Apple Receives Holiday-Quarter Boost But Guidance Suffers On Inventory Changes And Software Revenue Deferrals

Apple (NASDAQ:AAPL) announced a strong set of Q1 FY2014 results on January 27th, as strong iPhone and iPad sales during the holiday season pushed the company’s revenues and operating profits to its highest ever in a quarter. The company benefited from the early iPhone launch in China and the addition of NTT Docomo as a carrier partner in Japan, as iPhone unit sales grew by 7% year-on-year (y-o-y) to over 51 million. What also contributed to the stellar quarter was a higher-than-expected mix of iPhone 5S within the overall numbers, which propped up Apple’s gross margins to more than the high-end of its guidance. iPad sales also contributed to the overall outperformance, growing y-o-y by almost 14% as sales more than doubled in China on increased demand for new iPad models. However, the company faced headwinds from dollar strengthening against foreign currencies such as the yen and the Australian dollar, and a greater proportion of revenues being deferred to account for additional software such as iWork and iLife, which it recently started offering for free with new hardware purchases. Excluding these factors, Apple’s revenues would have increased by about $1.3 billion, or around 2.3%.

However, Apple’s guidance for the second quarter implies a higher-than-expected level of seasonality, with revenues at the mid-point of guidance expected to drop year-over-year for the first time in almost 10 years. The company clarified during the earnings call that expectations had to be tempered due to channel inventory changes, not because of underlying sell-through. Apple exited the quarter with supply almost in balance with demand for both the iPhone as well as the iPad, unlike last year when the iPhone 5 and the iPad mini were highly supply-constrained. While this helped Apple out-perform during the holiday quarter, its second quarter is likely to face the brunt of lower sell-in of the mobile devices. This, together with the expected decline in iPod sales, a strengthening U.S. dollar and higher software revenue deferrals, had a negative impact of about $2 billion on Apple’s overall guidance. Going forward, we don’t expect major inventory changes of any kind, and the revenue deferrals should be accretive to the top-line in the coming quarters. We have slightly revised our price estimate for Apple to $620, to account for the higher net cash balance and lower share count due to buybacks.

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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 and 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.

Focus Needs To Shift Toward Emerging Markets

However, Apple’s top-line growth will be a concern, with or without inventory changes, as long as it doesn’t come up with a strategy to entice the vast majority of the population in emerging markets who cannot afford premium products. The high-end smartphone market seems to be nearing saturation levels and carriers in developed markets such as the U.S. are increasingly looking to cut down on subsidy costs. Verizon and AT&T, which account for a bulk of the iPhone sales in the U.S., have increased the upgrade cycle for smartphone upgraded from 20 to 24 months. As a result, Verizon activated only 8.8 million smartphones during the holiday quarter – about 10% lower than the year-ago quarter. AT&T is scheduled to release its results today and will, in all probability, also announce a decline in its smartphone sales. This resulted in Apple’s North American sales falling by about 1% over the same period last year.

The addition of China Mobile to Apple’s list of carrier partners is a welcome development given this background of developed-market headwinds. China Mobile is the world’s largest wireless carrier with a subscriber base of over 760 million that overshadows Verizon and AT&T by more than seven times. Although a large proportion of these subscribers are on 2G currently, China Mobile’s 3G penetration is growing rapidly and its 4G rollout is expected to drive more of its subscriber base to data services. 3G/4G penetration in the Chinese mobile market currently stands at only 34%, but China Mobile’s aggressive posturing and 4G launch could help the figure grow significantly in the coming quarters. This will expand Apple’s addressable market in China, thereby allowing it to not only bring more Chinese subscribers into its fold, but also generating developer momentum around its Chinese app ecosystem. Greater developer participation in creating apps for the Chinese market will not only help increase sales of the iPhone but also the iPad and any new products that Apple may be looking to launch this year.

We expect Apple’s emerging-market strategy to hinge around the cheaper iPhone 5C, to some extent, in the coming quarters. However, the 5C, which is basically the now-discontinued iPhone 5 in colorful garb, hasn’t been able to meet Apple’s sales expectations so far. But that is probably because much of the initial euphoria surrounding iPhone launches are usually directed towards the higher-end products, which could have caused sales to skew towards the 5S initially. Since Apple generally doesn’t refresh its products for a full year, the sales mix of the 5C is likely to increase going forward, with additional marketing for the 5C helping the company attract more new users over an entire product cycle than it would have with the older-generation iPhone 5. CEO Tim Cook said during the earnings call that the 5C was able to attract a significant number of new iPhone users, in line with what he had expected.

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