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Apple Turnaround May Become Reality

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Apple (NASDAQ: AAPL) reported a fairly solid quarter. While many may like to dismiss the potential of Apple, and what it can offer investors, I have to be a bigger optimist than the rest of the Street. It is really hard to find a product that brings out greater life from its consumers than an Apple can. Perhaps, just a bit of the rebelliousness within all of us is satisfied by being an Apple customer.

Earnings went all over the place

The company was able to generate some fairly strong revenue growth from its tablets. Gross margin compression came as a result of some unfavorable accounting changes, along with greater contribution from the Apple iPad mini. The problem with the Apple iPad mini is that it has a lower gross margin, which lowered the total gross margin of the company to 37.5% from a 47% gross margin a year earlier. The lowered margin is a discouraging signal, as Apple has finally resorted to lower-pricing in order to maintain its competitive position in tablets.

On the bright side, the company was able to grow revenue by 7% in the Americas (year-over-year). The seasonal demand has definitely dropped off with quarter-over-quarter revenue declining by 31% (consumer electronics tend to experience added demand toward the holiday season). Apple’s revenue growth was driven by the iPad (which grew by 40% year-over-year). iTunes also contributed to revenue growth by 30% year-over-year (although its impact is fairly immaterial to shareholders). That being the case, iPhone unit volume rose by 7%, part of the weakening volume was the lack of support from China as China year-over-year revenue only rose by 8% (analysts were hoping for China to contribute more to top line performance). The iPhone generated revenue growth of 3% year-over-year. Consumers aren’t anticipating a new iPhone model until the middle or end of 2013. The first quarter growth performance shouldn’t be troubling, as Apple’s revenue growth is likely to improve due to a product refresh cycle, the larger build out of 4G LTE on Sprint, Verizon, and AT&T networks should encourage product upgrades in fiscal year 2013.

Apple’s net sales grew from $39.186 billion to $43.603 billion, year-over-year. The growth in sales was also followed by cost increases. With the cost of sales increasing from $20.6 billion to $27 billion year-over-year, total operating expenses increased from $3.180 billion to $3.791 billion. The company reported a decline in net-income (guess there’s a first for everything). The company reported $9.547 billion in net income; year-earlier net income was at $11.622 billion. Net income declined by a staggering 17.8%, year-over-year. With earnings per share declining from $12.45 in 2012 to $10.16, Tim Cooks announced a $100 billion share buy-back program in order to boost the earnings per share figure. The recent share buy-back announcement is the biggest in corporate history. Returning cash to shareholders became a priority as the company’s basic EPS figures tanked in the latest earnings announcement.

How this announcement affects others in the space

The iPad mini certainly made it more difficult for Microsoft (NASDAQ: MSFT) to enter the tablet space, leaving Intel shareholders bummed out. Intel’s attempt into mobile was thwarted by the Apple-Qualcomm duo. That being the case, Microsoft’s position in consumer electronic is likely to improve with the launch of its Xbox 720, rumored to come in Christmas of 2013. Microsoft’s bigger growth catalysts will be Skype, which grew call volumes by 50% over the previous year. Skype will be integrated with Microsoft messenger and will also be on Xbox 360’s. Xbox live was able to increase its membership figures by 18%. Microsoft’s launch of Windows 8 will be a financial success, as Microsoft’s dominance in the desktop computing space is pretty well established.

Apple investors shouldn’t expect Microsoft to encroach upon the tablet territory with any reasonable financial success. But, at the same time, Apple shouldn’t be able to expect any significant improvements in desktop and laptop sales, as Microsoft’s Windows 8 launch is likely to keep Microsoft’s position in the computing space firmly established. Apple’s Mac division generated 7% year-over-year growth in the latest quarter, while Microsoft’s Windows division was able to grow revenue by 23%, comparatively.

Amazon’s (NASDAQ: AMZN) Kindle will continue to be crushed by the iPad mini. I can literally hold the iPad mini in one hand (show-stopper); case closed. Apple was able to grow iPad sales by a staggering 40%, year-over-year.

Amazon, on the other hand, doesn’t fully divulge the performance of its Kindle division. The unit volumes are likely to be in the millions (whole-year), based on estimates from experienced bloggers in the finance space (hardware has higher profit margins). As of Amazon’s latest earnings announcement, the company generated a profit margin figure of -0.06%. The decline in profitability could be off-set with hardware sales (higher profit margins), but then again the Kindle is priced so low $69-$269. I highly doubt Amazon’s Kindle is driving any serious margins to its bottom line. The Kindle Fire, at $269, is the closest competitor to Apple iPad Mini ($330). The Apple iPad mini has the “cool factor,” plus the app store, iBook store, and the Amazon store, so why bother buying the Kindle? Good point, let’s just trashcan the Kindle, as the iPad Mini is a proven financial success. Apple doesn’t mind bragging about its iPad mini’s success, despite hurting the company’s gross margin figures for the quarter. The Kindle, on the other hand, has to be swept underneath the rug, as Amazon doesn’t want to reveal the Kindle’s unit volumes (I dug through the annual report, it’s not there).

Conclusion and outward guidance

The first quarter is always the toughest quarter for technology stocks. Consumer electronics are driven by consumer sentiment. Demand for consumer electronics is seasonal. Likewise, investors shouldn’t read too deeply into the first quarter, as it is likely that Apple will make up for its EPS losses through share buy-backs, iPhone refresh (iPhone 6), and incremental revenue improvements from its iTunes and iPad division.

There are rumors that Apple will come out with a lower-priced iPhone for the Chinese market, which will hurt profit margins but increase total profitability. What could generate some steam is the Apple iWatch. I like the idea of immersive-wearable-computing. It’s a trend that’s building up steam. Maybe the watch will give out beams of light, like Cyclops from X-Men. Okay, that was dumb. But, perhaps the watch will synchronize with your iPhone. After all, I’d prefer talking directly to my watch, rather than going through the added motions of pulling my iPhone out from my pocket. The iWatch is a product compliment that could make up for declining iPod sales (iPod sales declined by 20% year-over-year). The Apple iPhone made the iPod Touch completely unnecessary (creative destruction). Wearable computing could be the next growth category, as it is expected to make up for lost sales from iPod product cannibalization.

Analysts, on a consensus basis, anticipate earnings to decline by 1.10% in 2013. The decline in EPS will most likely be offset through the $100 billion share buy-back program, which will inflate EPS. Apple expects gross margins to stay at 37% for the third quarter. Assuming revenue continues to grow, and margin remains stable, the net income may beat the negative 2.6% year-over-year growth estimates analysts have for the next quarter.

Apple’s position may turn around going forward. Wearable computing, product refresh, and share buy-backs could put a floor beneath the price of the stock. Longer-term investors may breathe a sigh of relief, for once.

Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Apple. The Motley Fool owns shares of Amazon.com, Apple, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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