Apple (NASDAQ:AAPL) announced a mixed set of Q3 FY 2013 earnings on July 24, beating market expectations with record iPhone sales but disappointing on the iPad front. The report mitigated concerns that the high-end smartphone market is nearing saturation as the company shipped as many as 31.2 million iPhones during the quarter, posting growth of 20% over the year-ago quarter.
The good news was however tempered by the fact that Apple achieved this by selling more of the lower-end iPhone models such as the iPhone 4, which caused ASPs (average selling prices) to decline 4% y-o-y. Still, investors will be pleased that Apple’s strategy of pushing discounted iPhone 4 models in the predominantly prepaid developing markets of India and Philippines is working. iPad sales however disappointed, declining 14% y-o-y and 25% q-o-q. Most of the y-o-y decline was driven by reduced inventory levels as compared to the year-ago quarter when Apple had just launched the third-generation iPad.
The higher mix of iPhones caused gross margins to come in closer to the high end of Apple’s guidance at 36.9%. Still, it is almost 6 percentage points lower than 42.8% reported in Q3 2012. Looking forward, however, the most important takeaway from the earnings call was that Apple is getting ready to launch new products and services, both in existing as well as new categories. In addition to existing product upgrades, we expect a cheaper iPhone to be launched, which would go a long way in propping up iPhone sales in emerging markets. An iTV and an iWatch could also be launched, either during the fall or in 2014, as has been rumored for quite some time. With the company also decreasing its cost of capital by tapping the low-cost debt markets recently, our revised $600 price estimate is about 40% ahead of the current market price.
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iPhone Surprise Shows Cheaper iPhone Potential
While Apple’s iPhone shipments did surprise the market by growing at a rate of almost 20% y-o-y, it had to take a hit on ASPs in order to do so. The ASP pressure may continue in the coming quarters as well if Apple launches a cheaper iPhone. It is therefore a good sign that despite selling more of the lower-end iPhone models, gross margins held up pretty well and came in at the higher end of Apple’s guidance for the quarter. Not only does this indicate Apple’s ability to generate good profits even at lower price points but also that the iPhone remains the more popular choice when pitted against Android at similar price points. The latter can be seen not only from increased emerging market demand for the discounted models but also that half the smartphone buyers at AT&T and Verizon chose to buy an iPhone in a quarter that saw Samsung launch its latest generation Galaxy S4.
Part of the reason for Apple’s outperformance may have been its recent deal with T-Mobile, which helped it reach many first-time smartphone buyers upgrading from a feature phone. According to research firm Kantar Worldpanel, Apple’s market share in the U.S. jumped by about 3.5% between March and May due to the T-Mobile deal. The iPhone accounted for almost 31% of the carrier’s smartphone sales despite being launched only in the middle of the three-month period.  Targeting the first-time smartphone buyer seems to be part of Apple’s global strategy to drive iPhone growth as high-end smartphone upgrades near saturation.
It is here that coming up with a cheaper iPhone will prove value-accretive to Apple. Not only will such a move help Apple take on Android in emerging markets but also target first-time buyers who are likely to contribute the most to smartphone growth in the future. Apple’s China story has been floundering of late in the absence of an iPhone deal with the largest carrier, China Mobile, which accounts for about 65% of the country’s wireless subscribers. Revenues from China declined about 43% sequentially and 14% y-o-y. With subsidy concerns likely to hold up talks between the two, we believe offering a cheaper iPhone will also help Apple decrease the per-phone subsidy costs and potentially bring China Mobile aboard.
iPad Decline Not A Worry
The decline in iPad sales doesn’t seem to be a big reason for concern – not just because the iPad accounts for only about 12% of Apple’s value by our estimates but also because of the different schedule of iPad launches this year. Last year, Apple had launched its third-generation iPad just before the start of the June quarter which is why it pushed 1.2 million iPads into its sales channel. This year, however, Apple seems to be readying new iPads for launch during the holiday season and has therefore chosen to clear the inventory levels by pushing out 700,000 fewer iPads. Adjusting for the 2 million iPad inventory differential, Apple saw iPad sell-through decline only 3% y-o-y – not bad considering that the iPad was last refreshed in November last year.
Still, it does seem that the iPad mini is cannibalizing more of the higher-margin iPad sales than actually adding much value to Apple. If we compare iPad sales for the period of four quarters ending June for the last two years, we see that the growth in iPad unit sales has declined from about 117% in 2012 to less than 30% this year. Granted that the tablet market was in a very nascent stage then, but the sharp decline in iPad sales growth points to increasing competition from low-end Android tablets as well as iPad’s inability to add a lot of value to Apple in the longer term. The iPhone, in comparison, never grew at a rate less than 60% annually even four years after the first iPhone was launched. We have used the year-ending-June period for this analysis since Apple has never had more than one iPad refresh during this period.Notes:
- Strong T-Mobile iPhone sales help iOS market share gain on Android, BGR.com, July 8th, 2013 [↩]