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April 24, 2013

Apple: Complete Reset of Expectations Could Mark The Bottom

Apple reported its second quarter 2013 earnings at the high end of expectations and guidance. However, the real news surrounded the company’s guidance for the next quarter, commentary on future product introductions, and a large increase in the company’s capital allocation program to return cash to shareholders.

For the near-term, I see these factors in rough balance but not enough to lead to a major rally in the shares. If anything, the lack of near-term positive data points is likely to keep the shares near their recent lows. However, I do think the worst news is out and there is a good chance that positives emerge as we move into late summer and fall. As a result, I think the risk-reward tradeoff for the balance of 2013 supports holding the shares. If things go well, I think the stock can rally toward $500 later this year. Downside is now supported by the dividend increase and share buyback and reset of investor expectations. Barring a sharp market pullback, I think the share should hold in the mid $300s. That is a 2:1 ratio of upside to downside enough to keep me in the stock.

Revenues of $43.6 billion and EPS of $10.09 were at the high end of Apple’s guidance and street expectations. EPS fell 18%, the first decline in years. Gross margins of 37.5% were the culprit and came in at the low end of guidance and Street guidance. Declining gross margins reflect tough competition and a loss of product innovation leadership. This cuts confidence in Apple’s long-term positioning and keeps pressure on the shares even when the P-E ratio seems remarkably low. Unit sales of iPhones, iPads, iPods, and Macs were all inline to above expectations. Pricing was OK with iPhone average selling prices a little low as iPhone4 remains popular. This also suggests that the iPhone5 product cycle has been below expectations.

Guidance and the product roadmap is where the report fell short. Even with rampant fears of weak guidance, the company’s projection of $34.5 billion in revenue and 36.5% gross margins were well below the lowest estimates. The implication is that iPhone unit sales will be around 25 million, down vs. a year ago. EPS will be around $7.00, down 25% year over year. Making matters worse, the company indicated new products would not be coming until the fall. This suggests that the September quarter will be quite similar to the June quarter, pushing out the recovery in Apple’s growth profile to at least the December quarter. Previously, I had been willing to wait out the downside in the stock on the expectation that the June quarter would mark the bottom.

The capital allocation announcement was ahead of expectations with the company committing to $100 billion over 2013 thru 2015, composed of $40 billion in dividends and $60 billion in share buybacks. The big surprise was in the share buyback which previously was only at $10 billion. The dividend went up 15% and now sits at $12.20 for a current yield of 3% at today’s prices. Management clearly was sending a message that they think the future is bright and the stock is going back up. The company can buy back about 5% of its shares per year, a material amount and enough to boost EPS.

My overall takeaway is that this quarter marks a complete reset of expectations for Apple. The prior of Apple is over. In fact, I think one could argue that we should not even be comparing Apple of 2013 -2015 to Apple of 2005 – 2012. The company is taking an extra-long break on new product introductions; probably to market sure they get it right this time after the relatively poor reception to a complete suite of new products last December. Those products have not sold as well as expected and the company executed poorly in delivering them to market.

Apple will probably earn about $38 per share in FY 13, down from $44 in FY 12. The question now is what the earnings will be in 2014. Current consensus is around $44 and assumes new products are successful and rollout beginning this fall and thru 2014 in line with management’s comments on the conference call.

A bull case is that expectations have bottomed and investor confidence and sentiment and company growth will resume in the fourth quarter. Despite the crushing decline in the stock since last fall, I believe there is enough residual bullishness on Apple that if renewed growth becomes apparent this fall, the shares can rally sharply. This rally would be in anticipation of a new growth cycle. Ultimately, though, successful products are necessary to provide anything more than a relief rally. If new products fail to revive growth, Apple will look an awful like slow growth tech stocks such as Microsoft, Intel, and Cisco Systems. Those stocks never recovered from the collapse in their growth rates last decade.

With expectations reset to hopefully worst case levels , the share buyback and dividend increase announced, and minimal new products coming, I think Apple will be a boring stock over the next few months. Low expectations set the stage for better stock price performance as investors begin to anticipate the fall new products. Maybe the June software developer’s conference will provide some excitement with a new version of iOS hinting at a big IPhone launch in the fall. I am willing to bet that the next major move in the stock is up in anticipation of the fall product releases and resumed earnings growth in the December quarter. As a result, I am going to stick with Apple in client accounts but remember that Apple as we knew it is over and the story needs t be analyzed from scratch.

Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. Apple is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

Posted by Steve Birenberg at April 24, 2013 09:58 AM in AAPL