Very little good news in Apple's results

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. The market was certainly disappointed by Apple’s fiscal first-quarter results and guidance for the next quarter. I’m here with Brian Colello, our Apple analyst, to get his thoughts.

Brian, thanks for joining me today.

Brian Colello: Thanks for having me.

Glaser: So what’s your overall view of this quarter for Apple?

Colello: Well, I think you have some good news in terms of they did have a revenue beat, they did have an EPS beat in terms of their guidance for the fiscal first quarter, for the December 2012 quarter. However, iPhone units were a little bit disappointing; iPad units were a little bit disappointing. So it wasn’t a great beat on that front. It was actually relatively in line with consensus depending on where you look at.

So it wasn’t the sort of blow-out quarter that you might normally expect and maybe what bullish investors were hoping for in light of all of these new product launches. The bigger issue, I think, was the forecast for the March quarter, their fiscal second quarter. That was much lighter than expected. Again, if you had a blow-out quarter, you could see Apple maybe getting away with a lighter forecast for March, but since the December quarter was in line, that March forecast is especially disappointing.

Glaser: So, maybe not a lot of great news. On the iPhone side, prior to this earnings report, there were some reports of supply chain cuts, some worries about iPhone units. How many did they ship, and was that a number that is in line with a product that might not be doing as well as we had thought?

Colello: Well, they shipped 48 million units. So that’s much better than the 37 million at the height of the iPhone 4S launch a year ago. So, certainly there's some growth there, and even if you looked at that initial weekend, 5 million of sales versus 4 million for the 4S, you kind of saw that you would have a stepped increase in iPhone sales. So, it was good, but investor expectations were for $50 million or within that range. And so it was a little bit on the lower side there, and that’s a little disappointing.

One of the positives thing actually is that ASPs held up pretty well, the price of the phones, because you heard from Verizon that perhaps it was an unfavorable mix that they sold more cheaper 4S and 4s rather than the iPhone 5 this quarter. Apple’s results don’t really point towards that. They still had pretty good pricing there on those iPhones.

So, I think there was good iPhone revenue, but again the forecast for the March quarter is disappointing. When you think about the 4S launch, it not only did have a great December 2011, the first-quarter launch, it also followed it up with a really strong March 2012 when it sold into China and other places. So, the forecast doesn’t really point to that this time around.

Glaser: So, looking at China and other emerging markets, do we have any sense of how the iPhone is doing there? There is some talk that maybe without the bigger screen, the phone wasn’t as competitive. Did we get any color on that this quarter?

Colello: We didn’t, but certainly China is a market to look at going forward. I think in China you have a big break-down of the low end Android handsets that customers are going to buy, price-sensitive customers. Obviously not everybody in that region can afford a $600 or an $800 phone. So, a lot of the market is going to be lower-end. Where Samsung is doing well is Korea and Europe and in some other places.

So, iPhone is still growing well in China and the company is splitting that out, the revenue mix a little more. It’s going to be important to keep an eye on that. That doesn’t include a China Mobile launch that we think is in the works over a couple of years because that’s China’s biggest carrier, so that would be a new avenue for growth. We kind of bake that in into our longer-term projections, but not necessarily something big for the recent quarter.

Glaser: How about iPad sales? We have some more sales data on the Mini through the holiday season, anything unexpected there?

Colello: We heard that consensus was somewhere between 23 million and 25 million units and they came in at about 22. So for that reason, iPad sales were disappointing. I think you had , based on Tim Cook’s comments, strong sales of larger iPads and iPad Mini, but the iPad Mini sounds like it’s at a significantly lower gross margin than the corporate average, probably lower than the iPad itself, so they may not lead to great profitability.

But again iPad sales in this important holiday season with these new product releases being a little less than expectations is not particularly good. And again the forecast points to the fact that there won’t be a bounce back in March either, and you have to expect lower sales in March and probably the middle of 2013, as well.

Glaser: Macs has been an important portion of the company’s revenue even if it’s smaller than it was in the past, certainly compared with iPhone and the iPad. With some new models out there, did they see any traction? Were they able to keep growing faster than market as a whole?

Colello: Macs, maybe even relative to iPhones and iPads, was the most disappointing of all of the segments because you had in the prior quarter, in September, you had strong Mac growth in the face of a weak PC environment. So, you thought that Apple might be able to do that again. They might have some good traction in terms of converting some Windows people over to Macs. It didn’t really have that in the December quarter. They said a lot of the products were supply constrained, that they weren’t able to ship everything that they wanted to. And so that weighed on sales and on revenue for that business line. Maybe they get some of that back in March, but again it is looking similar to the PC market, which is weak, and I think iPads are cannibalizing Macs to a certain extent, but certainly that’s an area where there could have been a pleasant surprise, and instead you probably had more of a disappointment.

Glaser: The future of Apple’s gross margins have been a long-term concern for investors. Did we see anything this quarter that kind of pointed to Apple not being able to maintain their current margin levels? What do you expect on that front?

Colello: We have always modeled gross margin declines. I think it’s just inevitable as Apple competes more and more in emerging markets as they try and sell to additional smartphone customers, people converting from a basic flip phone to a smartphone, that they are going to pick the lower-end devices. It's harder to save on the component costs and make similar margins. So, we think gross margins will decline in iPhone and then as a percentage of the business as iPads become an increasing portion; that's a lower-margin business relative to iPhone.

So, we do think there is long-term gross margin decline. Nothing announced in the quarter is going to help stem those concerns, and maybe it will be a little sharper than what we anticipated or what Wall Street anticipated. Again, if iPad Mini is a bigger part of the iPad mix that's a negative for margins. If iPhone sales start to wane, maybe Apple needs to give bigger discounts in order to do so. You have carrier subsidy concerns, and things like that.

So, maybe iPhone gross margins don't hold up either and so the long-term gross margin picture isn't the decline. It's the rate of that decline or I guess the size of that decline on percentage terms that will determine long-term valuation, and there was little good news from this quarter that points to that.

Glaser: Let's take a look at the forecast itself. You mentioned that was another disappointing part of this quarter. What is the forecast that they give mean in terms of what their expectations are? And do you think this is just another conservative expectation and they are going to beat it, or will they really be stuck in this range?

Colello: I think some interesting commentary was around the guidance where the company used to give a single number of revenue and an EPS number, and usually it was very conservative. In that regard you always expected a beat by Apple. Now they say they gave a range and they expect to be within that range. That's going to be difficult because we have certainly come to expect a beat from Apple.

So, when they said $41 billion to $43 billion--the Street was looking at something like $46 billion and Apple said they will probably be within that [$41 billion-$43 billion] range--that's certainly a negative. That's an issue that implies iPhone sales are certainly not in the $40 million range; they're something in the $30 million range. And then the seasonal decline in iPads after the holiday season, so weaker sales there.

But all of those things kind of imply a soft March quarter. You don't get the sort of bounce-back that you might have been expecting based on the December quarter that was about in line with what was expected, a little light, but not disastrous, but you are not seeing a big bounce-back in March either.

Glaser: Well, Brian, thanks so much for your analysis today.

Colello: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.