The Bears React to Weak Guidance
Apple's (AAPL) highly conservative gross margin guidance in their latest earnings call (FYQ4 2012) has added gasoline to the fire for those bearish on the stock. Despite the company's history of delivering exceptional holiday quarter financial results compared to its guidance, the market's reaction has been nothing short of panic. Careful consideration of statements by company leadership during the most recent call may bring into question the market's highly bearish sentiment. Apple constantly challenges and likely provides incentives for its operations team to beat its guidance and has high expectations that the team will deliver. Given the exceptional performance record, investors should consider the wisdom of betting against the Apple team.
AAPL is down about 25% from its recent highs. Analysts, journalists, and anti-Apple detractors have offered myriad explanations. Any long time Apple follower would note that this type of price action has happened before. Widely varied sentiments on the positive and negative side affect the price every day. However, outside of the financial crisis, large and protracted price swings exceeding 20% have occurred only when a fundamental concern is incited by real elements in the company's financial results or future guidance.
This happened to the negative side with Apple's fiscal Q4 2012 report and gross margin guidance. The company performed admirably, but its earnings were considered a miss even though the miss was only due to anomalies in GAAP accounting (see: The Real Truth About Apple's Q4 Results). Margins were down slightly in the quarter, and CFO Peter Oppenheimer delivered another ultraconservative forecast for fiscal Q1 2013. Negative sentiment predominated in the weeks leading up to the earnings release primarily because Apple "only" sold a record 5 million iPhone 5 units in the launch weekend, not meeting trumped up expectations even though the constraint was supply and not demand. The gross margin concerns added a critical fundamental company valuation element to the bearish sentiment, providing impetus for the dramatic price drop.
Overreactions to Guidance Have Happened Before
When Apple releases new products, part of its financial success formula is to challenge its operations team to ramp-up production and move down the cost curve as quickly as possible. The challenge Apple management laid out to its operations team this quarter is perhaps its greatest yet. If we look at the last decade, that team has delivered every time. I would not bet against them this quarter.
With regard to reactions to its guidance over the last decade, Apple's stock price has experienced a more than its share of significant short-term price swings. The September 21, 2012 through December 2012 price drop is not the most extreme example of a negative price decline in normal market conditions. Another unusual situation was in the May-July 2006 time frame when Apple fell 31.2% from an intraday high of $72.89 on May 4, 2006 to an intra-day low of $50.16 on July 14, 2006. Three days after July 14th, they released blow out earnings and the stock reached new highs by early September.
Change the product names to iPod (vs. iPhone) and Mac mini (vs. iPad mini) at the time, and we heard many similar justifications as heard today to explain the 31% drop in the stock's price in mid-2006. Important to note is that Oppenheimer issued his typically conservative forecast for the June 2006 quarter guiding gross margins down by 150 basis points from 29.8% in the March quarter to 28.4% for the June quarter. Analysts were highly concerned about the margin guidance, and it was heavily discussed on the Q2 FY2006 earnings call. However, the margin fears were not fully addressed on the call. As the quarter progressed, negative technical and emotional issues arose about the company, and fundamentalists began to genuinely worry about the margin forecast. The stock price plummeted.
It turned out, this 31% price drop in mid-2006 was one of those unique situations which legendary investors like Warren Buffett relish, when you can follow Baron Rothschild's advice and "buy when there is blood in the streets." Whether this quarter's price action is another such situation, you will have to decide for yourself. In January, Apple will release financials for the quarter. Three months from now we will know whether history repeated itself with the stock price or not. As we all know, past performance is no guarantee of future results. Nevertheless, the parallels are interesting. Apple reported 30.3% gross margins for the June quarter of 2006, blowing away the guidance.
Apple Challenges its Operations Team
Peter Oppenheimer is in a difficult situation attempting to manage financial expectations for a company whose stock price can see such immense swings. Oppenheimer is also a member of the executive leadership team, and it is evident from numerous conference call discussions that Apple leadership looks to challenge their team to beat the guidance. Apple likely devises its targets for a number of internal incentives based on the guidance. In the FYQ1 2012 conference call, after Apple beat their guidance by huge margins, both Cook and Oppenheimer could not say enough about the great work that the operations team had done for the quarter.
Since Peter Oppenheimer took over as CFO for Apple, I can find no record of an instance when the company delivered revenue or earnings results lower than the guidance. Oppenheimer may be one of the most conservative forecasters ever. Nonetheless, Apple is obligated to issue guidance that ties to internal plans. After it beats the guidance, Oppenheimer will typically spend a paragraph or two in a conference call explaining the reasons margin were better than forecast. In the high performance Apple culture it is important that people feel they are succeeding-- under promise and over perform. Cook and Oppenheimer are delighted when Apple blows out the numbers. It fuels the fire to over perform again.
The problem today is that Apple's latest gross margin guidance has everyone spooked. After completing a fiscal year at 43.9% gross margin, the company guided to 36% for the December 2012 quarter. Analysts on the quarterly earnings call were in disbelief, but Oppenheimer gave his typical line of reasoning to justify his forecast. This left concern that Apple had made a conscious decision to lower its margins.
However, in answering the last question on the call concerning whether the margin decrease was a long-term expectation, Tim Cook addressed that concern. Speaking to the quarterly margin forecast, he noted
what is different for us this time is the sheer number of products we have introduced in the last six weeks, and we have just not had that magnitude in the past. I don't see something structurally different.
With that statement Cook told us that the low forecast is not the result of a structural decision. They do not expect margins to be at 36% in the future. Apple is working through a massive new product ramp and expects to see margin improvement as manufacturing efficiencies and component costs improve. They are working hard to beat the guidance in the current quarter.
Cook ended the call discussing this operational and manufacturing cost challenge with this statement: "And we will report to you in January how we did." His tone was one of confidence. Folks, the best operations guy in the technology business was laying out the challenge to his team and looks forward to reporting in January's how they performed. The market is betting against them. You can decide where to place your bet.
A History of Under Promising and Over Performing
One might also consider the record of the company in beating its margin forecasts. In the last eight quarters, the closest Oppenheimer's guidance for gross margins came to the actual reported gross margins was in FYQ4 2012 where he guided 150 basis points under the actual results (38.5% forecast vs. 40.0% actual). His second closest call was one year earlier in FYQ4 2011 where he was off by 230 basis points (38% forecast vs. 40.3% actual). It is notable that these two quarters preceded holiday quarters where significant positive swings vs. guidance have typically come.
In the previous two holiday quarters, Apple heightened the conservatism in its guidance. Essentially, this set up the operations teams to be heroes, and the company hit it out of the park on both occasions. Apple guided the December 2010 holiday quarter to 36% gross margin and beat that by 250 basis points. In the 2011 holiday quarter, Apple guided to 40% gross margins, and blew it away with a 44.7% result. Given the precedent and the narrow beat of the FY Q4 2012 margin guidance, it is likely that Apple was highly conservative in the December 2012 quarterly forecast.
Where Would You Place Your Bet?
Historically, Apple trades with greater emotion than most stocks. The magnitude of the downward price swing since September 2012 is consistent with price swings of the past. Outside of the financial crisis, investors should note that these significant (-20% or more) swings have occurred when a meaningful fundamental factor in the company's previous earnings report or guidance has lent credence to the litany of negative emotional and technical factors that typically arise in a quarter.
During the last earnings call, Peter Oppenheimer released an incredibly weak margin forecast for this holiday quarter. The fear of declining margins seems to have spooked the market. Nearly 80% of what Apple sells this quarter will be less than six months in production. Demand has been outstanding by all accounts. In the details of the conference call it appears evident that part of the reason for the low margin guidance is to challenge the Apple operations team as they work through this massive new product ramp-up. In recent history, the company has always beaten guidance, and the pressure on their operations team and the entire company to do so this quarter is extreme.
Will the company swoon investors with mind-boggling results and blow away the guidance like it has in the past? Can Apple pull off another margin miracle? Speaking about the operational challenges the company faces this quarter at the end of the latest conference call, Tim Cook calmly and confidently laid out the task his operational team faces: "So no change in what we are going to try and work on, and we will report to you in January how we did."
Some analysts are forecasting 38%+ gross margins, 200 basis points above guidance. My bet is on the Apple team and that investors will again be amazed and delighted by the results the company delivers for its quarter.