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July 25, 2012

Apple Misses and Guides Lower

In an extremely unusual development, Apple reported revenues and earnings well below the Street's estimates. More normally, the company guided earnings for the September quarter below estimates. However, the gap to analyst estimates was unusually large, effectively making this quarter and a "miss and lower." In response Apple shares are trading down 5%.

Given the magnitude of the shortfalls in revenue, earnings, margins, and iPhone and Mac shipments, a 5% decline is quite modest. This is due to two factors. First, the news is not a shock. Most of the shortfall is probably related to a pause in iPhone demand ahead of the expected October launch of iPhone 5. Foreign exchange also played a factor along with some product mix shifts that cut average selling prices. Second, by all indications including many surveys, demand for the iPhone 5 is going to be extraordinary. Intent to buy measures are at all time highs among current and potentially new iPhone users. As a result, Wall Street is willing to cut Apple a lot of slack as it assumes that any shortfalls will be made up in the December 2012 and March 2013 quarters when iPhone 5 is released around the world.

I remain very optimistic about Apple shares. The stock is very cheap. After backing out over $120 in cash earning little with interest rates at 0%, the stock trades at just 10 times earnings. Even with the six month pause in iPhone demand (when the company will ship about 50 million phones!), Apple is growing at a rate of more than 20% a year, a growth rate that will accelerate later this year. I still see the shares having one more good run based on the current product lineup (Mac, iPhone, iPad, iPod, and integrated software) with a target of $750 easily achievable.

All that said, there were some troubling issues in the quarter not present in prior quarters where Apple disappointed the street. The product mix shift could be a sign that Apple's newer products are facing increased competition and losing market share. It is hard to tell if lower average selling prices were due solely to the fewer high end iPhones sold or if a clear customer preference for older models was responsible.

ASPs may also be feeling pressure from tighter upgrade and subsidy policies from wireless service providers around the globe. This impact will cycle through over three more quarters. I was surprised to hear minimal questions on this topic on the conference call. Follow-up analyst reports also touched on upgrades policies less than I expected.

Another issue was much lower margin guidance. Apple usually guides margins conservatively but the guide for the September quarter is still surprisingly low. Apple's margins are incredibly high on hardware, 3-4 times the best other hardware manufacturers. This is the result of Apple's tight integration of its best in breed software. However, as competitors catch up -- Samsung phones and Google tablets, in particular -- the long feared margin compression could be coming sooner than expected.

While I respect the greater competition argument, I suspect other things are at work. The global economy has weakened and this impacts even companies as strong as Apple. The company specifically pointed to negligible growth in Europe. Foreign exchange also took a bigger bite out of financial performance. The street should have figured this out given the massive overseas growth the company has enjoyed. It was unusual to hear Apple management discuss macroeconomic impact in such great detail. It is likely legitimate but still raises a caution flag.

Misunderstood inventory shifts as new products rolled out over the last year also may be at work. As Apple's market share has grown ever larger and its products have reached around the entire globe, the impact of a single new product on the company has also risen. Quarter-to-quarter volatility is going to be greater and even with Apple's regular discussion of channel inventories forecasting inventory shifts and thus shipments is going to be more difficult. I think that was the case in the most recently reported quarter.

To repeat, I still see Apple shares heading comfortably north of $700 within the twelve months based on the current product lineup and the still massive growth in penetration of smartphones and tablets. Less than 20% of mobile phones currently in use around the world are smartphones. To move significantly above that, I believe the company will have to find another new product that opens up a huge market opportunity. TV seems the most likely. Innovation in new product categories has brought Apple this far.

The next innovation will determine if Apple can be the first trillion dollar market cap company. That requires almost another doubling in the share price. I think the odds are in Apple's favor. Fortunately, as is, there remains 30% upside in the shares.

Disclosure: Apple and Google are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an Illinois-registered investment advisor. Filings can be found at www.sec.gov. Apple and Google are net long positions in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds.

Posted by Steve Birenberg at July 25, 2012 11:12 AM in AAPL