The Maestri Code, Fiscal Q3 2014, Part 2 (Revenue Mix/”Bonus Estimate”): Will Apple Keep Sandbagging During its “Slowest” Quarter?

(Advance TL;DR warning)

It’s funny how “hopeful” fiscal Q3 turned out to be in the span of less than 2 hours on April 23, 2014.

I guess at Apple, a good CFO always keeps analysts guessing. At the same time, Maestri and Oppenheimer made it very clear (perhaps quite intentionally) that actual results can and will exceed the top end of guided revenue by more than a “measly few hundred million” without prior notice. Which is a nice wrinkle to add (to those bullish on AAPL), even as it goes against the “reasonably likely to report within” stated purpose of the current range methodology.

Considering the strong financial results from Q2 and high optimism from management during the last conference call, how might a humble home gamer (say, me 😀 ) go about etch-a-sketching a revenue projection for the seasonally-slowest June quarter? (“Bonus” AAPL Tree home game estimate follows at the end of this post.)


You know all about Apple’s Q2 earnings beat by now – just in case you don’t, I typed up a quick recap here, and you can read a more detailed rundown of the numbers here (Macworld).

As with last quarter, this post forms the basis for my humble home game “earnings estimate”, absent an unusual event like a guidance-related 8-K filing from Apple. Consider this something like a thought exercise and not much else. If I’m half-right on general trends, that’s great, but the overall point of the earnings preview has always been to…well…preview earnings, rather than show how stunningly accurate I am.  😛

Let’s proceed once again to the intense wild-guess-type analysis. With last quarter’s overall earnings surprise, nothing changes under current range methodology other than the upside surprise factor. Apple continues to show a strong unwillingness to overpromise. All actual revenue numbers since fiscal Q2 2013 have been at the upper range of the guidance range or better.

So what revenue number will I draw out a hat this time? With guided revs being $36B-$38B…I’ll over-correct for being too conservative at exactly the wrong time :D, and say Apple rings in around $38.5B in revenues.

Before my revenue mix projection, let’s see the actual results from the year-ago quarter, fiscal Q3 2013 (NOTE:  I abbreviate “iTunes/Software/Services” as “iTunes/software” to save on space):

REVENUES revs units ASP***
iPhone $18.154B 31.241M 581.10
iPad $6.374B 14.617M 436.07
Mac $4.893B 3.754M 1303.41
iPod $733M 4.569M 160.43
iTunes/software $3.99B
Accessories $1.179B
Total revs $35.323B

Once again, we “force-fit” the six revenue categories to my $38.5B revenue projection. “If Apple reaches this revenue level, how did it get there?” Here’s my humble take on this, and yes, your opinion may vary – considerably:

Revenue “Estimate”:

REVENUES revs units ASP
iPhone $20.292B 35.6M 570
iPad $6.930B 15.4M 450
Mac $5.306B 4.02M 1320
iPod $288M 1.8M 160
iTunes/software $4.489B
Accessories $1.208B
YOY iPhone 13.95%
YOY iPad 5.36%
Total revs $38.514B YOY Mac 7.09%
YOY iPod -60.60%
YOY iTunes/SW 12.50%
YOY Accessories 2.50%

$38.514B. That’s about “right”.

Now for some quick home gamer commentary on each revenue category, starting with iPhone and working our way down the revenue categories to Accessories.


iPhone – “Broad-Based” Strength

Can CFOs “troll”? Is that a thing outside the Internet?

Let’s just say that “we expect the value of the underlying sellthrough to grow year-over-year” was one heck of an understatement…because Apple’s total GAAP (sell-in) revenues not only grew, they grew well above expectations in Q2.

Of course, that was driven primarily by considerably-better-than-expected iPhone unit sales. But was that relative to everyone’s expectations – or just the inherently-less-informed “everyone except Apple”?

Anyway, since iPhone has been the steadiest (and strongest) growth engine for Apple lately, I’m *ahem* going out on a limb and guessing that this will also hold true for the July quarter, despite iPhone being at its “lowest ebb” on account of seasonality and (probably) being the last full quarter without new iPhones on offer. Basically, I’m making the assumption that Apple will continue to prove it can grow iPhone year-over-year worldwide by leveraging growth cadences in various international markets, even if “stronghold” markets such as the US don’t grow in the quarter.

I know, the iPhone 6 anticipation factor is an unknown quantity, but iPhone units didn’t stop growing in Q3 2013 because of iPhone 5S anticipation. It also helps that at least one Wall Street analyst – Katy Huberty of Morgan Stanley, who’s generally been more accurate on iPhone than the pro analyst mean – sees robust iPhone demand (Huberty’s AlphaWise survey tracker actually estimates “iPhone demand” of 39M units, almost 25% YOY growth assuming demand equals a sale, in fiscal Q3).

Given the constraints of my chosen revenue number, why do I have iPhone growing about 14%? Part of it is my ASP projection of $570. There does appear to be a gradual overall downtrend in iPhone ASP, considering an “ASP” of about $613 in Q2 2013 and about $596 in Q2 2014 – increased per-unit deferral (which I’m estimating at $5 extra/unit) doesn’t account for the entire difference. Higher mix of lower-priced iPhones in growing emerging markets is the more significant cause. Lower ASP, higher units for same revenue. Simplistic, but hey, it does keep things simple. And it’s logical that 5S demand will weaken as iPhone 6 anticipation builds (not to mention those waiting on the 5S to move to the second-tier, slightly cheaper spot on Apple’s lineup).

So, is 14% unit growth “high”? Well, iPhone unit sales grew 20% YOY in Q3 2013, and without any benefit from carriers like NTT DoCoMo or China Mobile (though that benefit may be reduced by China Unicom/Telecom selling iPhone at launch, much earlier than usual). It’s notable that iPhone units grew 17% YOY in Q2 2014 despite the year-ago quarter having an unfavorable (to GAAP unit growth) channel inventory compare, and despite growth pressure in the US market (Cook cited more restrictive upgrades on postpaid plans) which proved to be unrepresentative of the worldwide iPhone market.

I’ll sum up the iPhone section with a quote from Tim Cook in the Q2 conference call (transcript via Morningstar, emphasis mine):

“I think that this quarter, if you were unsure, hopefully this quarter demonstrates to you that we can do well in a number of geographies from emerging market[s] to develop[ed] market[s]. Some of the numbers that we’ve experienced just to quote some of the more historic prepaid market; through the first half of ’14, Brazil was up 61%, Russia was up 97%, Turkey was up 56%, India was up 55%, Vietnam was up 262%. I could go on, but the point is that there’s a number of markets out there where we are beginning to really catch on to a number of customers, and I am particularly proud of the results in these markets because these have not been historic strong points for Apple.”

My wild guess – Cook knew full well that citing these Q2 YOY growth figures also set expectations for Q3. Will Apple deliver?

 

iPad – Management is Confident, But How Will iPad Unit Sales Fare Before November?

iPad is not in any danger, if you believe the executives at Cupertino – not in the least. Call me naive (or “worse” – a fanboy! :P) but I’m giving management the benefit of the doubt on account of Apple’s strong Q2 results.

Of course, if Tim Cook’s still bullish on iPad, the question remains – when will growth return to the product line? iPad Air is a nice redesign and advance of the line, even if the screen resolution and the rear camera remain the same. For whatever reason, the arrival of the unicorn iPad mini retina was not met with the kind of reception that the “fuzzy-screened” first-generation iPad mini received, at least from a perceptible YOY growth perspective. And I don’t think the price was that much of a problem, considering the iPad mini retina is very nearly the equal of the iPad Air except for screen size.

Touch ID – which is surely to be added to all new iPads in short order – will be nice. But Touch ID, “a faster processor” and iOS 8 don’t seem to have sales-curve-boosting potential on their own. In other words, if the present trend is plateauing/slackening demand, “incremental” features may not be enough to reverse it.

And it’s not necessarily an Apple-specific problem either. Regarding China – a market relatively free of traditional PCs – Cook cited an IDC market forecast of flat tablet growth in the Jan-Mar quarter (vs. 6% iPad sell-through-basis unit (?) growth). Speaking of which, IDC fairly recently reduced its worldwide tablet growth forecast from almost 19% to 12.1%, and that’s including “2-in-1” “ultrabook” tablets that are really laptop hybrids (perhaps niche, but still worth noting).

(To provide a more “complete” picture, Gartner gives a much rosier projection of about 24% worldwide tablet growth this year.)

iPad’s ascendance – heck, the tablet market’s ascendance in general, whether it be new-generation PMPs right on up to 2560×1600-screened heavyweight contenders – has been stunningly swift. So much so that maybe a plateau-ish period shouldn’t be too surprising. As long as worldwide computing needs don’t settle on a different form factor in the meantime (such as “good enough” phablets), you’d figure tablets, with their built-in price advantages, will continue gaining ground in some inverse proportion to PCs losing ground. And if PCs “stubbornly” resist downtrend? Then we’ll see if there’s anything to my tinfoil “total addressable dollars” theory.

Meanwhile, we wait to see if iPad growth can resume before the refresh/next generation iPads likely due in November or so. For purposes of this “estimate”, I’m projecting (yes, wild-guessing 😀 ) slight YOY unit growth of around 5% since:

(1) Apple reduced channel inventory in fiscal Q2 (less need for drawdown in fiscal Q3, more favorable YOY compare conditions?)

(2) Apple will have some level of channel fill (channel inventory increase, which is part of GAAP sell-in units) on account of its iPad + LTE distribution agreements with China Mobile (beginning of April) and NTT DoCoMo (June 10). One would also assume some actual sales to justify the channel fill. 😛

(3) As many of you know, the $399/529 iPad received a tremendous upgrade, jumping from iPad 2 to iPad 4 in mid-March. Not necessarily “good” for ASP depending on sales mix, but considering the venerable-but-aging iPad 2 dates back to early 2011, the much-improved “cheap full-size iPad” should help in the units department, right?

…y’know, maybe iPad won’t fare “so badly” in fiscal Q3 after all. But we’ll see if a YOY delta of around +800,000 iPads was anywhere close to the mark before long.

As far as ASP, I assumed a $14 YOY increase (around $20 accounting for the increased deferrals starting September 2013, which I guessed to be $5 more per iPad). It does represent a $15 sequential decline. iPad 4 is a wild card of sorts, but I’m choosing to go with the YOY trend from the prior fiscal quarter, where ASP increased over $15 compared to fiscal Q2 2013. A “side benefit” of higher ASP is built-in unit growth conservatism for a fixed revenue target.

 

Mac – Accessible MacBook Air, Quiet (-Selling?) Mac Pro

There’s been very little going on in Mac-land – as you might expect from a company that, for better or for worse, seems to launch nearly all of its products in the latter half, even third third, of the year.

  • The MacBook Air lineup got a speed bump and $100 price drops across the board in late April, which is helpful for growth since it’s the most affordable (and likely popular) non-BYODKM Mac in the lineup.
  • Apple “value engineered” the low-end 21.5″ iMac (mid-June) with lesser specs to hit a $1,099 starting price, but it’s hard to see that one model being much of a needle-mover except for maybe certain education markets (but what do I know).
  • Mac Pro now ships within 24 hours (as of early/mid June). And I think that’s pretty much it.

Gartner and IDC, unusually, are in essential consensus that Mac US shipments will decline around 1.5% YOY. As it turned out, worldwide Mac units grew close to 5% YOY in fiscal Q2, “overcoming” US unit decline estimates by both Gartner and IDC in calendar Q1. (If you were interested, I recently wrote a mini-post on this here.)

Will Apple make it three quarters of worldwide unit growth in a row? My guess – yes. Tim Cook reported unit growth of 13% in the Greater China revenue geography, strongly outperforming the IDC forecast of -8% growth in China that he mentioned. Luca Maestri also noted that Mac ended fiscal Q2 slightly below Apple’s 4-to-5-week channel inventory target range.

Not much to go on, but when you balance the above “plusses” (including a meaningfully better MacBook Air lineup vs. most of Q3 2013 and the second-gen Mac Pro) against Gartner’s/IDC’s projection of a Mac sales headwind in the US, will Apple manage around 7% YOY Mac unit growth? Hmm. I wonder if it’s actually iPad that’ll outperform Mac in unit growth terms – at least I won’t have to wait too long to find out.

One other puzzle – ASP didn’t seem to be affected much by the advent of Mac Pro, which had its first full quarter of availability (albeit supply-constrained throughout) in fiscal Q2. I’m guessing there’ll be a sequential ASP decline but a YOY ASP increase, though you might say that depends on Mac Pro “making itself known” in the product mix despite its niche status in Apple’s lineup. The YOY ASP delta is actually about $36, not $16, on account of the $20/Mac increased deferral beginning around September 2013.

Now to quickly go over the remaining revenue categories.

 

iPod – Soon to Be Overshadowed By…the Other Income & Expense Category?

I mean, OI&E is around $200M.

iPod unit sales continue to tumble in what appears to be an any-day-now transition to…something else. Is the iPod trademark destined for imminent disuse, with an iWearable supposedly on the way? Or is iPod simply consolidating to mostly iPod touch in the near future, in which case we would be anticipating a refresh at some point? For now, I applied a negative growth projection of 60% or so, and we’re off to iTunes/Software/Services.

 

iTunes/Software/Services – Still Chugging Along

19% YOY growth for the holiday quarter, 11% YOY growth for Q2. For now, I’ll just keep the Q3 revenue growth assumption at 12.5%. Is the category somewhat seasonal? Maybe the data between Q3 2014 and Q1 2015 will provide clues. Whatever the case, as long as overall iPhone/iPad/Mac unit growth continues, and installed base continues to rise, it’s hard to see this category not continuing to grow YOY, and steadily gaining more stature/importance in Apple’s business. Even if the actual contribution to earnings could be relatively modest compared to Apple’s combined hardware margins in percentage terms.

 

Accessories – In Need of a Jump-Start, or Just a Cash Cow-Type Business Line?

Accessories revenue growth is quite slow these days. 2% YOY for Q1 2014. 3% for Q2. Is this part of the reason Angela Ahrendts was hired, and/or part of the reason Beats was acquired? Or have people sufficiently stocked up on Lightning cables? 😛 For now, I’ve adjusted the growth rate assumption to 2.5%.

 

“Bonus”: My Home Game Estimates for Fiscal Q2 2014

Finally, my estimates for the quarter:

$38.513B revs (9% YOY growth)

35.6M iPhones
15.4M iPads
4.02M Macs
1.8M iPods a.k.a. once-great-product-category-reduced-to-rounding-error

$4.489B iTunes/software/services revenue
$1.208B Accessories revenue

38% GM (could be conservative)
$4.42B OpEx (might be a bit high)
26.5% tax rate
$7.655B net income (11% YOY growth)

$1.28 EPS based on estimated 5.99B shares outstanding (share-weighted basis)


Next up, should I get to all of it – a checkup on OpEx, an update on gross margin/operating margin, and a look at analyst expectations for the fiscal Q3 and in-progress fiscal Q4.

*** Note:  ASP isn’t quite true average selling price due to deferred revenue.  But since the vast majority of the product’s price is recognized at the time of sale (and refining ASP to account for deferrals, amortization, etc. is basically impossible), the simple division of revs by units is “good enough” for home gamer purposes.  If you want full details, you can check out Oppenheimer’s iCloud revenue deferral here (pages 4-5 of the presentation section) and any Apple 10-Q filing.  Note that AppleCare revenue is part of iTunes/software category revenues (note c, page 27 of the Apple Q3 2013 10-Q filing).

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