Decoding Apple’s Earnings

There are some brands that consumers just can’t resist–even during a recesion. Apple is one of them. Here are my top three takeaways from Apple’s earnings announcement:

The Mac rules: Analysts were expecting Apple to sell between 2.0 to 2.2 million Macs. In the first three months of 2008, the company sold nearly 2.3 million–handily beating estimates. Both the desktop and laptops are on fire. More than ever, the Mac is the engine of Apple, with the iPod and iPhone sales growth rates slowing. Mac revenues grew 54%, while shipments grew 51%, helping Apple to snag 6% of the US PC market, up from 4.9% a year ago. There is huge upside potential for the Mac–especially as corporations warm up to the platform.

Vertical Integration: Perhaps the most interesting announcement Apple made yesterday had nothing to do with its earnings. By confirming that it had purchased PA Semi, a fabless chip designer, for $278 million, Apple declared a new strategy of vertical integration. It also suggests that Apple will likely expand its product portfolio even further–otherwise why spend money to guarantee your company chip inventory if you were not going to need more of it down the road. The purchase is also a blow to Intel, which hoped that its new low-power Atom chip would be chosen by Apple. Apparently, PA Semi’s chips are very efficient yet powerful, requiring 30% less power.

One interesting side not: PA Semi was founded by a former star engineer of Digital Equipment–Dan Dobberpuhl–who helped design the StrongARM chip that eventually became the XScale processor.

Unlocked phones are a growing problem: The big mystery of the quarter was why Apple lowered its profit forecast from $1.10 to $1. My hunch is that the growing number of unlocked iPhones is the culprit. Most analysts estimate that there are about 1 million unlocked iPhones, or phones that have disconnected from Apple’s preferred carrier of choice. The problem for Apple is that when customers unlock the phones, Apple does not get an undisclosed fee from the carrier. This is not chump change. For every 1 million iPhones that get sold for unlocking, Sanford Bernstein analyst Toni Sacconaghi estimates Apple forgoes $300 to $500 million in future revenues and profits. On the conference call, Apple admitted that the number of unlocked iPhones “remains a significant number.” Analysts estimate about 1 in every 4 phones is unlocked.

Here’s the dilemma, though: If Apple stopped the sale of unlocked iPhones (by forcing customers to activate them at the point of purchase, say) it might miss its target of selling 10 million iPhones in 2008. But if Apple does nothing, its margins and profits take it on the chin. (Unlocked iPhones generate 50% less revenue for Apple and 70-75% less profit, according to Sacconaghi). The black market also crimps Apple’s ability to grow in new markets. If Apple can’t stop the flow of unlocked iPhones into a country like China, why should a local carrier pay Apple a premium for the right to be that country’s exclusive provider?

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