The Maestri Code, Fiscal Q3 2014, Part 1 (Net Income Preview): Improved Visibility and a Chance at a Profit Growth Threepeat

(NOTE: Edits made in certain places to reflect the 7-for-1 share split.)

Same Code, Different Name

Welcome to the fifth (!) installment of my humble home game AAPL earnings preview series.

Hey, isn’t Oppenheimer still CFO right now? Well, yes, until June per Apple, but Oppenheimer barely spoke at the last conference call. It’s only four times a year, but presenting and taking questions at conference calls is an important Apple CFO responsibility. So I’m renaming the series “The Maestri Code” just a little bit early.

And make no mistake, it was very much Luca Maestri’s financial presentation. Very smooth and polished…no surprise, given that Maestri’s already been a CFO (for Xerox). With a few differences from Oppenheimer. Maestri seems to be a little more methodical when explaining growth and giving the percentages. And when deemed necessary, Maestri also seems to take just that little bit of extra time to discuss sellthrough (in Q2, for iPad) and provide some helpful context beyond a GAAP sell-in number.

That’s different from playing guidance close to the vest, though. Just when analysts thought they had Apple’s range guidance figured out, Apple reports a big beat over guided revenues and even analysts’ old expectations of Q2 EPS guidance. The guessing game is on again just as Maestri takes over.

Running the Ranges

Here’s how the net income and EPS numbers look based upon guidance and the latest buyback information.

Apple’s range guidance for fiscal Q3 2014 (against the backdrop of a very confident Apple management, who had the numbers to back it up) was:

  • revenue between $36 billion and $38 billion
  • gross margin between 37 percent and 38 percent
  • operating expenses between $4.4 billion and $4.5 billion
  • other income/(expense) of $200 million
  • tax rate of 26.1 percent

March 2013 actual results were:  $35.3B revs, $7.47 EPS, 36.9% GM, $3.82B OpEx, $6.9B net income, with about 924M shares outstanding.

Running the ranges yields net income guidance of about $6.67-7.57B. Which is a really big deal.

Why? Because net income range guidance has never overlapped with year-ago results. In other words: Apple has never guided to the possibility of year-over-year profit growth under the current guidance methodology, until just a couple of weeks ago.

Margin stabilization plus revenue growth sure help that way. And Apple currently expects both revenue and gross margin to grow YOY, though OpEx (along with higher per-unit deferrals, to some degree) will be a significant profit headwind.

Should Apple report net income growth in fiscal Q3 (it seems reasonably likely since midpoint profit guidance is $7.12B), it’ll effectively be the third straight fiscal quarter of profit growth. Fiscal Q1 2014 did see a YOY profit decline of $6 million, but that incorporates probably around $500M in additional deferred ESP revenue compared to the year-ago quarter (counting only the delta in per-unit deferral) – translating to a net profit impact of over $350M.

Estimating Diluted Shares Outstanding and “Implied EPS” Guidance

How many shares outstanding will be counted at the end of the quarter? Apple currently says there’s about 861M shares outstanding, which I don’t think is the total for EPS/diluted share purposes (we’ll deal with the 7-for-1 share split next quarter). Apple reported 879M diluted shares at the end of Q2, with some share repurchases yet to be fully incorporated plus some unknown amount of new share repurchases in the works for Q3.

I’d originally assumed Apple would purchase around 27.7M shares with its reported $14B buy (as a base case), and about 17M would be reflected in fiscal Q2.

What actually happened? Apple “bought back” 31.7M shares (page 49, Q2 2014 10-Q). Here’s how it breaks down.

– Apple repurchased about 11.4M shares on the open market for $6B (page 17 of the 10-Q).

– Given that it used up $18B in total cash for repurchases in Q2 (page 24 of the 10-Q), that leaves $12B for “all other repurchases”, which were all from an ASR (accelerated share repurchase) arrangement Apple entered into in January 2014. (By the way, Apple’s two larger ASRs from April 2013 and January 2014 have each been $12B in total payments; take a wild guess what the third one will be for.) Given the way the ASRs work per the 10-Qs, though, the entire amount to be used is paid up front, with the entire amount to be actually spent on purchases by a certain end date – in the case of the January 2014 ASR, on or before the end of the year.

– Apple actually received about 20.3M shares under its two ASR programs in Q2 (the April 2013 one just wrapped up).

Doing some quick math, Apple repurchased 4 million shares more than I “guessed”, and it net-share-settled about 5M more shares in Q2 than I estimated. So to arrive at an estimated diluted share count for Q3:

– I’m factoring in about 2.5M total shares worth of share creep for Q2 and Q3 given the current run-rate of about $700M in share-based compensation per quarter (page 19 of 10-Q).

– That means in a “base case” scenario (assumes no buybacks in Q3), Apple will net-share-settle almost 29.5M shares between the start of Q2 and the end of Q3. Under that scenario, Apple’s diluted share count for Q3 will be about 872M, a decrease of about 7M shares from Q2.

– I doubt Apple raised $12B from new bond issues to not enter into a new ASR arrangement right away, though. I’m also guessing that Apple will continue opportunistic open market share purchases. So I’m going to estimate that Apple will repurchase an additional, I dunno, 7M shares (conservatively) on a share-weighted basis in Q3, resulting in reported diluted share count of 865M (or around 6.05B in late July, if you wanna get all technical).

Given all that, “implied EPS” would be around $7.71 – $8.75 per share (diluted), which is now $1.10 – $1.25 per share post-share split. So unless Apple misses guidance (I seem to remember Tim Cook saying something about Oppenheimer never guiding over actual), it’s almost a “certainty” that EPS will grow YOY, even if actual net income doesn’t.

For reference, Yahoo! Finance currently has the analyst consensus EPS at $8.52. (UPDATE: As of early July, the analyst consensus has moved up very slightly to $1.22, or basically $8.54 on a pre-split basis.) I could be ridiculously wrong on this, but considering last quarter’s big surprise, I’m guessing managing Wall Street expectations is all going according to plan at Cupertino HQ.

Changing of the CFO Guard

To wrap up: It’s a great time to be a new Apple CFO, and a great time to be a CFO-elect. Maestri gets his start as Apple’s “voice” of finance with a combination of good results and “good enough” guidance, and it’s not too much of a stretch to guess that still-better times are ahead, meaning Maestri will in reasonably short order have even better results and guidance to deliver to Wall Street. That alone is a nice gift from Apple Inc. and Oppenheimer.

As far as the CFO-elect part, it’s possible that Oppenheimer guided Apple through the most “tumultuous” financial phase that the company will see for quite some time. Maestri avoided the public-facing brunt of attention (though as VP Finance/Controller, he lived a large part of the margin transition plan, which is plenty challenging enough), while taking a year-long master class from Oppenheimer on how Apple handles these “situations” in conference calls. When you think about it, Oppenheimer really does deserve a bunch of credit for his transition plan…it almost makes you wonder if he doesn’t get a little extra very-well-deserved enjoyment from the fruits of his long labor by staying around in a transitional capacity until September.

Ciao, Luca! Happy trails and happy flying, Oppenheimer. Apple guidance was incredibly tough to figure out – meaning you did your company proud, never mind the whole galactic revenue, profit and cash growth under your tenure part. Now it’s time for another accomplished CFO – maybe even the mastermind behind Apple’s current capital return program – to take the stage, and preside over what is quite likely to be a third straight quarter of profit growth.

I’ll continue my fiscal Q2 earnings preview as we get closer to July, the usual time for the Q3 earnings release.

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