Arik Hesseldahl

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Apple Talks Lower Margins Now, Ginormous Sales Later

Apple just reported another one of those uncomfortable quarters where consumers were holding back and waiting for new stuff. And it showed.

Profits on a per share basis at $8.67 were well short of the $8.75 analysts had expected, even though they were up 24 percent year on year. Sales, though ahead of the consensus, were a little light, too, at $35.97 billion.

Obviously, there was a lot of pent-up demand for new iPads, which Apple announced last week, new Macs, and even iPhones in the quarter. That means that having come in a little light this quarter, expectations for Apple to make it up in the first quarter — including the holiday period — will be higher.

The earnings conference call is just about to start. We’ll see what Apple executives have to say about all this.

Update: So the call is over. There were a handful of interesting comments from Apple CEO Tim Cook and CFO Peter Oppenheimer. One came by way of explanation for the lower-than-expected profits and gross margins. All those new products that Apple released this week? They’re a little more expensive to make than the prior generation. And so gross margins are a little bit lower than they otherwise would have been.

Another interesting admission concerned the iPad mini. Its gross margin, Oppenheimer said, is a little “lower than the corporate average.”

But just wait until the first quarter of Apple’s fiscal year 2013, now in progress. That’s the holiday season quarter, and all those products are going to start selling. Oppenheimer said Apple expects to report sales of $52 billion in a single quarter. For perspective: That’s nearly $10 billion more than the revenue Apple reported for the entire year in 2009.

Here’s my rough transcript of the earnings conference call.

2:02 pm: And the call is getting under way. CFO Peter Oppenheimer is speaking.

Oppenheimer: 4.9 million Macs is 1 percent growth, and a record for a September quarter, and is better than the 8 percent market contraction that IDC predicted.

Oppenheimer is now running through the product announcements made earlier this week.

Mac Channel inventory is three to four weeks, below target of four to five weeks.

Now he’s talking about iPod, which is still the top selling MP3 player in the world. Apple sold 5.3 million iPods during the quarter.

iTunes brought in $2.1 billion in revenue. A revamped iTunes is coming. No mention yet of the radio service that was reported earlier today and totally killed Pandora shares.

Oppenheimer: Now speaking about iPhone 5. Demand has been phenomenal, he says. Demand outstrips supply. We ended the quarter with 9.1 million iPhones in channel inventory and that’s below target of four to six weeks channel inventory.

Oppenheimer: Talking about business adoption of iPhones. Canon has given them to its field sales team.

2:08 pm: Oppenheimer: Amtrak uses an in-house app for ticketing; reporters around the world are using iPhones to capture video.

And now he’s talking about iPad. They were ahead of our expectations. Strong sales year over year.

Oppenheimer: Recognized revenue from iPad and accessories was $7.5 billion vs. $6.9 billion. Ended quarter with 3.4 million iPads in inventory, just higher than the target of three to four weeks.

Oppenheimer: Volkswagen has developed in-house iPad apps across the company. Also a Chinese insurance company, the name of which I will not attempt to spell.

Oppenheimer: We will not stop until Maps — the troubled iPhone app — lives up to our standards.

Oppenheimer: Apple finished the quarter with 390 stores.

Oppenheimer: Operating expenses were $3.5 billion. Cash: $121.3 billion up from $117.2 billion last quarter. Increase was net of $2.5 billion worth of dividends paid, which amounts to $2.65 a share. About 82 percent of cash was offshore. Also, in August, Apple said it would buy back some shares.

Oppenheimer: Here’s the outlook. Revenue at $52 billion vs. $43.6 billion. Gross margin 36 percent. Opex $4.05 billion. EPS $11.75.

2:17 pm: Oppenheimer is wrapping up which means its almost time for the Q&A.

Katy Huberty: Asks about the possibility of EPS declines year on year. What’s driving the gross margins down?

Oppenheimer: The change year over year is being driven by the extra week last year. That along with a stronger U.S. dollar and the change in gross margin.

Oppenheimer: As you pointed out, this is the most prolific product period in Apple’s history. New products represent 80 percent of expected revenue. We’ve never before introduced so many new products with new form factors at once, and each one has higher costs. (I’m paraphrasing here.)

Oppenheimer: We’re heading into the quarter with the strongest iPhone line-up ever. Also, the iPad mini is priced aggressively. Its gross margin is significantly below the corporate average. (I guess that answers the critics who said the price wasn’t low enough!)

2:22 pm: Oppenheimer: We will work hard to get down the cost curves and improve our efficiencies. To be in a position to anticipate demand for $50 billion or more in revenue reflects our strength.

CEO Tim Cook is speaking: We’re unwilling to cut corners. This is the reason our customers choose to buy our products. We’re managing the company for the long run and will make great long-term decisions.

Question from Bill Schope of Goldman Sachs: Asking about the supply ramp for the iPhone in the holiday quarter.

Cook: Demand for iPhone is extremely robust. We are in a significant state of backlog right now. Our output has improved significantly. I’m very pleased with the progress. This is the largest volume ramp in Apple’s history. Difficult to predict when supply and demand will balance.

Question from Toni Sacconaghi from Sanford Bernstein. He’s asking again about the ramp of iPhone. Do you expect all 100+ countries this quarter? And will the supply contraints have material impact on cost of goods sold? Will COGS decline?

Cook: In regard to the first question, we still continue to expect to roll out to 100 countries. It is our largest ever, there will be some larger countries in December. With each new product we see learning curves in terms of production. The difference is the number of new products that we have moving at once. This is the most prolific period in our history in terms of new product introductions. We do see all of these costs associated. But I don’t see costs accelerating on a per-unit basis.

2:28 pm: Cook we continue to be confident that the tablet market will surpass the PC market. It is already extremely compelling for many customers to choose a tablet, in particular an iPad, over a PC. There is an enormous opportunity for Apple there. We do think the iPad, mini and iPad 2 will all be an extremely attractive offering in lieu of a PC. We will focus on the future of the iPad.

Question from Shannon Cross: Talk a little about China. Clearly with the revenue guidance it remains strong, but with the economy it’s mixed.

Cook: Revenue was $5.7 billion. IPad was up 45 percent in Greater China. Iphone was up 38, all in all a fantastic quarter in China. That brings us to a full year $23.8 billion in China, which is really phenomenal when you think about it. That’s up $10 billion year on year, and amounts to about 15 percent for all of Apple. We are continuing to invest in our retail stores there. We continue to expand distribution with channel partners there. We see it as an extremely exciting market.

2:32 pm: Cross again: With the launch of Microsoft Surface today, talk about the competitive landscape.

Cook: I haven’t played with a Surface yet. What we’re reading about it is that it’s a fairly compromised and confusing product. One of the toughest things you do with a product is make hard trade-offs and decide really what it should be. I suppose you could design a car that flies and floats, but I don’t think it would do all of those things very well. I think people, when they look at the iPad versus competitors, they will conclude they really want an iPad and they will continue to do that.

2:33 pm: Question from Ben Reitzes at Barclays: Is there more of an education focus with the mini? How do we think about the cannibalization of the form factor vs. the old product?

Cook: The way we look at this is that we provide a fantastic iPod touch, an incredible 4th generation iPad, and mini. The customer will decide what they would like and will buy them. We’ve learned over the years not to worry about the cannibalization of our own product. There’s still 300 million PCs being bought each year and a great many of those will be better off with an iPad or a Mac. Instead of being focused on cannibalizing ourselves, its really an enormous incremental opportunity for us.

Reitzes is asking about AppleTV. We haven’t heard about your hobby lately?

Cook: We sold 1.4 million AppleTVs. That’s more than 5 million during the fiscal year. Almost double the previous year. The business continues to do very well, but if you look at the revenue of the business versus the others, it’s quite small. Still a hobby, but a beloved hobby. We’ll continue to pull the string and see where it takes us.

2:37 pm: Gene Munster asking about the deceleration of iPad sales.

Cook: June to September quarter was 17 million to 14 million. June contained a 1.2 million increase in channel inventory. The sell-through looks different from reported sell-in numbers. The 14 million exceeded what we expected to do in iPad. We expected it to decline. Based on prior results, we would see a seasonal reduction in the September quarter. K-12 schools buy heaviy in the June quarter, versus the higher ed market. That is exaggerated when we announce a new product in March and have enormous demand in June and then a natural phase down. In addition to all that, it’s clear they held back on purchases due to new product rumors. These intensified in September.

2:39 pm: Cook: On a year-over-year basis, because of the year-ago quarter having a channel inventory build, the sell-through grew 44 pecent, so the underlying sell-through was extremely strong. We feel great about how iPad has done.

Munster: Given what we’re seeing in margins, as some of these products get more expensive, would you be willing to pass those costs onto customers?

Cook: It’s a hypothetical question. We think we’ve made great choices here.

Question from Mark Moskowitz: He’s asking about iPhone and iPad comparisons in sequential quarters.

Oppenheimer: We expect large sequential increases.

Moskowitz: Asking about iPhone 5 rollout. Will you have supply contraints in all markets or will there be certain markets where you intend to hit equilibrium?

Cook: What we did initially, we planned the first 30-40 countries, and rolled that across September in two different dates. We planned with an eye toward supply and what we think the demand will be. We do plan these in advance. It is not a precise science. We have to plan them with several weeks of notice. Occasionally it can be different than what we think.

Question from Steve Milunovish of UBS: Asking about pricing philosophy of the iPad mini.

Oppenheimer: When we set out to build the iPad mini, we didn’t set out to build a small cheap tablet. We set out to build a smaller device with the full iPad experience.

2:45 pm: Cook: We try to create a product that people will love for months and years and continue to use it in a robust way. You can really see that by looking at usage statistics. More than 90 percent of Web traffic from tablets comes from iPads. Apple will not make a product that people rarely use once they get it home. (Paraphrasing.)

2:46 pm: Milunovich is asking about the enterprise opportunity.

Cook: We now have almost all of the Fortune 500 who are testing or deploying iPads. We’ve also pushed fairly aggressively in the Global 500 and those are above 80 percent on iPhone and iPad. We’re doing fairly well there. There’s clearly much more to do but I’m felling pretty good about it.

2:47 pm: Question about the component environment (didn’t catch the name of who’s asking).

Cook: In terms of iPad and iPhone, I don’t see a component shortage gating us for the quarter in the numbers we have given you in the guidance. I think we have solved some challenges there and feel good about our position.

In terms of general shortage, the iMac will be constrained in a significant way. There will be a short amount of time during the quarter to build them. We will have a significant shortage there. (Hint: If you want an iMac, order it right away!)

2:50 pm: ISI, Brian Marshall asks about iPhone unit growth vs. revenue growth. He’s seeing a variance between that pattern and the iPad. Is it less accessories or a dollar spend?

Oppenheimer: The iPhone ASP were relatively flat year on year and up slightly sequentially. Ipad ASPs were down year on year in a low-double-digit way. This was reflective of price reduction on iPad 2 and stronger dollar and a little change in the mix. That drove the ASP change year on year. Sequentially, ASP was flat.

Marshall is asking about U.S. iPhone activations being faster than international.

Cook: We launched iPhone 5 during the quarter. I would have expected that versus the rest of the world.

2:52 pm: Question from Keith Bachman, BMO: Will the iPhone 5 launch in China in the December quarter?

Cook: Yes, it will.

Bachman: Will you end the quarter with a backlog?

Cook: I am not projecting whether supply and demand will be in balance. I’m confident we’ll be able to supply quite a few during the quarter. Demand is very robust.

Chris Whitmore of Deutsche Bank asking about the iPad. Specifically asking Cook for his view for emerging model of subsidies on tablets. Like Amazon’s Kindle Fire. How is that impacting the iPad business?

Cook: We’ve seen low-cost challengers before. Ipad beats every product at any price. We’re confident our focus on making the best product is what will win at the end of the day and we will stay true to that.

Whitmore: Asking about suppliers. Is that creating an added layer of complexity and to what extent is that contributing to higher cost structure?

Cook: I would not say there has been a significant change in supplier partners. I wouldn’t describe any change as significant. There hasn’t been one that would drive more cost.

Whitmore: I was asking about LCD screens and Samsung.

Cook: No change in cost, and we continue to have a commercial relationship with Samsung (despite the epic lawsuits).

2:57 pm: Question from someone whose name I didn’t get: Why is the time for iPad mini now right?

Cook: The comment that I think you’re referencing are comments that Steve Jobs had made about 7-inch tablets. We would not make a 7-inch tablet. We don’t think they’re good products. We would never make one. One of the reasons is size. Not sure if you saw our keynote, but the difference in just the real estate size in 7.9 vs. 7 is 35 percent, and when you look at usable area is much great than that, more like 57 percent. IPad mini has the same number of pixels as the iPad 2 does. You have all 275,000 apps that are iPad ready. IPad mini is a fantastic product, it is not a compromised product. It’s in a whole different league.

Sorry, I missed that guy’s second question. Oppenheimer is now speaking about gross margins and the effect on them by the sheer number of products that Apple just announced.

Oppenheimer: We are also going to work to get down the cost curves as we have done in the past. No change in what we try and work on and we’ll report to you in January how we did.

And that’s it. Thanks for being here.

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I think the NSA has a job to do and we need the NSA. But as (physicist) Robert Oppenheimer said, “When you see something that is technically sweet, you go ahead and do it and argue about what to do about it only after you’ve had your technical success. That is the way it was with the atomic bomb.”

— Phil Zimmerman, PGP inventor and Silent Circle co-founder, in an interview with Om Malik