Apple's iPhone 5C Fiasco Is Not the End of the World

By Michael Comeau  JAN 28, 2014 1:25 PM

Apple dropped earnings yesterday, the highlight of which was a massive shortfall in its iPhone business. But that doesn't mean the whole quarter was a disaster.

 


Did the smartphone bear finally bite Apple (NASDAQ:AAPL)?

It's already chomped up Google's (NASDAQ:GOOG) Motorola, HTC (TPE:2498), BlackBerry (NASDAQ:BBRY), and LG (KRX:066570), and even Samsung (OTCMKTS:SSNLF) is taking some punishment as too many smartphones chase too few buyers.

And yesterday after the close, Apple dropped its fiscal first-quarter earnings report, the highlight of which was a massive shortfall in its iPhone business.

Apple did beat Wall Street's earnings and revenue expectations, but it sold just 51 million iPhones, well under the 55 million consensus.

That means with the best smartphone on the market -- the iPhone 5S -- Apple sold just 7% more units than last year within an industry growing at about 40%. (And yes, even at these growth rates, there are still too many phones out there.)

So what happened? Where did things go wrong? Didn't Carl Icahn say this stock was a no-brainer?

Well, one problem was that Apple couldn't meet demand for the iPhone 5S.

The second problem is that nobody cared about the cheaper-but-still-not-quite-cheap iPhone 5C that was introduced alongside the mighty 5S.

On the conference call, CEO Tim Cook didn't come out and say the 5C was a failure, but he definitely implied it underperformed. He did mention that the 5S had a "higher mix of sales" and that the 5C "demand percentage turned out to be different what we thought."

So, Apple overallocated resources to the poorly selling 5C, which caused a shortfall in the 5S, a product seeing legitimate demand.

Apple also said its North American business took a hit due to carriers limiting early upgrades.

Does it make sense to throw the 5C under the bus here?

I think so. I don't know about you, but I can't remember the last time I saw an iPhone 5C out in the wild -- even in the mobile device jungle that is the New York City subway system. I've seen more Microsoft (NASDAQ:MSFT) Windows Phone devices. And I can't remember a single telecom carrier or retailer or market research firm saying anything remotely positive about 5C demand relative to the 5S.

So was the quarter a disaster?

Most definitely not. Apple screwed up a product planning decision, and it's not the end of the world.

Additionally, pricing was quite strong, with the iPhone ASP falling less than 1% in an industry that's seeing monumental deflation.

Plus, iPad sales beat expectations by about 4% at 26 million units. And as with the 5S, Apple faced production constraints with the iPad.

Assuming Apple could have shipped 3 million more iPhones and 1 million more iPads if not for these constraints, it would have brought in $2.4 billion in additional revenue, resulting in an even bigger earnings beat.

And this bring us to Apple's revenue guidance, which has me downright puzzled.

For fiscal Q2 (the March quarter), Apple is forecasting revenues of $42-44 billion, implying a 1.4% year-over-year revenue decline at the midpoint, and growth of 0.9% at the high end. The Wall Street consensus was $46 billion heading into the quarter.

First of all, it's not easy to make the usual "Apple always lowballs guidance" argument. As our friend Herb Greenberg reminded us yesterday, in January 2013, Apple said it was going to start taking a more realistic approach to guidance:

In recent years, our guidance reflected a conservative point estimate or results every quarter that we had reasonable confidence in achieving. Going forward, we plan to provide a range of guidance that reflects our belief of what we are likely to achieve. While we cannot forecast with complete accuracy, we believe we are likely to report within the range of guidance we provide.

On the conference call, Apple cited a number of mitigating factors that would drag revenue down $2 billion relative to last year.

Let's get the easy thing out of the way: The stronger dollar is a problem, and that's largely out of the company's control. Yes, Apple can try to hedge FX risk more, but hedging costs money and with a company so large operating all over the world, it's got to be an enormously complex process.

There's another hit from increased revenue deferrals related to free Mac and iOS software and future upgrade rights. This isn't a brand-new issue, but these types of accounting treatments are difficult to forecast, and in fact, I regard them as anti-investor because they add confusion to the research process. So we can let that one go.

In the bizarro category, there's falling iPod sales, which seems odd to mention because as of now, it's a recurring business. If Apple was planning to shut it down it would be another story, but come on.

The biggest issue, however, according to CFO Peter Oppenheimer, was a lack of channel inventory build relative to last year, but the year-over-year comparisons don't look especially tough. In fiscal Q2 of last year, iPhone units grew just 7% year-over-year, and company revenue grew by 11%.

Plus, you'd think that between the China Mobile (NYSE:CHL) deal kicking in and the opportunity represented by unmet iPhone and iPad demand, that real growth would materialize. Tim Cook emphasized that the underlying sell-in (which is sales from retailers to consumers and businesses) is strong, but still, this guidance looks a little funky in the face of what seem to be some decent tailwinds.

I'm not quite ready to throw in the towel yet because I think Apple's built for the long run in a way no other hardware company is, but some uncertainty is clearly justified here.

Twitter: @MichaelComeau

No positions in stocks mentioned.

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