Quick Thoughts: Apple – Yes, but Can They Keep it Up?

Written October 28th, 2013 by

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-       Apple beat consensus with 4QFY13 revs of $37.5B vs. $36.9B and EPS of $8.26 vs. $7.96, but the dreaded whisper number was apparently higher still

-       Expectations and iPhone launches aside, the results are kind of “meh” – sales are up just 4% YoY, gross margins are down 300bp, and EPS is off 4.7%

-       1Q guidance is for more single digit YoY growth and flattish sequential margins. It’s probably a low-ball, but also probably a 4th straight quarter of falling EPS.

-       Apple has been getting increasingly seasonal – without new products and with rich expectations, FQ2 and FQ3 could prove a considerable challenge.

Yes, Apple handily beat consensus expectations; yes, cash flows were characteristically fantastic; yes, the company returned $7.8B to investors via dividends and buybacks; and, yes, guidance for the Holiday quarter was more or less in line with published estimates. Still, market reaction to the F4Q13 was decidedly nonplussed. Blame those pesky whisper numbers. Apple stock had run up in the weeks since the post iPhone launch positive pre-announcement, and many were expecting a bigger beat and more effusive Holiday season guidance.

You can also blame the results themselves. 4% annual sales growth is hardly a head-turner for the tech investor, particularly when paired with a 300bp deterioration in gross margins and a 4.7% drop in EPS. F1Q14 guidance promises a bit of improvement, but not enough to be completely confident of breaking the 3 quarter string of YoY earnings deterioration. Given that this is the quarter when the primary impact of those two new iPhones, the iPad Air and the Retina Mini will be felt, the projections are distinctly lukewarm.

Management does seem to have drawn a line in the sand on margins. The new products were announced at defiantly rich price points. CFO Oppenheimer went out of his way to point out that gross margins could have been higher if they hadn’t begun deferring more revenue to cover a range of software products that it is now giving away for free. CEO Cook chipped in that margins on the new products were expected to rise in future quarters as production kinks were smoothed and parts got cheaper. However, these points will be moot if Apple can’t maintain its high prices in the face of increasingly aggressive competition and the presumed saturation of the high-end mobile device market.

Near term, Apple is justifiably confident in sustaining those margins. The products are brand spanking new, positioned well against a known slate of high end alternatives. Looking at the number of iPhone customers likely up for renewal at subsidy granting carriers suggests that there may be more than 40M iPhone 4 and 4S users ready for upgrades in F1Q14. Last year it sold 47.8M iPhones during the holiday quarter and odds are good that it will shatter that record this holiday quarter, yielding topline upside to Apple’s $55-58B sales guidance for FQ1 2014.

However, by January, many of the Apple fanboys will already have their iPhone 5Ss and iPad Airs, and demand will hinge on new customers with less invested in the Apple brand and minds open to the raft of new Android powered products likely to hit the shelves. In the last few years, Apple has grown increasingly seasonal, with robust product introductions in the fall followed by 6 months of relative disappointment. Last year, March quarter revenues were off 20% vs. December, and June saw another 19% sequential drop. This year, analysts are hoping for a 19% drop in March, and a 12.5% drop in June. History says the cyclicality should be getting worse, not better.

If this year’s F2Q and F3Q drop offs are similar or worse than last year, Apple faces the prospect of no better than low single digit growth for the full year. Even if gross margins can come up a little bit, it is hard to imagine investors getting very excited about 4 or 5% earnings growth without a clear path to better growth further down the line. Given Apple’s massive sales and industry defying profitability, it is difficult to see where that growth will come from. Bulls will prostelytize about cash flows and valuation, but history has given us a clear example of a wildly profitable and cash rich company that struggled with growth – see Microsoft, circa 2003.

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

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