Apple Dials In Strong 2Q on Smartphone Growth

 Apple (AAPL) reported strong fiscal second-quarter earnings that exceeded expectations. The outperformance was driven primarily by solid iPhone unit sales in both developed markets and in China, the latter via the firm's recent partnership with  China Mobile . We're raising our fair value estimate to $600 per share, and we maintain Apple's narrow economic moat rating.

Apple's revenue was $45.6 billion, above the firm's forecast of $42 billion to $44 billion as disclosed in January. IPhone unit sales of 43.7 million were the clear bright spot and well above expectations. Not only is the firm's launch with China Mobile faring well, but Apple believes it gained market share in developed markets like the United States and United Kingdom, as well as other emerging markets. IPhone average selling prices dipped 6% sequentially, to $596, with half of the decline stemming from a less favorable mix toward sales of older, cheaper phones in emerging markets. IPad unit sales to end customers were down 3% sequentially, a bit lower than expected, but not as bad as the reported 16% sequential decline that factors in iPad inventory sold to retailers each quarter.

Due to strong iPhone sales, gross margins were 39.3%, well above Apple's prior forecast of 37%-38%. Apple also bought back a whopping $18 billion worth of stock during the reporting period, and is authorized to buy back another $44 billion by the end of calendar-year 2015.

Apple's revenue forecast of $36 billion-$38 billion for the June quarter was slightly below our expectations, but isn't especially disappointing, in our view. We estimate that the outlook implies June iPhone sales in the mid-30 million unit range, which would still represent solid annual growth. All in all, we remain encouraged that Apple's narrow economic moat is allowing the firm to hold on to loyal customers in developed markets, while the firm's expanded presence in China has enabled Apple to pick up millions of first-time iOS device buyers, as well.

This quarter, Apple's iPhone business was the clear bright spot on many levels. First, solid unit sales growth in the U.S. was encouraging, considering the possibility that wireless carriers may try to shift customers to unsubsidized wireless plans. Apple's results don't yet indicate a meaningful drag on iPhone sales as a result of carrier pricing. Instead, modest headwinds have come from elongated upgrade cycles at  AT&T (T) and  Verizon (VZ), which we see as near-term, one-off issues.

We recognize fears around the possibility that U.S. carriers may encourage some, or many, of their customers to an unsubsidized business model where customers pay a higher up-front sticker price for phones in exchange for (presumably) lower monthly usage plans. Such a move may encourage customers to switch to either cheaper iPhones or non-iOS devices, rather than buy the latest and greatest iPhone, or perhaps hold on to their existing devices for a while longer. CEO Tim Cook addressed this threat. He believes that the more important consideration is attracting customers to the ecosystem.

We agree with his assessment that there may be noise around such plans. Certainly, some customers will opt for lower-priced devices (possibly iPhones, but perhaps other smartphone brands), but there is also potential that an unsubsidized model allows high-income customers to buy iPhones every year, rather than every two years. We should also note that Apple has still fared quite well in markets such as the U.K. where unsubsidized models are more prevalent, so we are not yet certain that such a wireless model in the U.S. will be a death knell for Apple's domestic iPhone sales.

Also, most other premium smartphones carry similar prices to high-end iPhones. We suspect that any significant up-front savings from customers will come with performance trade-offs if these subscribers buy midrange devices instead. In short, we do see risks associated with a shift to an unsubsidized wireless carrier model in the U.S. But we believe that such risks are adequately factored in to our relatively modest long-term iPhone growth projections, as well as baked into Apple's share price at recent levels.

We were also pleased to see strong iPhone outperformance in China. The company's revenue forecast for the March quarter, which was announced in January, was disappointing to us (and presumably the market), as we believed that it implied a relatively weak iPhone launch at China Mobile. Instead, iPad turned out to be the main culprit for the lower revenue, a great sign for Apple's profitability (as evidenced by strong gross margins), as iPads carry much lower gross margins than iPhones. It now appears that the China Mobile deal did, in fact, contribute to solid year-over-year iPhone unit sales growth in the March quarter. We have greater conviction that China Mobile will aid in further year-over-year iPhone growth in the spring and summer months, as well.

We still believe that Apple's narrow economic moat will play an increasingly important role in future iPhone sales in the long term. Switching costs should help the firm retain current iOS users who are loyal to the ecosystem, and who will likely make repeat device purchases (as long as Apple doesn't release a couple of product flops). We believe that iOS device sales to this loyal customer base imposes a bit of a floor on the company's valuation (which became an area of importance, in our view, when Apple's shares traded in the high-$300 range). Along these lines, any outsized future iPhone growth will likely come from Apple's ability to attract any remaining first-time smartphone buyers, either in emerging markets or from late adopters in developed markets.

In this context, we are encouraged by Apple's disclosure that 85% of iPhone 4s and 69% of iPhone 5c buyers in the quarter were first-time iOS customers, with roughly 60% of these customers switching over from   Google's (GOOGL) Android platform. Sales to new users not only indicates that Apple can still make inroads in the premium part of the smartphone space but may also enable Apple to expand the size of its loyal customer base over time. Although Apple plays in brutally competitive consumer-centric industries like smartphones and tablets, this loyal, sticky customer base may ultimately provide greater stability to the firm's future product sales and, in turn, free cash flow generation.

On the surface, iPad unit sales incurred a brutal 16% decline from the year-ago quarter. We are a bit relieved to see that a good portion of the sales decline stemmed from lower iPad sales to retailers in the March 2014 quarter, as well as a tough comparison with the March 2013 quarter, when iPad sales were artificially boosted a bit by higher sales to retail partners. The 3% unit sales decline to end customers still isn't great, as the iPad was Apple's fastest-growing product a couple of years ago. However, in light of much lower gross margins on tablet sales compared with iPhones, we'd much prefer to see Apple's current product mix, where an especially high proportion of device sales come from the iPhone. If rumors are true that the iPhone 6 will not only come with a 4.8-inch screen but also in the form of a 5.5-inch "phablet," then a trade-off toward iPhone 6 phablets and away from iPad Minis, for example, would be welcome news.

Our newly increased fair value estimate of $600 per share stems from optimism around iPhone sales at China Mobile and elsewhere. This should fuel future iPhone revenue growth which, in turn, drives overall revenue growth and promotes Apple's gross margin resilience. Partially offsetting this optimism, however, is our revised downward projections for flattish long-term iPad revenue in light of recent lackluster results.

Finally, we're not especially surprised by either Apple's expanded stock buyback program to $90 billion (with $44 billion still available through calendar 2015), or its 8% dividend increase. Apple indicated that it will take on more debt to fund future repurchases. We anticipate that not only will the company issue bonds in fiscal 2014 but also fiscal 2015 if the firm wishes to fully satisfy its $90 billion authorization.

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