UBS Global Research analysts Steven Milunovich and Peter Christiansen maintain a Buy rating for Apple Inc. (NASDAQ:AAPL) as margins still look attractive and the introduction of new products are a second-half catalyst.
Underlying profitability starting to see “S-year” benefits
We estimate that fixed cost under-absorption and increased warranty accruals negatively impacted the gross margin by 20 and 60bps, respectively, in F1Q. Fixed cost under-absorption was the primary reason for a lower gross margin in F2013, representing more than half of the decline. This quarter’s negligible impact marks a notable improvement. We expect under-absorption effects to ease during the “S” year. As expected, the step up in the deferred revenue rate lowered the gross margin by 1.5 points YoY. Excluding these items, the gross margin would have been 1.6 points higher with an improving mix shift providing almost all of the gain.
Apple’s regional profitability mixed
Most regions saw a decline in operating margin year-over-year. Japan remained the highest margin country at 48% and China the lowest at 35%. Americas profitability was negatively impacted by fewer Apple Inc. (NASDAQ:AAPL)’s iPhone sales in the US while Japan’s margin decline primarily was attributable to Yen weakness. Offsetting China and a 2.8 point decline in Japan, the rest of Asia improved 3.5 points. Greater China margin at one point was near 50%; faster growth in China will weigh on margins over time.
Decline in Apple’s purchase commitments
Purchase commitments declined 15% from a year ago, perhaps indicating mediocre demand. “Other obligations,” which includes advertising, R&D, and telecom services, typically ramp a few quarters before major product introductions. The current rate is relatively low historically. There was no change in Apple Inc. (NASDAQ:AAPL)’s F14 capital spending outlook of $11bn, up 35% from $8.2bn in F13.
Valuation
We maintain our Buy with new products a second-half catalyst. Potential Apple iPhone maturity is a legitimate concern, but growth should improve as China Mobile Ltd. (ADR) (NYSE:CHL) (HKG:0941) ramps and new products are introduced. Our price target of $625 per share for Apple Inc. (NASDAQ:AAPL) is based on a NTM EV/FCF multiple of 9.5x, more in line with other large cap tech names.
