On the Bright Side

January 24, 2013 (11:45 am)

As with many Apple investors, it seems like our emotions have already been through the entire 12-step process over the last 18 hours. We wanted to gather our thoughts, putting emotion to the side, before posting our take on Apple’s latest quarter. The company reported $13.81 in EPS on $54.5 billion in revenues, making it one of the highest grossing quarters for any company in history. But it’s profit barely budget from last year. What happened? We’ll be posting a thorough analysis of our expectations vs. the actual figures for the quarter this afternoon. In the meantime, here are our quick thoughts.

  1. Supply Constraints. On the conference call, Tim Cook said that they simply couldn’t make enough iMacs, iPad mini’s and iPhone 4’s to meet demand. If the company was able to produce enough of any one of these three products, they likely would have handily beat expectations.
  2. Mac Sales. Mac sales were down significantly versus our expectations. Part of this is explained by the supply constraints of the iMac. But another important factor is cannibalization by the iPad and iPad mini. Tim Cook said that Apple prefers to cannibalize its own products because, if they don’t, somebody else will. Good – we agree. It’s a shame that the replacement device (iPad) is so much cheaper than the device it replaces (Mac), but that’s a dynamic we fully anticipated. It’s just happening more quickly than we expected.
  3. iPhone 4 Supply Constraints? They couldn’t make enough iPhone 4’s? That’s not iPhone 4S – it’s the iPhone 4. The original iPhone 4. And they couldn’t make enough? The must not have anticipated the demand for the device that sells for $0.99 on most carriers. Is demand becoming more elastic? This is something that we need a full post to delve into.
  4. iPad Mini. It’s becoming clear that the iPad mini is the new “hit” product. They likely sold an equal amount of iPad’s and iPad mini’s this quarter. We’d expect the iPad mini to significantly outperform the iPad going forward. It’s almost akin to the comparison between the PC and the iPad. In this case, the iPad is the 4×4 truck that allows for content creation, whereas the iPad mini is the convertible that allows for easy, comfortable and seamless content consumption.
  5. iPhone Screen Size. Tim Cook deflected questions in two key areas: the first was rumors of a larger iPhone. We were disappointed by the iPhone sales numbers. Domestic (U.S.) iPhone sales as a percentage of global sales remained fairly flat over last year’s holiday quarter. With the aggressive global roll out and introduction in China, we expected significantly higher sales in the Asian and emerging markets. In our view, Apple must address those consumers who prefer a larger screen. They are missing an enormous opportunity here, and are simply handing customers to their main competitor Samsung. Why in the world would they give up this market? Adding consumers to their ecosystem is, and should continue to be, their driving priority. With Jony Ive, we all know they could make it a beautiful device. That part of Apple will never change.
  6. Apple TV and iTV. The second question deflected by Tim Cook was around the Apple TV, or more appropriately, iTV. Apple sold over two million Apple TV’s last quarter. There is an enormous opportunity here. During his Nightly News interview, he led us all to believe that Apple is pursuing a grand plan in this arena, and we remain excited for the potential here. In our view, a fully-integrated TV would be great. But what really excites us is a different possibility. Think of your current cable provider’s set-top box. It’s probably a big, clunky, old and slow Motorola box. Apple could quickly come to dominate this market by simply replacing those Motorola boxes with the Apple TV set-top device that has a cable input. Then you simply use your Apple TV remote (in combination with Siri) to control your TV plus all the current features of the Apple TV. This is a device that we could reasonably see an enormous portion of the population buying for each TV in their home.

GUIDANCE. However, one of the most important take-aways from the conference call was this. Apple’s management is changing the way they provide guidance. Honestly, it seems like they changed this last April and are only now telling us. Instead of providing a conservative estimate of what they can reasonably achieve (i.e. sandbag guidance so they can easily beat it), they are now providing a range they believe they will reasonably fall within. So, where they once sandbagged analysts, they are now giving a truthful estimate of likely performance.

And on that, the shares took a massive hit. But take a step back, and think about this from another perspective. Management is now providing an unmatched level of transparency into future results that we have not seen before from Apple. They are giving analysts and investors a clearer view of earnings and cash flows. In our opinion, this change in guidance will be seen as positive once things shake out over the coming weeks. It is clear that Wall Street gives a higher valuation to transparency. Low (and even no) growth companies receive a far higher PE multiple than companies with an uncertain growth trajectory. Apple’s lower-than-hoped-for growth next quarter may actually drive up the valuation as investors will now be more comfortable valuing it for the longer term.

Let us know what you think.