Apple (NASDAQ:AAPL) announced a solid set of Q4 FY2013 results on Monday, slightly beating the high-end of its guidance on both revenues and margins. Revenues grew a healthy 4.2% over the year-ago quarter, bolstered by sales of the newly launched iPhones towards the end of the quarter, which drove handset unit sales to a Q4 record of 33.8 million. The strong performance was led by the addition of the Chinese market, as well as Japanese carrier NTT Docomo, to the initial launch markets for the iPhone 5S and 5C, which helped sales in the two countries increase year-on-year by 41% and 6% respectively. The company said that the underlying iPhone sales growth in China was even better at 25%, but iPad demand pressured overall growth as customers waited for the launch of the new iPads. The higher iPhone mix helped gross margins improve sequentially to just over 37%, which the company expects to sustain in the holiday quarter as well.
However, Apple’s guidance that its gross margins may not improve in a quarter that has traditionally seen the highest iPhone mix disappointed investors, with the company’s stock trading down by over 5% in after-hours trading immediately after the results were released. During the earnings call, however, the management clarified that expectations had to be tempered due to a likely increase in mix of the new iPads, which have lower margins than the company-average, as well as a greater proportion of revenues being deferred to account for additional software such as iWork and iLife being offered for free with new hardware purchases. Apple expects a $900 million sequential impact on revenues as a result of this accounting change, without which margin guidance would have been higher by at least 150 basis points. The clarification helped the stock recover most of its losses, and is currently trading about 12% below our $600 price estimate.
Software To Drive Value Instead of Price Cuts
The recent decision to make available a significant amount of software, including the iLife and iWork suite, for free with new iDevice purchases is in keeping with Apple’s core philosophy of using software as a means to drive hardware sales. Its iTunes Store, which has a huge repository of apps and content such as music and books, is another good example of this strategy. iTunes may not a big value contributor to the company in terms of margins and cash flows, but by keeping its margins low, Apple is able to bring developers as well as customers on board to create an ecosystem robust enough to drive future iPhone and iPad sales. By offering $60 worth of additional software (iWork and iLife) for free, Apple is offering more value with every new iPhone purchase while strengthening its OS ecosystem further.
This will allow it to keep its device prices high in the near-term, thereby maintaining the high-end premium appeal of the Apple brand. Since Apple is providing the iOS software for free only with new iDevice purchases, the marketing strategy seems to be primarily aimed at first-time iDevice buyers as well as retaining existing customers that haven’t yet bought iWork and iLife due to the high price. While this will further entrench existing customers into the iOS ecosystem, first-time iDevice buyers are likely to be enticed by the indirect discount of about 10% ($60 out of $650) on offer with a new entry-level iPhone 5S. With many new iPhone customers likely to come from emerging markets, Apple is looking for creative ways to leverage its ecosystem advantage to drive sales growth instead of taking a hit on price and margins.
China Mobile and new products
This strategy was also evident in Apple’s decision to not launch a sub-$400 iPhone this year, and instead package the iPhone 5 in colorful plastic to sell it as the 5C. That Apple priced the 5C at $550 shows that it is more intent on preserving its brand value and margins than making a market share play. The 5C is not that different from the 5 on the inside but is held together by a single polycarbonate shell, which likely makes the 5C cheaper and much easier to assemble than its predecessor, which had an anodized aluminium casing. The 5C’s introduction is therefore likely to help Apple defend its margins as the 5C sales mix increases following the initial launch euphoria. It is likely one of the reasons (apart from the deferred revenue impact) why the company has guided for flat margins in Q1 despite expecting to see a higher mix of iPad mini sales during the holiday quarter.
The focus on margins comes even as some of the smartphone momentum shifts to the low-end market in emerging economies, where Apple doesn’t have a big presence yet. Countries such as China, where 3G penetration is still pretty low at about 20%, are seeing burgeoning smartphone sales as carriers there look to transition their huge subscriber bases to 3G. Apple has subsidy arrangements with two of the three major carriers in China, but a deal with the largest carrier – China Mobile – has remained elusive so far due to technological incompatibilities and subsidy concerns. However, such a deal seems imminent after one of Apple’s handsets recently secured regulatory approval to run on China Mobile’s network.  Handset vendors generally tend to start selling new phones within months of receiving regulatory approval. We expect a potential China Mobile deal to unlock a lot of value for Apple, and could add as much as $50 billion to its valuation.
Additionally, the company reiterated that it expects to enter into new product categories, with product launches that can be expected either this year or the next. If Apple is reluctant to enter the mid-end $300-$400 smartphone segment, new product categories could go a long way in driving value and sustaining the ecosystem momentum that Apple has built up in recent years.Notes: