Apple’s core business remains solid

New hit products could provide some upside for Apple but aren’t needed to support the current valuation, says Morningstar’s Brian Colello.

Jeremy Glaser 29 October, 2013 | 6:00PM Brian Colello, CPA

 

 

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. I’m here today with Brian Colello. He is our senior equity analyst who covers Apple. We’re going to look at the tech firm’s latest quarter and what it could mean for investors.

Brian, thanks for joining me.

Brian Colello: Thanks for having me.

Glaser: So let’s start with just kind of a brief overview of your first take on the quarter. You just got off the earnings call. What did you think about this quarter?

Colello: Sure. Well, it was a solid quarter. The fourth quarter results, they reported $37.5 billion of revenue, a little ahead of consensus; EPS of $8.26, again, beating Street estimates, a little ahead of our expectations. But really the outlook, most of the focus is on the guidance for the December quarter, Apple’s fiscal first quarter, and it was solid guidance. The guidance was $55 billion to $58 billion of revenue. The Street was looking for $55.5 billion, so solid there. The one problem that led to a little bit of a selloff after hours was the gross margin guidance. They guided for 37%. I think investors, because of the iPhone 5S launched as being a premium product, because they didn’t come out with a low-end iPhone 5C in emerging markets, I think investors were looking for a little bit stronger profitability.

So what we found out on the call on the bright side is, so they guided to 37%, but there is basically a software adjustment for deferred revenue, basically because of giving more of the software away for free and the iOS upgrades, they’re taking a gross margin hit. If you adjust for that, which has not really been material in prior quarters, the gross margin guidance probably worked out to something like 38.5%. That would have been better than anticipated. So you saw the stock trade from down 2% after hours to pretty much flat. So, all in all, I think the guidance looked strong.

We think that guidance implies something in the low to mid-50 million unit range for iPhone, if you think about it they sold 47 million in the December 2012 with the iPhone 5. So this implies some growth. Now, that’s going to come from carriers. They struck a deal with NTT DoCoMo; you’ve T-Mobile this year. You’re selling in China a quarter early. So you kind of understand the reasons and that implies flattish sales for the rest of the world, but that's a strong number. When this stock was trading in the $400 range, I think investors were looking at much less than that. So overall I think it's a good guidance and a good outlook for December.

Glaser Let’s dive into that margin number a little bit. You said it’s this deferred revenue adjustment, but they are giving away a lot more software for free. They’re giving away the operating system for free; going from charging $130 to $19, and now to nothing. Is this a winning strategy, to give away the software?

Colello: I think in the broader context of what they're trying to do against the low-cost Android competitor, it is. The growth is going – most of the growth in this market in smartphones and in tablets will come from the low-end. We're seeing increased – it’s increasingly coming from price sensitive customers in emerging markets, even late adopters in developed markets. So the way Apple’s combating that, they're not getting in the price wars with the Amazons of the world and not creating that low-cost $300 iPhone. They’re doubling down on their strength; focusing on the truly premium product. So you saw the iPhone 5C come out for $550(US), when I think everyone was expecting $450 or lower.

So, now if you’re going to sell all of these products at the high end and charge a premium, you need to give an experience that differentiates yourself from Android and makes customers willing to pay that amount. Part of that strategy embedded in that is giving the software away for free, so building productivity tools like iWorks and pages and numbers, which aren’t gaining much traction. Those aren’t big pieces of the Apple puzzle today, but by giving them away for free you can sell more software and services to justify that premium. So in that context, we do think it's a good move.

Glaser: That’s true on the PC side as well?

Colello: Yes. So they’re giving away the Mavericks operating system upgrade and actually going back to older hardware as well. So, again, part of their selling points, if you buy a Mac, is that this device will last longer, because we’re going to give you more and more software upgrades and Mavericks is a slimmed-down version, saves battery life, and kind of is a leaner-meaner operating system. So you could buy hardware today and you’ll pay a premium for that Mac hardware. But if you get the software upgrades to make that Mac last five, six, seven years instead of four years for a PC, that answers into the buying equation a little bit.

Glaser: What about the iPad business? We talked about how iPad – excuse me – iPhone demand seems like it’s pretty steady. What's happening there and what do you foresee these new iPad models that were just announced doing to sales?

Colello: Sure. I think the iPad, unlike the iPhone, because iPhone you have more contracts come up through the years, iPad is more similar to iPod. In that, you get a big bump in the holiday season. It’s a perfect gift for kids of all ages, I guess. So you do get a big seasonal boost in December and they're expecting another one again and these products are coming out right in time. The iPad mini with the retina display that is now priced at $399(S), that’s higher than the last one, but the retina display is a more costly item and so I think they needed to raise the price there. But they talked about some supply constraints there. They’re going to be hard-pressed to build enough to meet demand, but if they get there they’ll get the margins they want. They’ve talked about good expectations for iPad growth in the December quarter, and so it's a big part of strategy. We think they’ll do quite well.

Glaser: Tim Cook mentioned that in 2014 we should expect some new product categories from Apple. One of the persistent rumors is on an iWatch. Samsung rolled out smartwatch product. It hasn't been particularly well received yet. Are any of these new categories real opportunities for Apple or is their core business still going to be iPhone, iPad? Are they really going to be able to move into those new spaces?

Colello: Sure. Well, we think the biggest driver of valuation is the iPhone, and that's by far the biggest part. I think there is opportunity for Apple to grow within iWatch.

Samsung, you could question if Samsung threw together a watch based on what they think Apple might do with this watch. So I think where Samsung may be falling short with the watch on two features; one is battery life. I think it lasts only a couple of days. I think that's borderline unacceptable for a watch, or perhaps for mainstream. So I think any watch needs to kind of have a longer battery life than that.

The other one is actual functionality and the Samsung product does a lot of things that your phone does. It saves you the benefit of not having the phone right in front of you. It can be on your desk, on your nightstand, or wherever else and you get some of those notifications. But it doesn't sound like it does a whole lot more than that. So I think this is Samsung's first attempt. I think they’ll see what they like and what customers don't like and what sticks, and that’s certainly a viable part of their strategy. But Apple does have an opportunity, if they come up with something even more innovative, longer-lasting, does new features that maybe customers aren’t looking for, they might be willing to pay that price.

Now, it doesn’t – we think our valuation for Apple and the stock incorporates – there is some optionality for some growth for some new products. We’re not necessarily counting on that. So if they do come out with a killer watch that everyone wants to buy for $200, $300 and they sell 30 million of these things a year, obviously, that drives some upside and it could happen, but we’re not necessarily counting on that right now. We think the core businesses, iPhone/iPad is enough.

Glaser: So looking at the valuation today, what are your general thoughts on the shares?

Colello: Sure. Well, we came in with $600 fair value; stock is trading at $530 and it's about flat right now. So there's a little bit more – we were thinking there is a little bit more room to run on the upside. But certainly the guidance, the results don't point to $400 stock, which it was just a few months ago. We think at that point, again, you had to assume that the iPhone was in decline, and again the results and the good guidance implies that that's not the case. They’ll at least be flat on iPhones in most of the rest of the world, and then get growth from new carriers and things like that. We think a China Mobile deal comes on later, so that helps. We think there’s going to be some modest growth, and quite frankly, that’s all you need to get to $530 stock price today or something higher than that. As long as iPhone isn’t in structural decline, we think that the stock is reasonably priced here and I think that's all you really need. You don't need to gain massive market share 500 and to justify something in the 500 range. Probably did at the 800 range, but not at these levels.

Glaser: Brian, thanks as always for your thoughts.

Colello: Thanks for having me.

Glaser: For Morningstar, I’m Jeremy Glaser.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Apple Inc202.62 USD-4.63

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Jeremy Glaser

Jeremy Glaser  Jeremy Glaser is the Markets Editor for Morningstar.com.