April 22, 2013: Quick Thoughts: Apple – Downward Revisions Ahead, Wait for Capitulation

Written April 22nd, 2013 by

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-          Current sentiment for Apple’s FY 2Q13 is horrible – consensus EPS is down 15% over the last 90 days and Cirrus’s warning drove shares back below $400, off nearly 25% over the same time frame.

-          Consensus says Apple is cheap – 5.8x estimated FY13 EPS and 5.2x FY14, adjusting for $137B in cash and investments – but consensus assumes double digit sales growth and rising gross margins.

-          2Q13 estimates for 8.4% YoY sales growth and 38.5% GMs are tenuous, yet analysts are backend loading 4Q at 20% sales growth and 39% GM, with 12% FY14 growth on stable 39% GMs.

-          Consensus forecasts of reaccelerating growth and rising margins are not credible. Apple may be cheap, but it is unlikely to perform until the megabulls have capitulated and estimates are reasonable.

“Apple under $400 has GOT to be cheap enough, right? It has $137B in cash and investments on the balance sheet and is projected to generate another $51.5B in cash from operations this fiscal year. It trades for just 9 times consensus EPS for FY2013, only 5.8x if you adjust for all of that cash. Sure the company has hit a competitive bump, but a low cost iPhone is on the way, just in time to dominate in China once China Mobile signs that inevitable megadeal to carry it. Furthermore, a new, larger screen iPhone and a major iOS upgrade are also coming to put Samsung and Google in their place. By the way, don’t forget about the Apple Television – Asian manufacturers are working on prototypes as we speak – and the iWatch wrist-based peripheral. That’s two more legs for the Apple stool. Once the big increase in the dividend is announced, watch out! Reiterating strong Buy, with a price target of a ba-jillion dollars.”

It must have been tough being an Apple Bull this past quarter – publishing that same call for the umpteenth time and subjecting yourself to yet another perp walk performance on CNBC. Still, at some point, the national nightmare will have to end, Apple will hit bottom and the bulls will be right again. However, no amount of cheerleading is going to hasten the coming of that day, and in fact, the cheerleaders may, in fact, be their own worst enemies. Buy-side sentiment is indeed bad, but sell side estimates are nowhere near bad enough.

The market has baked in an Apple miss for the 2nd fiscal quarter, to be announced after the close tomorrow. After notable March quarter slip-ups and dire forward predictions from Apple partners Foxconn, Cirrus logic, and LG Displays, and surprisingly low iPhone numbers from Verizon, no one believes Apple will hit the 40 million iPhone unit mark that had been bandied about earlier in the quarter, with flat YoY shipments of 35 million the psychological Mendoza Line for many investors. Apple shares are off nearly 25% since the beginning of the quarter, dropping more than 7% just in the past 4 trading sessions.

Meanwhile, sell-side analysts are holding out hope. While consensus EPS has come down 15% over the course of the quarter, the sell side still hews to the high end of the company’s guidance for 2Q13 – $41-43B in sales with gross margins between 37.5 and 38.5% – even after management’s admonishment that it was getting serious about offering realistic guidance and despite the bearish data points that have been inconveniently cropping up (Exhibits 1-2). Moreover, many analysts are just pushing their recovery projections out a quarter or two. Consensus YoY sales growth for 2Q13 is just 8.2%, but expectations for 4Q13 project a robust recovery to 20.6% growth rolling into 12% growth for the full 2014 fiscal year.. Gross margins, which fell 880bp from 47.4% in 1Q12 to 38.6% just a year later, are projected to bottom out at 38.5% and begin rising, reaching 39% in 4Q13 and holding the line there for 2014.

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These expectations for 4Q13 and 2014 pipe dreams. Apple’s highest margin product, the iPhone is under assault by companies with arguably superior products at lower prices, while carriers begin to push back on Apple device subsidies that have been 40% higher than those for its competitors. Apple’s unit volumes have stagnated, with even bullish projections targeting 5% YoY unit growth. At the same time, the mix of iPhones, which drive nearly 60% of Apple’s overall profits, is shifting toward the cheaper and less profitable older models. Apple may fight back by introducing new models, such as the widely rumored low-end iPhone, but while these products may buttress the company’s market share as the industry growth turns increasingly toward emerging markets, it is very unlikely that they will have a positive effect on overall margins. The growth story is better in the iPad business, where Apple is losing share but in a much faster growing market segment. Still, growth in tablets comes at a cost, as iPads sport much lower margins than the carrier subsidized iPhone. Moreover, competition is spoiling the tablet party too – Amazon and Google are willing to sell their devices at cost and make it up on e-commerce and advertising, leaving Apple’s relatively profitable products at a 40-60% premium price that is increasingly hard to justify.

These trends aren’t stopping just because analysts want them to. If Apple manages to stem its sharp margin erosion, it will come at the expense of market share and growth, and if it looks to reaccelerate its top line, then margins will continue to fall. Nor will the introduction of an Apple iTelevision or iWatch save the day. The sales of iPhones and iPads are simply too big for these wish list products to make a difference to Apple, particularly given the product launch costs and slow ramp that would be associated with either gambit.

The reality is that Apple consensus numbers have still got to come down … A LOT … before the stock can work. While the idea that it is cheap relative to its real long term cash flow power has merit, it is very difficult for a stock to perform well during a protracted period of difficult news flow, earnings misses and sharp downward revisions. It is never “all in the stock” and only with capitulation will it be safe to get back in the water. Ironically, the only way for the biggest Apple bulls to be right is to stop being so bullish.

For our full research notes, please visit our published research site.

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