What’s On Steve’s Mind?

Apple (NASDAQ:AAPL) reported a strong third quarter driven by strong Mac and iPhone sales. With the Palm Pre out and many other products competing with the iPhone, Apple is suddenly faced with tough competition. Let’s take a closer look.

Reacting to the competition from Palm, Apple reduced its iPhone prices and blocked the Palm Pre’s ability to sync with iTunes. In other words, Apple is playing dirty. If the company can get away with it, well, all’s fair in love and war, and this, most certainly, is war.

But Apple has also been getting a dose of its own medicine. Recently Microsoft, to counter its staid image, reacted to Apple’s “I’m a Mac, I’m a PC” ad campaign with its own successful series of ads, Laptop Hunter, that conveys the message that consumers pay a steep premium for Apple’s coolness. Following the release of the Microsoft ads, Apple cut its notebook prices by $100. I have to say, I smiled when I saw this. Apple’s great, it’s creative, it’s innovative. But it is also a great bully, and that Microsoft gave it a whack back was delightful to watch in this soap opera.

As for Apple’s financials, Q3 revenue was up 12% to $8.34 billion, beating analyst estimates of $8.21 billion. Net income increased to $1.23 billion or $1.35 per share versus $1.07 billion or $1.19 per share last year. Analysts expected earnings of $1.17 per share. The company ended the quarter with $31.1 billion in cash, compared to $28.9 billion at the end of the second quarter. Maybe it should starting lending to President Obama, who seems to have an insatiable appetite.

Gross margin was 36.3%, up from 34.8% last year even after Apple reduced iPhone and MacBook Pro prices in the face of increasing competition. Margins improved with the growing demand for iPhones. The iPhone is a high-margin product, and according to a recent report, Apple and RIM account for 3% of global cellphone sales but earn about 35% of the operating profits. But dropping the price to $99 will surely have an impact on the margin bonanza.

Another reason Apple cut iPhone prices is the release of the new model, the iPhone 3GS, which has longer battery life, a 3 MP autofocus camera, video recording and hands-free voice control. The iPhone 3GS is available at $199 for the 16GB model and at $299 for the 32GB model and includes the new iPhone OS 3.0, which has features such as cut, copy and paste, MMS, and a landscape keyboard. This model also provides access to over 65,000 applications from the App Store, which has already seen over 1.5 billion downloads.

Apple sold 1 million iPhone 3GS in the first weekend of launch, and iPhones unit sales grew 626% to 5.2 million in Q3. Demand for the iPhone 3GS surged at the end of the quarter, catching Apple off guard and resulting in shortages. Recognized revenue from iPhone handset sales, accessory sales, and carrier payments was up 300% to $1.69 billion or about 20% of total revenue.

Mac sales were about 26% of total revenue. Mac shipments were up by 4% to 2.6 million, driven by 13% growth in Mac portable shipments. Apple also announced the launch of its Snow Leopard OS in September. This upgrade to the Leopard OS will be available to existing users for $29. The launch comes in the face of Microsoft’s Windows 7, which is expected to go on sale in October with prices starting at $120.

Microsoft also plans to open Microsoft retail stores next to Apple retail stores. Revenue from Apple retail stores in the quarter was $1.5 billion, compared to $1.45 billion last year. Apple sold 10.2 million iPods during the quarter, down 7% mainly due to reduction in inventory by 400,000 and a 4% decline in sell-through.

For the fourth quarter, Apple expects revenue in the range of $8.7 billion to $8.9 billion and EPS in the range of $1.18 to $1.23. CEO Steve Jobs returned to work in late June after undergoing a liver transplant.

So, what segment is Apple’s next burst of innovation going to target? TV seems to be a good place — a natural extension of Apple’s strengths. Readers may recall my conversation with Mitch Berman of ZillionTV on the future of television. No matter how many startups go after TV, it is Apple that is best positioned to address the dysfunctions of television.

Another segment in which there has been war in recent weeks is e-books. Barnes & Noble is going after Amazon with a comprehensive e-books store. Amazon’s Kindle has progressively gained momentum. Steve Jobs must have been mulling this over while recovering from his operating. Maybe he was even reading books on Kindle. I am eager to see what he might come up with, especially if he can do something that will encourage people to read more.

Apple is currently trading around $156.74 with market cap of about $139.8 billion, surpassing the 52-week high of $155.04 on July 20. Up, up and away!