Why Apple Will Blow Away Forecasts This Quarter

Jul.20.09 | About: Apple Inc. (AAPL)

Every quarter there's a story behind Apple's (NASDAQ:AAPL) earnings results which causes Apple to repeatedly beat the street by a staggering margin. Last quarter the story was how Apple's dramatic beat on gross margin and iPod sales expectations resulted in the company surpassing even the highest forecast on EPS. I think that for this quarter the story is going be about how the analysts fully underestimated Apple's ability to sustain relatively high gross margins through Q3. There doesn't seem to be much disagreement among the analysts with regards to unit sales data or total revenue on the quarter. In fact, my revenue expectations are exactly in line with the Wall Street consensus owing to the higher levels of predictability in estimating ASPs and unit sales this quarter when compared to previous quarters.

Yet, the main intersection of disagreement between Wall Street analysts and several unaffiliated analysts, day traders and bloggers is on expectations for gross margin percentage as reflected in the rather sizable divergence on EPS expectations between Wall Street analysts and traders/bloggers/unaffiliated analysts and the like. Only Mike Abramsky put out estimates that are in line with a lot of the non-Wall Street analysts.

Quarter-to-quarter margins

If one considers that in the past three years of earnings, there has never been an instance where Q2 gross margin percentage surpassed Q3 gross margin percentage. And I think this can be explained in part by the simple observation that the conditions determining Q2 gross margins don't substantially change from the conditions determining Q3 gross margins. In fact, in many ways, the conditions favoring higher gross margins improve in Q3 if only slightly. For one, there is generally a marked increase in computer sales in Q3 over Q2 propelled by the start of the back to school shopping season promotion, and computer sales tend to carry better gross margins than do iPod sales.

As a percentage of total revenue, Macintosh computers generally comprise of a larger percentage of total revenue in Q3 than in Q2 while iPods tend to dominate Q2 than in any other quarter save Q1. While history by itself isn't a very good predictor of a particular future outcome, it is an indicator that may help explain certain unknown factors which tend to lead to these seemingly repeatable results. Historical data shouldn't be the only data relied upon to draw forecasts but it also shouldn't be entirely ignored either. The data below lists in chronological order Apple's gross margin percentages for each quarter of the past few years. As you can see, the higher gross margins in Q2 tend to be sustained and even surpassed in Q3.

Apple's Gross Margin Percentage 2006-2009
Q1 2006: 27.20%
Q2 2006: 29.76%
Q3 2006: 30.32%

Q4 2006: 29.20%

Q1 2007: 31.20%
Q2 2007: 35.13%
Q3 2007: 36.88%

Q4 2007: 33.61%

Q1 2008: 34.68%
Q2 2008: 32.90%
Q3 2008: 34.83%

Q4 2008: 34.69%

Q1 2009: 34.74%
Q2 2009: 36.40%
Q3 2009: 36.90%*

*Estimate. Not actual results.

Another factor which may impact this quarter's gross margin is recognized iPhone revenue (revenue which carries extremely high gross margins in excess of 50%) which is playing an increasingly larger role in Apple's earnings results. In fact, iPhone revenue in Q3 will likely dethrone the iPod to hold the #2 spot for overall revenue contribution for the first time ever. Since 2003, the iPod has either been the largest or second largest contributor of Apple's total revenue. It looks like that is going to change this quarter which will explain how Apple's gross margin percentage will outperform Q2.

Another indication that gross margins will do better this quarter is Apple's unusually aggressive guidance on gross margin. For Q3, Apple's management has noted that it expects gross margin percentage to reach 33%. This is the most aggressive gross margin forecast Apple has put out to date! Even more bullish than Apple's 32.5% gross margin guidance it gave for Q2. What this indicates is that Apple's management, those who are in the best position to know how gross margins will perform, have high expectations for whatever reason. The tables below list my Q3 2009 estimates and revenue breakdown, and my fiscal 2009 forecast.

Andy Zaky's Earnings Estimates for Q3 2009 (in Millions, except for per share data)

GAAP-Based Est.

Non-GAAP Est.

Difference

Revenue

$8,249

$9,433

$1,184 (14.4%)

Cost of Goods Sold

$5,205

$5,613

$408 (7.8%)

Gross Margin

(36.9%) $3,044

(40.5%) $3,820

$515 (18.2%)

Operating Expenses

$1,360

$1,360

-

Operating Income

$1,684

$2,460

$776 (46.1%)

OI&E

$60

$60

-

Net, Before Taxes

$1,744

$2,520

$776 (44.5%)

Taxes

(30.4%) $529

(30.3%) $764

$235 (44.2%)

Net Income

$1,215

$1,756

$541 (44.5%)

Earnings Per Share

$1.34

$1.94

$0.60 (44.8%)

Diluted Shares

903,000,000

903,000,000

-

Click to enlarge

Revenue Breakdown by Product Summary for Q2 2009

Product

Unit Sales

ASP

GAAP Revenue

Non-GAAP Revenue

iPods

10,300,000

$145.00

$1.4935 Billion

$1.4935 Billion

Macintosh Computers

2,400,000

$1300.00

$3.12 Billion

$3.12 Billion

iPhone Sales

5,200,000

$545.00

$1.650 Billion

$2.834 Billion

iTunes

-

-

$975 Million

$975 Million

Software

-

-

$640 Million

$640 Million

Peripherals

-

-

$370 Million

$370 Million

Total Revenue

-

-

$8.249 Billion

$9.433 Billion

Click to enlarge

Andy Zaky's GAAP-Based Earnings Estimates for FY 2009 (in Millions)

Q1 2009

Q2 2009

Q3 2009

Q4 2009

FYE 2009

Revenue

$10,167

$8,163

$8,249

$9,378

$35,957

Cost of Goods Sold

$6,635

$5,192

$5,205

$6,002

$23,034

Gross Margin

$3,532

$2,971

$3,044

$3,376

$12,923

Operating Expenses

$1,406

$1,304

$1,360

$1,400

$5,470

Operating Income

$2,126

$1,667

$1,684

$1,976

$7,453

OI&E

$158

$63

$60

$80

$361

Net, Before Taxes

$2,284

$1,730

$1,744

$2,056

$7,814

Taxes

$679

$525

$529

$576

$2,309

Net Income

$1,605

$1,205

$1,215

$1,480

$5,505

Earnings Per Share

$1.78

$1.33

$1.34

$1.63

$6.08

Diluted Shares

901

903

903

903

903

Click to enlarge

Disclosure: At the time of this writing, the author held no position in Apple, short or long. But that can change at any time.