Investors Don't Understand Apple's Math - A Mistake

Nov.14.12 | About: Apple Inc. (AAPL)

ESPN, the sports network, has a show called Numbers Never Lie. A panel of sports analysts explain a bunch of numbers and their significance. For example, a football team leads the league in fewest points allowed, and subsequently, that team is in first place in the league. On the face of it, numbers never lie. A fact is a fact. However, numbers don't always tell the whole story either. For instance, back to a football reference for a second. Between 2009 and 2011, 0% of games that went to overtime ended in ties. While every game during that period that went to overtime ended with one team winning, it didn't mean that a tie couldn't occur. We saw a tie this weekend.

One place in today's market that numbers are misleading are in regards to Apple (NASDAQ:AAPL). With Apple being so big, there are millions of numbers you could use to analyze Apple. For the average investor, that may be too much. But lately, Apple's stock has come down quite a bit, and investors might not understand fully why. It has to do with some Apple math that investors don't quite understand, and that's a mistake. Today, I'll show a bunch of numbers that don't show the whole truth, and why Apple is still a great buy at current levels.

Q1 Guidance - Growth numbers:

Take a look at the following table, showing guidance for what appears to be two different quarters. Which quarter would you rather have?

You would rather have Quarter B, right? Well, what if I told you that both Quarter A and Quarter B are the same quarter? You would tell me that's impossible. It's not, and the numbers above are for Apple's current Q1, and the guidance given during it's fourth quarter results.

So how are they the same? Well, Quarter A is the projected revenue and earnings growth (or decline) numbers compared to the first quarter from the prior year. Apple guided to $52 billion in revenues and diluted earnings per share of about $11.75, compared to $46.33 billion in revenues and $13.87 in the year ago period. So that's Quarter A.

But there is a very important fact here that many don't realize. Apple's first quarter last year was 14 weeks long, not the traditional 13. So when Apple reported a huge number last year, you have to realize that the quarter had an extra week. If you were to take last year's revenues and earnings, averaged over 14 weeks, and subtract out a week, you get a comparable 13 week period. Quarter B above does that.

Investors that are scared about Apple's slowing growth shouldn't be that afraid. The numbers don't look that good to begin with, but there is a clear reason why. It has to do with the calendar and simple math.

Apple and its conservative guidance:

I've received a lot of questions recently about Apple's results compared to the guidance given by the company. Apple has been known for giving conservative guidance, and then beating it handily. So the following two tables show Apple's guidance and actual numbers over the last couple of years. First will be revenues, then EPS.

*Difference compared to midpoint of guidance if range is given.

Now, you can't ignore the fact that the difference, or the percentage they have beaten by, has come down tremendously in the past few quarters. That is certainly true. But again, you have to think about the base value. At the beginning of the revenue table, a $2 billion beat was a difference of 17.86%. In the most recent quarter, a $2 billion beat was a difference of just 5.88%. Again, it's the math.

But another difference here is Apple versus the analysts. When Apple gives guidance, it basically is giving guidance based on what products they expect to launch during the period. Analysts can only estimate when certain product launches will be. Thus, you may see Apple provide guidance that seems way off, because Apple has information that the analysts don't. That's why it is better to usually look at Apple's guidance than what the analysts are projecting.

Dropping margins - is something seriously wrong?

There seems to be a lot of surprise over Apple's declaration for just 36% gross margins in fiscal Q1. That would be down from last year's Q1 number of 44.68% and 40.04% from the recent Q4 number. Apple is usually conservative with their guidance, so I'm guessing they'll do a bit better than that.

I think the problem here is that Apple investors got spoiled. Apple's margins soared thanks to the iPhone 4S. That product sent margins higher quickly, but it also had to do with product mix. As iPhone revenues, as a percentage of Apple's total revenues, were higher, Apple's gross margins were higher. Just look at the table below. It shows Apple's product mix as a percentage of sales each quarter, along with the three primary margins. Note the two quarters in yellow.

Click to enlarge

*Other includes items such as iTunes, App store, other hardware and peripherals, as well software, service, and other sales.

Apple released the iPhone 4S in Q1 of 2012, and thanks to the iPhone sales percentage soaring, gross margins jumped. Then in Q2, the iPhone represented a higher percentage of sales, and gross margins jumped even more. This is when investors seemed to be spoiled.

Late in Q2 of 2012, Apple released the third generation iPad, which was a bit more expensive for Apple to produce. They sold a ton of those newer iPads in Q3, so with less iPhone sales and higher iPad sales (iPads with lower margins), gross margins came down. Margins came down even further in Q4, because the iPhone 5 was a bit more expensive to produce, and Apple notes that quarters with big product launches always see reduced margins. Q4 was also the first full selling quarter for a bunch of new Macs.

So why is Apple predicting such low margins in fiscal Q1 here? Well, it first starts with currency. The dollar has gotten stronger over the past year. That has impacted results a bit already, and will continue to do so. But the main reasons can be found in the statement below, taken from Apple's most recent conference call.

"This is the most prolific product period in Apple's history. We have an unprecedented number of new product introductions over the last six weeks, and this has led to record levels of demand. New or re-priced versions of our products announced during this time frame represent over 80% of the total expected December quarter revenue.

But there are costs associated with such dramatic change and demand. The iPhone 5, iPad Mini, iMac, MacBook Pro 13-inch, iPod Touch and iPod Nano have completely new form factors with great new features, and we've never before introduced so many new form factors at once. All of these products have higher costs than their predecessors, and therefore lower gross margins as they are at the height of the cost curve.

This has been the case with new products in the past, so nothing new. The difference this time is the sheer number of new products we are introducing in a very short period of time. Additionally, we lowered the price of the iPhone 4S and iPhone 4, delivering incredible value to our customer.

We head into this holiday quarter with the strongest iPhone line-up that we have ever had with the iPhone 4 starting at three in the subsidized markets. We also added the iPad Mini to our iPad line-up. The iPad Mini has the full iPad experience, and we priced it aggressively at $329, delivering incredible value to our customers. Its gross margin is significantly below the corporate average.

So in summary, we expect our gross margin to decline by about 400 basis points sequentially. We expect the benefit from positive leverage on a sequentially higher revenue and a greater mix of iPhone, but we expect these benefits will be more than offset by a number of factors.

First, margins on new products are lower than their predecessors including the iPhone 5 and we have been aggressive with the iPad Mini. Second, we've lowered the price of the iPhone 4S and the iPhone 4. Third, we will experience transitionary cost associated with multiple new product ramp. Fourth, the high anticipated volume of iPhone and other new products will generate significantly greater deferred revenue sequentially."

That seems like a long worded explanation, and there's more throughout the call, so here is a quick summary:

  1. U.S. dollar strength has hurt.
  2. iPad mini margins are below the corporate average.
  3. New products, especially the iPhone 5, are more expensive.
  4. Product launch quarters see lower margins.
  5. They is the biggest product launch cycle in company history.

Apple is basically saying that this quarter will see the worst of it. That seems logical, as they won't have certain product launch expenses in Q2. Also, the iPad mini is going to hurt, and with so many of them expected to be sold in Q1, the iPhone sales percentage will be lower. Additionally, Apple also stated that due to the high demand of many of its products, it will utilize faster shipping methods to get products to consumers quicker. For instance, if a product was normally transported by ship, it might be transported by plane now. This will get products to the point of sale quicker, but shipping costs will be higher. As the initial demand settles down in future months, they'll probably go back to regular shipping methods, and cost will come back down.

Now this margin issue isn't an Apple specific issue. Just look at how fast Google's (NASDAQ:GOOG) margins are coming down. Google's gross margins have plunged nearly 11 full percentage points in the past two quarters, and Google's net margins have nearly been halved in the past roughly two years. Google has gone from roughly 30% net margins to just 15.4% net margins in the past seven quarters. Over that same time period, Apple's net margins will probably only drop from about 25.5% to 20% at the worst, and we know that Apple's margins will rebound going forward. You would think Google's stock has been hit worse than Apple, given the large drop in margins and Google's absolutely dreadful quarter. Well, you'd be wrong. Since their respective 52-week highs, Apple has lost 23%, while Google is only down 14%. Google is also trading at 14.35 times fiscal 2013 earnings, while Apple trades for just 10.83 times fiscal 2013 earnings (Apple's fiscal 2013 ends in September). That means Google trades for a 32.5% premium to Apple. That just doesn't make sense to me, and it shouldn't to you either.

Conclusion - buy the fear:

I showed in a recent article that it was about this time last year, late November into early December, where Apple's stock bottomed and started higher for what would be one of the greatest rallies in history. Apple's stock is down 23% from it's 52-week and all-time high, and I believe that is a mistake.

It all comes down to numbers, and the perception behind those numbers. Investors see Apple's guidance, and think revenue growth is slowing tremendously and earnings are plunging. That's not exactly the case. Investors see conservative guidance, and they get spooked. Well, that's the history of Apple. Investors see Apple proclaiming low margins, and they panic. But that will mostly be a one quarter issue, they will rebound. Numbers are sometimes misleading, and they have built up so much fear around Apple that the stock keeps dropping. Once people understand the numbers, they'll realize Apple is still doing quite well. Last year, I stated that buying Apple under $375 was a tremendous opportunity when there was just as much fear. This year, Apple under $550 is just as good of an opportunity.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.