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Apple Inc. (AAPL) reported robust sales and earnings growth in the third quarter of 2011.

The company’s earnings per share (EPS) comfortably exceeded the Zacks Consensus Estimate of $5.81 per share by $1.98 (34.1%) in the quarter.

Operating Performance

Apple reported earnings of $7.79 per share in the third quarter, well ahead of its conservative guidance of $5.03. Earnings shot up 122.0% from the year-ago quarter.

Net income stood at $7.31 billion, reflecting a remarkable growth of 124.7% from $3.25 billion in the previous year.

Gross margin expanded 170 basis points (bps) year over year to 41.7%, well above management’s forecast of 39.0%. Operating margin increased to 32.8% from 27.0% in the year-ago quarter.

The margin expansion was due to a higher mix of iPhone and lower commodity and other costs. Total operating expenses increased 33.7% year over year to $2.54 billion (down 320 bps to 8.9% as a percentage of revenue).

Revenues

Total sales in the reported quarter surged 82.0% year over year to $28.57 billion, representing the highest sales in the company’s history. The growth was primarily driven by strong sales of the iPhone and the iPad.

Revenues beat the Zacks Consensus Estimate of $24.87 billion and Apple’s own forecast of $23.00 billion. International sales accounted for 62.0% of the total revenue in the quarter.

Product Highlights

Macintosh: Apple shipped 3.95 million Macintosh computers in the reported quarter, representing a 14.0% year-over-year increase, attributable to strong demand for Macs across all geographic regions. In the Asia-Pacific region, Mac sales grew 57.0% year over year. The growth in Mac sales was driven primarily by strong sales of MacBook Air and MacBook Pro. In May 2011, Apple updated the iMac with its next-generation quad core processors, powerful new graphics, high speed input/output technology and a new space time, high definition camera.

Apple outperformed the personal computer (PC) market for the 29^th consecutive quarter, which according to research group IDC, increased 3.0% in the quarter ended June 30, 2011.

Apple is set to launch the new Macintosh operating system Lion on July 21, 2011. The new operating system includes more than 250 new features such as a multi-touch gestures, system-wide support for full screen apps, mission control and many other features. We believe the new operating system will further boost Apple’s revenue growth going forward.

Retail Stores: Retail revenues in the quarter were a record $3.5 billion, up 36.0% from the year-ago quarter, primarily attributable to increased Macintosh, iPhone and iPad sales. The retail stores sold 768,000 Macs in the quarter compared with 677,000 in the year-ago quarter, an increase of 13.0%. Half of the Macintoshs sold through retail stores in the quarter were to new customers. During the quarter, Apple opened 4 new stores, including 2 in France and 1 each in Germany and U.K. At quarter end, Apple had 327 stores worldwide, with 91 stores located outside the U.S.

The iTunes store also delivered strong sales of $1.4 billion in the reported quarter, driven by higher revenue from music, video, iOS apps and books.

iPods: Apple sold 7.5 million iPods during the quarter, representing a unit decline of 20.0% from the year-ago quarter. According to NPD data, Apple's share of MP3 players in the U.S. was over 70% in the month of June, and iPod was the highest-selling MP3 player based on the latest data published by GFK. iPod touch sales remained strong, accounting for over 50% of all iPods sold during the quarter.

iPhones: The iPhone continues to be a star performer for Apple, with strong growth in both the Americas and the Asia-Pacific regions. Overall, iPhone unit sales were 20.3 million during the quarter, representing a surge of 142.0% from the year-ago quarter. iPhone sales growth also outpaced IDC’s estimated growth of 67% for the global smartphone market in the June quarter.

Revenues from iPhone handset sales, accessory sales and carrier payments totaled $13.3 billion compared with $5.33 billion in the year-ago quarter, a significant increase of 150.0%. The company had iPhone distribution agreements with 228 carriers in 105 countries at quarter-end.

iPads: Total iPad units sold in the quarter were 9.2 million, up from 3.3 million sold in the previous year quarter. During the quarter, Apple launched iPad 2 in 36 additional countries. Combining the original iPad and iPad 2, the tablet device is currently available in 64 countries.  Recognized revenues from sales of iPad and iPad accessories during the quarter totaled $6.0 billion. 

Apple’s app store continues to top the charts with more than 425,000 apps and over 15 billion downloads to date.

Balance Sheet

Apple’s balance sheet remains strong. Cash and investments were $76.1 billion at the end of the quarter compared with $65.8 billion in the previous quarter. The company generated cash flow of $11.1 billion during the quarter versus $6.2 billion in the previous quarter.

Fourth Quarter Guidance

For the fourth quarter of fiscal 2011, Apple expects revenues to be approximately $25.0 billion. Earnings are projected at approximately $5.50 per share. The Zacks Consensus Estimate was pegged at $6.40 per share at the time the company reported its second quarter results.

Apple expects gross margins of 38.0%, reflecting stock-based compensation expense of approximately $55 million. Operating expenses are estimated to be $2.7 billion, including about $245 million related to stock-based compensation, while Other Income and expenses are anticipated at around $50 million. The tax rate is estimated to be about 24.0%.

Our Take

We believe Apple is well positioned to achieve strong top-line growth over the long term, based on product innovation. Apple provided conservative revenue and earnings guidance for the fourth quarter of 2011. Apple expects sequential revenue growth (12.5%) and earnings growth (29.4%) for the upcoming quarter.

However, we differ from the company’s outlook based on the upcoming release of iOS 5 and iCloud. iCloud, which is a complete suite of services (iPhone, iPad, iPod touch running iOS 5, Macintosh running Mac OS X Lion with a valid Apple ID), enabling Apple product users to store and retrieve applications in the cloud for free. We believe that the new product releases will drive further growth for Apple.

The new iCloud service will likely generate incremental revenue for the company. With this new offering, the company is focused on strengthening its footprint in the emerging cloud computing market. Apple has three data centers to support iCloud.

We also believe that iCloud will also provide Apple a competitive edge over the music services launched by Google Inc. (GOOG) and Amazon Inc. (AMZN) as Apple has license agreements with three top record companies. These agreements favorably position Apple with its licensed cloud-music service.

The company is also rumored to launch iPhone 5 in September. The hype around the new iPhone has already scaled new heights and if Apple realizes iPhone 5 revenue for an entire month (if it chooses to release the product in early September), it will be major revenue driver going forward.

However, Apple continues to face tough competition in the smartphone and tablet market from Research In Motion Ltd. (RIMM), Hewlett-Packard Co. (HPQ), Dell Inc. (DELL), Samsung, Cisco Systems Inc. (CSCO), Toshiba and Acer.

As Apple remains heavily dependent of iPhone and iPad sales (68.8% of the third quarter revenue), the company is taking every possible step to safeguard its dominant position in the smartphone and tablet market, including further lawsuits against major competitors and allies such as Samsung and HTC.

Apple remains entangled in a number of lawsuits against Eastman Kodak (EK), Amazon and Microsoft Corp. (MSFT) over a number of other issues. As the outcome remains uncertain, we believe the lawsuits will remain an overhang on the stock going forward.

We maintain our Neutral rating over the long term (6-12 months). Currently, Apple has a Zacks #2 Rank, which implies a Buy rating in the near term.

 
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