Quick Thoughts on Apple's Earnings

Apple reported another weak earnings report. Even though Apple plays the expectations game, I see no reason to spend time hating those involved in creating the game. Apple’s quarterly reports contain a lot of information, most of which is more suitable for tweets and random musings. I will leave all of the growth rates and other metrics to others and instead focus on the big picture.

Apple is still in the beginning of a massive capital investment phase (which has been detailed in 10Q and 10K filings).  In the span of four weeks, Apple updated practically its entire product line.  Few were expecting such widespread updates. While the iPhone 5 was the worst kept secret, as well as the rumored iPad mini, Apple surprised us with new iPods, new Macs, and a new iPad with Retina display.  All of these updates are taking a toll on the company in terms of upfront costs, hurting margins. The first iPhone 5 produced is more expensive than the Xth iPhone 5 produced next year. The same can be said for every updated Apple product. 

When thinking of massive capital investment plans, Disney comes to mind. As the U.S. economy was collapsing in 2008, Disney’s management team, which I regard as one of the most talented teams in this global economy, placed the bet that it was the right time to increase capital spend and make needed improvements to its Parks division. The stock market hated the idea (due to the unknown involved), but management stayed the course. Fast forward to 2012, Disney’s Parks margins are only now beginning to increase as guests enjoy the final product. Disney is now able to turn on the earnings faucet and reap the rewards. 

I think Apple is following a similar path. 

Once Apple perfects the processes required to make all of these new iGadgets, the costs will come down and margins will rise. The iPhone 5 form factor will most likely stay around for the new iPhone in 2013, helping margins. The iPad lineup will probably not see any additional revisions until next fall (when I expect a thinner and lighter iPad with Retina display). Constrained supplies will dissipate and the Apple earnings faucet will be operational once again. Additional implications include the high likelihood of no new Apple products until at least WWDC in June 2013, as well as continued lumpy quarterly earnings. Competition and component availability may also change product plans. In terms of modeling, I think Apple is becoming harder to forecast. I am afraid many independent (and professional) analysts will continue to forecast near-term earnings incorrectly as the number of input assumptions increase. Finally, I have been very public about my concern that product cycles were becoming too planned and orderly (i.e. iPad in March, iPhone in the fall), which artificially impacts demand as customers alter purchasing habits, but all of this is more noise than anything else, and these patterns eventually end.  

It doesn’t matter if Apple is a few dollars short of expected 1Q13 earnings or if iPad mini margins are a few 100 basis points lower than normal. Such details change from quarter to quarter. At the end of the day, Apple’s most important goal is making great products. Everything else is mostly noise.  

Tackling the AAPL Unknown

Humans hate the unknown. Some look towards charts and tables, while others simply create stories to turn the unknown into easy to understand answers. 

Apple is currently facing the following questions (I suppose you can say its my attempt at tackling the unknown): 

1) Is iPhone growth slowing?  Maybe. We don’t know. iPhone 5 supply/demand is not in equilibrium. Apple is currently selling every iPhone 5 it can produce. After reporting 81% annual iPhone unit sales growth in 2011, Apple is tracking towards 70% growth in 2012. Will growth continue to decline or can the iPhone 5 stem the inevitable for a few more quarters? 

2) How should we think about iPad? I’m left somewhat confused following Apple’s iPad event. Heading into today, my gut was telling me the iPad (3) was not selling too well compared to the iPad 2 - a sign that consumers’ needs were being met with a cheaper, lower quality iPad. I also assumed an iPad mini would be positioned as a content consumption device to the iPad 2 and 3.  

Instead, Apple revised the iPad (4), kept the iPad 2 alive (seemingly to float in no man’s land), and unveiled an iPad mini that by all measures is as capable as a full-size iPad and just as worthy as its larger, and more expensive, siblings.  Will iPad’s ASP continue to decline? Where are margins heading? Are consumers’ technology needs being met by iPad? Questions are certainly outnumbering answers. 

3) Will Apple introduce new product categories?  Maybe. We don’t know. We can assume that Apple has plenty of new stuff cooking in the labs, but we have few concrete details on anything.  Will 2013 be the year of the next “big thing”? 

4) Is the economy impacting Apple?  Maybe. We don’t know. Apple was able to survive the financial crisis of 2008-2009 without much damage, however Apple was a much smaller company at that time appealing to a more niche audience. Are consumers delaying technology purchases due to economic pressures?  Apple continues to have supply issues, but once demand/supply equilibrium is met, sales are increasingly disappointing as product cycles appear to be accelerating. 

Now compare today’s unknown with the “AAPL story” of early 2012:

1) The iPad (3) was widely expected to be introduced and replace the iPad 2 as the top-selling iPad.

2) The iPhone 4S was selling well and the iPhone 5 was widely believed to be in the works.

3) Overall product margins were making new highs and expected to continue.

4) Management announced a dividend initiation (which may have included some front-running by AAPL shareholders). 

AAPL observers had a much easier time turning the unknown facing Apple from January to April into a convenient and easy to understand story. AAPL stock also went up 50% during the same time period. Are the two related?  Does a stock go up or down due to a specific reason or is that another example of humans trying to cope with the unknown?

Apple’s unknown will eventually be packaged into a clean story. It may take a day, week, month, or year, but it will happen because humans hate the unknown. 

AAPL 4Q12 Estimate

Revenue: $36.2 billion (AAPL guidance: $34.0 billion/Consensus: $36.2 billion) 

  • I expect iPad and iPhone to represent approximately 69% of Apple’s quarterly revenue.  

GM: 40.8% (AAPL guidance: 38.5%/Consensus: 40.4%)

  • Apple’s margin will likely decline sequentially from 3Q12 due to the iPhone 5 and continued iPad 2 sales. A key question facing AAPL in the near-term is the margin run rate. In 2011, Apple reported a 40.5% gross margin, which increased to approximately 44% in 2012. Looking at 2013, I expect margins to decline a few hundred basis points to 42% related to the iPad mini and ongoing costs related to the iPhone’s new form factor.

EPS: $8.95 (AAPL guidance: $7.65/Consensus: $8.85) 

  • I expect Apple to report 27% yoy EPS growth.  Interestingly, my $8.95 estimate is close to the Street’s $8.85 average, with 17 analysts projecting EPS higher than my $8.95. I attribute my low estimate to weaker iPhone sales, a lower iPhone average selling price (ASP), and a lower overall margin.

Product Unit Sales and Commentary

Macs: 5.5 million (12% yoy growth)

  • Mac growth is slowing as tablets and smartphones satisfy many consumers’ computing needs. I expect double-digit growth in portables, driven by back-to-school purchases, to be partially offset by a modest decline in desktop sales due to stale models.

iPad: 18.4 million (65% yoy growth)

  • I expect Apple to report record iPad sales for 4Q12. My iPad estimate assumes approximately 1.5 million iPads sold per week (including iPad 2 sales), which compares to the approximate 1.4 million weekly run rate last quarter. Supply/demand is in balance. Anecdotally, iPad 2 sales in education and business appear robust following the price cut, while lower component and manufacturing pricing should help limit drastic margin compression.

iPod: 6.1 million (8% yoy decline)

iPhone: 24.8 million (45% yoy growth)

  • My estimate reflects 7 million iPhone 5 units and approximately 18 million iPhone 4S units (and to a lesser extent iPhone 4 and 3GS). Apple is currently suffering from a supply/demand imbalance for iPhone 5, which will limit sales in the near-term (including 1Q13). Other unknowns include the iPhone 4S sales run-rate prior to the iPhone 5 introduction and iPhone 4S popularity following the price drop. My 18 million iPhone 4S estimate reflects the impact from consumers delaying iPhone purchases ahead of the iPhone 5 release.  I am including a declining ASP due to robust iPhone 4S sales following the price drop (an observation partially derived from Verizon’s earnings which showed strong non-iPhone 5 sales, which I attribute to the price drop).  


When Apple releases earnings on October 25, investors will focus on product ASPs and margin. Publicized iPhone 5 supply shortages and iPad mini rumors should go a long way in explaining any moderate misses in iPhone and iPad unit sales, respectively. Nevertheless, any evidence of continued margin weakness and declining ASP in iPad and iPhone may push observers to reduce forward earnings, which have a high sensitivity to margins. A 100 basis point change in margin corresponds to a 3% change in Apple quarterly EPS.