Apple's FY09 EPS Estimate Is Too Low

Apple Inc (AAPL)- Apple’s FY09 EPS estimate continues to be revised downward and now stands at $5.08, a level Apple should easily exceed. The consensus FY09 estimate represents a 5.2% decline from FY08 $5.36 EPS, although revenues are forecasted to increase 11.8%, or $3.8B to $36.3B. Thus, analysts are expecting significant margin compression. Specifically, the consensus estimates for EPS and revenue imply net margin will be 12.8% in FY09, a decline of 2.1% from 14.9% recorded in FY08.

It’s not that I don’t believe the recession will take a major toll on Apple, it will. Instead of achieving 35%-40% earnings growth likely to occur in a normal economy, Apple’s EPS should increase at least 5%-10% in FY09. Due to deferred revenue recognition and upward margin pressure, it’s very unlikely Apple’s earnings will decline, certainly not to the 20%-30% magnitude some analysts predict.

I believe there are two major factors being ignored with respect to FY09 estimates that suggest higher earnings. First, there are multiple factors in play that argue against margin deterioration. This includes lower product and overhead costs, and a more favorable sales mix towards high margin products. iPod revenue (as percentage of total sales) will be much lower in FY09 which is significant since iPod has the lowest margins. iPhone and software have the highest margins and will contribute a much larger portion of Apple’s total revenue.

Second, Apple will recognize a sizable amount of deferred revenue associated with high margin segments, such as iPhone and AppleCare. Also, Apple’s $25B cash position will produce a decent amount of income. Thus, without even having to make a single sale, Apple should still produce $2.67/share in incremental after-tax income.

Assuming 19M iPhone unit sales, incremental taxed EPS for iPhone segment would be $2.99/share. Combining deferred revenue, interest income, and iPhone sales; I estimate incremental EPS will be $4.04. Apple would only have to earn $1.04/share in its other segments to meet the FY09 consensus.

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According to Yahoo Finance, the lowest estimate for FY09 is $3.70 (High- $6.00). I have been seeing many estimates being revised down to the mid-to-low $4 range. In my opinion, these estimates are ridiculously low. Canaccord Adams puts FY09 EPS @ $3.70 (31% decline) with an $80 price target and Morgan Stanley’s FY09 estimate is $4.37 (18.5% decline) with price target of $95.

PROFIT MARGIN OUTLOOK:
I recently did a detailed analysis of Apple’s profit margin outlook and concluded that FY09 gross margin expectations are too low. I highlight some of my main points below.

I. Favorable Cost Environment:

All of the factors listed below should lead to lower costs, hence higher margins. At the least, provide margin stability by eliminating upward pressure on costs. Considering most of FY08 was marked by a commodity bubble and $100-plus crude, FY09 should be a much more favorable cost environment.

1) Raw Material / Component Prices
2) Energy- Transportation / Overhead
3) Occupancy / Labor (stable)
4) Marketing
5) Scale Benefits & Shared Costs

II. Margin Expansion From Increased iPhone Revenue:
The primary driver for higher margins for FY09 is iPhone revenue. The iPhone generates substantially higher margins than the Mac and iPod segments. Due the subscription accounting whereby iPhone sales are recognized over 8 quarters, the margin effects were minor for FY08 since only $1.84 Billion of iPhone revenue was recognized. This equates to roughly 5.7% of Apple’s total FY08 revenue.

Most analysts and myself included, expect iPhone revenue to come in above $7B for FY09. Not only will the iPhone supply more than 20% of Apple’s total sales (FY09), the subsidy payment agreement of the new 3G model translates into even higher margins compared to the legacy iPhone. I calculated that the gross margin of the new 3G model was 55% in 4Q08.

If Apple recognized iPhone revenue in the period sold, instead of deferring, 4Q08 gross margin would have been 39% compared to GAAP 34.7%, net margin would have been 20.9% vs. 14.4%, and EPS $2.69 vs. $1.26. As deferred revenue continues to pile up on the balance sheet, the portion recognized in current quarterly revenue will continue to increase each quarter.

III. Other Margin Drivers:
There are several other factors that could aid profitability this year. First, software revenue, which has huge margins, will be much higher in FY09. Apple is releasing new iWork and iLife editions, and it’s expected to release Mac OSX 10.6 “Snow Leopard” this year. MobileMe also carries high margins, yet even though revenue won’t be much, the yr/yr incremental will be sizable. Second, Apple will incur and recognize more of its high margin AppleCare revenue.

Looking at operational expenses, such as SG&A and R&D, these items should fall on a percentage basis (of total sales) due to leverage effects if sales continue to increase as expected. Looking at the table one can see the trend in declining operating expense and rising profit margins.

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The other side of the margin equation is selling price. Margin compression can still occur even while costs are decreasing if selling prices drop more. Apple’s brand is unique and it products command premium prices. Apple’s products are highly differentiated which eliminates price competition. I don’t expect Apple to make drastic price reductions. I recently explained why Macs sell at premium ASPs.

SALES OUTLOOK:
The Street is expecting sales to increase 11.8%, or $3.8B to $36.3B (FY09) vs. $32.5B (FY08). By default, Apple’s sales will increase $3.5B from recognizing 4.85B in current deferred revenue. Apple will also take in around $400 million from iPhone carrier payments and $650 million in investment income. Thus, even with out making a single sale in FY09, Apple will still post nearly $6B in revenue.

Total FY09 iPhone revenue will likely increase by at least $5B, implying Apple’s other revenue is expected to decline if consensus sales growth is $4B. Most analysts expect iPod revenue to drop significantly, coupled with either a slight increase/decrease in Mac sales. I see iPod unit sales declining 25%-30%, but iPod revenue only dropping 15%-20% due to the shift towards the higher ASP touch model.

• iPhone:

According to my estimates, Apple will report iPhone FY09 sales of $7.0B, $3.1B originating from new sales, and 3.9B from recognition of deferred revenue and carrier payments. This assumes Apple sells 19M units. With 56% gross margins, iPhone will contribute $2.99 in EPS. Hence, all other segments only need to earn $2.09/shr to meet the Street’s estimate.

I estimate only 60 cents of $5.36 FY08 EPS is associated with iPhone, which leaves $4.76 from all other segments. This means FY09 non-iPhone EPS could decline 55% or $2.67 to $2.09 and match the $5.08 consensus if iPhone can pull in $2.99/share.

• Mac:

With new MacBooks released in Q1, and new desktops expected in Q2/Q3, FY09 Mac sales should continue to grow despite the weak economy. MacBook hasn’t seen a redesign since being released in 2006. This has provided little reason to replace/ upgrade. Looking at unit sales growth, it is evident that the product line had become very tired and in need of a refresh as growth began to lag desktops. There are probably 5M MacBooks that may be replaced in the coming year.

Mac revenue has grown roughly 40% for the past two years, and under favorable economic conditions, I would expect growth to continue if not exceed that pace. Given the harsh economic conditions, I expect single-digit unit growth for FY09.

• Pod:

Unit sales will probably see a sharp decline in FY09 due to the economic landscape and product saturation. The iPod touch model will be popular causing unit sales to exceed forecasts. In addition, the touch will boost ASPs, which will soften the decline in dollar sales.

• Music & Software/Services:

Music segment revenue increased 34% to $3.34B in FY08. Music sales will continue to demonstrate strong growth due to the direct placement of the iTunes music store on the iPhone and iPod touch allowing purchases/ downloads in seconds over cellular and Wi-Fi network connections. The iTunes App store could add up to one billion in additional sales this year.

Software sales could get a billion dollar boost from iWork ’09, iLife ’09, Snow Leopard, and MobileMe plus other titles. Typically software delivers high profit margins, thus these software introductions should offer margin support.

CONCLUSION:
When considering the amount of high margin deferred revenue and interest income Apple will recognize this year coupled with multiple drivers lending margin support, it’s unlikely Apple’s earnings will fall in FY09. Apple won’t earn $7 to $8 in EPS possible in a favorable economic climate, but EPS won’t decline as analysts predict.

Apple already has $2.89 in incremental EPS in the bag. Including my estimates for new iPhone sales, the incremental EPS effect is $4.04. Considering SG&A and R&D expense, I estimate that EPS from deferred revenue recognition, interest income, and iPhone sales will be $3.43. Adding Mac, iPod, and all other segments, EPS will easily top the $5.08 concensus.

Disclosure: Long AAPL

Comments

[win-y:]

you havent mentioned the huge CHINA factor ..

Jan 11 08:23 AM

[Titan100:]

I totally agree with your assumptions, why the big brokerage houses continue to reduce 2009 earning estimates without regard to deferred earnings I would have to call a conspiracy, if one believes in them. Apple is still posting revenue from the 1st Iphones sold. I personally know 3 people who purchased an iphone in the first quarter they were available so AT&T is still making monthly payments to Apple for them. The Iphone revenue is a huge snowball rolling down hill and picking up steam. Even if Apple does not sell a single Iphone ever again earnings for them cannot decline until the September quarter. I am looking forward to this months earnings call and anticipating a huge beat. I am long Apple and can afford to wait this out.

Jan 11 08:26 AM

[mollytjm:]

as usual, a good article...i always read yours. agree with all and in addition, the business world is starting to wake up (albeit slowly) to the fact that it's just cheaper to have Macs because they are easier to use and cheaper to maintain and support. i've seem companies that are ready to get new computers, go with Mac...this includes some companies of thousands of employees. media companies are already either Mac or going there.

Jan 11 10:32 AM

[BOBH501:]

AGAIN YOU HAVE TO ASK YOURSELF WHAT THE IDIOTS ON WALL STREET ARE DOING. ALL YOU HAVE TO DO TO SEE THE GROWTH OF THE IPHONE IS GO OUT IN PUBLIC. I AM AN EARLY IPHONE USER AND DONATED MY FIRST ONE TO MY DAUGHTER WHEN I WENT 3G. MY PHONE USED TO BE UNIQUE BUT NOW YOU SEE THEM EVERY WHERE. I ALSO HAVE SEEN 4 OF MY FRIENDS SWITCH FROM WINDOWS TO APPLE. FINALLY, GO INTO ANY APPLE STORE ANY TIME OF THE DAY, THEY ARE ALWAYS FULL.

Jan 11 01:28 PM

[iNeal:]

My small business employs about 10 freelance technical people, all of whom supply their own laptops. They all started out as PC users, but in the last few years have all switched to MacBooks. Most analysts rely too much on the replacement rate of Mac products and don't see the larger potential of winning over the PC crowd. There is a huge opportunity to increase market share in the business world as younger and hipper people move into the workforce.

Jan 11 02:13 PM

[hunter thom...:]

I agree absolutely. Both TV and web media seem out to get Apple.
There has to be $$ behind the negative campaigning.
It smells like 10 years ago when Microsoft paid off the editors of all the trades to start the "Mac is Dead" movement.
Apple went from $87 to $97 within a couple of days. Not a word from the media.

On Jan 11 08:26 AM Titan100 wrote:
> I would have to call a conspiracy,

Jan 11 08:52 PM

[yet another...:]

You're letting facts get in the way of a good story. ("Apple is doomed... Apple is doomed because it hasn't cut prices.... Apple is doomed because it will have to cut prices.")

Apple makes for a remarkable long term holding... there is just so much earnings and cash flow baked into the cake.

And you're the first analyst I've seen to point out that the recession could actually HELP margins. Commodity components are a huge amount of Apple's costs and if the merely drops prices less than the commodity prices, margins grow.

So far, there is scant evidence of Apple cutting prices AT ALL. They are either stupid and brain dead or.... sales are holding up decently.

And of course, GAAP EPS--deferring iphone earnings--are a joke.

But Wall Street never lets the facts get in the way of a good story...

Jan 11 10:04 PM

[rd4sndk:]

I think your estimates for iphone sales are growsly off. I'll stake my reputation on the fact that Apple will continue to gain smart phone market share based primarily on this years upgrade cycle, continued geographic expansion and the app store ability to pull sales.

This year's iphone upgrades should be the most remarkable and dramatic. I believe the first versions of iphones built with the PA semi processors will release 2H09. As apple takes advantage of PA semi's power management expertise, these units will set new standards for smart phones uptime and cost. It's quite possible that we may see subsidized iphones for under $75 and in Europe for free. At these price levels the iphone will ship in quantities approaching 100 million. Your 19 million units are laughable given that the shift to smart phones will occur significantly in fy09.

With now the #1 retailer, the #1 cell phone company and the #1 CE retailer on board to sell iphones, plans to distribute the lower cost iphone are in place to mark a remarkable year for apple.

If apple sales (as I believe) north of 45 million iphones, $8 a share this year will be in the cards.

Jan 12 12:46 AM

[jmmx:]

Overall I agree with your analysis, although the depth of the recession may very well take a greater toll than we anticipate.

One caveat: So not put too much hope on revenue from Snow Leopard. It will be absolutely outstanding technology - a real game changer. However, there will not be a lot of independent sales compared with previous releases.

1- It will run only on Intel Macs. There are a lot of the PowerPC Macs out there.
2- There will not be very many new "killer" features. The main purposes of the development effort are to decrease the footprint, to increase the efficiency, and to integrate technical advances (e.g. OpenCL). These are vital to the future strategy of the company, but not a compelling reason to upgrade. This speed increase is of little value to the business user wanting to do email, WP and spreadsheets. In this tight economy few home users are going to upgrade just so that iPhoto and iMovie will run a little faster. So I would look to purchases mostly by the professionals in the graphics/video trades and perhaps heavy gamers. My guess is only 20-30% adoption rate, and I lean to the lower end.

Where it will make the most significant impact will be in the new MacBooks, and newly designed desktops to come that will harbor multiple GPUs. These are going to make a quantum jump in performance.

The other area will be (in my opinion) in the iPhone/Touch. When these get upgraded with new HW, they will have the ability to fit the smaller footprint OSX. As rd4sndk points out: "these units will set new standards for smart phones... " (tho I would just put a period there).

So, the recession will take its toll. We all know that. But the future is still bright a Apple innovates us into the future.

Jan 12 03:18 AM

[HardHead:]

Turley Muller reports on Apple have beaten most analyst on Wall St. He could easily replace Katie Huberty at Morgan Stanley. Great article... as always very accurate.

HH

Jan 12 05:16 AM

[Turley Muller:]

My estimates my be grossly off, but I can at least spell "grossly." It was intention for this exercise to be conservative, in order to sell my point. Yes, I do think Apple can sell more than 19M units, but that is a discussion for a later time. This article was intended to show that Apple should easily beat estimates from deferred revenue recognition, and incremental EPS will be $4.04 if it ONLY sells 19M.

On Jan 12 12:46 AM rd4sndk wrote:

> I think your estimates for iphone sales are growsly off. I'll stake
> my reputation on the fact that Apple will continue to gain smart
> phone market share based primarily on this years upgrade cycle, continued
> geographic expansion and the app store ability to pull sales.

>
>
> This year's iphone upgrades should be the most remarkable and dramatic.
> I believe the first versions of iphones built with the PA semi processors
> will release 2H09. As apple takes advantage of PA semi's power management
> expertise, these units will set new standards for smart phones uptime
> and cost. It's quite possible that we may see subsidized iphones
> for under $75 and in Europe for free. At these price levels the
> iphone will ship in quantities approaching 100 million. Your 19
> million units are laughable given that the shift to smart phones
> will occur significantly in fy09.
>
> With now the #1 retailer, the #1 cell phone company and the #1 CE
> retailer on board to sell iphones, plans to distribute the lower
> cost iphone are in place to mark a remarkable year for apple.

>
>
> If apple sales (as I believe) north of 45 million iphones, $8 a share
> this year will be in the cards.

Jan 12 02:55 PM

[jenny:]

While I had initially though that iPod sales coupled with the economy would have a pretty big effect on Apple, your article made me consider the other factors so while I still think that EPS will be that favorable, it probably won't decline as much as analysts believe it will. Sentiment is extremely bearish this morning for Apple (www.predictwallstreet....) but I think investors are seeing to many dismal reports and pessimistic headlines to think otherwise. It's been a rough beginning of the year but that doesn't mean it will necessarily be like this all the time in 09.

Jan 12 03:28 PM