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Apple Inc. (AAPL - Analyst Report) reported earnings of $10.09 per share that missed the Zacks Consensus Estimate by approximately 9 cents in the second quarter of 2013. Earnings per share declined 18.0% year over year and 26.9% sequentially in the reported quarter.

Revenues

Total revenue was up 11.3% year over year but declined 20.0% sequentially to $43.60 billion, slightly ahead of the company’s guided range of $41.0 billion to $43.0 billion. However, revenues fell shy of the Zacks Consensus Estimate of $44.30 billion for the fourth consecutive quarter.

iPhone unit sales climbed 7.0% year over year but decreased 22.0% from the previous quarter to 37.43 million. Revenues climbed 3.0% from the year-ago quarter but plunged 25.1% from the previous quarter to $22.96 billion in the reported 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 GlaxoSmithKline (GSK - Analyst Report).

iPad unit sales jumped 65.0% year over year but plunged 40% sequentially to 19.48 million. iPad revenues were up 39.6% year over year but declined 18.1% quarter over quarter to $8.75 billion in the quarter.

Apple experienced strong iPad sales in most of its markets, particularly in Greater China (up 138.0% year over year) and Japan where sales more than doubled on a year-over- year basis.

Apple shipped 3.95 million Macintosh in the reported quarter, down 2.0% from the year-ago quarter and 3.0% on a sequential basis. Revenues increased 7.0% year over year but declined 1.0% quarter over quarter to $5.45 billion.

iPod units and sales on a year-over-year basis continued to decline in the quarter. Apple sold 5.6 million iPods (down 27.0% year over year) and earned $962.0 million (down 20.0% year over year) in the quarter. On a sequential basis, iPod shipments and revenues plunged 56.0% and 55.0%, respectively.

Revenues from iTunes/ Software/ Services improved 30.0% year over year and 12.0% sequentially to $4.11 billion. Accessories surged 15.0% from the year-ago quarter but decreased 25.0% from the previous quarter to $1.38 billion.

Retail revenues in the quarter increased 19.1% year over year but declined 18.6% sequentially to $5.24 billion. At quarter end, Apple operated 402 stores worldwide, of which 151 are located outside the U.S.

Greater China revenues increased 7.5% year over year and 20.2% sequentially in the reported quarter. Rest of Asia-Pacific and Japan grew 25.7% and 18.5% year over year, respectively. On a sequential basis, Rest of Asia-Pacific and Japan declined 20.8% and 29.4%, respectively.

Americas grew 6.6% year over year while Europe increased 11.3% from the year-ago quarter. However, sequentially Americas plunged 30.9% and Europe fell 21.4% in the reported quarter.

Margins

Gross margin contracted to 37.5% from 47.4% in the year-ago quarter and met the lower end of management’s guided range of 37.5% to 38.5%. On a sequential basis, gross margin declined 110 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 60 bps year over year and 160 bps from the previous quarter to 8.7%. The rise was due to higher research & development expense (up 50 bps year over year and 70 bps sequentially) in the second quarter.

Operating margin plunged to 28.8% from 39.3% reported in the year-ago quarter, reflecting lower gross margin base. On a sequential basis, operating margin contracted 280 bps to 28.8%.

Net income as a percentage of revenues was 21.9% compared with 29.7% in the year-ago quarter and 24.0% in the previous quarter.

Balance Sheet and Cash Flow

Apple’s balance sheet remains strong with cash and investments of $144.7 billion at the end of the second quarter compared with $137.1 billion in the previous quarter. Cash flow from operating activities was $12.5 billion in the reported quarter.

Third Quarter Guidance

For third quarter 2013, Apple forecasts revenues to be in the range of $33.5 billion to $35.5 billion. Gross margin is expected to be in the range of 36.0% to 37.0%, while operating expenses are projected to be within $3.85 to $3.95 billion range. Other income/(expense) is forecasted to be $300.0 million while the tax rate is likely to be 26%.

Apple expects to open approximately 30 new stores and remodel at least 20 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.

Capital Return Program Details

Apple announced significant expansion of its share repurchase activity and dividend payout by allocating $100.0 billion (up $55.0 billion from the program announced last year) for the program. The company expects to buy back shares worth $60.0 billion (up from $10.0 billion of the last year program) by the end of 2015.

Apple also raised the dividend payout by 15.0% to $3.05 (up from $2.65) per share. Going forward, Apple expects to tap the U.S debt market and has already secured debt ratings from S&P and Moody’s (MCO - Analyst Report).

Our Take

Apple’s not so impressive second quarter results reflect the fundamental challenges it currently faces in the market. Lack of innovation in its product pipeline (Apple does not expect to launch any new product over the next two quarters), declining margins and significant competition in both domestic and international markets will remain an overhang on the shares in the near term.

Nonetheless, we believe that Apple’s growth story is based on its Apps, iCloud and loyal customer base. Apple is also well positioned to gain from international expansion going forward. Moreover, the recent 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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