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Apple Inc (AAPL - Analyst Report) reported earnings of $8.26 per share for the fourth quarter of fiscal 2013, comprehensively beating the Zacks Consensus Estimate by approximately 38 cents (4.8%). However, earnings declined 4.7% on a year over year basis due to contraction in gross margin. Sequentially, earnings jumped 10.7% primarily due to higher revenues and lower operating expenses.

Revenues

Revenues increased 4.2% year over year and 6.1% sequentially to $37.47 billion, higher than the company’s guided range of $34.0 billion to $37.0 billion. Revenues were slightly better than the Zacks Consensus Estimate of $36.74 billion.

iPhone unit sales climbed 26.0% year over year and 8.0% from the previous quarter to 33.79 million. iPhone revenues climbed 17.0% from the year-ago quarter and 7.0% from the previous quarter to $19.51 billion in the quarter.

Apple experienced strong iPhone sales in the developing countries of Latin America, the Middle East, Russia and India. The company added NTT Docomo as its carrier in Japan, which further drove its quarterly result in the country.

iPhone’s growth continues to be driven by higher customer adoption as employees of more than 35,000 companies including the likes of Johnson Controls (JCI - Analyst Report) in the U.S. and AVIC International in China use the device for building customized applications.

During the quarter, Apple launched two new iPhones, namely iPhone 5S and 5C. These new products are expected to drive strong growth in the upcoming holiday season. However, stiff competition from Samsung, Microsoft (MSFT - Analyst Report) and low-cost Asian smartphone makers remain a major concern going forward.

iPad unit sales remained flat on a year-over-year basis but declined 4.0% sequentially to 14.07 million. iPad revenues were down 13.0% year over year and 3.0% quarter over quarter to $6.19 billion in the quarter. Apple witnessed strong year-over-year growth in Japan, Russia and the Middle-East as well as from solid back-to-school demand in the U.S. and Canada.

Most recently, Apple introduced iPads that feature the powerful A7 chip with 64-bit desktop-class architecture, ultrafast wireless and expanded LTE connectivity. Apple introduced iPad Air, which is 20% thinner and 28% lighter than the fourth generation iPad.

Apple shipped 4.57 million Macintosh in the reported quarter, down 7.0% from the year-ago quarter but up 22.0% on a sequential basis. Revenues decreased 15.0% year over year but surged 15.0% quarter over quarter to $4.57 billion.

The sequential improvement was primarily driven by robust performance from MacBook Air, which Apple updated in June this year. Late last quarter, Apple updated iMac with fourth generation quad-core processors from Intel Corp (INTC - Analyst Report). Most recently, the company launched new versions of MacBook Pro with retina display and OS X Mavericks that comprises more than 200 new features.

iPod unit sales and revenues continued to decline year over year. Apple sold 3.49 million iPods (down 35.0% year over year) and earned $0.6 million (down 30.0% year over year) in the quarter. On a sequential basis, iPod shipments and revenues plunged 23.0% and 22.0%, respectively.

Revenues from iTunes/Software/Services improved 22.0% year over year and 7.0% sequentially to $4.26 billion. Apple launched iOS 7 in September and also introduced its iRadio service. Accessories surged 5.0% from the year-ago quarter and 12.0% from the previous quarter to $1.32 billion.

Retail revenues in the quarter increased 6.0% year over year and 10.0% sequentially to $4.47 billion. At quarter end, Apple operated 416 stores worldwide, of which 162 are located outside the U.S. In fiscal 2013, Apple opened/remodeled 49 stores and it is significant to note that revenue per store was $50.0 million.

Greater China revenues increased 6.0% year over year and 24.0% sequentially in the reported quarter. Rest of Asia-Pacific decreased 6.0% year over year and 3.0% sequentially. Japan surged 41.0% year over year and 31.0% quarter over quarter.

Americas grew 1.0% year over year but declined 3.0% sequentially. Europe remained flat on a year-over-year basis but increased 5.0% sequentially.

Margins

Gross margin contracted to 37.0% from 40.0% in the year-ago quarter and met the higher end of management’s guided range of 36.0% to 37.0%. The gross margin contraction primarily resulted from unfavorable product mix in the quarter. On a sequential basis, gross margin improved 10 basis points (bps) in the quarter.

Operating expenses, as a percentage of revenues, increased 70 bps on a year-over-year basis but decreased 50 bps from the previous quarter to 10.3%. The year-over-year rise was due to higher research & development expense (up 60 bps) in the fourth quarter.

However, sequentially both research & development expense and selling, general & administrative expense decreased 20 bps and 40 bps respectively.

Operating margin plunged 360 bps from the year-ago quarter, reflecting contraction in gross margin base as well as higher operating expenses. On a sequential basis, operating margin improved 80 bps due to higher revenues and lower operating expense.

Net income margin was 20.0% compared with 22.9% in the year-ago quarter and 19.5% in the previous quarter.

Balance Sheet and Cash Flow

Apple’s balance sheet remains strong with cash and investments of $147.8 billion ($111.3 billion in offshore) at the end of the fourth quarter compared with $146.6 billion in the previous quarter. Long term debt was $16.96 billion at the end of the quarter. Cash flow from operating activities was $9.9 billion in the reported quarter.

Guidance

For the first quarter of fiscal 2014, Apple forecasts revenues to be in the range of $55.0 billion to $58.0 billion. Gross margin is expected to be in the range of 36.5% to 37.5%, while operating expenses are projected to be within $4.4 to $4.5 billion. Other income/(expense) is forecast to be $200.0 million while the tax rate is likely to be 26.25%.

Apple expects to open approximately 30 new stores (about 20 will be outside the U.S.) and remodel 20 stores by the end of fiscal 2014.

Most recently, Apple announced that it is making iPhoto, iMovie, Pages, Numbers and Keynotes available as free downloads to customers who purchase new iOS devices. The company is also making Mavericks and future OS X upgrades as well as iLife and iWork free for Macintosh customers.

However, this along with higher volume growth expectation in the upcoming quarter (due to holiday season sales) is expected to increase deferred revenue by approximately $900.0 million on a sequential basis.

Apple expects gross margin to remain under pressure in the first quarter due to higher deferrals, unfavorable mix of low priced new iPad’s, MacBook pro and iMac as well as unfavorable foreign exchange headwind related to yen.

Our Take

Although Apple reported a better-than-expected fourth quarter result, it failed to impress the market. Lower-than-expected revenue growth in the U.S, falling margins and a lack of innovation are expected to remain the primary headwinds in the near term.

Apple reported strong revenue growth in China in the fourth quarter. However, we believe that it will be difficult for the company to sustain this growth rate due to increasing competition from Asian handset makers such as Samsung and HTC. However a partnership with China Mobile will add significant impetus to Apple’s growth trajectory in Greater China going forward.

Besides China, 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 the U.S and Rest of Asia suggests market share loss to low cost smartphones and tablets produced by Samsung, HTC, LG, Huawei and Amazon.

Nevertheless, we believe that Apple’s strength lies in its ability to innovate. We believe that the company is working on a new gadget. Moreover, the refreshed product line-up will boost top-line growth in the near term. 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 #2 (Buy).

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