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Apple Inc. (AAPL - Analyst Report) reported a mixed first quarter of fiscal 2014. Although earnings of $14.50 per share comprehensively beat the Zacks Consensus Estimate by approximately 46 cents, revenues lagged the same.

Moreover, Apple’s second quarter guidance was unimpressive. Shares fell approximately 7% in after-hours trading.

Revenues

Revenues increased 5.7% year over year and 53.7% sequentially to $57.6 billion and were within the company’s guided range of $55.0 billion to $58.0 billion. However, revenues marginally missed the Zacks Consensus Estimate of $57.7 billion.

iPhone unit sales climbed 7.0% year over year and 51.0% from the previous quarter to 51.02 million, which was approximately 5 million less than expectations. iPhone revenues climbed 6.0% from the year-ago quarter and 67.0% from the previous quarter to $32.49 billion.

Apple experienced strong iPhone sales in Japan, thanks to the addition of NTT Docomo in September and the continued partnership with the likes of Softbank and KDDI. Strong iPhone sales were noticed in other emerging nations like greater China, Latin America, the Middle East, and Russia during the quarter.

Many companies, including Accenture (ACN - Analyst Report), Cisco (CSCO - Analyst Report) and American Airlines, have tens of thousands of employees using iPhones for work. In fact, some, including Deloitte and GE, have over 50,000 iPhones each on their networks around the world.

However, stiff competition from Samsung, Microsoft (MSFT - Analyst Report) and low-cost Asian smartphone makers remain a major concern going forward.

iPad unit sales increased 85.0% and 14.0% on a year-over-year basis and sequentially, respectively to 26.04 million. iPad revenues were up 7.0% year over year and 85.0% quarter over quarter to $11.47 billion in the quarter.

iPod unit sales and revenues continued to decline year over year. Apple sold 6.05 million iPods (down 52.0% year over year) and earned $1.0 billion (down 55.0% year over year) in the quarter. On a sequential basis, iPod shipments and revenues plunged 73.0% and 70.0%, respectively.

iPad sales saw strong growth in Mainland China, Middle East, Latin America, Russia and parts of Western Europe during the quarter. The new iPad Air and iPad Mini with Retina Display introduced last October have already become popular with customers and response to the more affordable iPad Mini has been very strong.

Revenues from iTunes/Software/Services improved 19.0% year over year and 3.0% sequentially to $4.4 billion. Accessories surged 2.0% from the year-ago quarter and 41.0% from the previous quarter to $1.86 billion.

Retail revenues in the quarter increased 9.0% year over year and 56.0% sequentially to $6.99 billion.

Greater China revenues increased 29.0% year over year and 54.0% sequentially in the reported quarter. Rest of Asia-Pacific decreased 9.0% year over year and increased 83.0% sequentially. Japan surged 11.0% year over year and 48.0% quarter over quarter.

Americas grew 44.0% sequentially but declined 1.0% on a year-over-year basis. Europe revenues increased 63.0% on a sequential basis and 5.0% on a year over year basis.

Apple completed the remodeling of six stores and opened four new stores during the quarter, ending with a total of 420 stores, including 166 outside the United States. With an average of 418 stores open during the December quarter, average revenue per store was $16.7 million compared with $16.3 million in the year ago quarter.

Margins

Gross margin contracted to 37.9% from 38.6% in the year-ago quarter but was above 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 90 basis points (bps) in the quarter.

Operating expenses, as a percentage of revenues, increased 50 bps on a year-over-year basis but decreased 270 bps from the previous quarter to 7.6%. The year-over-year rise was due to higher research & development expense (up 40 bps) in the first quarter.

Operating margin plunged 130 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 350 bps due to higher revenues and lower operating expense.

Net income margin was 22.7% compared with 24.0% in the year-ago quarter and 20.0% in the previous quarter.

Balance Sheet and Cash Flow

Apple’s balance sheet remains strong with cash and investments of $158.8 billion at the end of the first quarter compared with $146.8 billion in the previous quarter. Long-term debt was $16.96 billion at the end of the quarter. Cash flow from operating activities was $22.7 billion in the reported quarter.

Guidance

For the second quarter of fiscal 2014, Apple forecasts revenues to be in the range of $42.0 billion to $44.0 billion. Currently, the Zacks Consensus Estimate for revenues is pegged at $46.03 billion, which we expect to come down going forward.

Gross margin is expected to be in the range of 37.0% to 38.0%, while operating expenses are projected to be within $4.3 to $4.4 billion. Other income/(expense) is forecast to be $200.0 million while tax rate is likely to be 26.2%.

Our Take

Apple reported a mixed first quarter result that failed to impress the market. The company’s second quarter outlook range is inline with the year-ago quarter revenues and is expected to decline significantly on a quarter-over-quarter basis. Despite a refreshed product line-up this modest revenue outlook reflects intensifying competition.

Additionally, following the sluggish unit sales, iPhone 5Cs uncertain future is expected to remain an overhang on the stock.

Nevertheless, we believe that Apple’s strength lies in its ability to innovate. We believe that the company is working on a new gadget, which it expects to launch in 2014. Additionally, shareholder friendly moves such as higher dividend payment and expanded share buyback are expected to drive the stock going forward.

Additionally, Apple’s partnership with China Mobile to sell its iPhones through their expansive network of stores in China seems to be a positive catalyst. This is expected  bolster its growth and profitability going forward.

Currently, Apple has a Zacks Rank #2 (Buy).

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