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Market Update

As the iPhone Goes, So Does Apple

Despite the drop in iPhone shipments, there is no evidence to suggest that Apple's fundamental ability to attract new customers is fading, says Morningstar's Michael Holt.

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 Apple (AAPL) delivered third-quarter results below our expectations because of an unexpectedly sharp drop in iPhone shipments. We believe the headwinds are primarily short-term in nature and product-cycle driven. Competition is increasing but there is no evidence to suggest that Apple's fundamental ability to attract new customers is fading or that the lock-in of existing customers is eroding. We are maintaining our $670 fair value estimate.

Apple delivered revenue of $35 billion during the quarter, up 23% over the prior year, but down 11% sequentially and 25% from the firm's blockbuster first quarter. The iPhone and iPad account for approximately 73% of Apple's total revenue and remain the key drivers of Apple's iOS platform and the firm's overall business model. Apple shipped 26 million iPhone units this quarter, a 28% year-over-year increase, but a 26% sequential decline. The sequential decline works out to approximately 9 million units, but falls to a 6-million-unit decline after adjusting for differences in channel inventory.

We were surprised by the magnitude of the drop in iPhone unit shipments, but directionally and fundamentally, this quarter played out exactly as we expected. There are two key drivers of the iPhone softness. First, consumers are more attuned to the product release cycle and would-be customers are delaying purchases until later this year. Second, there is greater competition from Google's Android phones--larger screens and faster data connections--that can make the iPhone look stale more quickly as it ages past 6 months old.

The iPad product line was the highlight of Apple's quarter, with unit shipments rising 84% year over year and 44% sequentially. This is in line with our expectations as the third quarter represents the first full quarter of availability for both the Next Generation iPad and the discounted iPad 2.

The importance of the iPhone to Apple's bottom line is clear with the strength of iPad unit shipments unable to offset the surprise miss in iPhone shipments. Apple's gross margin fell 460 basis points to 42.8% during the quarter, largely driven by the revenue mix-shift away from the iPhone. In the second quarter, the iPhone delivered 58% of Apple's revenue--in the third quarter the revenue contribution from iPhone fell to 46%. Also contributing to the decline in Apple's gross profitability is the growing proportion of older generation devices as a percentage of iPhones and iPads sold.

This quarter also delivered one of the first signs that our long-term thesis on product mix is beginning to play out, with the average sale price of both the iPhone and the iPad falling approximately 4% sequentially. We have long held that Apple will need to offer products at lower price points in order to drive unit growth during the next few years, especially as the center of the smartphone transition shifts from developed to emerging economies. Apple has a plan in place, offering older versions of its products, the iPad 2 and the iPhone 4 concurrently with the latest and greatest iterations of these devices. Until now, however, the insatiable demand for the very latest device has kept average selling prices from falling. The product mix-shift has become more pronounced this quarter because the iPhone 4S has been out for three quarters and Apple began offering the iPad2 at the lower $399 price point. We expect prices to continue falling and will be watching the rate of decline closely during the next several years.

The true test for Apple was not this quarter, nor is it the fourth quarter. In fact, we expect to see greater volatility in Apple's quarterly results going forward due to the growing importance of the product cycle. It will not be until the next generation iPhone launches that investors will get a true reading of Apple's positioning in the market. We maintain that the next iPhone launch will demonstrate Apple's continued ability to assimilate new users and retain the existing user base by layering on additional sticky services. In the meantime, any pullback in the stock that would send this Apple's shares toward our 5-star price and below $500 would provide investors with an excellent opportunity to own this high-quality name with an attractive margin of safety.

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Michael Holt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.