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October 26, 2012

Mixed Bag of Apples

Apple reported decent September quarter results against low expectations following lots of worry about demand trends and recent data that revealed iPad sales would be below expectations. Revenues of $36 billion were up 12% year over year and in line with consensus forecasts. EPS of $8.67 rose 23% vs. a year ago but slightly missed consensus estimate of $8.81. EPS would have been about 20 cents higher except for an unexpected and unusual negative swing in other expense related to foreign exchange hedging that should reverse next quarter.

At the product level, Mac sales of 4.9 million units were right on target. iPhone sales of 26.9 million units were ahead of expectations indicating that demand remained reasonable for the 4S even ahead of the launch of iPhone5. iPads came in at a disappointing 14 million units. An iPad shortfall was expected after Apple announced that it had sold its 100 millionth iPad earlier this week. iPad inventories were unchanged and management indicated that it saw a slowdown in demand in August and September as rumors mounted about the iPad mini. iPods, no long an important product at just 2% of revenue, were slightly below estimates at 5.3 million units.

Overall, the quarter was solid against low expectations by Apple standards. The much bigger news concerned guidance for the September quarter. Management forecast revenue of $52 billion and EPS of $11.75 against consensus estimates of $55 billion and $15.50. By Apple standards, the revenue guide was actually pretty good. However, EPS are way below estimates even by Apple's usual conservative standard. The issue is gross margins, which Apple forecast at 36% against 40% in the September quarter.

Gross margins have not been below 40% since the December quarter of 2010 and have averaged 42.1% in the past eight quarters. Management noted that newly introduced products would make up over 80% of December quarter sales and that costs are highest in the first quarter a product is introduced before economies of scale kick in. This is a legitimate point although it has not been as obvious of an issue in past quarters with heavy new products flow.

Apple shares are barely changed following the report after a 15% pullback over the past month. I think there are several takeaways from the quarter. First, the stock price action indicates that the stock already reflects the lower expectations. At $610, the shares seem to have discounted the weak EPS guidance. Second, I think we should start to accept that Tim Cook provides realistic guidance. Most of the quarters since he took over have been closer to company guidance than to analyst estimates. Analysts have been trained to view Apple guidance as extremely conservative. Maybe that is changing under Cook's leadership. Whether this is because Apple's financial momentum is waning is a key question.

Most importantly to me, Apple may have finally reset growth expectations (or the market have reset growth expectations for Apple). Trailing twelve month earnings growth over the past eight quarters has varied from 60% to 96%. If guidance proves correct, earnings growth in calendar 2012 will be just 20%. For a long time, Apple shares have traded at what seems like a very low P-E multiple relative to the growth rate of its earnings and to its product and market share momentum. This is because investors had long anticipated that the growth rate would slow if for no other reason than the law of large numbers. Apple sold 37 million iPhones in the December quarter a year ago. The guidance implies around 46 million this year. To sustain 20% growth means next year they must sell 55 million. At some point, the end market and Apple's market becomes mature.

Investors are smart and realized this was coming and kept Apple's valuation in check. Current controversy over iPad demand and corporate gross margins is likely to be what determines whether Apple shares get their upside mojo back. Management discussed the huge opportunity for iPads against 300 million PCs still sold each year (Apple has sold 100 million iPads in 18 months). iPhones still have growth as smartphone penetration continues to grow on a global basis but the sheer size of iPhone revenue ($29 billion in the most recent quarter representing 55% of sales) means that iPads have to pick up the slack. Broadening the product line with iPad mini makes sense in this regard.

Gross margins also have to firm up. Another key question is whether Apple has to accept lower margins to drive product sales. Maybe the competition is catching up? This is a fair interpretation of the guidance. Management indicated that margins should rise as production ramps and products mature. Apple does usually guide gross margins conservatively. If that proves to be the case this quarter then investors will be comfortable in the company's competitive position and the likelihood that future growth is sustained at 20% or even re-accelerates.

I believe that the combination of recent worries, the reported guidance, the acknowledgment of the slowing growth rate, and the 15% pullback in the shares have effectively reset the investment case for Apple. Backing out cash, the shares trade for less than 10 times forward earnings. Against 20% growth in FY13, this is a very reasonable valuation with much lower expectations on the part of investors.

A new catalyst will have to emerge to get the shares back on track. Signals of strong demand this holiday season and easing of supply constraints are the most likely until the company reports earnings again in January. I think both of those things will occur. If they do, then it will be clear that guidance is going to be comfortably exceeded. This is the bull case for the near-term. It is also the case I believe will occur. And never forget that as the largest market cap stock on the planet, Apple shares are going to be heavily influenced by sentiment and direction of the overall market.

Apple is widely held by Northlake Capital Management LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, a long only registered investment adviser. Apple is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, communications and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the funds' investment management company and has personal monies invested in the funds.

Posted by Steve Birenberg at October 26, 2012 09:05 AM in AAPL