Apple's Margins Are The Key To This Quarter And Beyond

| About: Apple Inc. (AAPL)

On Wednesday, January 23, Apple (NASDAQ:AAPL) will report its earnings for its first fiscal quarter of 2013, which was the fourth quarter of calendar 2012. The company previously indicated that it expects its revenue to come in around $52 billion and diluted earnings would be roughly $11 billion or about $11.75 per share. The market is filled with many different viewpoints on how Apple may actually report, but most expectations anticipate that Apple will handily outperform its own guidance.

Wall Street estimates anticipate about a five percent beat on revenue, with an average street estimate of $54.7 billion, and about a ten percent beat on EPS, or about $13.42 per share. If Apple is unable to meet these estimates, the market will be disappointed. Moreover, despite the continued popularity of the iPhone, iPad, Apple's Mac computers and the iTunes store, concerns continue to mount that Apple is doomed to disappoint.

Apple is generally known for underestimating its own numbers. The company does not generally provide guidance updates beyond possibly some milestone sales numbers for the release weekend of a device. Because of Apples history of underestimating, and often substantially so, the market will not consider its earnings to be a beat unless it beats the higher Wall Street expectations.

Nonetheless, the guidance Apple provided was considerable. For example, the company estimated revenue of $52 billion, which would be the company's largest quarterly sales number ever. In the same quarter the year prior, Apple had $46.3 billion in sales, which was an excellent quarter for the company. It is a holiday quarter, and those are generally the strongest quarter for retailers like Apple.

Moreover, this last quarter included the release of Apples iPad mini and its iPhone 5 was launched just before the start of the quarter, both of which are anticipated to be big sellers. Apple also released the iPhone 5 in China on December 14, selling two million units in the first three days in China alone. Apple had already released the phone in Hong Kong.

The company also released multiple new versions of some of its hardware, including a MacBook Pro laptop with a Retina Display, a revised iMac desktop and the iPad Mini, all of which may sell rather well within each of their markets. On December 4, Apple also launched the availability of its iTunes store in Russia, Turkey, India, South Africa and 52 additional countries. This made Apple's online retail site available in 119 countries. This increased iTunes range also included some particularly large and potentially growing markets within India and Russia. All of these abovementioned product launches should help give Apple a strong quarter of sales. The overwhelming majority these sales should be generated by the iPhone 5 and iPad mini, but its new Mac models and the substantial expansion of iTunes should participate.

Since 2010, Apple has outperformed its revenue guidance by an average of about 15 percent. In 2012, Apple's revenue beats were less substantial than in prior quarters, but the company still outperformed guidance. Moreover, the company has had some of its largest revenue beats during holiday quarters, including the 2011 holiday quarter. Holiday shopping is usually strong, and Apple products have become popular gifts for family members, among others.

There are also some external indications that Apple's quarter should be decent, or at last that it should have good iPhone sales numbers. For example, On Tuesday, January 22, Verizon Communications (NYSE:VZ) reported its earnings and during Verizon's conference call, the company noted that it activated 6.2 million iPhones during its Q4, or about two-thirds of the 9.8 million smartphones it activated in total for the quarter. The company also indicated that about half of those iPhones were the newest model, the iPhone 5, while the other half were made of older models. Also, AT&T (NYSE:T) indicated that it sold a record number of iPhones during the quarter, which means the mobile carrier unloaded over seven and a half million iPhones in the last three months, though not all of those sales were necessarily iPhone 5 models. AT&T will report its Q4 on Thursday, January 24.

Beyond these sales by major U.S. telecom carriers, there is little iPhone 5 sales data to go on other than the two million iPhone 5 sales that the company reported having in the first three days of the model's availability in China. International sales are of growing importance to the company. In the third quarter of 2012, or Apples fiscal Q4, the company reported that 60 percent of its sales were international, and China was its fastest growing major market. Apple's Chinese revenue totaled $5.7 billion for the quarter, which was a 26 percent year-over-year increase.

For its full fiscal 2012 that completed in September of 2012, Apple generated $23.8 billion in revenue within China, which was about a $10 billion or 78 percent year-on-year increase, and China totaled about 15 percent of Apple's annual sales. Beyond the iPhone, Chinese consumers have been shown to have an appetite for its other devices too. Last year, the company's Mac sales increased by 44 percent, iPad sales were up 45 percent and iPhone sales were up 38 percent.

All of this indicates that Apple has a strong likelihood of not only beating its own revenue guidance but also beating Wall Street estimates for its revenue for the prior quarter. Be that as it may, the more difficult bar could be income, though one that Apple should be able to beat. Apple expects to earn $11.75 per share, which is about 15 percent below the $13.87 that the company earned in that same quarter last year. Chances are that the company will be able to beat its guidance, but possibly not report earnings that beat the $13.87 it earned last year during the quarter.

One important issue is that Apple's profit margin has been declining over the last several quarters. For the holiday quarter in 2011, Apple's gross profit margin was 44.7 percent, but for the third quarter of calendar 2012, or as of Apple's last reporting, Apple's gross margin declined to 40 percent (this was still higher than Apple's guidance of 38.5 percent). For this holiday quarter, Apple estimated its gross margin would decline to 36 percent, so if historic under-guidance is any indicator of future results, it would indicate that Apple should report a gross margin of about 37-38 percent for the holiday quarter.

If Apple's profit margin does not at least meet its own guidance, the market will certainly take that news negatively, unless it is able to do so while simultaneously earning more than it did last year. New hardware generally initially sells its highest margin, but Apple has actually been able to make some of its profits more profitable after a year due to scaling continued production of components that themselves had declining margins over time. Nonetheless, competition and volume should eventually reduce margins, and it should not be too surprising if smaller tablets begin to compete in a price range between $99 and $199 within a year or two.

Apple's margins should inevitably decline from their recent lofty perch, but the pace at which that decline occurs is still rather unclear. Further, declining margins do not necessarily mean that Apple would also have declining earnings in the future, as it is possible for the market to continue to grow and for Apple's market share to also grow. Of course, it is also possible that Apple's market share will contract, and especially so if competition begins to offer competitively equipped products at considerably lower prices.

All in all, Apple is likely to blow out revenue guidance and estimate. Apple's earnings are likely to beat its guidance, and possibly also estimates, but may fall short of the $13.87 that the company earned last year. In the end, provided Apple can report within those parameters, and maintain a gross margin above 37 percent, the market should take the report positively.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.