Apple (NASDAQ:AAPL) announced record holiday quarter results on January 23rd, but shares tumbled almost 10% in post-market trading as net income remained flat year-over-year. The company sold almost 48 million iPhones (in line with what we were expecting after Verizon’s (NYSE:VZ) and AT&T’s (NYSE:T) sales guidance earlier this month) and 23 million iPads around the world, besting its previous quarterly record both in terms of unit sales as well as revenues.
However, the iPhone 5’s fast rollout and the number of product refreshes that Apple came out with last quarter saw manufacturing costs burgeon, denting margins by almost 600 basis points y-o-y and 140 basis points q-o-q. The company however managed to beat its gross margins guidance by 260 basis points as the sales mix came in better than expected.
Despite the highly negative market reaction to earnings, Apple actually managed to increased its cash flow from operations by more than 33% over the same period last year. Also, this holiday quarter was a week shorter than last year’s, which impacts the headline sales growth comparison. On average, Apple brought in $4.2 billion per week last quarter which if added to the reported revenues is a growth of about 26% y-o-y. Moreover, Tim Cook’s comments about the iPhone 5′s contribution to overall iPhone sales being the same as last year’s iPhone 4S mix – was also borne out by the less than 1% decrease in iPhone ASPs y-o-y – assuages one of our biggest concerns about declining customer demand for the latest iPhone in lieu of the older models.
China sales meanwhile continued to account for a growing portion of Apple’s sales as the company launched the iPhone 5 in the country towards the end of the quarter and saw revenues from the region grow by 67% y-o-y. The company is now even highlighting this region by breaking out financials for Greater China separately in its results.
Additionally, going forward, we see untapped opportunities in China (an in-the-works deal with China Mobile should be the catalyst) and the enterprise contributing heavily to Apple’s growth both in terms of iPhone and iPad sales. Accounting for that as well as the subsequent margin pressures due to rising competition in a maturing market, we have revised our estimate to around $660 price estimate for Apple’s stock, which is still about 40% ahead of the current market price.
iPhone growth needs emerging markets
At about 50% of Apple’s value, according to Trefis estimates, the iPhone is the single most important product for the company. The iPhone’s global mobile phone market share steadily increased from zero at the start of 2007 to around 5.4% in 2011 as iPhone unit sales grew at an average annual rate of about 90% every year. In 2012, however, iPhone sales grew by only about 43% despite a strong last quarter.
With the smartphone market in developed regions such as the U.S. getting more saturated (U.S. smartphone sales grew y-o-y by just 9% in Q2) and in turn competitive, Apple will look to tap the fast-growing emerging markets such as China to drive growth.
China, despite being only in the early stages of smartphone adoption, has already pulled ahead of the U.S. as the world’s largest smartphone market by volume. This is an incredible statistic given that 3G penetration in China stands at only about 20% currently. Considering the huge 2G subscriber base that the Chinese carriers are looking to upgrade to 3G, the potential for Apple to ride the boom is huge. This was borne out by the opening weekend sales for the iPhone 5 in China last month, which crossed the 2 million mark and made it Apple’s best ever launch in the country. We expect the launch to help shore up Apple’s market share in the region, which dropped to the sixth place in Q3 as people deferred purchasing an iPhone in anticipation of the new release.
A cheaper iPhone may make sense
However, Apple currently sells the iPhone through the smaller two of the three carriers in the country, China Unicom and China Telecom. A deal with the largest wireless carrier in the world, China Mobile, remains elusive until Apple can work out a subsidy deal with the carrier. How soon that will happen is open to speculation considering the Chinese government’s possible opposition to the huge iPhone subsidies. (see Apple’s China Potential Could Be Limited By A Subsidy Compromise With China Mobile) But knowing that the carrier’s 3G growth has been hurting due to unavailability of the iPhone, such a deal should not be too far along. This deal is very important for Apple as it can instantly double the iPhone’s current addressable market in China and act as the next big boost to its stock. (see Apple Could Have A $750 Fair Value If China Mobile Deal Works Out)
The important thing to note here is that despite not having a China Mobile deal, Apple hasn’t performed too badly in China so far. Revenues from greater China, which includes mainland China, Hong Kong and Taiwan, in the September quarter grew 26% year-over-year and accounted for 15% of Apple’s revenues for FY2011. This brought Apple’s FY2012 revenues from the region to about $24 billion, about 80% growth over FY 2011.
In order to benefit more from the China potential, it may behoove Apple to consider a cheaper iPhone for the emerging markets that does not compromise much on the build quality and margins, in a move similar to the iPad mini. This will also help lower the per phone subsidy costs and potentially help bring China Mobile on board. This would undoubtedly translate well to other developing markets that may want Apple’s iPhones but may find the subsidy costs and retail price tag too high.