Sunday, October 2, 2011

Why Apple's FQ4 Earnings Will Approach $10 Per Share

There's no other company on the planet that excites the imagination of its product users as much as Apple. In developing revenue and earnings estimates for the company, I am guided by one overarching principle:
Apple doesn't sell products. Apple crafts customer relationships and those relationships sell Apple products. 
Understanding Apple's Pathways To Success
Understanding Apple's pathways to success requires more than an effort at counting the number of individual products that might be sold. It necessitates understanding the company's eco-systems and what motivates enterprises and consumers to invest in the purchase of Apple-branded products. 

My analysis relies heavily on the company's historical growth trends and an evaluation of the phenomena that occur when appealing and abundant content is made readily available for smartly designed devices. These products are offered to customers who have established a relationship with Apple through iTunes, through visits to the company's retail stores or have a long-standing relationship with the company through the use of Apple's popular Macintosh line of personal computers. 
Below are my estimates for the company's September quarter and an overview of the elements that underly the assumption Apple's FQ4 earnings will approach $10 per share:

Revenue Segment

Units FQ4 ’11
Units FQ4 ’10
Unit Growth
FQ4 Revenue











Software, Services


Other Music


Revenue Total


Cost of Sales



Gross Margin



Operating Expenses



Operating Income


Other Income


Income Before Taxes


Provision For Taxes



Net Income


Earnings Per Share

(Based on 940.825 million shares)

In the four fiscal quarters ended in June, Apple's revenue surpassed $100 billion. In that 12-month period, 61% of reported revenue was generated through the sales of Apple iPhones and Apple iPads. Neither of these products existed in the market as recently as five years ago. This concentration of revenue from two of the company's four major product lines is neither alarming nor unprecedented in the company's storied history.

The opening of the iTunes music store in 2003 and the release of iTunes for Windows catapulted the revenue generated from the sales of Apple iPods well beyond the revenue generated by the sales of the company's personal computers. In 2008, the opening of the Apple App Store ignited frenetic rates of iPhone unit sales growth and the early success of the Apple iPad can be attributed to the depth and array of content available through iTunes for the company's iOS-based devices. Simply put, content sells devices and the iTunes store and the company's retail stores are essential elements of Apple's sales success.

Apple's revenue and earnings growth have become a continuum. The fiscal quarter reports are merely static, 91-day snapshots to measure the company's continuing success.  

During that 12-month period ended in June, Apple's revenue rose 75.73%. The company's extraordinary rates of revenue growth are fueled in part by the availability of content on iTunes and the more than 350 retail stores now open for business. The retail stores alone generated $14.1 billion in revenue during the period and roughly 50% of 3.3 million Macintosh computers sold at the stores were to customers new to the platform. 
Content sells devices and the Apple retail stores are at the epicenter of what I call the "Apple product mutual halo effect." 
Macintosh Sales
During the 12-month period ended in June, the Macintosh line of personal computers generated just over 20% of the company's revenue. In the first three quarters of FY 2011 Macintosh unit sales rose 21.1%. However, in the June quarter the rate of unit sales growth slowed to 13.7%. The slowing rate of unit sales growth can be attributed in part to the success of the Apple iPad. Fast adoption of iPads in the K-12 education market, for example, influenced the June quarter Macintosh unit sales results. The September quarter is the back-to-school quarter for student purchases and I expect Mac unit sales to rise 16% year-over-year. The iPad's adoption on college campuses will occur over time. 

The Apple iPad will impact Macintosh unit sales growth. But the iPad is also driving customers to the retail stores in droves. The Apple iPad will have a far greater impact on sales of Windows PCs in part because Apple's retail stores are a magnet to attract converts from Windows to the Mac. The rate of Macintosh unit sales growth will continue to outpace the growth rate in the PC market as a whole. 
iPhone Sales
Over the first nine months of the fiscal year, iPhone unit sales rose 133%. This included a 142% unit sales rise in the June quarter as Apple brought channel inventory to the desired 4 - 6 weeks of supply. 
The anticipated release of the iPhone 5 will have dampened the rate of iPhone unit sales growth in the September quarter. My estimate for the quarter is an 88% increase in unit sales over the prior-year period. The addition of new iPhone carriers in regions around the world, the opening of new retail stores and the availability of the iPhone on the Verizon network in the US supports strong unit sales growth even as demand builds for the new phone that is expected to be announced this week. 
iPod Sales
Every iPhone is an iPod. Consumer demand for specific-use digital music players has fallen off dramatically as the mass migration to smartphones occurs around the world. In the September quarter Apple offered college students $100 in iTunes content as the promotional giveaway for purchasing a new Mac. In years past Apple offered students a free iPod touch as part of the promotional deal. The change in the back-to-school promotion this year will further pressure iPod sales. I expect a reported 20% drop in iPod unit sales in the September quarter.
iPad Sales
In the September quarter, I expect iPad unit sales growth of 246% to 14.5 million units. Apple ended the June quarter with scant iPad channel supply. Filling the channel with the desired 4 - 6 weeks of inventory is equal to at least 3 weeks of additional product sales. Since the release of the Apple iPad 2 the company had been challenged to match demand with supply. Meeting pent-up demand, filling the channel with supply and providing product to new markets will have fueled an extraordinary rate of iPad unit sales growth in the three-month period. 
Apple's revenue performance is influenced by the periodic release of new products and existing product refresh cycles. However, long-term revenue growth is also influenced by the availability of content for the company's devices, the depth and scope of the company's existing customer relationships and new customer relationships crafted at the more than 350 Apple retail stores. The more than 225 million iTunes customers and the hundreds of millions of consumers currently using Apple-branded products provide a foundation for continuing growth in revenue and earnings. For the September quarter, I estimate revenue growth of 80%, inline with the 82% rate of revenue growth realized in the June quarter. 
Gross Margins
In the June quarter, gross margins on products and services sold averaged 41.73%. In the September quarter, economies of scale as revenue continued to rise will have kept gross margins at or above the June quarter's performance. I estimate average gross margins in the September quarter of 41.8%.
Operating Expenses
Apple's ability to keep the rates of growth in operating expenses well below the rates of growth in revenue has had a significant impact on the company's bottom line. In the September quarter, I expect operating expenses to fall below 8.8% of revenue versus the 10.15% of revenue consumed by operating expenses in the September quarter one year ago. This alone will deliver at least an additional $.40 or 9% growth in earnings per share.
Net Income
Over the most recent twelve fiscal quarters the percentage of revenue that flows to the net income line has been on a steady rise. High gross margins, lower effective tax rates and diminishing percentages of revenue consumed by operating expenses have contributed to rates of net income growth that exceed the rates of growth in revenue. In the quarter I expect 25.7% of reported revenue to reach the net income line, producing a 119% rise in net income on year-over-year revenue growth of 80%.
I expect Apple's earnings per share in the quarter to reach $10 per share. An additional eight million shares in the fully diluted share count will keep the eps growth rate just below the anticipated rate of growth in net income.
In developing revenue and earnings estimates for Apple, I look beyond an effort to sum the expected units sales of the company's individual products. The expansion of the retail store network, the appeal of the content available through iTunes and the Mac app store and the more than 225 million iTunes customers with an established sales relationship with Apple all contribute to the prospects for robust revenue and earnings growth.
Apple's continuing success is sourced not only from smartly designed hardware devices, it's also grounded in the depth and scope of the company's customer relationships. The continual opening of new markets for Apple products and the development of new customer relationships in those markets are important sources for revenue growth over the next several quarters.
Disclosure: The author is long Apple shares
Robert Paul Leitao