Above all else, we believe in one simple rule when it comes to investing: all emotions and biases must be removed from the investing "equation." Investing decisions must be based on financials and informed assumptions about future business performance, not preconceived notions or emotionally charged sentiment. However, Apple (AAPL), as always, seems to be an exception to this rule. Over the past few months, the hysteria surrounding Apple has risen to record levels, and its Q1 2013 earnings release has only served to pour fuel onto the fire. Does Apple face more challenges in 2013 than in previous years? The competitive landscape certainly seems that way. But, we do not think this means that Apple's best days are behind it, and think that the hysteria surrounding Apple's business performance is overdone. In our view, Apple's best days are ahead of it, and while its Q1 2013 earnings release did contain items of concern, there were also items of note, many of which are being overlooked in the market.
Q1 2013 Earnings: Uncovering the Hidden Gems
Because Q1 2013 contained just 13 weeks, instead of the 14 weeks in Q1 2012, year-over-year comparisons are muddled, and make Apple's business look weaker than it actually is. As a result, Apple's business needs to be examined on a per-week basis. And when such an analysis is performed, the results show that this holiday quarter was a solid one for Apple (revenue and cash flow figures are in millions, unit sales are in thousands). Unit and revenue data is sourced from Apple's supplementary data accompanying its Q1 2013 earnings release.
Weekly iPhone Unit Sales
Weekly iPhone Revenue
Weekly iPad Unit Sales
Weekly iPad Revenue
Weekly Mac Unit Sales
Weekly Mac Revenue
Weekly Operating Cash Flow
Weekly Net Income
Weekly Diluted EPS
When Apple's performance in Q1 is examined on a weekly basis, it becomes clear that business is much better than expected. The company grew sales of both iPads and iPhones at a more than 30% pace in the quarter, and while net income and EPS both grew by less than 8%, operating cash flow soared by over 40%, a testament to Apple's ability to generate cash (while cash flow this quarter was driven by accounts payable, due to seasonality, the same effect was present in Q1 2012, making the comparison valid in our view).
Critics will point out that Apple's margins are falling, and they are correct. Margins are falling, and there is no way to deflect such charges, and simply say they do not matter. However, it is important to understand the sources of these margin declines. In Q1 2013, iPad unit sales grew by nearly 60%, but revenues grew by less than 32%. The divergence has been caused by iPad mini sales, which have structurally lower margins than traditional iPads. However, the market opportunity for these iPads is far larger than that for regular iPads, and Apple repeatedly stated on its conference call that it was simply unable to meet the insatiable demand for iPad minis in Q1 (CEO Tim Cook and CFO Peter Oppenheimer also stated that supplies of the iPhone 4 were constrained as well, which caused the company to leave even more sales on the table). It is a distinct possibility that Apple's margins may be in a secular decline, but investors should not rush to judgment in assuming that this is a clear negative for Apple. The market opportunity for lower priced iPads is enormous, as is the opportunity for a lower priced iPhone. Apple's data from China, now the company's 2nd largest market, confirms this thesis. Apple's China revenues grew 67% in Q1 2013, and iPhone sales grew over 100% in the quarter. On a weekly basis, Apple's Chinese performance becomes even more impressive. Weekly revenues in China grew from $291.43 million in Q1 2012 to $525.38 million, an increase of 80.28%. And this growth is occurring without an iPhone contract with China Mobile (CHL). If and when Apple signs a deal with China Mobile, the country's largest wireless carrier, the market potential will be quite large in our view. Speculation has abounded regarding a lower-priced iPhone, and CEO Tim Cook dodged the question when asked if Apple is "satisfied" that it has the right price points to meet international demand. Time will tell if Apple will introduce a new, cheaper iPhone, but for the moment, it appears that Apple's price points are appropriate, at least in China, the world's 2nd largest economy. Apple's margins are also being hurt by the cannibalization of Mac sales by iPads, something that CEO Tim Cook admitted on the company's earnings call. However, the decline is being managed. While weekly unit sales of Macs fell by almost 16%, weekly Mac revenue fell by less than 10%, and the company revamped much of its Mac lineup during the quarter, leaving less room for sales of its new Macs. According to NPD data, Mac notebook sales fell 6% during the 2012 holiday season. However, average selling prices increased $100 to $1,419, an increase of 7.58%. The average selling price of Windows laptops increased just $2 (0.48%) to $420. We believe that Q2 2013 Mac sales will rebound as the company ramps up production of new Macs to meet demand. CEO Tim Cook was asked about cannibalization, and he replied with an answer that combined both optimism about the future and a swipe at the Windows ecosystem. He stated that,
"In terms of cannibalization and how we think about this, I see cannibalization as a huge opportunity for us. One, our base philosophy is to never fear cannibalization. If we do, somebody else will just cannibalize it and so we never fear it. We know that iPhone has cannibalized some iPod business. It doesn't worry us, but it's done that. We know that iPad will cannibalize some Macs that doesn't worry us. On iPad in particular, we have the mother of all opportunities here, because the Windows market is much, much larger than the Mac market is. And I think it is clear that it is clear that it's already cannibalizing some and I think there is a tremendous amount more opportunity there. And as you know, I have said for two or three, actually three years now I believe that I believe the tablet market will be larger than the PC market at some point. And I still believe that. And you can see by the growth in tablets and the pressure on PCs that those lines are beginning to converge."
We agree with Tim Cook that the iPad should be seen as an opportunity for Apple, and not a threat to its existing business lines.
Q2 Guidance: Hidden Gems of Information
Perhaps what unnerved investors most about Apple's Q1 earnings was the guidance that it gave for Q2: revenues of between $41-$43 billion, a gross margin of 37.5-38.5%, and operating expenses of $3.8-$3.9 billion. Analysts were calling for revenues of $45 billion, meaning that the $42 billion midpoint of Apple's own guidance misses estimates, and implies year-over-year revenue growth of just 7.18%, hardly up to Apple's historical standards. And its forecast for a gross margin of 38% at the midpoint of guidance implies further year-over-year deterioration in gross margins (and a 63 basis point sequential drop as well). According to Walter Piecyck of BTIG, Apple's guidance implies EPS of $9.23-$10.23 ($9.73 at the midpoint). At the midpoint, this implies a 20.89% year-over-year drop in earnings. However, several factors serve to differentiate Q2 2013 from Q2 2012, which artificially inflated Q2 2012 earnings. The iPhone 4S was released in China during Q2 2012, and this quarter, the iPhone 5 will have already been out for several weeks, thereby denying Apple a launch-weekend boost to iPhone sales. In addition, the presence of the iPad mini, while serving as a boost to revenue, puts pressure on earnings due to the iPad mini's structurally lower margins. It will take time to ramp up iPad mini sales to a high enough volume to mitigate the effects of its lowered margins. While there are a variety of factors leading to Apple's implied year-over-year drop in earnings, we believe that investors should look beyond Apple's headline numbers. Rather, we wish to highlight what we see as a hidden gem in Apple's guidance: its operating expense forecast.
For Q2, Apple is forecasting operating expenses of $3.85 billion at the midpoint of guidance, which represents sequentially flat expenses relative to Q1 2013. However, that is a break from historical precedent. In Q2 2012, Apple's operating expenses dropped 5.44% from Q1 2012. But what we believe is even more important is Apple's research & development expenditures. In Q1 2013, Apple spent $1.01 billion on R&D, versus $758 million in Q1 2012, an increase of 33.25%. On a weekly basis, however, Apple's R&D spending rose 43.5% this quarter, and its operating expense guidance implies a 21.07% rise in expenses year-over-year in Q2 2013, and we expect a good deal of this increase to be driven by R&D spending. Apple is ramping up R&D spending, and the likely reason is that the company is preparing something new. On the Q1 earnings all, Tim Cook declined to answer any questions relating to the TV business, stating once again that it is "an area of intense interest" for Apple. And with R&D expenses up over 43% on a weekly basis in the company's last quarter, we believe that it is likely that Apple is studying ways to turn this interest into reality. In our view, while Q2 will be a soft quarter for Apple, it should not be seen as being representative of how Apple will perform in 2013. The company is ramping up R&D spending, and while only Apple's top executives know exactly what the company is spending on, it is safe to assume that there is more than just incremental updates to existing product lines in the works.
There is also another hidden gem in Apple's guidance, one that we believe serves to counter the notion that Apple is no longer innovating or investing in the future: Apple's capital expenditure forecast. On the company's conference call, CFO Peter Oppenheimer forecast capital expenditures of $10 billion for fiscal 2013, with just under $1 billion targeted for the company's retail stores. That is an increase of almost $2 billion over fiscal 2012 levels, and to us suggests that Apple is continuing to invest aggressively in its business, on optimizing its supply chain, and ensuring that can support future growth. While Apple was, as expected, coy about where it will be allocating these funds, with CFO Peter Oppenheimer saying only that one of the uses of cash will be to buy equipment for the company's supply chain partners, we believe that there is more to the Apple's capital expenditures forecast than the company is letting on. An increase of nearly $2 billion is sizeable even for Apple, and as Katy Huberty of Morgan Stanley points out, there has been a 97% correlation between revenues and non-retail capital expenditures at Apple over the past 7 fiscal years. Apple is ramping up spending in fiscal 2013, and the likely reason is that the company is readying itself for an expected rise in required manufacturing capacity, something that would imply a new line of products.
A Legacy, and a Future of Innovation
Since its renaissance in 1997, Apple has been one of the most innovative companies in the technology sector, producing many of the sector's most recognizable products. But, in recent months, that legacy of innovation has begun to be called into question. Apple's critics argue that the company's innovative days are behind it, and that in 2012, the company failed to introduce a revolutionary new product, offering only incremental updates to their existing product lines. However, if one were to go back and examine Apple's product history, they would discover that 2012 was not the year for such an announcement.
In 2001, Apple introduced the iPod, which helped revitalize the company and put it on the path to becoming the world's most valuable company. In 2004, Apple introduced the iPod Mini, which put the iPod into the hands of millions more consumers. In 2007, Apple introduced the iPhone, and in 2010, it introduced the iPad. Whether deliberate or not, Apple has established a 3-year pattern of establishing new product categories, with incremental updates in-between. Assuming that this pattern holds, 2013 will be the year that Apple establishes its next product category. The wave of negative press surrounding Apple in the 2nd half of 2012, combined with an "off" year in terms of new category launches served to undermine confidence in Apple, when in fact it is 2013 that should be the focus of investors. In our view, 2013 will be an innovative year for Apple, not only in terms of updating existing product lines, but introducing a new product category as well.
Financials & Valuation: Arguments Against the Hysteria
Apple dropped over 12% on January 24, as investors fretted over its earnings and guidance. To an observer unfamiliar with Apple, it would seem that the company was a richly valued technology stock that missed on several fronts, thereby warranting a revaluation of the company. The numbers tell a different story.
Based on its closing price of $450.50 on January 24, Apple trades at just 10.22x trailing 12-month earnings, hardly levels that can be considered overvalued. Based on the consensus earnings estimates for Apple's next 4 quarters ($50.42), the company trades at less than 9x earnings, a metric that is reduced even further if Apple's cash & investments are taken into account (assuming a 10% cut to forward estimates brings Apple's P/E multiple to 9.92x).
Apple ended Q1 2013 with $137.112 billion in cash & investments (around $43 billion of which is held in the United States), and based on 947,217,000 diluted shares outstanding, the company holds $144.75 per share in cash & investments. Based on Apple's closing price of $450.50 on January 24, 32.13% of Apple's market capitalization is in cash. In our view, this is unwarranted. Apple's cash balance now accounts for almost a third of the company's market value, and if it were to be excluded, Apple's trailing P/E would fall to 6.93, and its forward multiple would fall to just 6.06x. Are Apple's days of easy growth behind it? Perhaps they are. But with a trailing multiple approaching single digits, and forward multiples already there, Apple's shares are priced at multiples that suggest the company will never grow again. While Apple's Q2 guidance suggests that growth will slow in the quarter, Apple's forecasts for both operating expenses and capital expenditures imply the company is preparing for growth in the remainder of 2013, and we think it is unwise to jump to conclusions about the second half of the year based on one quarter of guidance. Apple's multiples are hardly stretched, and with a dividend yield of 2.35%, Apple's shares are pricing in a bleak future, something we believe is unwarranted.
The hysteria surrounding Apple's business performance and its market positioning has led to perceptions about the state of Apple becoming unhinged from reality. Apple's calendar year 2012 profits were the highest of any company in history, and its Q1 2013 earnings were the 4th largest quarterly profit of any company in history, behind only oil and gas companies Exxon Mobil (XOM), Royal Dutch Shell (RDS.A) and Gazprom. Apple's results for this quarter should be viewed on a weekly basis due to an extra week in Q1 2012, and on that basis, the company posted solid growth across many of its divisions. While Apple's Q2 2013 guidance seems light, it needs to be viewed in the context of last year's iPhone 4S launch and the presence of the iPad mini. And Apple's aggressive operating expense and capital expenditure forecasts are implying that the company is readying for a material change in the second half of fiscal 2013, something that we believe is tied to the launch of a new product category, something that Apple has done every 3 years since 2001. We continue to believe that Apple's best days are ahead of it, and think that this post-earnings selloff should be seen as a buying opportunity. In our view, investors who add to or initiate positions in Apple will be rewarded in the second half of 2013. Innovation is alive and well at Apple, and that innovation is likely to be put on full display in the second half of the year.