The Oppenheimer Code, Fiscal Q4 2013, Part 5: Turn Card, River Card – Weighing Analyst Earnings/Guidance Expectations

NOTE:  As a friendly reminder/disclaimer, this isn’t treatise-level or expert-level stuff, not even close.  Just one person’s exceedingly humble attempt to gain a bit more insight into Apple’s fundamentals.  This isn’t “forest from the trees” – it’s even higher up in the iClouds.  More expert AAPL fundamentals types need not read on.

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(Advance TL;DR warning.)

And now we reach the final part of my Oppenheimer Code series for the just-ended fiscal quarter – that darned expectations game.

In Texas Hold ‘Em terms, can Apple improve its hand in spite of the unhelpful flop?  (I’ll be here all week.)  And will Apple’s new product introductions (namely, iPad Air and high-res iPad mini) help – or hinder – Apple’s ability to post solid fiscal Q1 results?

While we mull that over (sorry, there’s no answers to be found in this post), let’s consult Yahoo! Finance to get an idea of analyst expectations.

Analyst Consensus Estimates for Fiscal Q4 2013 (“Turn Card”)

For the just-ended “September quarter”, as Oppenheimer and other Wall Street types call it, analysts are expecting Apple to report $36.8B in revenues and $7.89 EPS.  (Note:  Numbers are subject to revision by analysts and this data disappears shortly after earnings, though you can compare against Thomson First Call estimates after that point, since they’re always cited by financial reporters.)

Revenues are just within Oppenheimer’s guided range of $34B-37B (though many analysts are looking for a revenue beat, which is far from assured under Apple’s new guidance methodology).

EPS is somewhat trickier because everyone’s guessing for number of shares outstanding.  But using my more conservative buyback scenario from Part 1 of this quarter’s earnings posts, we get implied EPS between $6.88 – $8.04 (assumes a recognized repurchase of 11M shares for fiscal Q4 2013).  Again, not much room for “error” under guidance parameters, but at least Oppenheimer’s still moderating expectations “on his terms”.  Do note that we’ve yet to see Apple’s net income exceed the new-methodology guidance range.

Needless to say, iPhone is the deciding factor for the September quarter.  We’ll see what Oppenheimer “really meant” by expecting actual results to be in the upper range of guidance in about a week’s time.

Analyst Consensus Estimates for Fiscal Q1 2014 (“River Card”) (TL;DR WARNING)

Now we move on to the much bigger deal – the holiday quarter.  The moment of truth, the validation of Apple’s literal betting (on its product pipeline).  This is the quarter of “no excuses” – or at least, less excuses.  iPhone 5S and 5C will have their first full quarter of availability (in many major markets, at least), and iPads, if they remain popular, will need to ramp up quickly to meet demand as the holiday season approaches.  Very, very quickly in the case of the iPad mini, which carries an availability date of “later in November” (though probably in time for Black Friday sales).  The refreshed Retina MacBook Pros and Mac Pro will chip in, though modestly even compared to iPad.

As of today, analysts expect Apple to ring in $55.47B in revs and $13.82 EPS.  (That’s one penny higher than year-ago EPS.)

Here’s the actual results and profitability/EPS metrics from fiscal Q1 2013:

REVENUES revs units ASP
iPhone 30660000000 47789000 641.5702358
iPad 10674000000 22860000 466.9291339
Mac 5519000000 4061000 1359.024871
iPod 2143000000 12679000 169.0196388
iTunes/software 3687000000
Accessories 1829000000
Total revs $54.512B
Revs 54512000000 GM 38.63%
COGS 33452000000 OpEx Ratio 7.06%
Gross Margin 21060000000 Tax Rate 26.00%
Total OpEx $3.85B EPS $13.81
OI&E 462000000 # shares 947217000
Inc before tax 17672000000
Tax provision 4594000000
Net Income $13.078B

At first glance, this looks encouraging for AAPL bulls. Apparently, those 40 or so analysts tracked by Yahoo! Finance collectively think Apple will bump revenues by a whopping 1.7% year-over-year (as of now, anyway), and that EPS will remain unchanged (more than likely factoring in the ongoing share buyback as “protecting” EPS – meaning they feel actual net income will decline YOY).

Almost seems like a bar set for a mature blue-chip company, not a tech company.  So do we have in front of us the legendary “easy” compare – and a proverbial gift horse for AAPL bulls?

Not necessarily.

Never forget the wild card of Peter Oppenheimer himself.  Since he’s a legendary sandbagger, analysts have already adjusted for the potential of conservative range guidance. Wall Street fully expects the “consensus” number to fall within the revenue range Oppenheimer provides.

On the other hand, even though Oppenheimer remains tough to read and the new guidance methodology is, well, new, it has been shown that Apple can meet the top-end of guided revenue range and even slightly exceed it.  So, if Oppenheimer’s top-end range guidance is higher than, say, $56-58B, analysts will consider that favorably in my humble opinion.

With that in mind, let’s look at what I think are the most important elements – iPhone, iPad, and the bolded metrics of gross margin, OpEx, and net income.

iPhone revenue

iPhone 5 really wasn’t quite the success Apple hoped it would be.  Remember those head-scratching sequential compares that Tim Cook suddenly brought out during the fiscal Q1 2013 conference call?  And yet, despite iPhone 5’s less-than-stellar sales velocity, Apple still saw 29% YOY growth – and that was comparing against a 14-week holiday quarter, meaning “true sell-in” YOY growth was higher on a like-for-like basis.  And if you believe Oppenheimer’s assertion that Apple’s 14th week in fiscal Q1 2012 was “similar” to any other week in that quarter, a little straight-line extrapolation brings “adjusted” iPhone YOY growth from about 29% to 39%.

Of course, you can’t apply a 39% YOY growth factor to the Q1 2013 iPhone number and call it a day.  The bigger the base, the harder it is to grow at the same percentage.  And while iPhone 5S/5C may turn out to be “more successful” than iPhone 5, 47.79M iPhones is a tremendous number of phones to build on.  But if iPhone 5S and 5C’s initial reception is a useful indication of interest (I think it is, but we won’t know for sure until late January), iPhone is set to very comfortably exceed the 50M unit sales mark in the current, holiday quarter.

Since we’re only going as far as product-line revenue for now, the next checkpoint is ASP.  $641 is pretty high, and Apple’s iPhone ASP has seen consecutive YOY declines.  But if iPhone unit sales are up 20%, then an ASP decline of even 10% (which I consider unlikely) still equates to a net increase in revenues (around $2.5B using the Q1 2013 numbers).  Of course, if Apple’s truly turned around its slowing growth, Wall Street and AAPL bulls alike will be looking for considerably more impressive numbers to aid the “turnaround” narrative.

iPad revenue

While iPhone sales haven’t impressed much this year (fiscal Q3 2013 excepted), they have grown each quarter this fiscal year on a YOY basis.

iPads haven’t.  It’s possible iPad will see two consecutive quarters of YOY decline in fiscal 2013.  As I mentioned earlier this series, the skewed compares are partly responsible – but facts are facts, and it’s very fair to question exactly what is going on.  Even though I’m not yet concerned about iPad long-term, negative-to-no-growth is a far cry from high-double-digit to triple-digit growth.

So let’s look at unit growth first.  Wall Street sure wouldn’t like Apple putting in a no-to-low-growth number for iPad sales in the holiday quarter – not with a lineup of four iPads, led by iPad Air and Retina iPad mini.  Both iPads bristle with mostly-new technology and are certainly the most appealing iPads yet.  (Sure, Apple could struggle to bring production velocity and yields to optimal levels, but Apple’s a publicly-traded company and much is quite rightly expected from them.)

It’s more than reasonable to expect Apple to post some significant gain over the 22.86M iPads sold in the year-ago quarter.  But has Apple “painted itself into a corner”?  The iPad 2 and the slightly cheaper first-gen iPad mini will be all that Apple has to sell until November 1.  Don’t count on much unit contribution from those iPads.  And the much-anticipated Retina iPad mini sounds like it won’t be out until there’s around 6 weeks or less remaining in the holiday quarter.  Clearly, production rate and initial supply will be key factors here.  Not so much product rollout, though – there’s a long list of first-stage launch countries for iPad, and that includes China. The points of sale are there, they just have to be put to work, as it were.

Assuming Apple’s new iPads are popular enough and production levels good enough, that leaves the question of ASP.  Fortunately, at $467 per iPad, much of the iPad ASP “damage” was already done by the end of calendar 2012. iPads had an ASP of about $593 in fiscal Q1 2012.  In the July quarter, that number was $436, which I’m guessing is about as low as ASP will get.

For this quarter, the presumed-bestseller Retina iPad mini – that is, assuming people can “get over” the $70 price increase – starts at $399.  Prices top out at $829 on that model, up from $659, thanks to the addition of a 128GB model and the same price premium for cellular data that Apple’s had from iPad 1. And iPad Air retains the top-end price of $929 for a 128GB + LTE model.

Seems like ASP will “take care of itself” on account of Apple’s “pricier” Retina iPad minis alone.  The big question is whether people are willing to spend an additional $70 for the new mini’s very significant enhancements.  The very notion of $399 being “too dear” for an iPad seems bizarre, considering the pundits were shocked by Apple’s lower-than-expected $499 iPad base price back in 2010.

But times have changed and the competition is brutal.  Other tablets from the Nexus series to the Kindle Fires and countless other entrants are trying their best to be “good enough” and undercut Apple on price however they can.

This fiscal year promises to be very interesting, particularly since Apple has decided to pursue its traditional value-added strategy rather than engage in a race to the bottom.

Will Oppenheimer “let AAPL bulls down” and guide conservatively during this pivot in Apple’s iPad mini strategy, to say nothing of the ever-present specter of early supply/production constraints?  We’ll have some idea in a matter of days.

Gross Margin

Moving onto gross margin, the prior-year compare is 38.63%.  Considering that the year-ago compare before that was a formidable 44.68%, things are already looking up from a guidance standpoint.

(That is, just as long as Apple isn’t shifting its margin strategy yet again, after three or four quarters of relatively small sequential GM differentials.)

Considering that Oppenheimer’s guided a 100 basis point range in gross margins for the past three quarters, there’s a real precision to this aspect of guidance that there just wasn’t most quarters in the past.  So for the AAPL bulls, here’s hoping that anticipated high iPhone revenue mix and greater revenue leverage lead the way, allowing Oppenheimer the confidence to guide to around 36-37% gross margin at minimum.  Just don’t be surprised if Wall Street’s banking on iPhone sales to bring gross margins higher than that – maybe even higher than 38.63%.  That’s the expectations game for you – it’s not just about Oppenheimer guiding to “good enough” revs and net income ranges.

Between the 5S and the “5 by a another shell” 5C, iPhone margins should be fine.  What blended iPad margins will be in the holiday quarter is anyone’s guess – Apple never gives out specifics.  iPad Air is re-engineered, but some components remain the “same” (such as the Retina Display and rear camera) and some components have actually gotten smaller (the enclosure and the battery).  Meanwhile, iPad mini has clearly gotten more expensive to build, mostly similar enclosure aside, but the price is $70 higher to “compensate”.

OpEx

Here’s where things get particularly interesting. As in tricky from a year-ago compare standpoint.

OpEx was $3.85B in fiscal Q1 2013.  But the overall OpEx trend has clearly been up over the past 10+ quarters, and Apple is actually realizing “poorer” OpEx efficiency as a percentage of revenue than in the recent past, even with higher revenues.

Why?  My guess, it’s because overhead, R&D, and stock-based compensation expense don’t come cheap.  To build for the future, investments must be made, maintained, even expanded as needed.  If my guess is correct, Apple – in the “best case” scenario – will “stair-step” OpEx to a new quarterly range for fiscal 2014.  Exactly what that is, no one knows, but an increase of about $500M (extrapolating from fiscal 2012 to known/guided data for fiscal 2013) would have a net income impact of around $375M – which is roughly 3% of fiscal Q1 2013’s net income.  The EPS hit would be slightly amplified by a reduced share count.  This is a “problem” that can only be addressed with revenue growth and stable gross margin in the current holiday quarter.

Net Income, EPS and the Buyback Factor

To conclude with the bottom line, given what we know and can infer, Apple is capable of posting a YOY increase in net income if the stars of product availability and demand align.  The stage is set for stabilizing gross margin, absent some big increase in cost structure from the new iPads.

As a “fallback” Apple should be continuing its buyback program, which could make for a share reduction of 5% or more compared to fiscal Q1 2013.  Buybacks improve EPS, after all.  But I don’t see it as much of a fallback.  “Juicing the numbers” considerations aside,  Apple simply doesn’t provide EPS guidance any longer. So analysts will be left to their own devices post-fiscal Q4 2013-earnings.  How they’ll make their calculations, and express their findings/sentiments to the media and their clients based on those calculations, is anyone’s guess.  Love ’em or hate ’em, they have an undeniable influence on AAPL sentiment.

The AAPL bull would hope for guidance strong enough to provide most analysts with a “margin of error” even if they assume zero or minimal share count reduction in the holiday quarter.

This ends my Oppenheimer Code post series for fiscal Q4 2013.  Hope you found it a half-decent read!

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