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Apple’s Share Buybacks a Plus, Outlook Still a Concern

The tech giant’s dismal June-quarter guidance underscores to the importance of a successful iPhone 5S launch later this year, says Morningstar’s Brian Colello.

Brian Colello, CPA 24.04.2013 | 10:21
Apple's fiscal second-quarter results were in line with our expectations. We're modestly concerned about the company's third-quarter forecast until we gain further clarity on the timing of a new iPhone launch. Perhaps the biggest news, however, came from Apple's announcement of a 15% dividend increase, and an additional $50 billion stock buyback plan, as Apple distributes more of its vast cash cushion to investors. We're maintaining our $600 fair value estimate and narrow moat rating.
 
The 37 million-unit iPhone shipments in the March quarter were slightly better than the 35 million units sold during the year-ago quarter, which coincided with the iPhone 4S launch. However, a 4% decline in iPhone average selling prices, or ASPs, points toward shifting consumer preferences toward older, cheaper models. 

At 19.5 million, iPad unit sales were strong. However, a mix shift toward lower-priced iPad Minis led to a 4% decline in iPad ASPs. Mac unit sales were down only 3% sequentially, as Apple caught up to unmet demand in the December quarter, helping to offset an otherwise dismal PC demand environment. Corporate gross margins of 37.5% were at the low end of the company's forecast, reflecting the less favorable product mix stemming from Apple's focus on emerging market growth. We're also encouraged by the apparent new boldness in Apple's capital allocation plans, and think that tapping the debt markets in a low interest rate environment to fund a portion of its stock buybacks and dividend increase is a wise move. 

We view Apple's June outlook of $34.5 billion in revenue and just over $7 in EPS as a dismal forecast. However, if an exciting iPhone 5S were to arrive this summer, as some of Apple's chip suppliers have hinted, we'd consider the weak guidance to be less of a concern. However, CEO Tim Cook's comment about "really great stuff coming in the fall" clearly tempers such enthusiasm, and the forecast implies that June iPhone unit sales may be worse than the year-ago quarter. While we still foresee long-term iPhone growth as Apple grows in China and garners repeat sales to iOS customers in the U.S. and elsewhere, near-term iPhone sluggishness may place greater importance on Apple's ability to deliver a follow-up iPhone hit later this year.

Looking at iPhone results, unit sales of 37.4 million were down 22% sequentially but up 7% from the year-ago quarter, and in line with our expectations. We should note, however, that 1.0 million units were sold into the channel, and not yet sold to end customers. We believe that most iPhone buyers in the March quarter didn't come from previous iPhone owners--where Apple's moat is a factor--but rather new customers who traded in feature phones and older smartphone models for iOS devices. These unit sales levels are disappointing relative to expectations a few months ago, as it reflects a notable decline from 47.8 million units sold in the December 2012 quarter. Still, we don't believe that lower near-term iPhone sales, nor the company's outlook for the June quarter, point toward an eroding moat or weaker switching costs around the iOS platform.


One of our concerns from Apple's prior earnings call in January revolved around iPhone 4 shortages. ASPs of $613, down 4% sequentially, indicates an unfavorable trend of a greater portion of iPhone sales coming from older models. ASPs should erode further in the June quarter as Apple's iPhone lineup ages. We view such a mix shift as inevitable in the long-term, as Apple sees faster growth in emerging markets. However, the less favorable mix at the start of the iPhone 5 launch also indicates that customers may have perceived less value in Apple's newest flagship phone. 

Apple may need to reverse this trend with an even more exciting and innovative iPhone 5S later this year. We anticipate that Apple may make some notable iOS improvements this year now that Jony Ive is running the software division, and we continue to view software and services as a critical focus for Apple going forward. We're also encouraged by Apple's comments that it wouldn't rule out a larger screen iPhone as long as the screen doesn't skimp on power consumption or display quality. We continue to believe that screen size is one of Samsung's greatest differentiators from Apple today, but we don't view it as a sustainable competitive advantage, and hope to see Apple eventually counter it with a larger device.

For the June quarter, we think that Apple's forecast implies that iPhone sales could be around 27 million units, if not lower, which would result in negligible growth from the year-ago quarter. We'd be much less concerned about this forecast if a 5S were to arrive during the summer months, and data points from Apple suppliers like Cirrus Logic and Avago both hinted at a summer launch and suggested that their largest North American customer (i.e. Apple) was undergoing product transitions, with Avago commenting that such transitions were a quarter earlier than a year ago. However, Tim Cook's quote runs contrary to these data points, and suggests that Apple's June guidance might just be another disappointing outlook, rather than an understandable pause in demand before a new device hits the market. 

Our biggest concern about an autumn 2013 iPhone 5S launch isn't necessarily about short-term revenue, but instead about Apple retaining customers in the important U.S. market, as millions of customers likely bought iPhone 4Ss on two-year contracts in late 2011. During the summer months, those contracts start coming up for renewal, giving customers the option of buying either a nine-month old iPhone 5 that will soon become obsolete, waiting for a new 5S, or switching to a three-month old Samsung Galaxy S4 or HTC One. Although we believe that Apple's narrow economic moat and switching costs around the iOS platform will allow the firm to retain a good portion of its user base in the years ahead, a delayed iPhone launch could leave a portion of its user base susceptible to jumping ship to other platforms in the near-term, thus putting our thesis on switching costs through an unnecessary test.

Finally, iPad unit sales of 19.5 million units were about a million ahead of our prior expectations. However, we should note that Apple sold 1.4 million units (mostly iPad Minis) into the sales channel to replenish inventory levels, and that these units weren't sold to end customers. The 4% sequential iPad ASP decline to $449 is consistent with various supply chain data points that suggested a less favorable iPad revenue mix toward lower-priced Minis. We expected this shift to reverse in the June quarter as Apple sells a higher proportion of larger iPads to educational institutions at the end of their budget years, but Apple's dim gross margin guidance suggests that Minis may continue to be a hefty part of the iPad mix. 

Regardless of ASP mix, however, we still tend to believe that Apple's iPad Mini introduction was the right move as long as it keeps the company at the head of the tablet industry for the foreseeable future. We have revised our model to project modestly stronger iPad unit sales and revenue growth in the long-term, mostly offset by flattish Mac revenue in light of a gloomy PC end market.
 
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Om forfatteren

Brian Colello, CPA  er senior aksjeanalytiker hos Morningstar.