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Shares of Apple Inc. (AAPL - Analyst Report) surged approximately 4% ($16.39) in afterhours trading on the heels of a better-than-expected third quarter result. Apple reported earnings of $7.47 per share that comfortably surpassed the Zacks Consensus Estimate by approximately 17 cents (2.33%). However, earnings declined 19.9% year over year and 26.0% sequentially, primarily due to lower top-line and margin growth.

Revenues

Revenues  increased 1.0% year over year but declined 19.0% sequentially to $35.32 billion, within the company’s guided range of $33.5 billion to $35.5 billion. Revenues were slightly better than the Zacks Consensus Estimate of $35.15 billion.

iPhone unit sales climbed 20.0% year over year but decreased 17.0% from the previous quarter to 3.24 million. iPhone revenues climbed 15.0% from the year-ago quarter but plunged 21.0% from the previous quarter to $18.15 billion in the quarter.

iPhone growth continues to be driven by strong adoption from a number of U.S. government agencies as well as companies such as Cisco (CSCO - Analyst Report) and General Electric (GE - Analyst Report). Apple experienced strong iPhone sales in most of its markets, particularly in the U.S. (up 51.0% year over year), UK, Japan (up 66.0% from the year-ago quarter), Brazil, Russia, India, Thailand and Singapore.

iPad unit sales declined 14.0% year over year and 25.0% sequentially to 14.62 million. iPad revenues were down 27.0% both on a year-over-year and quarter-over-quarter basis to $6.37 billion in the quarter.

Apple shipped 3.75 million Macintosh in the reported quarter, down 7.0% from the year-ago quarter and 5.0% on a sequential basis. Revenues decreased 1.0% year over year and 5.0% quarter over quarter to $4.89 billion.

In June this year, Apple launched two new versions of MacBook Air, both of which have been well received. The company also unveiled the next generation Mac Pro, which is set to release in late 2013 and previewed OS Maverick, expected to be launched this fall.

iPod unit sales and revenues continued to decline year over year. Apple sold 4.57 million iPods (down 32.0% year over year) and earned $0.7 million (down 31.0% year over year) in the quarter. On a sequential basis, iPod shipments and revenues plunged 19.0% and 24.0%, respectively.

Revenues from iTunes/ Software/ Services improved 25.0% year over year but declined 3.0% sequentially to $3.99 billion. Accessories plunged 4.0% from the year-ago quarter and 15.0% from the previous quarter to $1.18 billion.

Retail revenues in the quarter remained flat on a year-over-year basis but declined 22.0% sequentially to $4.07 billion. At quarter end, Apple operated 408 stores worldwide, of which 156 are located outside the U.S.

Greater China revenues decreased 14.0% year over year and 43.0% sequentially in the reported quarter. Rest of Asia-Pacific decreased 18.0% year over year, while Japan increased 27.0% for the same period. On a sequential basis, Rest of Asia-Pacific and Japan declined 35.0% and 19.0%, respectively.

Americas grew 12.0% year over year and 3.0% sequentially. Europe decreased 8.0% from the year-ago quarter and 22.0% quarter over quarter.

Margins

Gross margin contracted to 36.9% from 42.8% in the year-ago quarter and met the higher end of management’s guided range of 36.0% to 37.0%. On a sequential basis, gross margin declined 60 basis points (“bps”) in the quarter.

The gross margin contraction primarily resulted from unfavorable product mix due to higher sales of lower margin iPhone 4 and 4S and iPad minis in the quarter

Operating expenses, as a percentage of revenues, increased 100 bps year over year and 210 bps from the previous quarter to 10.8%. The rise was due to higher research & development expense (up 80 bps year over year and 70 bps sequentially) in the third quarter.

Operating margin plunged to 26.0% from 33.0% reported in the year-ago quarter, reflecting lower gross margin base. On a sequential basis, operating margin contracted 280 bps.

Net income as a percentage of revenues was 19.5% compared with 25.2% in the year-ago quarter and 21.9% in the previous quarter.

Balance Sheet and Cash Flow

Apple’s balance sheet remains strong with cash and investments of $146.6 billion ($106.0 billion in offshore) at the end of the third quarter compared with $144.7 billion in the previous quarter. Cash flow from operating activities was $7.8 billion in the reported quarter.

Apple issued debt worth $17.0 billion during the quarter to fund its share repurchase activity and dividend payments. The company completed its $1.95 billion accelerated share repurchase program in April and utilized $16.0 billion for share buyback. The company paid dividend worth $2.8 billion during the quarter.

Fourth Quarter Guidance

For fourth quarter 2013, Apple forecasts revenues to be in the range of $34.0 billion to $37.0 billion. Gross margin is expected to be in the range of 36.0% to 37.0%, while operating expenses are projected to be within $3.9 to $3.95 billion. Other income/(expense) is forecast to be $200.0 million while the tax rate is likely to be 26.5%.

Management expects component costs to decline in the fourth quarter. However, negative foreign exchange due to the strengthening of the dollar against yen will hurt top-line growth in the forthcoming quarter.

Apple expects to open approximately 27 new stores and remodel 23 stores by the end of fiscal 2013. Apple expects to open 11 new stores in Greater China (currently 11 stores) over the next two years.

Our Take

Although Apple reported a better-than-expected third quarter result, it failed to impress us. A higher-than-expected revenue decline in China, falling margins and the lack of new innovations make us cautious on the stock in the near term.

Apple reported strong revenue growth in the U.S. in the third quarter. However, we believe that it will be difficult for the company to sustain this growth rate due to a maturing smartphone market and increasing competition from Asian handset makers such as Samsung and HTC.

Besides the U.S., Apple’s iOS continues to face significant competition from Google’s Android operating system in most of the other markets. The significant decline in revenues in China and Rest of Asia suggests market share loss to low cost smartphones produced by Samsung, HTC, LG and Huawei.

Nevertheless, we believe that Apple’s strength lies in its ability to innovate. We believe that the company is working on a new (as reflected by the recent executive hiring) gadget. Moreover, the upcoming refreshes of iPhone and iPad will boost top-line growth. Additionally, the shareholder friendly moves such as higher dividend payment and expanded share buyback are expected to drive the stock going forward.

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

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