January 4, 2013 (4:15 pm)
Apple is down another $13 today, after already falling $13 from its highs on Monday. It has retraced more than half of the $46 in gains during its Friday-Monday rally, and has formed an island top in the process. For more on what an island top is, see our detailed post on the subject here. Let’s think about this for a moment…
Consensus Estimates. Philip Elmer-DeWitt, the Fortune tech editor who covers Apple at his Apple 2.0 blog, releases consensus estimates (for both Wall Street and independent analysts) the day before earnings. So, while we won’t have exact consensus estimates for two weeks, here is the range of estimates I have heard thus far. In parentheses we also include the actual figures from the year ago holiday quarter.
- iPhone: 44mm – 48mm (37.0mm)
- iPad: 20mm+ (15.4mm)
- iPod: No estimates (15.4mm)
- Mac: 5mm (5.2mm)
- Revenues: $54bn+ ($46.3bn)
- EPS: $13.33 ($13.88)
Let’s look at the two factors that will really drive additional revenues this quarter. The average analyst and investor is looking for approximately 10 million more iPhones (~$6.5bn in additional revenues) and 5 million more iPads (~$2.5bn in additional revenues) this quarter. This high-level math checks out, as the additional $9bn in revenues would bring Apple from $46.3bn last year to $55.3bn. That’s within 2% of the low-end revenue estimates around $54bn.
Margin Compression. So Apple is likely to pull in, conservatively, $9 billion in additional revenues this quarter when compared to the year ago period. But the average analyst is looking for a sequential decline in EPS by over $0.50. If you hold all else fairly constant – which will probably prove accurate in the big picture – it’s clear that this is a story of margins. Margin compression, or lack there of, will be the focal point of the Apple story when they release their quarterly report in 19 days.
Let’s talk about margins. Gross margins, the kind Apple analysts and investors tend to focus on, represent the total revenues brought in by a company less the cost of goods sold. An important aspect of operating a company that sells physical products (versus services) is that the cost of building the first widget is substantially higher than building the millionth. This is achieved through economies of scale, which Apple is able to reach relatively quickly. It purchases production material in bulk, which enables them to spread production and limits any potential bottlenecks. Their size also allows them to purchase supplies in bulk and receive discounts compared to smaller companies that would have to pay a higher price per unit. Historically, Apple has achieved a 42.1% gross margin over the past eight quarters.
So why is this quarter different? The primary factor that has analysts worried is the fact that Apple released updated products throughout its entire lineup during (or just before, in the case of the iPhone 5) the December quarter. Remember, the first widget built is more expensive than the millionth. And because Apple decided to introduce new a new product lineup during this quarter, each of its several product lines are facing their highest costs during the same quarter. This hasn’t taken place before.
The Compounding Effect of Margins. We are including relatively conservative margin expectations for the quarter, although they’re higher than the average Street expectation (and higher than Apple’s guidance). Our rationale comes down to the fact that Apple released an entirely new product lineup heading into the holidays. This will lead to an increase in sales, above and beyond Apple’s initial guidance to the Street. Each additional sale of a product slightly increases margins, as fixed costs are spread out among a higher number of units and economies of scale kicks in. For every additional unit sold above Apple’s guidance, margins should increase slightly. This has a compounding effect. If revenues come in substantially above guidance, as we expect they will, margins will increase beyond current expectations. This will have an even larger impact on earnings per share, as a greater percentage of the higher revenue number will flow through to net income.
Clearly the market doesn’t trust Apple right now. The growth story is “dead”. But even beyond that, the uncertainty around growth going forward is forcing Apple’s P/E ratio well below that of companies that have low to absolutely no growth going forward. Apparently, the word “uncertainty” is worse than “bad” for the markets. We expect certainty to take regain its crown on January 23rd.
Our earnings expectations, unchanged from the last time we posted them, are below.