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Apple Shares Fall on 3Q Miss

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Shares of Apple Inc. (AAPL - Free Report) plunged 5.51% to $567.80 in after-hours trading, on the heels of a lackluster third quarter of 2012 by the iPhone maker. Apple reported earnings of $9.32 per share, which missed the Zacks Consensus Estimate by 10%.

Earnings increased 19.6% from $7.79 per share earned in the year-ago quarter and were also ahead of Apple’s conservative guidance of $8.68. The year-over-year growth was driven by higher revenue in the quarter.

Apple’s third-quarter miss was primarily due to lower-than-expected iPhone sales, which reflects that consumers deferred their purchases based on the rumors surrounding the release of iPhone 5. This negatively impacted the sales growth on a sequential basis, as it declined a massive 28.0% since the release of iPhone 4S in October 2011.

Revenue Details

Total revenue was up 22.6% year over year to $35.02 billion and beat the company’s forecast of $34.00 billion. However, revenue fell shy of the Zacks Consensus Estimate of $37.49 billion. The year-over-year upside in revenue was primarily driven by strong iPad sales in the quarter.

iPad tablet unit sales surged 84.0% year over year to 17.0 million. Revenue shot up 52.0% year over year to $9.17 million in the quarter. However, iPhone was the major disappointment in the quarter, as unit sales increased only a modest 28.0% year over year to 26.03 million, well below 28.4 million expected by Bloomberg. Revenues, however, were up 22.0% year over year to $16.25 billion in the quarter.

Apple shipped 4.02 million Macintosh computers in the reported quarter, up 2.0% annually. However, revenue declined 3.0% year over year to $4.93 billion, primarily due to sluggish sales of desktops (down 19%), partially offset by strong portables (up 3.0%).

iPod unit and sales continued to decline in the quarter. Apple sold 6.75 million iPods (down 10.0% year over year) and earned $1.06 million (down 20% year over year) in the quarter. Revenue from music related products and services (iTunes store, App Store, iBookstore in addition to sales of iPod services and accessories) improved 31.1% year over year to $2.06 million.

Retail revenues in the quarter increased 16.5% year over year to $4.1 billion, primarily attributable to higher iPhone and iPad sales. During the quarter, Apple opened 9 new retail stores. At quarter end, Apple operated 372 stores worldwide.

Apple achieved growth in most of the geographies, with the strongest being Japan and Asia-Pacific. Apple earned $5.7 billion in China, up 48.0% year over year. iPhone revenues surged 100% year over year in China, primarily due to the strong demand. However, this was partially offset by sluggish demand in Europe.

Operating Details

Gross profit jumped 25.8% year over year to $14.99 billion in the third quarter. Gross margin expanded 110 basis points (bps) year over year to 42.8%, well above management’s forecast of 41.5%, driven by lower commodity and other product costs, partially offset by stronger mix of iPad sales, higher mix of lower priced iPhones and a strong U.S. dollar.

Operating expenses spiked 34.5% year over year to $3.42 billion, much higher than management’s expectation of $3.3 billion. Operating expenses, as a percentage of revenue, expanded 90 bps annually to 9.8%, driven by strong growth in research & development expense (up 30 bps) and selling, general & administrative expense (up 60 bps) in the third quarter.

Operating profit increased 23.4% year over year to $11.57 million. Operating margin increased slightly (20 bps annually) to 33.0%, reflecting strong growth in operating expenses but was fully offset by a higher gross margin base in the quarter.

Other income & expense surged 67.4% year over year to $288.0 million, much higher than management guidance of $175.0 million. Net income increased 20.7% year over year to $8.82 billion in the quarter.

Balance Sheet

Apple’s balance sheet remains strong with cash and investments of $117.2 billion at the end of the quarter compared with $110.2 billion in the previous quarter. Apple recently announced a dividend of $2.65 per share payable on August 16, this year. Apple’s Board of Directors also authorized a three-year share repurchase program worth $10 billion, starting from fiscal year 2013.

Fourth Quarter Guidance

For the fourth quarter of fiscal 2012, Apple expects revenues of approximately $34.0 billion. Earnings are projected at approximately $7.65 per share. Apple expects gross margin to be 38.5%, reflecting stock-based compensation expense of approximately $70.0 million.

Operating expenses are estimated to be $3.5 billion, including about $390.0 million in stock-based compensation, while other income and expenses are anticipated to be around $175.0 million. The tax rate is estimated to be about 25.5%.

Our Take

Apple has outperformed the broader market in recent times. Apple shares have surged 46.13% year to date compared to a 4.8% growth in S&P 500. However, we expect Apple shares to remain range bound in the near term.

We believe that consumers will continue to defer their purchases based on the rumors surrounding the fall release of iPhone, which may hurt Apple’s top-line growth in the upcoming fourth quarter. Although Apple continues to update its major product lines on a regular basis, we don’t see a new catalyst (such as a new product like iTV) in the horizon, which will drive the shares in the near term.

Apple continues to face increasing competition from Google’s Android based products manufactured by Asian handset and tablet makers like Samsung and HTC. Although Apple has been trying to block the sales of products from these companies all over the world, its efforts have not been entirely successful.

The company has lost significant battle against Motorola (now owned by Google) and HTC lately. Its success rate against ally-turned-foe Samsung is also mixed. In the first quarter, Samsung replaced Apple as the top smartphone seller with approximately 26.0% global market share.

We believe that Samsung will continue to grab market share, particularly in the developing countries such as China, based on its diversified product portfolio that caters to every income group. Apple’s ability to spur the popularity of its products in developing nations, where pricing is often an important consideration, will go a long way in deciding the company’s future growth, in our view.

Despite these near-term headwinds, we believe that Apple remains the biggest growth story over the long term based on its superior product pipeline, Apps, iCloud and loyal customer base. Apple is also well positioned to gain from international expansion going forward, in our view.

Moreover, the recent shareholder friendly moves such as dividend payment and share buyback are expected to drive the stock going forward.

We maintain our Outperform recommendation over the long term (6-12 months). Currently, Apple has a Zacks #3 Rank, which implies a Hold rating in the near term.

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