The Maestri Code, Fiscal Q1 2015 Part 2/2 (OpEx, Margins, and Current Quarter Guidance) – Great Expectations

(Reminder: This blog does not dispense financial/trading advice of ANY kind.)

Welcome back to the second installment of the Semi-Abridged Maestri Code for the December quarter!

Like the previous quarter (and the five before that), we’ll take a quick look at operating expenses, margins and those always-interesting analyst expectations. Operating expenses might or might not continue on a linear-esque path, gross margins are always hyper-scrutinized by Wall Street, operating margins tracking will change considerably as of the upcoming earnings release and analyst expectations…seem pretty imposing at first glance.

Best to not waste any more time with the intro, and get right to the home gamer “good stuff”.

Operating Expenses Update

The OpEx “escalation game” continues. Or…does it?

Well, in the literal sense of escalation, yes. The sequential driver in fiscal Q4 was actually SG&A expense. That’s unusual as of late. Yes, SG&A has “always” been the majority component of OpEx, but it’s been basically sequentially flat from Q3 to Q4 in fiscal 2012 and 2013, with a $110M jump in the same interval back in fiscal 2011 ($1.915B >> $2.025B). But in fiscal 2014, the sequential increase was a much higher than “usual” $308M jump from Q3 to Q4 ($2.85B >> $3.158B). Why the jump at that time? Your guess is as good as mine. Management’s annual explanation of SG&A trends is, well, only year by year (2014 10-K page 33):

The growth in SG&A expense during 2014 compared to 2013 was primarily due to increased headcount and related expenses, including share-based compensation costs; higher spending on marketing, advertising and professional services; and the Company’s continued expansion of its Retail segment. The growth in SG&A during 2013 compared to 2012 was primarily due to the Company’s continued expansion of its Retail segment and increased headcount and related expenses, partially offset by decreased spending on professional services.

R&D spending did increase sequentially, though at its “slowest pace” for the fiscal year ($1.603B >> $1.686B). Now, SBCE (share-based compensation expense) was roughly $2.4B or so of all OpEx for fiscal 2014, but it’s still well under 20% of that amount (~$18B).

Apple’s December quarter OpEx guidance of $5.4-5.5B (“minimum” year-over-year increase of ~$1B) is notable for being the largest year-over-year increase since the Q1 2011 to Q1 2012 interval (which was ~$900M). Steps, escalators that suddenly look less-than-linear, who knows? No one asked at the conference call that I can recall, and management probably would’ve answered in general terms anyway (besides, Apple had just guided up to a Street-thumping $66.5B in revenues). Is it related to Apple Watch? Staffing up for 2015? A big retail, advertising push? A large sequential jump in R&D spending for products beyond Apple Watch and Apple Pay? Maybe all of the above.

Luckily, Apple’s revenue growth just might keep better pace with Apple’s OpEx this fiscal year.

A quick chart, and off we go to margins.


Margin Checkup

Operating Margins


Starting FQ1 2015, things could look considerably different thanks to the inclusion of Retail into operating results. The effect? A “truer” sense of revenue region performance, but “lower” operating margins, since Retail, well, just has lower operating margins. Luckily, there will be some amount of reconciliation into the past – we’ll take another look at things once that data is released.

Note several considerations in play for FQ4 2014, including: (1) the unknown effect of the iPhone 6/Plus sales pause, then sales surge; (2) increased ESP deferrals beginning at the tail end of FQ4 2013; (3) ForEx (US dollar strengthened against many currencies, particularly during the second half of 2014); and (4) sellthrough vs. GAAP (as Tim Cook explained, for instance, Greater China performed far better than GAAP results suggested – iPhone sellthrough units were up a very strong 32% YOY without a new iPhone launch in the quarter, vs. a benefit from the iPhone 5S launching during FQ4 2013 with China Unicom and China Telecom).

Quick additional notes: Americas and Europe were strong revenue growth regions at ~16.5% and 19% YOY growth respectively. Europe also had solid YOY operating margin growth of about 200 basis points. Greater China had tremendous operating margin growth, to 37.7% in FQ4 2014 from 31% in the year-ago quarter. Rest of Asia Pacific also saw solid operating margin growth of 270 basis points YOY – and if you add in Retail, its overall operating margin probably comfortably exceeded the Americas region (which has the majority of the world’s Apple Retail Stores). Japan appeared “underperforming” in operating margin, though revenue was up about 5% YOY. And 46.3% operating margin, considering also the above factors, is nothing to complain about.

Gross Margin


I’m guessing a gross margin beat of 70 basis points over top-end guidance – so 39.2% vs. Maestri’s top-end guidance of 38.5%. Apple has beaten its own GM guidance in three of the past four fiscal quarters (in FQ4, it matched top-end guidance of 38%). Apple faces strong ForEx headwinds, yes, but it also has one of the best ForEx hedging teams in the business. It also seems like Apple will have, in addition to unprecedented revenue leverage, an absolutely enormous share of (initially higher cost-structure) iPhones in its revenue mix, with less margin dilution from iPad. Of course, should actual GM be right around 38.5%, consider that a “statement” from Luca Maestri – at least for the time being – that GM guidance is to be taken with greater “seriousness”.

Analyst Expectations for Fiscal Q1 2015, Q2 2015

I actually overviewed much of FQ1 2015 expectations in Part 1. Analysts just keep raising their numbers – and now, it’s over management guided revenue by around $750M. Might we be looking at a sudden “consensus” revenue estimate of close to $68B right before earnings? One thing I think I know – Luca Maestri knew full well what he was doing in guiding FQ1 revenues “as high as he did”. And Maestri, like Oppenheimer before him, and Anderson before him, does not appear to be particularly aggressive in his guidance “strategy”…the, uh, “sandbag torch” appears to have passed to Maestri without a hitch.

Though expectations are high (analysts are expecting the top end of “implied EPS” – $2.58 – and may well exceed that), I suspect Apple will not disappoint. It just wouldn’t make sense to “begin” the FQ1 earnings season with so much enthusiasm without management expecting even better things by quarter-end.

Of course, that’s not the only consideration for those with a stake in AAPL (stock, options, both, whatever) at earnings time. As always, the quarter in progress will be on Wall Street’s mind.

So, what are analysts expecting (for now) in Q2 2015? $53.63B in revenues (up 17.5% YOY), and EPS of $2.00 (vs. $1.66 in FQ2 2014, a delta of 20%).

The “EPS part” isn’t the problem. Apple should have at least 5% fewer diluted shares outstanding compared to FQ2 2014, for starters, and iPhone 6 will find its way down the cost curve at record pace given record volumes. That leaves revenues. And given the 17.5% YOY revenue growth expectation (from a company already on a projected run rate of over $200B, mind you), analysts seem to be expecting continued strong iPhone (6/Plus) demand to lead the way.

Tough crowd. Analyst expectations aren’t unreasonable under the circumstances, but they’re not terribly far from that point either.

Luckily, Apple will have its first full quarter of “the iPhone everyone really wanted” availability across all three major China celcos in FQ2 2015 – and Chinese New Year is sure to be a positive on unit sales. It’s unlikely that iPhone 6/Plus demand worldwide will dramatically subside, excluding seasonality effects, this early in its life cycle. Additionally, Apple has the ability to use a one-time “safety valve” of increasing iPhone and iPad channel inventory from the current 4-6 week target to the new 5-7 week target (and it’ll get to that target range eventually). That’s a decent amount of “wiggle room” – and supply/demand balance was only recently attained. Of course, sellthrough is the metric that really matters – as long as Apple both delivers and adequately educates/informs on that score.

iPad could weigh, but due to seasonality, there will be fewer units to affect overall revenue. With the high overall revenue growth expectation, though, a return to iPad unit growth would obviously be welcome for bulls. Mac may well continue to grow, but it seems very unlikely that the two hardware lines combined would be able to maintain a 17.5% revenue growth rate – particularly given the current $1200-ish ASP of Macs.

The greatest unknown for this quarter would be Apple Watch. “Timing is everything”, as is customer uptake. If Apple managed $1B in Apple Watch revenue between now and late March – well – every bit of new growth helps. It could well be “the tiebreaker”, so to speak. Even though Apple itself would probably be just fine with a “disappointing” $52B March quarter. It’d only be the third highest revenue quarter in company history after all.

How AAPL would react to “less than outstanding” earnings OR guidance – whatever that means – is another matter entirely.

Once again, though, this goes back to Luca Maestri and his finance team, who were surely aware of the effects strong FQ1 guidance would have not only on FQ1 estimates, but FQ2 and the entire fiscal year. I assume Maestri is quite savvy enough to have chosen his words carefully and run the appropriate financial forecasting/etc. beforehand (to “back it up”). By the end of this year, we will see just how savvy he was in this regard.

That wraps up my home game AAPL earnings preview for the 7th straight quarter. Hope you enjoyed it!

It’s gonna be a very interesting earnings announcement.

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