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AAPL 4Q11 Earnings Cheat Sheet

AAPL Orchard Estimates (change from previous estimate in italics)

Revenue: $32.6 billion (up $600 million) (guidance: $25.0 billion/consensus: $29.0 billion)

GM: 40.5% (down 40 basis points) (guidance: 38.0%/consensus 39.6%).

EPS: $8.55 (up $0.10) (guidance: $5.50/consensus: $7.16).

Product Unit Sales Estimates 

Macs: 4.8 million (up 100,000)

iPad: 11.8 million (up 700,000)

iPod: 7.2 million (unchanged)

iPhone: 23.3 million (unchanged)

I remain confident in my initial quarterly estimates, published July 26, making only modest tweaks to a few variables. I raised my iPad sales estimate 700,000 units to reflect a higher production yield. I am maintaining my iPhone sales estimate (which I initially thought was too high) as the iPhone 4S is pushed out to 1Q12 and iPhone 4 supply draw-down did not occur to any major extent in 4Q.

Things to look for:

iPad Sales. Apple may provide an iPad sales update at next week’s iPhone event. Apple was successful in increasing iPad production in 3Q11 and many will look for continued gains in 4Q11. While my estimate calls for 11.8 million iPads, Street consensus may actually be slightly higher. I think iPad sales greater than 10 million will be deemed okay by the Street, while more than 13 million iPads will be considered strong.

iPhone Sales. With the iPhone 4S launch pushed out to 1Q12, I don’t think we will see too much of a drop-off in iPhone 4 demand, especially considering iPhone 4 was recently brought to new carriers and countries. Apple may still get a pass if iPhone sales are on the weak side as analysts will simply blame iPhone 4S ramifications such as pent-up demand. iPhone sales greater than 20 million will be deemed good, while more than 25 million will be considered strong. iPhone 4S launch weekend sales figures may also be shared on the call (although it is just as possible that the iPhone launch will occur after October 18 or Apple will choose to not disclose initial sales).

Guidance.  Similar to previous quarters, investors will look for Apple’s 1Q12 guidance for evidence of any economic impact or weaker iPad/iPhone production plans. Unfortunately, management’s conservative nature will make it very difficult to reach solid conclusions.  My initial 1Q12 EPS estimate is $10.00 (Street consensus is $8.83) on $39.7 billion of revenue.  I would consider EPS guidance around $7.00, with revenue in high $20s billion, as solid.

Two other scenarios may occur: 1) Apple may announce extra conservative EPS guidance due to economic concerns or 2) iPhone supply concerns related to the iPhone 4S launch. I think extra conservative EPS guidance would be something like $5.50, which compares to Apple’s reported $6.43 in 1Q11 (one could make the argument that Apple will put guidance at least above last year’s $6.43 EPS).

If Apple delivers a blow out 4Q11 quarter, chances are good Apple may run with extra conservative 1Q12 guidance as analysts won’t necessarily increase 1Q12 estimates, but would still maintain Apple target prices due to the 4Q11 beat. Accordingly, expectations wouldn’t be raised too high and Apple will be in a good position for another solid holiday quarter.

Anchoring Bias Impacting Wall Street's View on Apple

Predicting tech trends beyond 6-12 months is somewhat of a futile endeavor, but two groups of analysts attempt the feat: paid and non-paid.  Paid analysts largely encompass sell-side analysts - think along the lines of Goldman Sachs and Piper Jaffray. Non-paid analysts include everyone else and seem to have acquired the “independent” nomenclature.  There remains another group - buy-side (think hedge funds and mutual funds) - who don’t actually publish Apple forecasts, instead utilizing paid (and independent) analysts forecasts. 

Modeling Apple’s business (and earnings) involves two parts:  

1) Knowing how to model a company’s financials. This is the easy part.  Setting up an excel sheet to model revenues, expenses, and earnings going forward.  Financial modeling is essentially Finance 101 (ironically many students have no clue what they are doing when they take intro Finance classes since the field is so disorganized academically in primary and high school).

2) Knowing how to model a company’s performance. This is the hard part. This is the part of modeling that is more art than science.  How many iPads will Apple sell next year?  How about iPhones?  Experience, intelligence, and a clear mind separate the amateurs from the professionals. 

I’ve discovered that looking at someone’s forward Apple projections reveals a lot about what they think of Apple and this is where things get interesting. Sell-side consensus for Apple earnings per share currently stands at $32.35 for fiscal year 2012 and $36.94 for fiscal year 2013.  From a stock valuation standpoint, these numbers are important, but converting these numbers into growth, Wall Street believes Apple will grow 18% in 2012 and 14% in 2013.

In order to put these numbers in context, I compare Apple’s projected earnings growth to other technology companies:

             2012     2013

GOOG:    19%       17%

IBM:        11%       11%

MSFT:      6%          9%

HPQ:      -1%          2%

RIMM:   -20%         2%

DELL:      26%       -2%

Average:  7%        7%

AAPL:     18%       14%

(consensus data from FactSet and current as of 9/10/11) 

Now we are getting a better picture of how Wall Street views Apple. Tim Cook and company are expected to outperform the overall technology sector, growing earnings 14% in 2013, versus a peer average of 7%.  However, Apple’s 14% projected growth in 2013 pails in comparison to current 70% growth.  What is going on here?

Instead of sell-side analysts “not getting it” - as some independent Apple analysts say, I think anchoring bias is the main culprit. 

I thought Wikipedia did a good job at trying to define anchoring in a few sentences:

Anchoring and adjustment is a psychological heuristic that influences the way people intuitively assess probabilities. According to this heuristic, people start with an implicitly suggested reference point (the “anchor”) and make adjustments to it to reach their estimate. A person begins with a first approximation (anchor) and then makes incremental adjustments based on additional information.

Sell-side analysts are comparing Apple to its peers too much. Although analysts still believe Apple will outperform, many are modeling Apple with a 5-10% technology industry growth rate in mind. Apple’s growth is then pegged above this range, albeit by only a small margin.  Apple is being anchored to its peers and corresponding lower growth rates.

Sell-side analysts may think Apple will sell a ton of iPhone and iPads, but end up with much lower Apple growth rates because Apple’s peers are performing so poorly. To make matters worse, much of this comparing, and anchoring, is occurring on a subconscious level, making it that much harder to acknowledge and correct. 

Meanwhile, independent Apple analysts aren’t subjected to anchoring bias since they are only modeling Apple.  In a way, they are able to put Apple in a valuation bubble.  If independent analysts began to model Apple peers on a regular basis, I would suspect anchoring would become a bigger issue among the group.

As an independent Apple analyst, how fast do I think Apple will grow earnings?

2012:   40%+

2013:   35%+

My 2012 earnings growth estimate is twice the pace of Wall Street’s 18% growth estimate.  

RIMM’s troubles, HPQ’s reorganization, MSFT’s status quo, and GOOG’s continuing mystery are causing Wall Street to view Apple with a more conservative eye. What is the solution? Unfortunately, I don’t expect Wall Street’s anchoring bias to end anytime soon. Apple will continue reporting large quarterly earnings beats, while Wall Street continues to gush over Apple’s growth.

Want to Beat iPad? Hire a Psychologist

When unveiled in 2010, Apple didn’t know why iPad would be a major hit.* After spending most of the keynote explaining some of iPad’s basic features, such as email, reading books, and surfing the web, Apple left the fundamental question of why iPad would become popular to the marketplace to answer.  

One year, and 19.5 million iPads, later, the marketplace has spoken. While users have a variety of reasons for liking iPad, I attribute its success primarily to its ability to transfer innovation to the user. Apple’s curated iOS ecosystem allows iPad to bring app innovation, and functionality, into users’ lives, all the while sustaining a satisfaction level that is unmatched in Silicon Valley. When selling technology to consumers, initial satisfaction is good, but being able to deliver continued satisfaction and enjoyment is even better.  

When putting iPad in this context, it’s easier to see the uphill battle facing competitors. The competition is having a hard time beating iPad because they don’t understand why people are actually buying iPad. To beat iPad, you can’t look at it as some piece of hardware that runs apps; you can’t look at it as “an iPad”, but instead as “iPad”. You have to understand the emotional connection between iPad and its user, which a psychologist could analyze at a steep price.  A cheaper option to see the connection between iPad and its user is to walk into an Apple store and hover around the iPad table. After a minute or two, you will see the connection when looking at people’s faces.

Competitors need to aim for users’ hearts and minds and not assume that consumers are buying iPads just because they have $499 lying around the house.  I have little confidence that competitors can successfully appeal to consumers in the same way that Apple does. Instead, competitors have two options for fighting iPad: low price commoditization with little emotional appeal, or reliance on innovation to beat Apple at its own game.

1) From a financial perspective, removing the emotion out of a product does not bode well as competition will lead to hardware commoditization and the ensuing margin collapse. Profits and brand power will quickly evaporate. Nevertheless, competitors need to convince users that some level of satisfaction can be received from a tablet form factor at a much lower cost than iPad. Apple understands this alternative strategy (some say due to its PC war history) and is relying on its massive $66 billion cash position to secure device components at prices that help lower iPad’s cost to a price point that is very difficult for the competition to slide under, while at the same time maintaining attractive margins. If you are curious what the tablet market would look like if iPad competitors choose the route of hardware commoditization and low cost, instead of appealing to consumer’s emotion, look no further than the MP3 player market, where Apple’s iPod and iTunes ecosystem maintains 70% market and emotion share.

2) You can only rely on apps and services to such a extent before poor financials, low product margins, and a lack of cash become too much to bear and competitors exit the market. If low-priced commoditization sounds unappealing, a better strategy for competing against iPad is to innovate and come up with something completely different. Once this new product is developed, control the emotional connection to your consumer and strive for increasing functionality and user satisfaction. Let iPad have its user base, while your product entice others with unique features and attributes. Try to beat Apple at its own game.

One year, and 19.5 million iPads, later, the marketplace has spoken, but competitors have spent more time talking instead of listening and watching. 

*I didn’t write “if iPad would be a major hit”, but instead, “why iPad would be a major hit”. Apple has a history of releasing major products only after it knows it is worthy of becoming a hit.

Big M&A Not in Apple's DNA

What will Apple do with its $50 billon cash hoard, which is growing nearly $20 billion annually? On January 6, a Bloomberg article-stating that Apple was shopping around for a new CFO-led some to think that Apple is interested in picking up its M&A pace. In recent months, rumored Apple targets have included Disney ($75 billion), Sony ($40 billion), Netflix ($10 billion), and Twitter ($5 billion). 

Steve Jobs, Apple’s CEO, stated on Apple’s most recent earnings call: 

[Apple] strongly believe[s] that one or more very strategic opportunities may come along that we’re in a unique position to take advantage of because of our strong cash position. And I think we’ve demonstrated a really strong track record of being very disciplined with the use of our cash. We don’t let it burn a hole in our pocket, we don’t allow it to motivate us to do stupid acquisitions. And so I think that we’d like to continue to keep our powder dry because we do feel that there are one or more strategic opportunities in the future. That’s the biggest reason. And there are other reasons as well that we could go into. But that’s the biggest one.

While Steve sure sounded like Apple is looking at a huge M&A deal, I don’t expect Apple to acquire any large companies (which I label as anything with a $3 billion and higher price tag).

Company Culture. It is an understatement to say that Apple’s corporate culture is unique.  Apple managers have roles that are not typical in other companies, with more time spent on actual product development and brainstorming. Apple managers rarely just manage. Former IBM executive Mark Papermaster reportedly left Apple only a few months on the job as SVP Devices Hardware Engineering due to cultural incompatibility. On top of that, Apple had spent months trying to fill the SVP Hardware position before settling on Papermaster. It is tough for Apple to fill its top ranks due to its unique culture. If Apple were to acquire a company with a large workforce, it would be tricky to assimilate these new Apple workers to the culture that has led to so much success. Conflicting company culture is one of the biggest reasons for failed M&A and that rings even truer in Silicon Valley. 

Company Structure.  As I discussed in a previous AAPL Orchard post, Apple’s structure allows decision makers to come in contact with everything that is shipped to the consumer (Macs, iPhones, iPads, etc) and more importantly everyone who is in charge of the product (designers, engineers, marketers, etc.). Ideas are not bounced off of committees. Finished products are not required to get a certain number of approvals. I know of few, if any, large companies with a similar structure. For Apple to acquire and assimilate a company with a management structure reminiscent of a Egyptian pyramid, more than luck and hard work would be needed. 

No Prior History for Large M&A[1]. Apple has never acquired a large company. Apple’s largest acquisition was NeXT in 1997 for $404 million ($540 million inflation adjusted). Recent acquisitions P.A. Semi and Quattro Wireless were $278 million and $275 million, respectively. 

What is the right kind of M&A for Apple?

Peter Oppenheimer, Apple CFO, on Apple’s F1Q10 earnings conference call was pretty clear:

[Apple] occasionally acquire[s] small companies from time to time for their technology and talent. That is why we do it.

Tim Cook, Apple COO, shed more light on Apple’s M&A strategy at an investor conference in 2010. 

[Apple has] always been about making the best product, not having the highest market share or the highest revenue, and so acquiring a company so our revenue gets larger isn’t something that drives us.

I think Tim Cook’s quote is important.  Apple is focused on making the best products, not growing it’s earnings.  Steve Jobs knows great products drives great earnings and Apple will never follow any other rule, or its continued success will be in jeopardy.

As an example, would Apple acquire Twitter? Would Twitter help make Apple’s current product lineup better? I don’t think so. (I am not even considering Twitter’s financials and possible sale price)

So what will Apple do with it’s cash?

1) Acquire talent to plug any holes in Apple’s current team and resources.  I suspect some software team acquisitions may be in the offering as distinguishing software will become even more important for Apple to set itself apart from the competition. Buying smaller teams of outside talent makes company assimilation, from both a culture and company structure viewpoint, easier to accomplish.  A small group of acquired software engineers can be quickly lumped within the iTunes or iOS team without much disruption. 

2) Long-term agreements (aka “strategic opportunities”) for product components. In 2009, Apple paid an up-front cost of $500 million to enter into a long-term agreement with Toshiba for NAND flash chips.  Recent rumors include Apple partnering with Sharp and Toshiba to build LCD factories with a price tag over $1 billion. Apple faces supply constraints whenever a new product is released and I expect Apple to pour billions into its infrastructure, forming new partnerships to guarantee that components are available, and at a good price, when needed. Finally, Apple needs additional investments, such as the $1 billion data center in North Carolina, to support and grow its current product lineup.

3) I don’t expect Apple to buyback its stock or issue stock dividends in the near term.

All of these investments and cash outlays won’t end up costing anywhere near $50 billion, but since when was having a lot of cash that bad of a thing? 

[1] Some will say it is for this reason that Apple is interested in a more experienced CFO. I would respond that Apple’s storied history is a result of no large M&A. For Apple to change course now, especially considering how its team is performing, would be shocking to me and serve as a worrying indicator that something is awry in Cupertino.  I am not ruling out large partnerships or agreements with certain companies that are not in a position to be acquired (Facebook, AT&T, Comcast etc.), but these are a whole other ball game compared to an acquisition.