Wall Street is a quarter-to-quarter world, and that means analysts are always going to obsess over the unit and ASP numbers for Apple's (Nasdaq:AAPL) iPhone and iPad. What I think is more important to consider, though, is the future path of Apple's margins. The inexorable reality for consumer electronics companies is lower ASPs and lower margins, and lower margins are never good for stocks. Even conservative free cash flow growth assumptions suggest Apple shares are much too cheap now, but the realities of holding shares in a company facing persistent margin erosion may mean that it's a long path to reaping that value.

Some Relief From Fiscal Q3 Earnings
Plenty of analysts lined up to predict that Apple would miss numbers for this quarter. Although they were wrong, it's not hard to see where they were coming from, as several other major phone developers (including SamsungHTC, and BlackBerry (Nasdaq:BBRY)) missed the mark for the quarter.

Revenue rose 1% from the year-ago period, but fell 21% sequentially as Apple goes through another product transition cycle. That revenue figure was slightly better than expected, and fueled by a sizable beat on unit shipments of iPhones (where revenue was up 15% and down 21%). Sales of the iPad disappointed, with revenue down 27% and 27% on a 14%/25% decline in units, while Mac revenue fell 1% and 10%. The iTunes/Software/Service unit saw 25% revenue growth (down 3% sequentially), while the iPod continues to decline (down 31% and 24%) and is now a trivial contributor to revenue. 

SEE: Earnings Season Investing Tip

Not surprisingly, Apple's margins continue to decline. Gross margin beat the average of sell-side estimates by 30bp, but fell about six points from last year and about half a point sequentially. Operating income fell 20% and 27%, as operating margin fell seven points and almost three points.

The Guide Likely Won't Matter Relative To New Launches
While Apple management did guide revenue down for the next quarter, I don't believe investors are going to care all that much about it. The revenue target moves down about 5% (to a midpoint of $35.5 billion, or virtually flat qoq), but it sounds as though gross margin will be stable and that's arguably just as important to Wall Street right now.

It's also well worth noting that guidance for the fiscal fourth quarter is the undercard to significant product launches later this year. Analysts continue to expect a new iPhone in the fall, with a new iPad mini later in the year (some say as early as October, others say as late as December). Moreover, bringing in China Mobile (NYSE:CHL) as a carrier is still expected for later this year.

What About Those Margins?
The inexorable truth of consumer electronics is that it's a business where it is all but impossible to maintain high margins for a sustained length of time. In that respect, Apple has already done better than most, but you can look at computers, TVs, music players, game consoles, and so on and the trend is pretty clear.
The question I have, then, is how Apple chooses to respond to these challenges. Will Apple ultimately go the route of analog chip company Linear Technology (Nasdaq:LLTC) and willingly turn away from sales to preserve margins, or will Apple bite the bullet and just accept lower margins in the future? It looks like the high-end phone and tablet markets are pretty much mature now, and while some prospective teardowns suggest that lower-end iPhones could still sport GMs in the mid-30%'s, that's not going to be true indefinitely.

SEE: A Primer On Investing In The Tech Industry

I think it's also true that expanding iTunes and/or services won't be that constructive for margins either. A quick look at the margins of payment companies like VeriFone (NYSE:PAY), Ingenico, and Gemalto doesn't suggest huge margin potential in payments, though streaming music/media services would likely be relatively better.

The Bottom Line
To me, Apple shares look like a paradox from a valuation perspective. Even virtually no growth in free cash flow in Apple's future would suggest a fair value above $600, and that assumption would allow for about 10 points of gross margin erosion. On the other hand, very few stocks do well while the company's margins are in decline, and so I'm concerned that Apple could turn into an income-generating value trap for large stretches of time.

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