Saturday, December 1, 2012

Why Apple Will Beat The Street

Apple ended November trading at $585.28 per share. At the closing price on November 30th, the shares traded at 13.28 times trailing12-month earnings and off 17% from the all-time high of $705.07 set on September 21, 2012. In the ten weeks since the all-time high, analysts have reduced their expectations for the company's December quarter and the fiscal year ending in late September. The changes in analyst expectations have contributed to the recent downward pressure on the share price. 

Apple will beat the Street's revenue and earnings consensus estimates for the December quarter and the Street's consensus estimates for the current fiscal year. In today's article I will explore the factors that will deliver an earnings surprise when Apple's quarterly results are released in late January. I expect the share price to retrace to the all-time high by the first trading day of February 2013 through a gradual recovery of lost ground over the next sixty days. Management's eps guidance and the Street's consensus eps estimate are not supported by the company's earnings to revenue ratios measured over the most recent eight fiscal quarters. 

Apple's Guidance and Analyst Expectations
For the December quarter, management offered revenue guidance of $52 billion and earnings per share guidance of $11.75. Management's guidance suggests revenue growth of 12.23% over the prior-year period and a decline in eps for the quarter of $2.12 or 15.28% from the $13.87 in earnings per share achieved last year. Management is quick to remind analysts the prior-year period contained 14 weeks versus Apple's usual 13-week fiscal quarters. In contrast to Apple's very low guidance numbers, Wall Street analysts are currently expecting revenue of $54.52 billion, representing expected revenue growth of 17.68% and earnings per share of $13.30, representing an expected decline in eps of 4.10%.

Net Income Per Revenue Dollar
Using an estimated 950 million fully diluted shares outstanding as a constant, management's December quarter guidance suggests about 21.5% of revenue will flow to net income. The Street consensus is a bit more positive, suggesting 23.17% of revenue will reach the bottom line. In an article published in early November, I illustrated the percentages of Apple's quarterly revenue that reached the net income line over the most recent twelve fiscal quarters. There's a direct correlation between the percentage of net income per revenue dollar on a quarterly basis and the iPhone product cycle. The graph below illustrates the percentage of revenue that flowed to net income over the most recent eight quarters as a reference for the performance comparisons in today's article. 
Net income per revenue dollar tends to fall during the quarters in which Apple's flagship iPhone handset reaches the end of its annual cycle. Net income per revenue dollar tends to rise during the first two quarters following the annual iPhone refresh. This is because the iPhone has the highest gross margin among Apple's device lines and the quarters in which the iPhone represents the highest percentage of revenue also yield the highest net income per revenue dollar.

Apple's Rates Of Revenue And Earnings Growth
The graph below illustrates Apple highest rates of revenue growth occur in quarters following the annual iPhone refresh and in these quarters Apple delivers the highest net income per revenue dollar.
The iPhone 4 introduced a new handset form factor while the iPhone 4S maintained the same form factor for a second model year. Although the iPhone 4S generated higher gross margin than its predecessor, it had an abbreviated period of peak demand. The iPhone 4 maintained strong global demand into the June quarter of FY2011. The iPhone 4S peaked as a product early in the March quarter of FY2012. The falloff in iPhone 4S demand through the June and September quarters of the fiscal year reduced the company's rates of year-over-year revenue growth and diminished the percentage of revenue that flowed to the net income line. 

Apple's Gross Margin Performance
Due to the use of the iPhone 4 series form factor for a second consecutive model year, the iPhone 4S delivered extraordinarily high gross margin in the December and March quarters of FY2012. In the December quarter gross margin averaged 44.58% and in the March quarter gross margin averaged a record 47.37%. 

Although the iPhone 4S delivered enviable gross margin during its year as the flagship iPhone handset, customer anticipation of a new form factor for the successor iPhone handset caused a dramatic reduction in the pace of product demand in the June and September quarters. A slackening in the pace of iPhone demand reduced the rates of revenue and earnings growth in the June and September quarters.

Contributing to management's underwhelming December quarter guidance of $11.75 in earnings per share is management's forecast of 36% gross margin for the quarter. Prior to the guidance for the current quarter, Apple had not forecast gross margin below 38% since the first quarter of FY2011. In that quarter average gross margin came in at 38.51%. This was 251 basis points higher than what Apple had guided for the period. In the current quarter, due to high volume sales of the iPhone 5 in its initial quarter of release, Apple will again deliver actual gross margin at least 250 basis points above management's forecast. 

The graph below illustrates management's gross margin guidance over the most recent eight fiscal quarters and actual gross margin results for the same quarterly periods.

Apple's Rates of Revenue Growth
Apple's guidance of 12.23% revenue growth in the December quarter and the current Street consensus suggesting 17.68% revenue growth will prove to be significantly lower than actual results. The graph below illustrates management's revenue guidance for the most recent eight fiscal quarters and the actual rates of revenue growth for the same fiscal periods. 

Apple's revenue guidance tends to be closer to actual results in the waning quarters of each iPhone model year. Actual rates of revenue growth tend to handily surpass management guidance in the quarters immediately following a new iPhone release. The iPhone 5 was introduced in September and the current quarter represents the first full quarter of unit sales. Although management has made much mention of this year's 13-week quarter versus last year's 14-week quarter as justification for underwhelming revenue guidance and the low rate of forecast revenue growth, iPhone 5 supply will have a bigger impact on the rate of revenue growth than the number of weeks in the period.

The quarter's rate of revenue growth will be governed more by the level of iPhone 5 production than the number of weeks in the fiscal period. iPhone 5 supply is a more important factor for revenue growth in the quarter than the number of weeks the handset is available for sale. Global demand will remain greater than supply through the end of the quarter. Apple will sell every iPhone 5 the company can produce in the quarter.

The graph below illustrates Apple's earnings growth guidance for the most recent eight fiscal quarters and actual earnings growth results for the same fiscal periods.
Again, Apple's guidance tends to be closer to actual results in the waning quarters of each iPhone model year. Actual earnings per share have been no less than 30% higher than guidance in the first two quarters following an iPhone handset refresh.

The Fixed Cost Factor
Cost of sales is comprised of both fixed and variable cost components. Fixed costs do not impact the cost of each additional unit manufactured for sale. The higher the number of units sold, the lower the reported cost of each unit sold because fixed costs do not change based on production activity.

In the December quarter Apple refreshed the iPhone and iPad lines and expanded the iPad line with the introduction of the mini. Additionally, Apple recently refreshed the iMac line of personal computers and expanded the MacBook Pro line to include a 13" Retina display model. These product refreshes and their associated fixed costs will impact gross margin and earnings per share in the quarter. However, as production rates rise, fixed cost components will have less influence over reported cost of sales. High production rates of the iPhone 5 and other devices will diminish the amount of fixed costs assigned to each unit sold. 

The iPhone 5, the iPad with Retina display and the iPad mini will deliver high unit sales in the December quarter. I expect gross margin at least 300 basis points above Apple's guidance and a positive earnings growth rate for the quarter.

The Apple iPhone Line
The Apple iPhone will deliver unit sales in the December quarter at a year-over-year growth rate approaching 50%. Supply will determine the number of reported units sold and the product line will sustain a peak demand period similar to the iPhone 4. I expect strong unit sales growth into the first weeks of the June quarter. 

In FQ1 2012, the iPhone represented 52.70% of reported revenue. In the current quarter, I expect iPhone revenue closer to 55% of reported revenue. For this reason, iPhone unit sales will be the single biggest factor in the company's revenue, gross margin and earnings per share results. 

Carrier additions and a higher volume of shipments into the Asia-Pacific region in the December quarter versus one year prior will boost the rates of revenue and earnings growth this quarter.

The Apple iPad Line
The addition of the iPad mini to the iPad line of products will assist in boosting the rate of unit sales growth above 70% in the quarter. However, the mini's lower price will reduce average revenue per unit sold in the year-over-year comparison. I expect the iPad line to deliver about 20% of reported revenue, similar to the line's percentage revenue contribution last fiscal year. 

The Macintosh
Falling global demand for personal computers will dampen the Mac line's unit sales growth rate in the December quarter and throughout the fiscal year. In the December quarter one year ago, Mac unit sales rose over 25%. I expect a low, single-digit unit sales growth rate in the current quarter. The refreshed iMac line will be a slight positive for unit sales in the period. 

Gross Margin Isn't All That Matters
The graph below illustrates one of the factors that keeps Apple's earnings on the rise. No matter the varying rates of revenue growth over the past eight quarters, Apple has consistently kept operating expenses below 10% of reported revenue. By keeping operating expenses low, more of Apple's reported revenue will flow to the net income line. Supply chain mastery coupled with operating expense discipline will deliver satisfactory results for the quarter.
The December Quarter Outcome
At this time I expect Apple's actual results in the quarter to surpass management guidance on revenue by about 15%, deliver in the range of 30% revenue growth year-over-year and beat the current Street revenue consensus estimate by close to 10%.

Apple will deliver earnings per share growth greater than 8% year-over-year, surpass management's earnings guidance by more than 25% and beat the current Street consensus estimate by well over 10% this quarter. I will publish my detailed estimates for the quarter as part of the Braeburn Group Index to be released in the first week of January.

Share Price Performance
The sharp sell-off in Apple's share price from the all-time high of $705.07 has been due in part to reduced analyst expectations for the December quarter and uncertainties about iPhone 5 production rates. The iPhone line will represent well over 50% of Apple's revenue in the quarter and has the highest gross margin among Apple's popular product lines. Concerns about iPhone 5 production rates have begun to subside and the new iPad mini will be among the winners with consumers this holiday season. 

The iPhone 5 will deliver strong year-over-year unit sales growth and high production rates will benefit gross margin and net income per revenue dollar. Apple is set to commence iPhone 5 shipments to the two authorized carriers on China's mainland this quarter. I expect the share price to retrace lost ground over the next sixty days and for the share price to revisit its all-time high soon after the release of December quarter results in late January.

Robert Paul Leitao

Disclosure: The author is long Apple shares