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.

Related Articles
  1. Investing News

    What You Can Learn from Carl Icahn's Mistakes

    Carl Icahn has been a stellar performer in the investment world for decades, but following his lead these days could be dangerous.
  2. Investing

    5 Up and Coming Social Media Startups

    Although the days of Facebook's dominance aren't close to being over, here are some new creative platforms gaining traction on the worldwide web.
  3. Investing News

    Public Vs. Private Tech Valuations: What's Driving the Divide?

    The gross valuations over the past five years are more indicative of the market than the true value of the company itself.
  4. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  5. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  6. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  7. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  8. Investing

    How Digital Payments Will Change Commerce in 2016

    The way we transfer and spend money is constantly evolving, and 2016 is poised to expand digital payments like we've never seen before.
  9. Entrepreneurship

    Digital Nomads in the Modern Economy

    Digital nomads compose a growing portion of the modern economy.
  10. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
RELATED FAQS
  1. Is Apple Pay safe and free?

    Apple Pay is a mobile payment system created by Apple to reduce the number of times shoppers and buyers have to pay for goods ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center