26 Jul 2012

Apple Q3 Results: What the Analysts Missed

Apple Q3 Results

Apple has just announced their financial results for Q3 2012, with quarterly revenue of $35.0 billion and profit of $8.8 billion. The company sold 26 million iPhones and 17 million iPads in the quarter. The results missed analyst estimates by a wide margin and dropped Apple's stock price by 5%. Apple's ultra-conservative forecast for Q4 2012 disappointed analysts & the market as well.

Apple's iPhone sales dropped by about 9 million from the last quarter. This in itself isn't a major cause for worry as it was most likely caused by rumors of the upcoming iPhone launch next quarter. As we have seen before, sales normally slow down before the launch of a major product. However, it is interesting to note that this drop in iPhone sales had minimal overlap with the availability of the Galaxy S3. The true impact of the Galaxy S3 launch should be felt in the Jul-Sep Quarter (Q4 on Apple's financial calendar) and could be a reason for Apple's more-conservative-than-usual forecast. This could also be another reason for rumors of Apple moving up the launch date of the iPhone 5 & iPad Mini to September.

Even though the iPhone sales drop in Q3 isn't cause for much concern, I did notice a few worrying signs in Apple's Q3 results. Let's take a look at these.

Dropping Revenues from China

Apple Q3 China Revenue

Apple's Q2 results were seen as a big win for Apple because of the success of the iPhone 4S launch in China. In the chart above, Apple's revenues from the Asia Pacific (dominated by China) show a distinctly larger drop as compared to other regions. Since iPhone sales form about 50% of Apple's revenues, they are the dominant factor affecting this pattern. Dropping revenues make sense for the other regions as the iPhone 4S was launched in October and consumers are expecting a new iPhone next quarter. However, Apple launched the iPhone 4S through Chinese carriers only last quarter. It is extremely unlikely that Chinese smartphone subscribers expect a new iPhone to be launched in the country just two quarters after the last launch. So, if Chinese consumers are not holding out for the new iPhone, what caused this drop? Apple CEO, Tim Cook, had the following to say:
As a reminder, in the previous quarter in our fiscal Q2, we launched the iPhone 4S in China in January. We added China Telecom as a second carrier in March. And as we proceeded across the quarter, we increased the channel inventory to accommodate the sales and to reach our target inventory of four to six weeks. The remainder of the sequential revenue decline is mainly attributable to normal seasonality after the very successful iPhone 4S launch. We did not see an obvious impact in Q3 that we would associate with the economy in mainland China.
So, according to Tim Cook, the build-up in channel inventory following last quarter's iPhone 4S launch led to lower channel sales in Q3. This means that the huge jump in Q2 iPhone sales was attributable to the channel inventory build-up, as opposed to sales to end consumers. This is similar to what happened to the Kindle Fire in Q1 of 2012. The only conclusion this gives us is that Apple's performance is China isn't as great as the Q2 results made them out to be and seem consistent with reports of the iPhone's market share in China.

Dropping Average Sales Price (ASP)

Despite the 26% sequential in iPhone sales from Q2, Apple reported a healthy 44% increase in iPad sales. The launch of the new iPad drove up unit volume to more than 17 million in Q3. But sales volume doesn't tell us the entire story. Let's take a look at the average sales price of the iPhone and iPad in the last three quarters.

iPhone iPad ASP Q3

Now, dropping ASPs make sense for most smartphone and tablet manufacturers as prices are continually adjusted to account for new product releases. But Apple is a special case here since they only launch one product a year and pricing is constant until the new product is launched. Therefore, the only explanation for dropping ASPs is that more and more consumers are buying older products, once the price is cut, or lower storage products that give Apple smaller margins. 

Since the iPhone 4S was launched in Q1, along with the lower priced iPhone 4, the drop in ASP is understandable. The bigger concern here is that even the launch of the new retina equipped iPad in the last quarter did not boost the iPad's ASP. This could only have been caused by significant cannibalization of new iPad sales by the $399 iPad 2. Based on this data, Apple can expect the new iPad Mini to cause even greater cannibalization of existing iPad models. Therefore, Apple would most likely need to limit iPad Mini storage options to 8GB only and price it at $299 in order to keep cannibalization of higher margin products at a more manageable level. This wouldn't be a great move from a market share perspective, but it would help Apple in maintaining its gross margins near current levels.

Conclusion - While Apple's Q3 results show a huge drop in iPhone sales, this is just a seasonal variation and not a long-term impact. The iPhone's performance in China and the dropping ASPs of the iPhone and iPad are greater cause for concern going forward. The drop in iPad's ASP may even have repercussions on Apple's strategy for the iPad Mini.