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July 31, 2013

Better Quarter Clears Deck for Apple New Products

Apple (AAPL) reported a better quarter although earnings are still down year-over-year. I expect that earnigns will turn positive again in the Decemebr quarter and growth will pick up as next year moves along, partially due to very easy comparisons beginning next spring. Renewal of earnings and product momentum is critical to get AAPL shares moving again.

The most recent quarter cleared the decks ahead of this fall’s new product launches and also contained a few pieces of good news. The summer and early fall can now play out bullish for the stock as investors can look ahead to new product introductions. Of course, those products will have to capture investor and consumer imagination. The stock has rebound over 10% in July and I think it has more upside heading into the product announcements. But I think $500 will be a topping area until we see the new products. In particular, we want to see the new high end iPhone and whether or not the the company introduces a lowe-end or mid-range smartphone for emerging markets.

In the June quarter, AAPL reported 1% revenue growth but EPS fell 20% as margins fell. One of the issues troubling AAPL shares is declining margins and fear that they could decline further if demand wanes for high end phones, pricing comes down, and the company introduces a lower margin, lower-priced phone. I have noted in the past that AAPL margins spiked way higher on introduction of the iPhone 4s. If you look at a trendline of margins it is clear that this period was unique. Margins have come down sharply since then (47% peak to 35% current). However, takeaway a couple of 4s quarters and margins have settled from the very low 40% range to the mid 30% area. The big question is what happens next. It is a tough call but I believe the street is too pessimistic. In fact, the caution now almost mirrors the optimism when the 4s performance and excitement over the iPhone 5 introduction drove the stock over $700.

Positives in the quarter included: (1) iPhone demand was well ahead of expectations at 31 million units vs. 26 million expectations, (2) margins came in at the high end of management guidance and ahead of street expectations despite lower average selling prices for iPhones as iPhone 4 and 4s drove upside in emerging markets, (3) software and services is becoming a big business, and (4) the company is very aggressively repurchasing its shares.

The big negative in the quarter was a material miss in iPad shipments. Management indicated that the comparison was tough vs. the iPad mini introduction a year ago but acceleration is necessary as iPhones alone are not enough to drive sustained long-term EPS growth.

Current consensus calls for AAPL to earn $39 in fiscal year 2013. Next year, the consensus calls for 9% growth to $42.50. Cash net of debt is $140 per share. This cash figure is unadjusted for taxes that would need to be paid on overseas repatriation. Adjusting for 100% of the cash, the shares trading are at less than 10 times for forward earnings estimates. Many hardware companies trade for similar multiples but I do not believe they have AAPL’s growth potential or financial power.

I can see the shares trading to over $600 on a little multiple expansion if AAPL gets back on an earnings growth track. Downside protection is offered by the aggressive share buyback that has shrunk shares outstanding by 3% in just six months. If Apple can just sustain 2014 projected earnings levels and uses its free cash flow to buy back stock, the company could reduce shares outstanding by 10% per year. Take into account the $140 in cash and the company could buy back all its shares just over 6 years.

The risk is that new products don’t sell well enough to drive revenue and competition drives margins significantly lower. With support from cheap valuation that seems to imply future growth will disappoint and the large share buyback, I think the current set up for the shares is favorable. Longer term the upcoming slate of products will tell the story and we will not see those for a couple of months.

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 July 31, 2013 12:16 PM in AAPL