Surging iPhone Sales Propel Apple

 Apple (AAPL) delivered tremendous results for the March-ending quarter, exceeding our near-term expectations. We are maintaining our fair value estimate of $670 per share. Total revenue of $39 billion was Apple's second-highest quarterly total, representing a 59% increase over the prior-year quarter. Apple's cash and investments on hand now total $110 billion, or $118 per share. The clear standout metric, however, was Apple's gross margin of 47.4%, up 600 basis points year over year and 270 basis points sequentially. The ability to expand the gross margin and deliver massive unit shipment growth signals that Apple is having no trouble moving premium-priced units. With nearly 75% of revenue derived from the iPhone and iPad, these product segments are clearly the driving force behind Apple's momentum. The March quarter represented a sequential decline in key unit shipments, but following the blockbuster December quarter, this was to be expected. Year-over-year unit shipment growth of 88% and 151% for the iPhone and iPad, respectively, was a strong showing for Apple, considering it was the second quarter of availability for the current generation iPhone and that the third generation iPad was only on the market for a few weeks during the quarter.

Despite Apple's near-term momentum, we are reluctant to change our longer-term forecast based on this quarter. As we look over a longer forecast period, we believe a product mix-shift could dampen Apple's earnings trajectory, even given our high expectations around unit shipment growth. There is no evidence to suggest that we have reached the inflection point in Apple's ascent yet, but a key issue for investors to determine is if Apple can continue its current growth trajectory as the smartphone market in the U.S. and other developing markets begins to mature. Clear opportunities exist in emerging markets. China, for example, is positioned to account for a greater percentage of smartphone shipments in 2012 than the United States and it delivers a much longer runway for smartphone growth. We believe Apple will successfully build its user base in these geographies. However, in addressing a market that lacks carrier subsidies and has more price-sensitive consumers, success against lower-priced Android phones could come from a higher mix of older models that could drive down the average sales prices and gross margins of its devices.

In order to analyze the impact of this potential shift in Apple's product mix, we are closely tracking two key indicators: the average revenue per iPhone and iPad. During the March quarter, the average revenue per iPhone shipped was $643, down just 1.9% year over year. Similarly, the average revenue per iPad shipped was $559, down 7.5% year over year. As we expected, this indicates that Apple is not yet experiencing the financial pressure of the potential product mix-shift. Over time, however, we suspect this mix-shift could be the key driver of Apple's results.

Looking ahead, Apple's guidance of $34 billion in revenue for the third fiscal quarter and a 41.5% gross margin sets a low bar, but we are forecasting a decline in both of these metrics. As we enter the later stages of the current iPhone's product cycle, there should be less benefit from launching in new geographies (the iPhone 4S launched in China during the March quarter), a few million less units shipped into channel inventory as supply and demand have balanced, and some demand being shifted into later quarters as consumers begin speculating about the availability of the next generation iPhone. On the gross margin side, management commented that roughly two thirds of the projected decline will be from product mix-shifts and an additional one third will be from reduced leverage and the loss of other nonrecurring benefits realized during the March quarter. Therefore, while we expect Apple to exceed the low bar it has set, the general direction of the firm's guidance is in line with our forecast.

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