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Apple’s Results a Mixed Bag, But All Eyes on iPhone 6

New product pipeline buzz and management’s bullishness on holiday revenue growth overshadow modestly disappointing third-quarter revenue, says Morningstar’s Brian Colello.

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 Apple (AAPL) reported solid third-quarter earnings, and gave investors a fourth-quarter outlook that was relatively in line with our expectations. However, the bigger story continues to revolve around buzz for the company’s upcoming products (iPhone 6, new iPads, and a possible iWatch). Management has set a bullish tone for its product pipeline and for revenue growth this holiday season. We expect to maintain our $87 fair value estimate, and Apple's narrow economic moat rating.

Apple’s $37.4 billion in quarterly revenue modestly trailed expectations, as it failed to reach the high end of its previously forecasted range of $36 billion to $38 billion. IPhone unit sales of 35.2 million were a shade below our expectations, but still relatively strong. iPad unit sales of 13.3 million were down 9% from the year-ago quarter, mainly due to soft sales in developed markets. However, Mac sales and iTunes revenue grew nicely, as did revenue from China (iPhone, iPad and Mac sales in the region were up 48%, 50%-plus and 39% from the year-ago quarter, respectively). Favorable component pricing helped Apple earn a healthy 39.4% gross margin, above expectations. Apple projects revenue of $37 billion to $40 billion in the September quarter, which we think implies modest iPhone unit sales growth, to the mid-to-high 30 million unit range.

Management was upbeat about its product pipeline and growth opportunities for the critically important holiday season. One concern around iPhone growth stems from changes to wireless carrier plans in the U.S., but Apple commented that programs like  AT&T (T) Next, which allow for early upgrades, are a net positive for the firm. Apple also expects to revitalize iPad demand with product enhancements. Combined with ongoing traction at  China Mobile (CHL) and reports that the firm is asking its suppliers to build over 70 million new iPhones for its impending launch, Apple may be well positioned for hearty sales growth later this year.

We consider the summer months to be Apple’s slow period, as results pertain to iPhone and other devices that have been on the market for six to nine months, and prices tend to dip as Apple moves away from the launch quarter. That said, heading into this reporting period, our biggest area of interest was iPhone unit sales, particularly in China. We were pleased to see that iPhone sales were up 48% from the year-ago quarter, which we think also implies that unit sales in the region were relatively flattish with the seasonally strong March quarter (which includes the Chinese New Year holiday season). We think this robust sales growth points to healthy ongoing penetration with China Mobile, a trend that should continue into late 2014 and early 2015 once the new iPhone 6 is launched.

Perhaps the more important Apple news this week came from the Wall Street Journal, which is reporting that Apple is asking its suppliers to build 70-80 million new iPhones for its upcoming product launch, as compared to 50-60 million built last year (and 51 million units sold in the December 2013 quarter). We would not use these figures as a one-to-one comparison for demand in the December quarter. Last year, for example, Apple’s 5s/5c launch exceeded expectations, yet only reached the low end of this reported build range. Further, we think it’s reasonable for Apple to frontload any production, as excess devices can continue to be sold in the March quarter as well. However, we’d view a 70-80 million production forecast as a good sign that Apple would anticipate sales of at least 60 million in the December 2014 quarter.

We currently estimate that Apple will sell 60 million iPhones two quarters from now, but suspect that some investors (and perhaps even Apple) are even more bullish. We think this slight disconnect around the iPhone 6 launch is one of two reasons why Apple's $87 fair value estimate trails its recent stock price. For the past 18 months, the bearish arguments around Apple have stemmed from slowing (or no) growth in the premium smartphone space, and fears of a negative iPhone mix shift and pricing declines as a higher proportion of sales are older, cheaper models made to emerging market customers.

We think both factors are still risks for Apple, regardless of whether an iPhone 6 has a 4 inch or 5.5 inch screen. We’re still not on the bearish side of this argument: We forecast some growth from premium smartphone customers in developed markets, and already factor in some gross margin compression associated with an iPhone mix shift. Apple’s comments about U.S. upgrades as part of plans like AT&T Next help to support our iPhone thesis that premium smartphone market growth is still in the cards. However, we don’t think these risks can be completely ignored. We also don’t see how a larger (and perhaps even higher-priced) iPhone would magically mitigate such risks.

Ultimately, we currently project strong (midteens) iPhone unit sales growth in December 2014, thanks to China Mobile penetration, a dominant market share position in Japan, and some U.S. growth among both late smartphone adopters and customers on early upgrade programs. We suspect that significant iPhone growth above and beyond our estimates (mid-60 million units sold) would have to come from direct, massive market share gains against Samsung in the premium smartphone space. We think such gains are possible, but particularly difficult to handicap, especially since the iPhone 6 hasn’t even been introduced yet.

Finally, we suspect that the gap between our fair value estimate and Apple's recent trading range stems from the fact that we exclude any financial contribution from unannounced product categories, such as iWatch, or a revamped Apple TV, into our assumptions. Instead, we view this "black box" of potential new products as positive optionality in our valuation model until such products are announced (including features, pricing, distribution, etc.). That said, we roughly calculate that an iWatch could add about 5% to Apple’s EPS in the long-term. In turn, we’d consider it reasonable to add about $4, or 5%, to our fair value estimate if one were to feel confident about an upcoming iWatch launch.

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Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.