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January 18, 2007

Apple December Quarter: Great But Provides Some Ammunition For Bears; Bears Will Run Out of Ammo, However

What follows is my analysis on Apple immediately following completion of the company's conference call to discuss December quarter earnings. I'll have more to say once I review analyst commentary but I am surprised that the shares are trading off sharply this morning. I think the drop will prove temporary – the results were good and there are plenty of positive catalysts ahead. This is a good example of short-term emotions and technical day trading driving a stock independent of long-term fundamentals.

Apple (AAPL) reported a great quarter, blowing away estimates. Revenues of $71 billion beat consensus of $6.4 billion and EPS came in at $1.14 versus estimates of 78 cents. Great gross margins and expense control allowed the excess revenues to flow through to net income. A slightly lower than expected tax rate added 2 cents.

As far the stock goes, I'd say the quarter leaves the debate over AAPL in pretty much the same place as before they reported. The company beat by 34 cents. Put a 30 multiple on that and you add $10 to the stock price. That is basically the increase in the AAPL shares heading into earnings and coming off MacWorld.

I think it is fair to say that analyst estimates won’t go up by much, probably by less than the beat. This factor will limit gains in the shares that would otherwise be expected by such a large beat. Management noted that unusually favorable commodity pricing boosted gross margin and that is unlikely to prove sustainable. Also, the massive beat on iPod units and good but not great Mac units will flow through analyst models in a way that limits EPS upside over the next three quarters.

I think the biggest issue that caused the stock to pullback off its initial post earnings spike was disappointment with Mac unit sales. The number was good at 1.6 million units but below many estimates, including my own, calling for 1.7 to 1.8 million. The effect on the income statement of any shortfall was mitigated by much better than expected ASPs which was a contributor to the gross margin beat.....

Apple had a good explanation for the Mac units, which beat internal goals. Management pointed out that extrapolations from the September quarter were biased by unusually strong educational and institutional demand, including two very large orders of 50,000 units. This was news to me. The next and obvious question was does this indicate that the "halo effect" is not as strong as expected. Here is the company's answer from the transcript:

There are several things that I feel really indicate there is a halo affect. One, we've grown at three times market. Two, that in the U.S., we've grown at 31% versus a market of 3%. Three, if you look at the latest student monitor information, the intent to buy a Mac is up substantially. As an example, the intent to buy a Mac portable went from 17% to 28% in a year. Also, my view is that we have significant momentum on the Mac. This is the eighth quarter of the last nine that the Mac outgrew the market. And I don't think a lot of people can say that. And so we are thrilled with this number. It is higher than what we projected. I can't speak to the models that you guys have worked, but we are thrilled internally on the number.

We can debate this all day. I'll take management's side based on my own observations of the halo effect and the data.

The music business was astounding in the quarter with 21 million iPods. The ASP came in as expected, under pressure due to the shuffle. But an inline ASP on blow away upside units means that strength was across all products, not just the shuffle. Music was also boosted by very high sales of gift cards, up two times versus a year ago. Analysts will clearly say this is the peak for the iPod. Could be, but they said that last year. The "iPod growth is going to slow dramatically" camp is a secondary but real reason why the shares pulled back in after hours trading.

Guidance will also be hotly debated and is probably the second biggest reason for the after hours action. The company guided below street estimates for the March quarter. That is not unusual but there was a feeling that analysts had it right this time. APPL explained the guidance on numerous occasions and my conclusion is that it is customarily cautious. Key issues for guidance include product mix, operating expense leverage, commodity input pricing, software sales, and expected heavy gift card redemptions. Each of these items is expected to put pressure on gross and/or operating margins relative to the December quarter. Seasonality on iPod and Mac sales is expected to be normal implying about 9 million iPods and 1.4 million Macs. iPod growth would be mid to upper single digits but last year had some unmet demand spillover from the holiday. Mac units will grow by 20-30% indicating the halo effect is healthy.

In summary, APPL is an overanalyzed stock (yours truly included). It is high profile, leading to a lot of posturing by bulls and bears alike. Analysts were tougher than usual on the call, which I think is because of bears accusing bulls of iPhone hype. Add the tough questioning to questions that will be raised about Mac units and guidance and a muted reaction the blowout earnings is not surprising.

I think the cautious posturing is healthy for the shares as is the overly critical analysis of the iPhone that is becoming conventional wisdom. As I began, the blowout earnings totally justify the latest $10 move in the stock. That leaves us right where we were before MacWorld. I think the caution will give way to bullishness, especially as approach what could be a big June quarter with initial iPhone shipments and a huge bump in high margin software sales when the new operating system is released. That will be followed by another big back to school season in the September quarter. Seems like a real good setup for the bulls to me.

Posted by Steve Birenberg at January 18, 2007 09:20 AM in AAPL