Apple executives speak: On toaster-fridges, financial guidance, and lawsuits

Apple has unveiled its earnings for another quarter, which usually means two things--a blockbuster financial performance and insights from CEO Tim Cook. The company certainly delivered on the blockbuster performance when it announced second quarter earnings on Tuesday. But this time around, in addition to Cook, chief financial officer Peter Oppenheimer also had a few noteworthy things to say about Apple's fortunes, its product line, and the state of the company. Here are some highlights of what Cook and Oppenheimer had to say to analysts during Tuesday's conference call.

The third quarter will see a sequential downtick, here's why

Oppenheimer: The manufacturing ramps for the iPhone 4S and the new iPad were extremely successful for us. They yielded the highest launch supply and the fastest country rollout for these product families that we've ever had. As a result, we were able to fulfill demand in the March quarter rather than the June quarter this year and that generated revenue of over 39 billion. Therefore, unlike last year, we expect a sequential decline in revenue this year.

I'd highlight five primary factors which has influenced our thinking. The first: the iPhone channel inventory changes. As I discussed in my prepared remarks, we increased our iPhone channel inventory by about 2.6 million units in the March quarter this year, and we exited within our target inventory range of about four to six weeks.

Last year, we continued to add new countries into the June quarter and we built an additional 700 thousand units of iPhone channel inventory last year in the June quarter. So the combination of these channel builds in the March quarter of this year and the June quarter of last year will impact the sequential comparisons from this year to last.

The second factor: Fabulous iPhone 4S execution. As we told you in January, we exited December with significant iPhone 4S backlog, which led to a huge January. We launched China and 20 other countries, also in January, which completed the rollout of the iPhone 4S into all the countries where iPhone is currently shipping. And as I said before, we exited the quarter within supply and demand balance.

The third factor: Our new iPad execution was also fabulous. We had an incredible start with the new iPad. We launched with significant supply, leading to sales of three million units in the first couple of days, which was also the fastest country rollout ever. We therefore were able to satisfy much more the demand for the new iPad in the March quarter this year, compared to the iPad 2 in the March quarter last year. This resulted in a shift of iPad volume into March this year versus last, and it will also affect the sequential compares this year to last.

Fourth, we decreased the entry price of the entry iPad to $399; and finally, the last factor to point out, the U.S. dollar has strengthened recently. We expect this to have an impact on the sequential compare, especially versus last year, where the dollar weakened against most currencies over the comparable time periods.

We've just reported the most amazing March quarter Apple's ever had. We feel very very good about our business and our new product pipeline.

I want to put something out just so it gets out on the call in case it's not asked, and talk a little bit about the gross margin guidance that we've provided for the June quarter.

We're pleased to be providing gross margin guidance of 41.5% for the quarter. We expect about 2/3rds of the sequential decline to be primarily driven by a higher mix of iPads and Macs, a full quarter selling the iPad lineup, and a loss of leverage on our revenue. We expect the remainder of the difference to be primarily driven by the items benefiting the March quarter gross margin that we don't expect to recur in June.

Cook: On the iPhone 4S, our target is to be between four and six, the addition of the 12.6 million allowed us to get within that range by the end of the quarter. We feel that we exited the quarter at supply and demand balance. Because our execution of the option was so good, the vast majority of supply/demand in the different countries was reached in the end of January.

We had the mother of all Januarys with really getting out the vast majority of the iPhone 4S backlog and launching China as well, so it was an incredible start to the quarter for us.

On lower price points

Oppenheimer: We're just learning about the elasticity of demand, and the $399 price point. It's doing well, but I have to tell you, the new iPad is on fire, and we're selling them as fast as we can make them. We'll learn more over this quarter especially as we get through the education buying season, which looks terrific for us, especially on the iPad.

Cook: On iPad 2, with the change in the entry price to $399, we're actually thrilled with the results that we've seen; although as Peter said, it's only been a few weeks and so it's too early to come to a clear conclusion. But from what we are seeing, this unlocked some education demand--that is, probably a more price-sensitive customer--also in several other countries there was a marked change in demand at that price point. And so on the early going, we feel great about it.

But I'd also point out that the new iPad was supply constrained last quarter for the full three weeks or so that it was shipping and is actually still constrained, and so the mix of the new iPad to the iPad 2, we're not certain of what that is yet. But we are certain with what we've seen so far, that the absolute sales of iPad 2, at least in the early going is very exciting.

On the iPhone, we continue to be very happy with the move that we made in pricing just a few months ago on the iPhone 3GS and the iPhone 4, and both of them contributed to our ability to achieve 35 million in sales which is our second highest quarter of all time.

Mac growth slowdowns

Cook: As you said, we did outgrow the market max rate about seven percent, where the market grew about two, and so this is the 24th straight quarter that we've outgrown the market and so we're extremely pleased with that. Compared to last year is largely affected by the fact that we changed the bulk of our portable line--the MacBook Pros in the February timeframe of 2011--and so it's a very tough compare, specifically the portables last year were up 53% year-on-year, and obviously that compare was very difficult.

If you look at it sequentially, you also have to factor in that we had fourteen weeks in the December quarter, so the 26% year-over-year growth in the December quarter is probably more like 17% when you factor out that 14th week. And so, yes, I think there was some cannibalization from iPad, and the market is slow, but the much much larger factor, and in fact it might be the vast majority of the difference, is compared to a year ago.

On the future of tablets, PCs, and hybrid devices

Cook: I think anything can be forced to converge, but the problem is that products are about tradeoffs, and you begin to make tradeoffs to the point where what you have left at the end of the day doesn't please anyone. You can converge a toaster and a refrigerator but y'know, those things are probably not going to be pleasing to the user.

Our view is that the tablet market is huge. And we've said that since day one, we didn't wait until we had a lot of results. We were using them [at Apple], and it was already clear to us that there was so much you could do, and that the reasons that people would use these would be so broad.

And that's precisely what we've seen, the iPad has taken off not only in consumer in a meaningful way, but in education, and in enterprise, and it's sort of everywhere you look now.

The applications are so easy to make very meaningful for someone, and there's such an abundance of those, that as the ecosystem gets better and better and as we continue to double-down on making great products, I think that the limit here is nowhere in sight.

We've now--through the last quarter, I should say, which is just two years after we shipped the initial iPad--we've sold 67 million. To put that in some context, it took us 24 years to sell that many Macs, and five years for that many iPods, and over three years for that many iPhones, and we were extremely happy with the trajectory on all of those products.

I think that iPad... it's a profound product. The breadth of it is incredible, and the appeal is universal. I could not be happier with being in the market, and the level at which we're innovating both the product and the ecosystem here is incredible.

Now in terms of the market itself, IDC and Gartner and Forrester has some numbers out there; I think Gartner is saying there's somewhere around 325 [million tablet devices] or so by 2015, Forrester is 375 million, somewhere around there, and so basically they're in the mid-300s which is about where the PC market is today, and 2015 is only three years from now.

I think even the more formal predictors outside of [Apple] are beginning to see these lines cross, and so I strongly believe that they will. Now, having said that, I also believe that there is a very good market for the MacBook Air and we continue to innovate in that product. But I do think that it appeals to someone that has a little bit different requirements.

You wouldn't want to put these things together because you wind up compromising in both and not pleasing either user. Some people will prefer to own both, and that's great too. But I think to make the compromises of convergence, we're not going to that party. Others might, from a defensive point of view, particularly. But we're going to play in both.

On carrier subsidies

Cook: Our focus is on making the very best smartphone in the world, and a phone that delivers an off-the-charts user experience that customers want to use every day of their lives. And at the end of the day, I think that carriers--the vast majority of carriers, or even all carriers--want to provide what their customers want to buy, and that's what they're most motivated for. And so the most important thing by far is for Apple to continue making great products that customers want, and we are deeply committed to doing this and are innovating at a rate and pace that's unbelievable in this area.

From the carrier's perspective, I think it's important to remember that the subsidy is not large relative to the sum of the monthly payments across a 24 month contract period. Any delta between iPhone and maybe another phone is an even smaller level of difference. The iPhone has some distinct advantages for the carriers over competing smartphones.

For example, many of the carrier executives have told me that returns from iPhone customers is the lowest of any phone they sell in their whole... in all of the phones they carry. That has a significant direct financial benefit to the carrier.

Also, our engineering teams work extremely hard to be efficient with data, and differently than some others, and we believe that as a result of this, that iPhone has far better data efficiency compared to other smartphones that are using an app-rich ecosystem.

Finally, we think that--and this is most important--iPhone is the best smartphone in the planet to entice a customer who is currently using a traditional mobile phone to upgrade to a smartphone. This is by far the largest opportunity for Apple, for our carrier partners, and is a great fantastic experience for the customer. So there's a win-win-win there.

I think that all of these factors are--some of these factors are missed in this general discussion on subsidies.

Spain carriers vs the world

Cook: Spain has been weak for us, and probably more broadly for many companies. Our revenues grew in Spain last quarter but materially less than we grew in Europe or worldwide. However, that wasn't cause-and-effect related to the issue you're on, Spain is just in a terrible economic situation and so I look at that as an unusual case.

To be clear about what was done, there's also some noise in the pipe on this one: What the carriers did was they still have subsidies for their existing customers. I don't want to talk about what their existing customer to new customer ratio is, but you can find out numbers from different parts of the world and model that. They pulled subsidies on new customers, and so it wasn't a pull of all subsidies, it was a pull of subsidies from new. All carriers in that market did not do that, a couple of the carriers did. So I wouldn't necessarily use that as a proxy for the world, I guess is my point.

iCloud and iTunes Match

Oppenheimer: Customers are using all the features of iCloud, response has been terrific, feedback has been terrific.

Pickup on storage [customers purchasing expanded storage or iTunes Match] is occurring and growing, because we just launched iCloud in October and we've now got over 125 million users that have come onto the service since then and they're building up documents and music and other things that they want to store, so I think storage growth will more come over time.

Our real desire here was not about selling more storage. We think Match is a great product and we recommend everybody use it, but it's a paid-for service.

We just really wanted to increase the customer delight from the entire ecosystem and platform of our iOS devices and the Mac, and that's why we've done iCloud; we couldn't be happier that just a couple months into this there's more than 125 million users around the world on iCloud.

On content in iTunes

Oppenheimer: We're actually thrilled with the rate that we're adding content into iTunes. This is something we have to do country by country, so it takes a bit of time to put in place. We have the largest catalogs of songs and movies available anywhere. Over 28 million songs, and this led to almost 1.9 billion dollars of revenue in the March quarter, which was up 35% year-over-year. We're thrilled with the progress that we're making in iTunes, and customers love it.

On China

Cook: It was an incredible quarter in China. Revenue was record, was record at 7.9 billion in greater China, which is up over three times year-over-year and brings the first half revenue for greater China to 12.4 billion. That compares to a full year, last year, of 13.3 [billion], so it is mind-boggling that we can do this well.

Part of this was the pent-up demand for iPhone 4S. As you know, we launched mainland China in January of this year. China was not able to get into the Q1 period, so all of that is in Q2. We also have very strong demand for iPad 2. We have not shipped in mainland China yet the new iPad, although we are shipping in Hong Kong.

It's a combination of these things and the halo that both of these products have produced for the Mac is also incredible. Mac was up over 60% year-over-year, and that compares to a market rate of growth of about 6%.

We have expanded point of sales. On a year-over-year basis, Mac is up 70%, but still in only 1,800 [retail stores] for all of greater China. And so there's obviously a lot more opportunity there. iPhone, we're up over 11,000 [stores], which is 138%, but 11,000 is a much smaller than we have in the U.S., and obviously China will in the next few years be a bigger opportunity. iPad is only in 2,500 points of sale.

Yes, we've expanded, we've expanded a lot, however, there's a lot of headroom there in our view.

[Any different mix of iPhone sales in China vs the rest of the world?]

Cook: I don't have that in front of me, but my recollection is that it wasn't materially different; keep in mind that iPhone 4S just launched within the quarter, and so usually when a new product launches within a quarter you would expect it to mix fairly much toward the new product.

Demand [for the new iPad] has been incredibly robust. We are selling them as fast as we can make them, as Peter mentioned earlier. In China, I believe on a macro basis, China has an enormous number of people moving into higher income groups, middle class if you will. This is creating a demand for goods, not just Apple's but other company's goods as well. I think that there's a tremendous opportunity for companies that understand China, and we're doing everything we can to understand it and serve the market as good as we can.

On potential component shortages

Cook: Tough question to answer. Obviously we're aware of the transition issue you mentioned [regarding Qualcomm chips] with 28 nanometer. We currently do not use 28 nanometer parts, but as you also know we don't comment on future products, so I can't talk about the future part.

Generally, outside of this, we work very closely with our supplier partners, and do everything that we can do to get supply, and sometimes we're successful with that, and sometimes we're not. You can bet that we are focused on anything that we think may impact us in trying to push every button within our disposal to work on it.

On partnering with Wal-Mart

Cook: There's no plan to be in 10,000 [stores]. We're trying some things, and as you know that doesn't include the Mac. We're trying some things and seeing how it goes. They've been a very good partner for us on iPod, been selling iPod for awhile, and are an increasingly more substantial partner in the iPad space as well, and an evolving partner on iPhone. And so, we're working with them, and enjoyed working with them, and hope to continue expanding.

On patents, lawsuits, and settling

Cook: Y'know, I've always hated litigation, and continue to hate it. We just want people to invent their own stuff. If we could get some kind of arrangement where we could be assured that's the case and a fair settlement on the stuff that's occurred, I would highly prefer to settle versus battle.

But the key thing is, it's very important that Apple not become the developer for the world. We need people to invent their own stuff.

On research and development

Oppenheimer: We view [R&D's uptick] as a good thing. We are investing in engineering to continue to bring out the most innovative products in the world to delight customers. We are making investments in our hardware and software engineering teams, we're shipping the best products that Apple has ever shipped today, and we've got some fabulous new products in the pipeline.

On the iPad in the enterprise

Cook: Initially, our focus was on working with the Fortune 500 and the Global 500 to get the iPad certified for their particular enterprise and I'm pleased to report that 94% of the Fortune 500 are testing or deploying iPads, and 75% of the Global 500 are testing or deploying iPads. These numbers are just off the charts for a product that's only 24 months old.

We are moving our focus away from this and focusing on penetration within these accounts. Peter alluded to some of the wins we've had in his opening comments. The incredible things about these are that they span across many verticals, through government, through education, and many different functions within the enterprise.

It's absolutely the most broad base product I have ever seen in my whole career in terms of adoption rate into the enterprise. Yes, this means that we're applying more resources in salespeople to interact directly with these customers. We also work with our carrier partners and our reseller partners in delivering both the product and services that are wrapped around that to these customers.

This story, "Apple executives speak: On toaster-fridges, financial guidance, and lawsuits" was originally published by Macworld.

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