Apple Beats Q3 Earnings; View Cautious; All Eyes on iPhone 6

Apple Inc. (AAPL) reported modest third-quarter 2014 revenue growth compared to Street estimates that were driven by strong iPhone and Mac sales and robust performance in China, partially offset by disappointing iPad sales.

Earnings of $1.28 per share jumped 19.6% year over year due to margin expansion, which comfortably beat the Zacks Consensus Estimate by 6 cents.

Apple provided cautious fourth-quarter guidance on lower iPhone sales. The company is apprehensive that customers will postpone purchase of iPhone due to the rumored launch of a new large-screen device in the fourth quarter. In the past two years, Apple has launched iPhones in September.

We believe that all eyes will be on the upcoming iPhone and rumored iWatch launch. A big screen iPhone will help Apple counter the intensifying competition from Samsung as well as low-priced Asian handset makers. iWatch, rumored to be launched in October, will be a key growth catalyst for Apple, in our view.

Quarter Details – Revenues

Revenues increased 6.0% year over year to $37.43 billion, slightly higher than the mid-point of the company’s guided range of $36.00 to $38.00 billion. iPhone unit sales increased 13.0% year over year to 35.20 million. Revenues climbed 9.0% from the year-ago quarter to $19.75 billion.

Apple experienced strong iPhone sales (up 55.0% year over year) in the BRIC (Brazil, Russia, India and China) countries during the quarter. Apple’s partnership with China Mobile (CHL) positively impacted results in Greater China. iPhone adoption continues to remain strong among enterprises such as Medtronic and Nestle.

Revenues from iTunes/Software/Services improved 12.0% year over year to $4.49 billion, primarily due to 25.0% growth in billings ($5.4 billion) from the year-ago quarter. Software & services revenues increased 19.0% on a year-over-year basis. Cumulative App downloads were 75 billion. Accessories increased 12.0% from the year-ago quarter to $1.33 billion.

Apple shipped 4.41 million Macintosh in the reported quarter, up 18.0% from the year-ago quarter. Revenues increased 13.0% year over year to $5.54 billion. The strong growth in unit sales was due to robust performance by the newly introduced low-priced MacBook Air. Mac achieved strong double-digit growth across many countries, including the U.S. Canada, Mexico, the U.K., Germany, France, Australia, China, India and the Middle-East.

However, iPad growth fell for the second consecutive quarter despite strong growth in developing countries. Per Apple, iPad sales were up 64.0% in the Middle-East, 51.0% in China and 45.0% in India.

Nevertheless, weakness in matured markets negatively impacted iPad growth, as unit sales declined 9.0% year over year to 13.27 million. Revenues were down 8.0% from the year-ago quarter to $5.89 billion in the quarter.

Although Apple cited smaller inventory and soft macro-environment in certain markets as the primary culprit behind the decline, we believe that intensifying competition from low-priced tablets also negatively impacted sales.

iPod unit sales and revenues continued to decline year over year. Apple sold 2.93 million iPods (down 36.0% year over year) and earned $0.4 billion (down 40.0% year over year) in the quarter.

Retail revenues in the quarter increased 1.0% on a year-over-year basis to $4.10 billion. Greater China revenues grew 28.0% year over year, while Rest of Asia-Pacific increased 6.0% from the year-ago quarter. Japan and the Americas grew 1.0% each, while Europe increased 6.0% on a year-over-year basis.

Margins

Gross margin expanded 250 basis points (bps) from the year-ago quarter and surpassed management’s guided range of 37.0% to 38.0%. The gross margin expansion primarily resulted from cost improvements (price declines in NAND, mobile DRAM and LCD) in the quarter.

Operating expenses, as a percentage of revenues, increased 90 bps on a year-over-year basis. The year-over-year rise was due to higher research & development expense (up 100 bps) in the third quarter. Selling, general & administrative expense increased 10 bps from the year-ago quarter.

Operating margin expanded 150 bps from the year-ago quarter due to higher revenues and gross margin base. Net income was $7.75 billion or $1.28 per share compared with $6.90 billion or $1.07 in the year-ago quarter.

Balance Sheet and Cash Flow

Apple’s balance sheet remains strong with cash and investments of $164.0 billion at the end of the third quarter compared with $150.6 billion at the previous quarter-end. Long-term debt was $29.03 billion at the end of the quarter. Cash flow from operating activities was $10.3 billion in the reported quarter.

Apple returned $8.3 billion to shareholders through share buybacks and dividend. The company has already used $51.0 billion on share buybacks with six remaining quarters to complete the $130.0 billion capital return program.

Guidance

For the third quarter of fiscal 2014, Apple forecasts revenues to be in the range of $37.0 to $40.0 billion. Gross margin is expected to be in the range of 37.0% to 38.0%, while operating expenses are projected within $4.75 to $4.85 billion. Other income/ (expense) is forecasted to be $250.0 million while tax rate is likely to be 26.1%.

Our Take

Apple’s third-quarter results were mixed, in our view. Going by its standards, the revenue growth was modest, as iPhone sales suffered from postponements. Strong Mac sales were a surprise as was the robust performance in China. Apple’s growing market share in the BRIC and emerging markets is a major positive.

We believe that the partnership with China Mobile will help Apple in the near term. Apple’s rumored upcoming large screen iPhones will receive good response in China, which will further boost top-line growth, going forward.

Although iPad reported a dismal quarter, its growing adoption in enterprises and education sectors is a significant growth catalyst. The availability of Microsoft (MSFT) office and the partnership with International Business Machines (IBM) will boost iPad adoption among enterprises over the long haul.

Apple continues to face significant competition from Asian handset makers such as Samsung and Lenovo’s acquisition of Motorola will further intensify competition in China. This will further hurt its average selling price, in turn negatively affecting gross margin.

Moreover, the ongoing litigation issues with Samsung, legal headwinds in China and the e-Book pricing case will remain overhangs on the stock in the near term.

Currently, Apple has a Zacks Rank #3 (Hold).