Wednesday, December 26, 2012 -- it's common for investors to easily forget that the best analyst with the best insight covering Apple's earnings is Apple's management. That is the first thing that any good secondary analyst understands about analyzing Apple's earnings. Apple's management is central to getting anywhere close to understanding what Apple is going to report on earnings. If one correctly interprets what Apple's management is telegraphing through its conference call and through its guidance, and you crack what Apple is going to report on earnings. That's because Apple's management has the best information. They know their supply chain partners (all of them), they know their production capacity and when Apple's management offers to us their expectations, they do so with nearly a month of the quarter under its belt already. So they and they alone have the best information on what will transpire in any given quarter.
Apple's Fiscal Q1 2013 is the most important quarterly report in both the stock and company's history. It will not only shed light on questions regarding how to interpret Apple's guidance going forward, but it will shed tremendous light on Apple's 2013 growth curve. There are two entirely different ways to interpret Apple's recently reported fiscal Q3 2012 and Q4 2012 (in terms of how the company guides), and fiscal Q1 2013 will add a lot of clarity on which interpretation is the correct one.
What every Apple investor should understand about Apple by now is that the company's history of sandbagging its EPS is and has been the direct result of Apple consistently offering ultra conservative revenue and gross margin guidance. In the end, how much Apple beats on the bottom line is almost entirely determined by how much it beats on the top-line and how much it outperforms on its gross margin percentage guidance.
Until this past July, when Apple reported fiscal Q3 2012, the company consistently offered both gross margin and revenue guidance that was well below what the company actually reported. This resulted in Apple being able to beat the bottom line by anything from 20% to 60% on a consistent basis for many years.
After changing from subscription to straight-line accounting of the iPhone, Apple regularly beat its top-line guidance by between 13% - 20%. And in fact, before Apple's fiscal Q3 2012, Apple beat its top-line guidance by over 20% in three out of the previous four quarters. In fiscal Q3 2010 it beat by 24.22%, in Q1 2012 it beat by 25.22% and in Q2 2012 it beat by 20.57%. See below:
Yet, for largely debatable reasons we will discuss below, Apple barely beat its top-line guidance by only 3.01% and 5.78% during the past two quarters. Those are both very small beats for Apple historically speaking and very close to an actual miss. Apple hasn't actually truly "missed" it's own earnings guidance for nearly a decade.
But one thing is very clear. These past two quarters were a very significant departure from its past history of beating by between 13% and 20% on top-line. This of course impacts the bottom-line because if Apple is selling less stuff, then less money is being pushed to the bottom-line which is resulting in lower EPS. But it all begins at the top-line.
The one thing Apple has been very consistent in doing -- until recently -- is offing revenue guidance that it has beaten by at least 10% pretty much every quarter in its modern history. So why did this happen and what does it mean for Apple's Q1 2013? What conclusions can be drawn as to what type of a revenue beat we should expect out of Apple's fiscal Q1 2013?
Either these two quarters were just flukes or outliers or they could be taken as an indication that Apple has changed its style in the way that it offers its revenue guidance. One can argue that the fact that we just saw two consecutive quarters where Apple beat its top-line guidance by only ~5% suggests that Apple may have changed its guidance style toward a more "realistic" or "aggressive" approach where Apple has chosen to essentially show all of their cards. That we are take its guidance exactly at face value.
The idea here would be that under Tim Cook, perhaps the days of Apple absolutely demolishing expectations are now behind us. Tim Cook seems to be more of an operations guy, and as an average everyday CEO, perhaps Apple may be shifting to a more normal guidance attitude where they offer shareholders a picture of what is likely to happen in the quarter.
But then this would beg the question: Why did Tim Cook come out and offer guidance that the company beat by 25.22% in Q1 2012 and 20.57% in Q2 2012 only to change mid-year? Why not change when he took over the company?
Look, I think the fact that Apple only beat its top-line by 3.01% in Q3 2012 and 5.78% in Q4 2012 could suggest that Apple has changed its guidance behavior to a more aggressive or "realistic" approach. I think that possibility is on the table. And if Apple comes in and barely beats on the top-line in Q1, then I will be squarely in that camp without reservation. Because three quarters in a row of coming in right above on the top-line is a clear trend.
So I think the bear-case for fiscal Q1 2013 is that Apple comes in with a 5% top-line beat on its guidance. It guided Q1 2013 to $52 billion in revenue which would mean that Apple would come in at $54.6 billion or essentially $55 billion in revenues. That's the bear-case. The bear-care is that Apple has changed its guidance behavior and instead of sand-bagging, Apple is now just telling us how it is. That would set Apple toward a particular growth curve for the 2013 fiscal year which we will discuss in more detail after Apple actually reports.
Now here is an alternative explanation. If Apple had sold a TOTAL of only 3-5 million more iPads, iPhones or a mix of both, it would have delivered results that were in-line with its historical trend in each of fiscal Q3 and fiscal Q4 2012. If it had sold 6-7 million more iPads, iPhones or a mix of both, we would have a near 20% top-line beat in each of both fiscal Q3 and fiscal Q4.
Here is what I think may have happened in Q3 2012. In the fiscal Q3 2012 conference call, Apple repeatedly mentioned that it had underestimated the amount of demand drop-off for the iPhone 4S as a result of rumors of the iPhone 5 coming out causing people to delay purchasing the iPhone 4S in Q3.
That unexpected drop-off on the demand curve made itself pretty clear not only as a result of Apple only beating its revenue guidance by 3.01%, but it was made clear by the gross margin shortfall. You see, Apple not only typically sandbags on the top-line. It also significantly sandbags on gross margins as well. For the last half-decade, Apple has consistently sandbagged on gross margins by an average of 300-basis. In fact, before fiscal Q3, the lowest gross margin beat we had seen was 190 basis-points in Q4 2010. In Q1 2012 Apple beat by 468 basis points and in Q2 2012 it beat by a whopping 537 basis points! That's insane.
In Apple's fiscal Q2 2012, it offered gross margin guidance of 42% and came in at 47.37%. That's a humongous beat on gross margins which in turn leads to the huge beat on the bottom-line as well. You have to understand that the reason this happen is because the iPhone is Apple's highest margin product. So the greater the number of iPhones sold ahead of Apple's internal expectations, the greater gross margins will increase above Apple's guidance.
The higher mix of iPhones to iPads and Macs, the greater the gross margin percentage. Well I think Apple's fiscal Q3 gross margin percentage tells a clear story of Apple misjudging the slack in demand for the iPhone 4S ahead of the launch of the iPhone 5. Apple went from beating its gross margin guidance by 537 basis points in Q2 2012 to only beating its gross margin guidance by 131 basis-points in Q3 2012 which was the lowest since Q2 2008. That's a four-year low in terms of how much Apple beat its gross-margin guidance.
I think what happened in Q3 2012 was that Apple was expecting demand for the iPhone to lead to sales of nearly 30 million iPhones on the quarter -- down from 35 million in Q3 2012 -- and instead the shortfall was by a few million devices as purchasers delayed ahead of the iPhone 5 launch.
If Apple sells 30 million iPhones in Q3 2012, we get not only a major beat on the top-line, we get a dramatically different gross margin number and obviously a much higher EPS number. With 4 million more iPhones sold in Q3, we have a 300 basis-point gross margin beat, and a 12% beat on the top-line.
This explanation I just outlined makes perfect sense for analysts, made sense for Wall Street, and until recently it made enough sense for investors to take Apple up to $700 a share. Even though there was a short-fall on revenues, gross margins and earnings, Wall Street brushed it off. Apple rallied $700 a share anyways.
What's more, even after Apple reported its fiscal Q3 2012 earnings, it was clear at the time of the report that fiscal Q4 would be highly uncertain as well. Mostly because if demand started dropping off as early as Q3, who the hell knows just how much that demand drop-off would continue into Q4 until the iPhone 5 launched. Also, you had to expect that Apple would allow iPhone 4S inventory to drawdown ahead of the iPhone 5 launch and at the time we had no idea when that launch would be. The drawdown in inventory would be a clear hit to Apple's fiscal Q4 to the benefit of fiscal Q1 obviously.
Yet, here's the big problem. This still doesn't explain why Apple repeated the same performance in Q4. One quarter is a fluke, two quarters and you have what forms the beginning of a potential negative trend.
That being said, I do think the short-fall in fiscal Q4 was due to an amalgam of different issues. Fiscal Q3 was pretty obvious. Apple made it clear that the revenue shortfall (and hence the margin shortfall) was the result of Apple misjudging the amount of slack in iPhone 4S demand as a result of consumers deferring purchase of the iPhone until the iPhone 5 was released.
I believe the shortfall in fiscal Q4 could be the result of a few different things all working together. You have to keep in mind here that the bottom-line isn't nearly as important when it comes to determining Apple's guidance behavior. Really, it comes down to analyzing how Apple guides its top-line and gross-margins that is most important. The bottom-line is just the result of understanding Apple's expectations for both revenues and gross margin.
In fiscal Q4, I believe the shortfall was the result of three factors. First, I believe we saw some deferring of iPad purchases as a result of rumors of an iPad mini being introduced during the first quarter. When the average non-stock follower keeps hearing about an iPad mini coming out, that is going to get some people to deferring purchasing an iPad until they have a chance to look at the mini first. Second, I believe Apple may have missed its internal target of delivering around 29 million iPhones on the quarter with a mix of iPhone 4S's and iPhone 5's helping reach the target. I think a few million of those iPhones may have slipped into Q1. Third, I believe Apple intentionally allowing iPad 3 inventory to drawdown ahead of the iPad 4 (refresh) was partly responsible for the shortfall. Apple did repeatedly explain that sell-through on the quarter was 44% which suggests that iPad inventory was intentionally drawn down on the quarter. The EPS short-fall -- as a complete side-note -- was also contributed in large part to Apple's unexpected currency hedge. For the better of the past decade, Apple has never reported a negative OI&E. Apple's Q4 was the first. That OI&E differential did have an impact of nearly $0.30 in EPS. But that's a complete side-note.
But coming back to this alternative theory, I think what we could have seen in Q3 and Q4 was two back to back exceptions to Apple's earnings-guidance trend as a result of Apple's management just slightly underestimating its shipments on both iPhones and iPads in each of the two quarters. And for totally different reasons.
What's more, it's very important to understand that fiscal Q1 and Q2 of 2012 were both supply-driven quarters. In a supply-driven quarter, Apple has a lot more control over total sales than it does in quarters were sales are at least in significant part driven by demand.
There's a distinct difference in a quarter that is driven by Apple recording sales as a result of shipping to its supply partners and a quarter that is driven by Apple having to gauge slack in demand. In fiscal Q1 -- and to a lesser extent Q2 -- the demand side of the equation was clear. There were more end-users and supply chain partners who wanted the device than Apple can produce the device. That's why we saw a nice distribution of sales between fiscal Q1 and fiscal Q2 -- 37 million iPhones in Q1 and 35 million iPhones in Q2 -- and a nice distribution of 20% top-line beats in Q1 and Q2.
However, in fiscal Q3, Apple only added a few smaller regional carriers, had largely met supply-demand parity and was thus required to gauge slack in demand when determining its guidance. That's why we saw two back to back 20%+ beats in Q1 and Q2 and then two back to back ~5% beats on the top-line in Q3 and Q4. Apple underestimated slack in demand, and we had all of the other factors discussed above.
Q1 2013 is a supply-driven quarter. That much is abundantly clear. What does that mean? It means Apple doesn't need to gauge demand in order to determine how many iPhones it will be able to ship on the quarter. Instead, Apple merely only needs to gauge its production capacity and visibility in terms of the number of iPhones it will be able to ship on the quarter. That's because demand for the iPhone 5 is much greater than the supply in the quarter. This means that Apple has a much better idea and grasp on how fiscal Q1 2013 is going to transpire than it did on how Q3 or Q4 2012 was going to transpire.
This much is and should be totally clear. It's pretty obvious the difference between Q3/Q4 and fiscal Q1 2013. The same goes for fiscal Q4 2011 and fiscal Q1 2012. That's why you have an analyst miss in Q4 2011 and the biggest blowout in Apple's history in Q1 2012. Why? Because Apple already knew how well it was going to do in Q1 2012 and decided to offer ultra conservative guidance.
Especially in light of the fact that it just missed or fell short of analyst expectations in Q4 2011. That's how we were able to determine the blowout would happen. Alright, so now let's think about where Apple stands right now and where it stood when it offered its guidance in October.
The bear-case is that Apple's management has shifted the way it has decided to deliver guidance for the reasons stated above. The bull case will argue that Apple just missed two quarters back to back as a result extenuating circumstances, and that as a result, you can expect that it offered extremely conservative guidance on the quarter. Again, for the reasons we stated above.
Let's suppose the bears are right and that Apple did change its character in offering guidance. Even if that were the case and Apple decided to start offering guidance that was a lot more realistic in terms of setting expectations, the company just delivered results that fell short of expectations twice in a row.
Accounting in general determines that it's always good practice to be more conservative after a miss. Its always better to under promise and over deliver, than to over promise and under deliver. In accounting, the first thing you learn is the "three C's." Consistency, conservatism and comparability. You want to be consistent in the way you do your accounting, you want to be conservative when choosing between two or more ways of viewing things and you want to deliver financial statements that are comparable i.e. you want to maintain the same accounting practices. If you change those practices, then you have to go back and amend earnings. That's why when Apple moved from subscription accounting back to "normal" accounting of the iPhone, it went back and adjusted all of its past earnings statements. So as to make the reports comparable.
Anyways. The point I'm making here is this. Even if the bear-case is right and Apple has decided to offer up "more realistic" guidance based on the evidence of seeing two back-to-back slight beats on the top-line (and on gross margin), Apple is still going to be more conservative with its guidance in Q1 because it just fell short of analyst expectations twice in a row. And that does in fact figure into the equation. When a company falls short of analyst expectations, it means that they aren't conveying to the public with enough clarity what to expect on earnings. And as we stated above, it's always better to be conservative and over-deliver than to be overly aggressive and potentially miss. Think about it from Tim Cook's perspective. A third miss and he be laughed at as the CEO who destroyed Apple. You have to consider that when thinking about Apple's guidance this quarter. Tim Cook knows that and knew that when he offered that Q1 guidance.
So I think even if Apple has decided to offer up more realistic earnings expectations -- and that will be decided when Apple reports Q1 2013 -- I still believe that Apple will set-up to beat its top-line by 7-10%. Even tough it only beat Q3 and Q4 by around 3-5%, I think it makes sense that they offer slightly more conservative guidance just to make sure that they can deliver on this new more realistic approach. Moreover, if Apple only beats by 7-10% on the top-line, it will start to become pretty clear to all analysts that the days of Apple sandbagging on earnings are over. That when Apple offers guidance, you have to take it at face value.
However, given the fact that Q3 and Q4 were demand-determined quarters and given the circumstances, I don't think its altogether clear yet whether Apple has chosen to go in that direction. Before those two quarters, Apple beat its top-line guidance by more the 20% in three out of the previous four quarters. And what's more, Q1 2013 is a supply-determined quarter -- like Q1 2012 and Q2 2012.
So who's to say that Apple hasn't sandbagged on the top-line and on gross-margin for Q1 2013 given that Apple has a lot more visibility on the quarter than it did in Q3 and Q4. Suppose for a moment that Q3 and Q4 were actual misses on the part of Apple to gauge demand and further suppose that Apple's historical policy of offering conservative guidance hasn't changed. We could be seeing a perfect storm for the mother of all blowouts on earnings just as we did last year. What if Apple says, "you know what, we missed on Q3 and Q4 internally, we're just going to be extremely cautious this quarter."
That possibility is certainly there. So now given that we have these different potential ways to view Q1 2013, we want to lay out what we think is a bear-case, bull-case and ultra-bull case (perfect storm). We're also going to talk about what Apple's guidance suggests in terms of iPhone 5 sales on the quarter.
As many of you know, Apple offered guidance of $52 billion in revenue on the quarter. Last year, it reported revenues of $46 billion and shipped 37 million iPhones. For Apple to be able to deliver $52 billion, it would have to sell substantially more than 37 million iPhones on the quarters.
What's more, you have to remember that Apple was likely being at least partially conservative even if it has changed its guidance practices. So you have to figure that this suggests that at the low-end, Apple is expecting to report $55.6 billion in revenues on the quarter.
If it's practice of being ultra-conservative is still in tact and Apple comes out and beats by 20%+ on the top-line, that would put Apple's revenue at $62 to $63 billion. If Apple beat on the top-line by the same amount it did last year in Q1 2012, it would report $65 billion in revenues.
Right now, analyst expectations are for Apple to report $54.56 billion and $13.31 in EPS. That would fall below the low-end of the range. Analysts on average are expecting less than a 5% beat on the top-line which is one of the lowest expectations in Apple's history. So expectations are running very low right now for the quarter. If Apple comes out and beats by the same margin it did last year or by the same margin it did in Q2 2012 or in Q3 2011, we could see a $10 billion top-line beat. What do you think that will do for sentiment?
What does $52 billion in revenue guidance suggest?
Now that we've laid out the different ways to view Apple's fiscal Q1 -- and I think regardless of how you view it, Apple is likely to beat expectations -- I would like to discuss what it would take for Apple to report $52 or $55 or $63 billion in revenues. First, you must understand that $52 billion in revenue is no joke. That is a massive revenue number. As I explained above, Apple reported $46 billion in Q1 of 2012 and that was on 37 million iPhones. So you can imagine that for Apple to just come in-line with its guidance, it would have to sell several million more iPhones and iPads just to meet its guidance. If it "disappointed" the same way it did in Q3 and Q4, that would be around $55 to $56 billion in revenue. I would like to discuss what it would take for Apple to meet that number.
Because it's important to understand what Apple's guidance suggests about the quarter and what it suggests about 2013 in general. It will also shed light on how to view the 2013 fiscal year, what Apple's TTM could end-up being and it sheds light on just how undervalued Apple is right now.
If Apple is still "conservative" then it is extremely undervalued right now and if Apple comes out and reports a similar beat to what we saw in Q1 2012 or Q2 2012 or Q3 2011, then we are likely to see an extreme revaluation of Apple's stock-price.
This table below outlines what we believe is the bear-case for Apple. This is what Apple's earnings report would look like if it reports a similar report as it did in Q3 and Q4, and if it has shifted towards a more aggressive or realistic policy of offering guidance:
What this table above assumes is that Apple beats its top-line by 7% and gross margins by 200 basis-points. Those would both be on the extreme low side relative to Apple's past history and in-line with how it performed in Q3 and Q4 of 2012. Notice that just to deliver a shitty report, Apple has to sell 48.2 million iPhones and 23 million iPads. That's pretty extraordinary when you think about it.
And here's why. Margins are going to increase as the year progresses and if Apple is selling 48 million iPhones and 23 million iPads a quarter, earnings on the year will probably be near $60 in EPS when it's all said and done. So keep that in mind. You also have to remember that during form factor changes, Apple tends to have an even distribution of iPhone sales over the course of the entire year. See the iPhone 4 for example where Apple saw increasing iPhone sales each quarter in 2011.
Now here is the bull-case. If Apple's fiscal Q3 and fiscal Q4 were just flukes, and if Tim Cook doesn't want to look like a total asshole who destroyed the greatest company on earth as an investment, he would probably offer ultra conservative guidance. I know if I was sitting in Tim Cook's shoes, I would not want to look like an asshole. But who knows. Maybe some people just want to go in that direction. Here is what Apple would deliver if it's policy of sandbagging guidance hasn't changed and if the circumstances explaining how Q3 and Q4 could be outliers were true, then this is what I think Apple would report:
Under these set of circumstances, Apple would deliver a 21.07% top-line beat -- similar to what it did in Q1 2012 and Q2 2012 -- and deliver a 400 basis-point beat on gross margin just as it did in Q1 and Q2 2012. This report mimics pretty closely what Apple did in Q3 2011, Q1 2012 and Q2 2012. It's up to you to decide what you think is more likely.
I've laid out the arguments for both cases. They are both very plausible. Could Apple deliver 55 million iPhones and 30 million iPads with the iPad mini? Definitely. This is a very plausible report. Can Apple deliver a 20% top-line beat? It has on four cases in the past. So why not again? Look if Apple has changed its guidance policy, that will become clear in Q1. If Apple comes out with a 20% top-line beat, then you know what happened in Q3 and Q4 were flukes. What's more, you have to consider the fact that the larger the top-line beat, the higher the gross margin beat. Why? Because as I explained above, the increase on the top-line would be the result of higher iPhone sales which carry higher margins. Hence, you get larger gross margin beats when you get larger top-line beats. That's why when Apple delivers those 20% top-line beats you get those 587 basis-point beats on gross margin as well. Which in turn leads to the huge bottom-line beats.
I'm inclined to give Apple the benefit of the doubt. Because it makes far more logical sense for a new CEO to tread carefully than it does for him to come out and offer aggressive guidance. That just doesn't make any sense to me whatsoever. So for that reason, I think the bull case is more likely. But that doesn't mean that the bears don't have a strong case. Because they do. It's up to you which to believe. You just have to carefully read the analysis and reasoning I laid out above and decide whether you think it makes more sense for Apple to report in-line with how it did in Q3 and Q4 of 2012 or with how it did in Q2 and Q1 of 2012. If you are in Tim Cook's shoes, and you just missed two quarters in a row, what do you do? Put yourself in his shoes. That will get you your answer.