The Oppenheimer Code, Fiscal Q2 2014, Part 5: “It’s a Trap!” (?) Analyst Expectations for Fiscal Q2/Q3 2014

itsatrap-starwars

____________________________________________

NOTE:  In case you’d like to refer back, click the following links for Part 1Part 2Part 3 and Part 4 of the current, fiscal Q1 2014 edition of my Oppenheimer Code home gamer earnings preview series.

My Oppenheimer Code posts for the prior three fiscal quarters are now collected in the Earnings Previews + Archive section.

NOTE:  As a friendly reminder/disclaimer, this isn’t treatise-level or expert-level stuff.  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.

____________________________________________

(Advance TL;DR warning.)  (Sorry I couldn’t give an advance bad pun warning. 😉 )

For the fourth quarter in a row, we reach the final part of my Oppenheimer Code series – the Wall Street expectations game.  Time to consult Yahoo! Finance once again to get an idea of analyst expectations, which seem “in-line” for the March quarter. As for the one after that…?

Analyst Consensus Estimates for Fiscal Q2 2014 (a.k.a. the “Turn Card”)

For the March quarter, as of now (a few days to go before the earnings release), “47.00” 😀 analysts polled by Yahoo! Finance are expecting Apple to report $43.55B in revenues (vs. $43.6B in the year-ago quarter) and $10.17 EPS on average (vs. $10.09 in the year-ago quarter).  (Reminder: Numbers are subject to continuous 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.)

That Oppenheimer certainly reset those expectations, didn’t he? If I typed them correctly back then, they were quite a bit higher as of about three months ago – $46.05B and $10.93 EPS.

After Oppenheimer emptied a giant bucket of ice water on analysts – and AAPL stock, you can see that analyst estimates “fell in line” with Oppenheimer’s $42B-$44B rev guidance range. That also goes for “implied EPS”, which I’ve calculated to range between $9.46-10.54 based on a “base case” of 884M share-weighted average of shares outstanding (if you’ll recall that $14B buyback back in February, which is only partly counted for the quarter).

Once again, there isn’t much room for “error” under guidance parameters, but Oppenheimer got the job done, as it were.  There’s a little bit of room for “upside surprise” even if Apple “merely” reports results at the top end of guidance.

Oppenheimer’s guidance prevents the possibility of a net income beat this quarter (without results being above guidance, of course), but if you’ve read Parts 3 and 4 of this quarter’s Oppenheimer Code posts (and maybe Part 3), you’d know why. It’s a combination of increased OpEx and increased deferrals.

Maybe it’s just me, but it doesn’t feel like anyone’s “expecting too much” from fiscal Q2. And without an 8-K or some data points (aside from one month’s worth of China Mobile’s 4G subscriber data), that’s certainly reasonable.

Was Apple “conservative enough” for this quiet quarter? We’ll get some answers next Wednesday.

Analyst Consensus Estimates for Fiscal Q3 2014 (a.k.a. the “River Card”) (TL;DR WARNING)

On to the “much bigger deal” – what analysts are looking for in the June quarter.

Here’s the actual results and profitability/EPS metrics from fiscal Q3 2013:

REVENUES revs units ASP
iPhone 18.15B 31.24M 581.10
iPad 6.374B 14.617M 436.07
Mac 4.893B 3.754M 1303.41
iPod 733M 4.569M 160.43
iTunes/software 3.99
Accessories 1.179B
Total revs $35.323B
METRICS
Revs 35.323B GM 36.87%
COGS $22.299B OpEx Ratio 10.82%
Gross Margin $13.024B Tax Rate 26.87%
Total OpEx $3.823B EPS 7.47
OI&E $234M # shares 924.27M
year-ago shares 947.06M
Inc before tax $9.435B
YOY share creep -2.41%
Tax provision $2.535B net share chg -22.794M
net inc ratio 19.53%
Net Income $6.900B

So the year ago compare was $35.3B in revs, a bit shy of $7B in net income, $7.47 EPS.

Let’s move right to analyst expectations for the June quarter.  Analysts polled by Yahoo! Finance expect Apple to ring up $38.26B in revs and $8.50 in EPS.

That represents 8.3% revenue growth YOY, and almost 14% YOY EPS growth. In “ordinary circumstances”, seems reasonable. But these aren’t ordinary circumstances in Apple’s growth story (at the moment, anyway).

First, let’s check EPS.

Assuming the same profitability results as last year, but accounting for, as a base case, the full 27M or so estimated shares Apple repurchased in February 2014 and nothing more, that leaves a diluted share count of around 874M or so. Divide accordingly and EPS becomes $7.89.

As far as revs, as I noted last quarter, analysts were thinking 5.6% YOY revenue growth. Apple’s response, via guidance? “Don’t expect anything better than about 1% rev growth, people.”

Well, it’s always best to look at things objectively when possible before jumping to any conclusions. So here’s what Apple “needs to do” in the June quarter to meet analyst expectations, starting with revenue, and wrapping up some paragraphs later with the EPS part of the equation.

Part I:  Fiscal Q3 2013 Revenue Commentary

– Right off the bat, we need to account for the unfavorable compare due to increased deferral for iPhones and iPads (which I believe is $5 more per unit) and the $20/unit increased deferral for Macs.  Assuming Apple can at least manage to sell around 45 million combined iPhones/iPads and close to 4 million Macs as it did in the year-ago quarter, that’s about $300M in additional deferred revenue impact.

– That means, since WS analysts can be assumed to have included the deferral impact, that revenues actually need to rise a little more than 9% from the year-ago quarter.

– Oh wait, I “forgot” about iPod. If it continues on its merry downward trend (no new iPods to boost sales, either), it’s very possible that iPod will contribute another $200M or so worth of revenue decline.

– Keeping things relatively simple, iPhone, iPad and Mac are three of Apple’s core businesses (accounted for about 83% of Apple’s revenue in fiscal Q3 2013), iPod will almost surely weigh, and iTunes/software/services plus Accessories will probably grow at a combined 10% or so year-over-year clip. So to meet the analyst consensus, Apple needs 10% revenue growth from all three of iPhone, iPad and Mac.

One or more lines can obviously compensate for underperformance, but we’ll just look at each product line by itself for the sake of brevity and focus.

iPhone revenue/units

Will iPhone revenue grow 10% YOY?

It helps that units were fairly “low”, at 31.2M units, along with a “low” ASP of $581 (under the previous deferral system). If iPhone ASP increases YOY, less unit growth is needed.

…but is unit growth a sure thing? It was 20% in fiscal Q3 2013 (sell-in basis), which may be why the analyst consensus is where it is.

We’ll probably need next Wednesday’s results and conference call remarks to get any clues, absent a new China Mobile data point before then. About that, at present there’s just no way to tell how well the TD-LTE iPhones are selling, or will sell. We’re lucky that China Mobile provided some color on iPhone’s “4G handset share” in the first place. Apple continues to increase points of sale/distribution, but the January quarter disappointed pretty much everyone despite, to give one example, China Unicom and China Telecom being able to sell iPhones for the full quarter.

My own way-over-actual miss aside (note the disclaimers I’ve posted), when the pros collectively guess 54.1M iPhones sold in fiscal Q1 2014 and Apple actually sells 51M, it makes you wonder whether expectations have been “properly” adjusted yet. Apple had its bright spots in key regions, but you wouldn’t know from the GAAP numbers alone.

This isn’t a bearish commentary on Apple Inc. (the financials should improve with sentiment by September or so), but it just isn’t very clear where the growth will be coming from (the US carriers sure don’t look to be helping in that department). Q1 2014 just wasn’t that great for iPhone growth-wise, and by Q3 2014, there shouldn’t be any channel inventory shortages from the year-ago quarter for Apple to really “take advantage of”. China Mobile has the potential to boost growth immensely all on its own, sure, but the TD-LTE network rollout continues, iPhone 5S/5C grow “older” and less popular by the day (as all smartphones do), the consumer ARPU and handset preference demographic is nothing like Japan or the US, and a bunch of China Mobile iPhone intenders are waiting on iPhone 6 with the potential for a broader/better high-speed cel network as a bonus.

Back to those “troublesome” US carriers. Per Oppenheimer, US iPhone unit sales increased 51% on a sell-in basis for fiscal Q3 2013. Uh, does anyone see anything like that happening in the current quarter?

Lest I seem too bearish, the unit growth “burden” may be lightened by a YOY increase in ASP, despite the $5/unit disadvantage. But as I pointed out in Part 2, higher ASP necessarily constrains units at a given revenue. Since Oppenheimer means what he guides (absent something like an 8-K filing), higher ASP in the March quarter “paradoxically” results in fewer units sold, hence slower growth in fiscal Q2 2013, therefore increasing the odds that analysts overshot the unit sales mark once again.

True, Oppenheimer cited the four factors of channel inventory, lower iPod sales, unfavorable currency environment and increased deferrals as impacting guidance by “over $2 billion” for the just-ended March quarter, but at least three will remain at some level to weigh down the June quarter, unless the US dollar starts weakening (any economists in the house?)

I won’t discount the possibility that some mental over-correction from last quarter is carrying over to this post, but it certainly seems like some third-quarter assists are no longer here, with some newly added negatives to further affect the growth story. It won’t take long to see if and how much I need to recalibrate.

iPad revenue/units

Let’s assume I “worried needlessly” about iPhone revenue, and ASP and units both grow year-over-year (the easiest way to meet the 10% rev growth target, after all). What about iPad? Can it carry its weight in revenue growth?

Apple sold a “low” 14.6M units at an ASP of $436 – last quarter’s ASP numbers and the newly introduced $399 and up iPad 4 suggest ASP won’t see any meaningful YOY upside. OK, so how about units? That 14.6M was the result of…well…a 14% YOY unit decline. Oppenheimer explained:

Turning to iPad, we sold 14.6 million iPads during the quarter compared to 17 million in the year-ago quarter. The tough year-over-year comparison was driven by both the significant channel inventory increase and the first full quarter of the availability of the 3rd generation iPad in the year-ago. We built 1.2 million units of iPad channel inventory in the June quarter last year, whereas we reduced channel inventory by 700,000 units in the June quarter this year.

Factoring in this 1.9 million unit channel inventory swing, iPad unit sell through was down 3% year-over-year. We exited the quarter with about 4.1 million units of iPad channel inventory within our target range of 4 to 6 weeks.

Granted, iPad’s “sales cadence” was completely thrown off in 2012. iPad 3 followed the prior trend of iPad launching in March or April. With iPad 4’s surprise launch in November 2012, consumers were “left” with no new iPad for Spring 2013. But at the same time, consumers also had more choice than ever before, with iPad 2, the iPad mini and iPad 4 all available and shipping worldwide. And that “how come iPad isn’t doing better with the improved lineup?” question lingered on for fiscal Q4 2013, where sales were roughly the same as the year-ago quarter (though it’s also true that iPads had never been “that stale” at that point in the year in previous years).

The product offer comparison is far superior this year, and last year saw a significant YOY channel inventory drawdown, which should help in some way. iPad mini 1, iPad 4, iPad mini retina and iPad Air are all available (four iPad families vs. three in the prior year). And TD-LTE iPads are being sold/channel-filled with China Mobile to some degree (with the 14.6M unit compare, it doesn’t take nearly as many units to move the needle). Will that be enough to, depending on how you look at it, result in significant YOY unit sales improvement, or stem the sequential decline as savvy consumers wait on iPad Air 2, a potential iPad mini retina redesign, and the possibility of a cheaper iPad mini retina?

It might, despite the collective competition upping their game as well. Adding a megacarrier to the list of third-party resellers always helps. But visibility’s poor when you don’t even really know how iPad performed in the just-ended March quarter…which is only the second opportunity to assess this particular cycle of iPad seasonality.

Mac revenue

Less important, and we’re already into extremely wordy territory, so I’ll keep this section relatively brief. How likely is it that Mac can grow revenues 10% YOY?

Quite likely, actually. With flat rest-of-Mac sales (it’s possible a MacBook or two could see a refresh in the June quarter, which would help) and steady ASP across those lines, it wouldn’t take “many” super-high-ASP Mac Pros to make their presence known. Particularly given the “low” 3.754M Mac unit number from fiscal Q3 2013. The major questions of the June quarter are how many Mac Pros the US assembly factory is capable of producing, how long this apparent initial wave of popularity will last, and how niche micro-workstations are in Mac work/creative/power-user/education settings, along with how many MacBook Pro and iMac sales are being redirected (versus an incremental sale) due to Mac Pro’s availability.

Part II:  Fiscal Q3 2013 EPS Commentary

Since it’s even less fun to slog through all this without the author’s opinion, just “for fun” I’ll guess that $38.26B analyst consensus revenues may lead them down a path of some disappointment. What of EPS?

Gross Margin

Prior year GM was 36.87% – with iPhone 4 mix being part of the “problem”. This year, iPhone 5S seems to be top-of-mind amongst iPhone consumers, which will certainly help counter the impact of increased deferrals. Speaking of which, Mac Pros will “laugh off” a $20 deferral given their high price and their potential to improve Mac gross margin substantially (I mean, $1200 to max out RAM), so there’s that too.

The thing is, if revenues are static, GM must increase to compensate to reach that $8.50 target – buybacks alone won’t do the trick (of course, Tim Cook telegraphed an intention to increase buybacks for a third time in February, and I expect Apple to make a multi-million-share statement – er, new share repurchase – in the June quarter).

If revenues grow, but GM doesn’t? That’s another way to bridge the gap between the “base case”, zero-growth $7.89 EPS projection and $8.50.  About 6% rev growth would be enough assuming a “maximum” diluted share count of 874M.

There is a significant complication on the road to higher EPS, though – OpEx.

OpEx

Q3 2013 OpEx was $3.823B. If my theory holds, Oppenheimer will guide OpEx to a low range of around $4.3B.

But let’s assume that low-end guidance rings in at $4.2B. That’s still an increase of almost 10% (which outpaces revenue even under the analyst consensus), and an after-tax impact of around $275M based on Apple’s recent 26% or so tax rates.

Potential impact on EPS? 30 cents. That’s the problem with things like steady-state R&D spending in a given fiscal year – often good for the long run, bad for quarterly compares. As far as revenues, Apple would now need just about $38.26B in revenues assuming static GM, tax rate and OI&E to reach $8.50.

Funny how easy it was to “arrive” at the analyst Q3 revenue consensus, isn’t it?

Assume Apple can increase GM to 37.5% in the June quarter – no small feat considering further reduced revenue leverage – and revenues “only” need to grow about 6.7% YOY (to around $37.5B) to reach $8.50 in EPS. Though that’s assuming OpEx is guided to as low as $4.2B.

“Bonus”: AAPL Tree Home Game “Out on a Limb” Q3 2013 Guidance Projection

Revs: $34.5B-36.5B

GM: 36-37%

OpEx: $4.3-4.4B

 

Finally, the big question – is it really a “trap” of too-high expectations? Apple has some pathways to growth in the June quarter, with a great slate of products and great cost control to go with generally good quality control. But Q1 results and Q2 guidance leave me “nervous” (not for Apple’s future, just short-term financial trends), and at least a couple of tailwinds have been basically replaced with headwinds. There’s also that ever-unpredictable “rumor factor” that management has actually cited for at least one sales pause, and rumor season seems to begin earlier and earlier each year. So y’know what, Admiral Ackbar? Better prepare for evasive maneuvers just in case.

 

This concludes my Oppenheimer Code post series for fiscal Q2 2014.  Hope you found it a decent read!

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s