The Maestri Code, Fiscal Q3 2014, Part 5: The Weight of (Analyst) Expectations for Fiscal Q3/Q4 2014

Last quarter was a trap all right. (Referring to last quarter’s Part 5 title.)

For all those who didn’t think Apple was capable of substantially outperforming its own guidance without an 8-K filing. (Which, of course, includes me, but it’s of some personal solace to know “all those” also includes pretty much everyone else.)

And so for the fifth (!!) quarter in a row, we reach the final part of my AAPL home game earnings preview series – the Wall Street expectations game.  Time to consult Yahoo! Finance once again to get an idea of analyst expectations……

(Advance TL;DR warning – it’s over 2500 words.)


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 (though if you do anyway, super!).


Analyst Consensus Estimates for Fiscal Q3 2014 (a.k.a. the “Turn Card”)

For the June quarter, as of now (about a week before the earnings release), “43.00” (never gets old 😀 ) analysts polled by Yahoo! Finance are expecting Apple to report $37.86B in revenues (vs. $35.32B in the year-ago quarter) and $1.22 EPS on average (vs. $1.07 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.)

Just another case of the Apple CFO (now Maestri) setting the bar, and analyst consensus quickly gravitating right around the top of that bar.

And you know what? I can’t blame analysts for having generally “rosy” projections for Q3, considering how Q2 results turned out. There’s pretty much “no room for error” based on the guidance range (which “tops out” at $38B) and my “implied EPS range” (which only guesses for shares outstanding – I believe it tops out at $1.25 per share).

Did Oppenheimer/Maestri do enough to keep analyst expectations in line, despite, well, not actually doing all that much to control them during the rather cheery Q2 conference call? 😀 We should find out on July 22.

Analyst Consensus Estimates for Fiscal Q4 2014 (a.k.a. the “River Card”) (TL;DR WARNING)

On to the much, much bigger deal – what analysts are looking for in the September quarter.

Y’know – the iPhone 6 launch quarter (so iPhone 6 intenders and AAPL bulls alike fervently hope).

Here’s the actual results and profitability/EPS metrics from fiscal Q4 2013:

REVENUES revs units ASP
iPhone 19.51B 33.797M 577.27
iPad 6.186B 14.079M 439.38
Mac 5.624B 4.574M 1229.56
iPod 573M 3.498M 163.81
iTunes/software 4.26B
Accessories 1.319B
Total revs $37.472B
METRICS
COGS $23.601B GM 37.02%
Gross Margin $13.871B OpEx Ratio 10.25%
Total OpEx $3.84B Tax Rate 25.94%
OI&E $113M EPS (adj)
$1.18
Inc before tax $10.143B # shares 6.36B
Tax provision $2.631B year-ago shares 6.52B
Net Income $7.512B YOY share creep -2.42%
net share chg 160M
net inc ratio 20.05%

So the year ago compare was $37.47B in revs, just about $7.5B in net income, $1.18 EPS.

For fiscal Q4, analysts polled by Yahoo! Finance expect Apple to ring up $40.65B in revs and $1.34 in EPS. That represents 8.5% revenue growth YOY, and close to 14% YOY EPS growth.

Hey, are the analysts on some strange median form of autopilot or something? Because that’s pretty much the same as last quarter! (If you need “proof”, you can check here.)

As always, the big question is – does that sound like something Apple can reasonably achieve – and will Apple “guide accordingly” (whatever that means)?

First, let’s check EPS.

My base case scenario for shares: About a further 70M net share reduction from fiscal Q3 – call it 5.92B shares outstanding. Assumes Apple kept the same rate of share-based compensation expense, and opened a new $12B ASR (accelerated share repurchase) with a “side” of open-market purchases, with most of the “shares due” under the ASR having been delivered, though not share-weighted, by the end of fiscal Q3.

So assuming net income doesn’t grow (you’d think it will YOY, absent intentionally higher iPhone 6 cost structure vs. even iPhone 5), that’s a roughly 7% YOY drop in shares outstanding. That equates to a “flat growth EPS” of $1.27, “meaning” that analysts “really” expect organic (EPS) growth of around 5.5%, assuming that their diluted share count is around the same as mine.

Second, revenues. In April, Apple guided to top-end revenue growth of about 7.6%. Who knows what they’ll do this quarter. In January, “actual-to-guidance” YOY growth expectations were “set” at about 1% (vs. analyst expectations of 5.6% rev growth).

Here’s what Apple “needs to do” in Q4 to meet analyst expectations, starting with revenue, and wrapping up some paragraphs later with the EPS part of the equation.

Part I:  Fiscal Q4 2014 Revenue Commentary

– Increased revenue deferral for Macs, iPad and iPhone will remain headwinds until fiscal Q1 2015, but at least Wall Street is adjusted to it. It’s $20/unit more for Macs compared to fiscal Q3 2014, and maybe around $5/unit for iPhones and iPads. Net deferral impact may well be less, however, when accounting for amortization. (We’ll see if I get around to updated deferral studies – which are highly “experimental” and full of unavoidable guesswork – before the earnings announcement.)

– Just like last quarter, the “10% growth test” seems like a half-decent way to puzzle out Apple’s growth prospects in fiscal Q4. iPhone, iPad and Mac account for the vast majority of Apple revenue, after allOf course, iPhone accounts for more than half of Apple’s revenues in any given quarter, so, as usual, it needs to be the product workhorse to drive growth for the time being.

– iPod will likely continue to hurt Apple’s revenues, maybe around $250M-$300M in revenue impact. On the other hand, iTunes/software/services growth should, given historical trends, “cancel that out” at the very minimum.

Moving on to some quick iPhone, iPad and Mac unit and revenue growth comments…

iPhone units and revenue – “The Workhorse”

In the year-ago quarter, iPhone revs were $19.51B; units were 33.8M; ASP was $577 (no increased deferrals which I estimate at $5 more/iPhone).

Will iPhone units grow about 10% YOY in Q4?

This actually looks like a “solid yes” – granted, provided a bunch of conditions are met. iPhone 6 demand wouldn’t seem to be a problem. After all, this is “the bigger iPhone Apple should’ve released at least two years ago”, and I think the sense of anticipation is fairly self-explanatory as well as self-evident. ASP should at least be more-or-less stable – the more iPhone 6 units get sold before Q4 ends, the better the ASP should be. And the 2-year-contract-before-upgrade requirement is being met for more and more people in the US now that September 2014 is rolling around.

Amusingly, this just might mean Apple’s ability to meet Wall Street’s Q4 expectations is “simply” a function of Apple’s supply chain and production capability. Of course, with a product redesign and one this important there’s all manner of uncertainties, of both the “blown-out-of-proportion-by-media-and-pundits” and the “actual genuine operational concerns Apple faces” variety. Apple has the resources and sales channels. Does it have the processes, the supplies, the production velocity, and the ability to launch iPhone 6 with “enough time to spare” in mid/late September? If so, it may well have all the demand it “needs” to grow units well over 10% YOY – and China Mobile should help with that to some degree.

Now, that’s the not the same as saying “if Apple doesn’t launch iPhone 6 by September 20, Apple is doomed” – though I’m guessing management won’t find it ideal in the least. This is just the “state of play” based on Apple’s iPhone 5 and 5S sales cadences. And with iOS 8 promised “in the Fall”, it’s at least reasonable for analysts and market participants to expect that there’s nothing different about the iPhone launch schedule this year.

iPad units and revenue – “The Laggard” (?)

This is gonna be a tough one.

In the year-ago quarter, iPad revs were $6.19B; units were 14.1M; ASP was $439 (no increased deferrals which I estimate at $5 more/iPad).

Will iPad units grow about 10% YOY in Q4? Until we get some indirect clues via Q3 results and management guidance for Q4…I’d actually be OK with iPad units and revenue just being flat YOY.

The good news is, “given sufficient demand” for (1) cellular iPads on new major carriers (read: China Mobile, NTT DoCoMo), and/or (2) the way-better-value-for-money “budget” iPad 4, there’s some positive market forces for iPad that just didn’t exist in the year-ago quarter. Quantifying these forces and netting them out against short/intermediate-term iPad growth uncertainty, though? That’s another matter entirely. I can make a wild guess that ASP, which was near historic lows in Q4 2013, will be stable to slightly positive, but that’s all it is – a wild guess.

I’ll be listening in to the conference call very carefully for any clues on demand and channel inventory. Is iPad now Apple’s most seasonality-affected product (mostly-irrelevant iPod aside)? The “good news” for AAPL bulls is that iPad usually accounts for under 20% of Apple’s revenues, so iPhone (and Mac to a limited degree) are able to “balance out” any weakness in iPad for its likely-slowest quarter (which of course assumes iPhone 6 will launch, and in sufficient quantity, to “compensate”). And since iPad doesn’t really start revving up until the holiday quarter, any “weakness” will have a “positive” side effect on gross margin.

Mac units and revenue – “The iPad Counterweight”

Interestingly, as iPad unit growth has waned, Mac unit growth has returned, jump-started by iMac in the holiday quarter. If Apple manages three straight quarters of Mac unit growth with the June quarter’s results – could Apple make it four straight growth quarters as the back-to-school season wraps up?

In the year-ago quarter, Mac revs were $5.624B; units were 4.574M; ASP was about $1230 (no increased deferrals which are confirmed as $20 more/Mac).

“Wait, $1230? Sure that’s supposed to be a ‘2’?”

Yes! Turns out it was an “anomalous” ASP in the context of the past 8 quarters or so. Mac ASP has typically been in the $1300 range as of late. IF the $1200ish ASP level is the exception, that could bode well for the Mac revenue compare in Q4. Assuming ASP returns to about $1300 (the increased deferral is a slight negative, amortization will alleviate some of it), that’s Mac segment revenue growth of over 5% without any unit growth.

That leaves the matter of units. Is it a “given” in this post-PC world that the Mac business has runway enough for consistent growth, even if muted? Well, any incremental Mac Pro demand will be incredibly helpful, however niche – by default, one incremental Mac Pro sale is “worth” more than two “normal” Macs, and given that most pro users probably have needs exceeding the base configuration, I’d expect Mac Pro ASP to be considerably north of $3000. Beyond that, it might be as “simple” as refreshing the MacBook Pro lineup (though iMac refreshes would also help). The X-factor – the new Apple unicorn product variant, the intriguing-yet-unseen Retina MacBook Air.

It could also be that Macs, despite Apple’s best efforts, will continue treading water at best as PCs continue to wane in popularity. We’ll still need several more quarters of data to get a better sense of the Mac growth trajectory.

Part II:  Fiscal Q4 2014 EPS Commentary

Net-net, I’m actually fairly optimistic about Apple’s Q4 prospects, provided Cook and Company can continue to “make it look easy” and get iPhone 6 out in massive quantities before the close of fiscal Q4.

If the units and revenues will be there (in that situation, which obviously is not guaranteed), what about EPS?

Gross Margin

Prior year GM was just about 37% (very close to historical lows since Q4 2008), with iPhone 4 proving surprisingly popular as the somewhat “unpopular” iPhone 5 reached the end of its top-tier product lifecycle.

A key determinant of gross margin will obviously be the cost structure of iPhone 6, what with its rumored A8 architecture, new enclosure, maybe new camera systems, and the maybe-higher-resolution panel with the might-be-sapphire-ish cover glass. There’ll be a lot happening at once in the event of an expected” September launch. Apple-wide margins should continue to improve to the extent products don’t get refreshed. There shouldn’t be any loss of revenue leverage, unless Apple has a very unpleasant surprise for AAPL bulls around the corner. Margin mix shouldn’t be a problem absent a surprise new iPad by September or an unanticipated demand spike.

The unknown? The relative gross margins of the “maturing” 5S (mostly same enclosure as iPhone 5, new chipset and Touch ID system) vs. the redesigned iPhone 6 (completely new enclosure, new chipset and probably other camera components, with the Touch ID system being the one of the few potential “carryovers”).

Of course, any negative or positive impact of iPhone 6 on overall iPhone margin will be blended in with Q4 sales of the current iPhone lineup. And assuming Apple intends to produce more iPhone 6 units than iPhone 5S units over their initial 12-month production cycle, Apple may be able to drive down the cost curve more quickly than with any prior iPhone – including iPhone 5.

Apple certainly has the ability to add as much value (read: cost) into iPhone 6 as it chooses, though it’s not like the iPhone 5S wasn’t a big upgrade over the 5. With Samsung sputtering, it’ll be interesting to see what Maestri’s gross margin guidance will point to. I’m sure the competition won’t be all that pleased with a “stable” sequential gross margin guide, considering that mysterious, unusually durable/bendable cover glass that’s been seen on YouTube here and there.

Operating Expenses

Q4 2013 OpEx was $3.84B. If my theory holds, Oppenheimer will guide OpEx to a low range of around $4.3-4.4B (ish).

Assuming it’s “no worse” than $4.4B on the low end, that’s an after-tax impact of slightly north of $400M. So it’s worth keeping an eye on.

Potential impact on EPS? Maybe 7 cents or so. A headwind affecting EPS by around 5%.

(Well, at least “level” quarterly OpEx spending “benefits” fiscal Q1s…even if it’s the only fiscal quarter that benefits.)

Assuming static GM/tax rate/OI&E from the previous year, Apple would need around $40.3B in revenues to reach $1.34 in EPS. Given that analysts are expecting revenues to be about $350M higher to net the same EPS result (and that Apple’s stair-step OpEx spending is no big secret), maybe they’re “bracing for” margins to be guided lower? Say, to around 36% on the top end? That’s my tinfoil theory, but who knows.

Buybacks

Apple’s current authorization is up to $90B. And it used $46B as of the Q2 2014 earnings release. If Apple “used” its bond issue on a new ASR and open market purchases like I’m guessing, Apple’s used about $60B or so of the authorization so far – meaning the first buyback expansion allotment (of up to $60B) is already spent with six fiscal quarters to go.

With the option to buy back $30B or so in additional shares in 18 months, Apple has no real need to rush – unless it thinks it might be best to “buy low” while it still can. On the other hand, Apple probably prefers to finance its buybacks with bond issues to the maximum extent possible – and it “only” has $18B or so in domestic cash (end of fiscal Q2 2014) vs. almost 90% of its total cash offshore. Assuming it uses borrowed funds to finance buybacks first, it could well be that Apple’s already expended the [EDIT: $12B] in bond proceeds from late April. So it’s a delicate, complicated balancing act, with Apple basically being “forced” to rely on domestic cash generation and the debt market to fund the buyback program, which necessarily slows it down.

What’s it all mean? Unless Apple returns to the debt market in short order, I’m not seeing very much in the way of new buybacks in Q4 2014 relative to the prior two quarters.


 

“Bonus”: AAPL Tree Home Game “Out on a Limb” Q4 2014 Guidance Projection

Revs: $37B-40B

GM: 36-37% (fine, call me overly optimistic)

OpEx: $4.4-4.5B

 


Wrapping up with the critical question – has Wall Street set expectations too high?

I could be hilariously wrong on this, but for Q4…I don’t think so. It’s not entirely out of the question that China Mobile alone could provide much, if not all, of the “necessary” iPhone unit/revenue growth that Apple “requires”. After all, “just 2 million iPhones” would equate to about 6% of Q4 2013’s unit sales. And it’s not like the rest of the world isn’t decently excited about iPhone 6 either.

To recap? Only my exceedingly humble opinion, but in order to meet analyst consensus, Apple basically “needs to” launch iPhone 6 with “enough” days to spare in September. It “needs to” have the necessary quantity to meet the probably-insane initial demand spike – which requires “sufficient” componentry, production capacity, and production velocity. And it “should” have refreshed MacBooks and maybe Mac minis on offer to “assist” growth – while we wait to see just how iPod-like the iPad line-up is in seasonal or even market-potential terms before the anticipated November-ish update.

Note the quotes, though. It’s not like Apple must adhere to any arbitrary timetable to survive, or even do very well. It’s just the current, actually-quite-sensible expectation that Wall Street shares with most everyone else watching Apple or waiting for that next new iPhone. We’ll see if Apple continues to follow the cadence set in 2012.

This concludes my Oppenheimer Code post series for fiscal Q4 2014.  Hope you found it a decent read!

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