company will say that inventory was making adjustments. So last year, if you go back around this time, they had problems building enough iPhone 5's, building enough iPad Minis. So, what they did in the March quarter was, they were finally able to get a supply/demand balance. So they shipped more units in March 2013. That led to relatively better sales than what they maybe would've reported a year ago. Although, if you go back a year ago, those sales weren't all that great, and that's when you started to see the stock dive a bit.

Now looking to March '14, they said they had better production of the 5s, better production of the iPads, and so they're not selling as many units into the retail channel. That's part of the adjustment. Again, that's not something that should have really mattered. We were expecting strong growth either way.

They also cited a strong U.S. dollar against the Japanese yen. They're selling very well in Japan, so that had headwinds. Looking at the total revenue forecast, they talked about the iPod being especially weak.

These are troublesome little things. Again, we thought that Apple's growth in core businesses, iPhone and iPad, would overcome a lot of these factors, and that just doesn't seem to be the case. It's very unlike Apple, especially if you think back to its heyday a couple of years ago in terms of growth, for them to be citing these sorts of the factors as weighing on revenue growth. We would expect Apple to do a little more than this.

The bright side is, gross margin guidance is still very strong. It's part of their strategy. They have priced products … I don't know if it's too high, but certainly higher than what we maybe would've expected, if you think about the 5c and the Retina Mini. So they're getting good profitability on what they're selling, but it just seems like they're going to sell fewer units than what we expected of their main products, and that's the strategy they are going with.

Glaser: Apple has historically provided some very conservative revenue estimates, and though they've said that they are going to do that less, and are going to try to be more spot-on, do you think that this is a bit of a sandbag number, or do you think that this is really what they are expecting?

Colello: Unfortunately, I don't they are sandbagging anymore. Since they've been doing this over the past few quarters, they've been darn close to the high-end of their guidance each time, but they've never really exceeded it by very much.

So, unfortunately, this $42 billion to $44 billion looks like that's going to be the range. If there was one quarter for them to have a blowout, it would've been this one, because the five 5s was so strong, because they had initial weekend sales. If you were going to pick a quarter where they were sandbagging, the December quarter would've been the one, and that wasn't the case.

Glaser: You mentioned a few new products up from the 5c to the Retina Mini. Are you surprised they haven't introduced more new products? They seem to have been teasing it for a long time, but we haven't seen any come to market. Is that a concern for you?

Colello: I'm not surprised, although we did get good commentary going back from what Tim Cook said a couple of quarters ago that there would be new product categories coming out in 2014. He reiterated that. So, it looks like there is something on the horizon. We don't necessarily model that. It's obviously hard to predict what the next new product is, whether it's wearables, whether it's TV. They've discussed iOS in the car as more of a software platform. So, I'm not necessarily expecting new hardware products for automobiles. But maybe that's on the table, so it remains to be seen.

Those are the areas where you'll be looking to perhaps provide some guidance, perhaps provide an uptick, especially after the stock being down after hours, obviously some pessimism. Maybe they do need that new product to bring back the spark a little bit.

Glaser: Given that it looks like we might have a pretty weak quarter coming up, then, does it really change your core thesis on the company? When you think about their competitive advantage, is it being eroded? Or are they just dealing with some short-term issues here?

Colello: It really doesn't. I think the real problem is that there is just very limited growth at this point. Growth is just not what is expected. … I view Apple with two levers: on the revenue pricing growth side versus profitability. I think they could get greater revenue growth if they cut prices on the 5c and 5s, but you go back to the same gross margin dollars, because by cutting prices you're taking a hit on profitability.

So, they either stay on the high end and make very good gross margins, but maybe growth is a little less than expected, or the other way around, they drive growth, but it's not very profitable. Either way, those are the dynamics that go into it.

Nothing on the call really changes our long-term thesis on the company. We still think that Apple customers are loyal to the platform. There are switching cost away from the iOS platform. If I own an iPhone plus an iPad, it's harder for me to give up my iPhone and go to Android for various reasons--whether it's media ownership, whether it's syncing of photos, all sort of iCloud services. So we think that's still in-line.

Again, they sold 51 million iPhones in the quarter. So there was growth in the December quarter. There is growth from a year ago. They are still making sales to those loyal customers and the repeat customers. They are just not getting further growth than what's expected, and I still don't expect that to change. The way I think about Apple valuation is you have this underlying base of loyal customers, of people that will stay with the platform, all else equal, assuming Apple doesn't make a bomb of a product. But again these loyal customers that will stay with the platform will buy iPhones, iPads, Macs. We think there is still a base of that. It's just trying to gauge how much further growth there is beyond that in places like China and other emerging markets, and right now it just looks like it's a little less than anticipated.

Glaser: Brian, thanks for the update.

Colello: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.