On Apple's (AAPL) December Q1 FY2013 earnings conference call CEO Tim Cook gave guidance for March Q2 FY2013. The most important aspect was the $41-43bn revenue projection, with the midpoint implying a 23 percent sequential decline. Rather than scrutinize his commentary first, many were quick to take his guidance at face value. Soon after the call ended, the negative remarks came - "Apple's growth is slowing," "Apples's margins are going down," "Apple is not innovating," etc. In short, anything unfavorable that could be said was said.
However, Apple's guidance needs to be taken into context. Apple had just delivered three consecutive quarters of lackluster results, each missing analyst expectations in some manner.
June Q3 FY2012 Results vs. Expectations
Revs: $35.0bn vs. $37.1bn miss
EPS: $9.32 vs. $10.37 miss
September Q4 FY2012 Results vs. Expectations
Revs: $36.0bn vs. $35.8bn in line
EPS: $8.67 vs. $8.75 miss
December Q1 FY2013 Results vs. Expectations
Revs: $54.51bn vs. $54.58bn in line
EPS: $13.81 vs. $13.34 above
iPhones: 50.0 million vs. 47.8 million miss
If you were Tim Cook would you want to deliver another uninspiring quarter? Of course not. Tim knows his company is on the hot seat and needs a clean beat next quarter to reestablish credibility. Listen to Eyal Waldman, CEO of Mellanox Technologies (MLNX), after the company missed December 2012 earnings and issued astonishing revenue guidance for March 1Q FY2013 that was 33 percent below analysts' estimates.
"This is the first time in six years that it's happened. We are disappointed that we did not meet our revenue guidance and we are trying not to have this occur again. We do know that companies sometimes they miss, and they miss the second time. We are definitely doing a lot not to miss the second time, so we are trying to be as responsible as we can."
Note: Mellanox immediately traded down more than 25 percent in after-hours action from $51.69 to $38.00. The next day the stock opened at $41.85 and closed at $51.01.
Tim may not have been as straightforward as Eyal (though Apple investors may wish he was), but it's hard to believe that Mr. Cook's goal is not the same - to give guidance with the potential to exceed. In listening to the conference call it appears that there is definitely room for an upside surprise. A mismatch between the positive qualitative commentary and the quantitative guidance does exist.
So where could Apple's guidance ($42bn in sales), be conservative and by how much?
Though the iPhone 5 was launched in 100 countries by the end of 2012, it might be too early to assume the honeymoon period is over. Last year after the iPhone 4S launch, the units sold fall off was 26 percent. Apple's current revenue guidance implies a similar drop and a few points of smartphone unit market share loss. But comparing the iPhone 5 to the iPhone 4S launch is like comparing apples to oranges. The iPhone 5 represents much more of an upgrade (specifically, legitimate 4G LTE capabilities) than the iPhone 4S did over the iPhone 4. Therefore, the demand for iPhone 5 should be stronger and longer in duration. The company also likely did not experience a full quarter of sales in December for each country and only beginning in February did they add 36 more carriers for LTE, more than doubling the existing number and bringing the total to 60. Lastly, the company held its own regarding smartphone unit market share for 2012, and without any substantial new competitive product launches in the March quarter, meaningful loss of share is unlikely.
Given the above, every one percent change in unit sales represents about $300mm in revenues. If the sequential slowdown in March 2Q FY2013 is less than expected, there is potential for upside.
Note: It is the Author's opinion that Samsung's competitiveness at the high-end (the source of most of the industry's profits) is exaggerated. This view is supported by the following: Samsung sold only 20 million of its Galaxy S3 in its first 100 days vs. Apple's 48 million iPhones in 90 days; In Dec Q 2012 Apple ended Samsung's five-year reign as the leading U.S. mobile phone vendor (Source: Strategy Analytics); and in 2012 Apple continued to increase its profit share (Source: Michael Walkley, Analyst at Canaccord Genuity).
From a high level, the iPad/tablet market is still an emerging product category. As such, there is not much history regarding December to March seasonality. It would therefore make sense if Apple took a cautious approach with its internal iPad projections. Last year seasonality resulted in a 24 percent drop in units sold. Apple's revenue guidance points towards a 30 percent sequential decline. However, in the previous year the company did not have two types of iPads, or more specifically, the iPad mini. It's clear from the earnings call that the iPad mini is still in launch mode and demand has not normalized. Peter Oppenheimer, Chief Financial Officer, said,
"With the iPad mini it's hard to know, we could not make enough in the quarter. We were constrained every week. Customers love the mini and we wish that we could have made more and we ended the quarter with significant backlog."
In other words, iPad demand is clearly trending above traditional post-holiday sales patterns. Language on the call also suggested that as of the earnings call the supply/demand balance still had not been reached. Given this information, unless Apple is suddenly able to meet demand and demand just suddenly falls off, expectations of a sharp March quarter decline is conservative.
Using the new ASPs (which accounts for the lower priced iPad minis) every one percent change in unit sales represents about $100mm in revenues. If the typical post holiday and/or new product launch lull does not occur in March 2Q FY2013, there is potential for upside.
Mac sales in the December quarter missed expectations. This was largely due to customers waiting for the release of the new 21.5 and 27 inch iMac models, which did not ship until the end of November and mid-December, respectively. Had customers not delayed purchases, Apple likely would have sold 5.2mm Macs, representing flat y/y growth instead of 4.1mm Macs, representing negative 22 percent y/y growth.
In March 2Q FY2013, now that product is readily available, iMac sales should benefit from pent up demand and rebound. If Apple is able to make up for December's lost sales, Mac unit sales would experience greater than 25 percent q/q growth.
However, Apple management is anticipating that the company will not be able to make up for all the lost units. Tim is probably trying to balance pent up demand with typical seasonal trends and slowing PC demand. Apple's revenue guidance points towards a 15 percent sequential increase, which implies 16 percent y/y growth for the March quarter, and a negative 5 percent y/y growth for the six-month October-March time period.
Assuming that Mr. Cook is thinking this way, those predictions would seem reasonable, until we examine the following: NPD Group reported that as of February 2013 Mac sales were up 14 percent YTD, and in the last few years, U.S. sales have on average lagged OUS sales. If foreign sales continue to outgrow domestic sales, thereby boosting March sequential growth, there is potential for upside. Every one percent change in unit sales represents about $55mm in revenues.
iTunes, Software and Services
Previously, iTunes Store, App Store, iBookstore and iPod accessories/related services sales were reported under "Other music," with iTunes accounting for approximately 88 percent of the total. This business unit grew 35 percent in FY September 2012, the highest since FY September 2006.
In the new reporting structure, "Other music" is now combined with the slower growing category previously known as the "Mac software and services" segment. If this unit is separated out for the December quarter, "Other music" grew approximately 35 percent, showing no signs of abating.
Why does this matter?
Though the hardware sales tend to grab the spotlight, it could be argued that the "Other music" segment captures the true long-term demand for Apple products. Hardware sales can be uneven based on new product launches and replacement cycles. However, if you are an Apple device owner, you also purchase products from iTunes, App Store, iBookstore, etc., whether your iPhone is one or three years old, or your Mac is three or five years old. Think of the hardware as the "razor" and the music and apps as the "blade." Assuming Apple customers are loyal their purchase of these products should be steady over time. Hence when you see growth in the "Other music" segment it means that Apple's customer base is increasing.
For the last six years, this business has grown consistently between 20 and 35 percent. At the end of December 2012 Apple just finished adding iTunes music stores in 56 countries, including Russia, Turkey, India and South Africa, bringing the total to 119 countries. Apple appears to have plenty of room to gain more market share.
The "Other music" category should not disappoint in the foreseeable future and will continue to be an indicator of increasing worldwide demand for Apple products.
As demonstrated, there are many puts and takes - multiple key products, seasonality, slowdown after initial sales for new products, immature end markets, etc. -- that could impact March 2Q FY2013 revenues. It was appropriate for Tim Cook to guide conservatively, or "disappointingly." After Apple's last three earnings reports, the company needed put itself in a position where it could at minimum meet expectations. Outside of new product launches, March's earnings results historically have been influential in predicting June's quarterly performance. Obviously, a strong March 2Q FY2013 result would probably lead to a better June 3Q FY2013 view.
This is extremely important as investors are actually more concerned regarding Apple's June 3Q FY2013 guidance - AAPL fell 5.5 percent on April 17, 2013 after Cirrus Logic (CRUS) warned and Digitimes reported that iPad mini shipments would fall 20-30 percent sequentially.
To address iPad concerns, Apple is likely to report that iPad unit sales represented just one-fifth of worldwide PC shipments for the first three months of 2013. But the big picture is that the tablet market is still in its infancy and market penetration remains low. So this news should signal an opportunity rather than a concern.
Don't fret, Apple investors. With no pre-announcement, AAPL down approximately 40 percent from its highs and barring a recession, most of the pain has already happened. Apple is ready to report a solid quarter.