Apple's Bruised Forecast Raises Long-Term Concerns

We'll reduce our fair value estimate for  Apple (AAPL) by 22% following its fiscal first-quarter results, reported Wednesday. Apple's latest quarterly earnings report was decent, in our view, and in line with both Wall Street's, and our own, expectations. However, Apple's highly disappointing March-quarter forecast implies slowing iPhone sales momentum, giving us less certainty about robust iPhone growth in the years ahead.

iPhone unit shipments of 47.8 million during the December quarter reflect a 29% increase from the 37 million iPhone 4S shipments during the year-ago period, but was modestly below consensus estimates of roughly 50 million. iPhone average selling prices (ASPs) of $642 each were fairly solid, in our view. iPad unit sales of 22.9 million were about in line with our estimates, but also below consensus estimates of approximately 24 million, and failed to provide the robust, exponential growth that some growth investors were seeking. iPad average selling prices of $467 each reflects a  21% decline from the prior year. In our view, this implies a sharp shift in product mix toward the iPad Mini. Apple will need to see tremendous iPad unit growth to make up for the negative mix shift toward these lower-priced tablets.

In our view, Macs were the quarter's biggest disappointment. At only 4.1 million units, Mac sales were down 18%, sequentially. This marks a far cry from the bright spot they represented during the September quarter, when Apple's management noted that they couldn't build enough iMacs to meet demand. PC cannibalization from iPads and an overall soft PC market were also likely headwinds. Revenue of $54.5 billion, gross margins of 38.6% and earnings per share (EPS) of $13.81 all beat Apple's traditionally conservative forecasts, but were relatively in line with our expectations and the Street's.

Apple's March-quarter forecast is the bigger concern. First, the company provided a projected revenue range of $41 billion-$43 billion. This marks a departure from past practice, when management would give a single -- usually extremely conservative -- sales target that investors never took too seriously. Not only is this range below our prior estimates (and the Street’s) of almost $46 billion, but management's comments regarding a revenue range indicates that investors should expect revenue to fall within the range, rather than exceed a single data point. We think this approach is meant to temper expectations for a possible upside surprise.

Given Apple's launch of several new products, we're disappointed that management expects sales to trail off so quickly.  iPad, Mac and iPod sales should dip due to seasonal weakness after the holiday season, but we think the forecast also implies a sharp retreat in iPhone sales to the mid-30 million unit range, which may bode poorly for the allure of the iPhone 5, and perhaps hints at a stale product line, or a lack of innovation.

In late 2011, Apple's iPhone 4S launch was a stellar success that led to its meteoric stock rise in early 2012, bolstered by a strong December launch of 37 million units, and a surprisingly robust follow up of 35 million units in the March 2012 quarter.
Now, Apple's forecast implies that no such follow up is expected with the iPhone 5 launch. Furthermore, Apple noted that the iPhone 5, iPhone 4, iPad Mini, and iMacs all faced supply constraints in the December quarter, and the company was unable to meet demand. Yet, Apple's forecast doesn't suggest that the company will make up for these lost sales in the following quarter, but perhaps miss out on these opportunities entirely. Tim Cook's experience as an operations guru makes this issue all the more puzzling to us: Innovation, rather than supply chain hiccups, would have been our biggest concern around Apple's management after the passing of Steve Jobs.

Longer term, we're cutting our iPhone unit sales estimates. The company's March forecast, along with iPhone 4 shortages and Verizon's commentary that half of its December iPhone sales were of older models, among other data points, raise our fears that the iPhone 5 will fail to live up to our previously lofty expectations, and that consumers might be less willing to pay up for Apple's premium devices. If the 4S launch provides a historical perspective, iPhone ASPs will also likely decline in 2013 until a new product transition occurs. In turn, we have modestly trimmed our iPhone gross margin assumptions, which will lead to lower long-term EPS projections.

Apple may be keeping its new product information close to the vest, but the firm also reiterated that a four-inch screen is the right size for a smartphone. In turn, Apple may concede sales of 4.8-inch and larger devices to firms like Samsung, which may end up costing the firm if screen size becomes a real differentiator among premium smartphone buyers. We also project lower long-term iPad and Mac unit sales, as future growth may come off of a lower sales base in 2013. Finally, we lowered our terminal long-term growth rate to account for the possibility that EPS may stagnate in 2017 and beyond if pricing and gross margin declines offset revenue growth in certain product categories. We should note that our fair value estimate does not account for any revolutionary Apple TV products or new innovations, but we recognize the optionality potential associated with Apple's ability to build a groundbreaking new product.

In short, we may not see a strong catalyst for Apple (outside of increased cash distribution to shareholders) until its next wave of product launches, which may come in mid-2013 rather than year-end, but we certainly think there is a chance that Apple can bounce back from a potentially ho-hum early 2013. We should also note that Apple's forecast a year ago, in March 2012, was for a 30% sequential revenue decline. Instead, the firm offered up one of its biggest earnings beats, seeing only a 15% decline. If Apple's projected 22% sales decline in March 2013 turns out to be similarly conservative, bullish investors may benefit from the sort of blowout quarter that Apple regularly reported in prior periods. Longer-term, we anticipate that an eventual iPhone introduction with  China Mobile  could provide Apple with a strong unit sales boost, and we still fail to see many iPhone killers on the market today, although Samsung's Galaxy S III's and Note's may come close.

Despite the recent slate of negative news, we still believe that Apple has a narrow economic moat and a positive moat trend. Apple's gloomy March forecast may imply that iPhone growth may not live up to our lofty expectations, but certainly doesn't indicate that consumers are abandoning the platform in droves. We still believe that Apple has a loyal customer base that will continue to buy iOS products, rather than switch to Android, in order to benefit from iCloud, synchronized content, and operating system familiarity. Apple will have to promote these advantages to future potential smartphone and tablet customers, but we think such switching costs provide a bit of a floor on future iOS product sales, unless new devices are a complete flop in the marketplace.

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