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Summary

  • Short-term caution with Apple is warranted.
  • Q3 estimates still seem high without any major product launches.
  • Capital returns might increase, but does that kill the growth story?
  • Gross margins likely to decrease this year with new products/services.

A couple of weeks ago, I detailed how the next couple of months could be crucial for technology giant, Apple (NASDAQ:AAPL). While new products are eventually coming, they might not be here in time for the June-ending quarter. That could lead to a repeat of January, where the stock fell on weak guidance.

Lately, there's been a lot of rumors coming out in regard to Apple, mostly about new products or services. Today, I'm going to look at some of those rumors in the grand scheme of things. While I do believe Apple goes higher towards the end of this year, I still think investors need to have some caution in the short term. I am not here today to ring any alarm bells or call for Apple shares to plummet, but investors do need to be aware of some possible risks.

First half versus second half:

While the deal with China Mobile (NYSE:CHL) will help boost numbers a bit, those gains will be partially offset by the other carriers in China that got the iPhone earlier than normal in 2013. The majority opinion is that the first half of calendar 2014 will be weak for Apple. This notion was detailed recently by a UBS analyst, and it has been something I've discussed for months. Everyone is waiting for big product launches like the larger-screen iPhone 6, which may not come until August or September.

The risk here remains with fiscal Q3, the April, May, and June quarter. Current analyst estimates still call for 9.5% revenue growth over the prior-year period. I think that number is a bit high at the moment, although I do expect estimates will come down a little into earnings. I've detailed this "panic time" theory before, where Apple analysts cut estimates into earnings to ensure a beat or make sure guidance doesn't look too bad. If I were an Apple shareholder, I'd be much happier with Q3 estimates at 5%-7% revenue growth going into the report. Where things stand now, guidance implies some sort of product launch, and maybe even a major one. If you don't think anything new is coming, estimates are too high. China Mobile sales, combined with the new cheaper 5C in Europe are not enough to get a $3.3 billion increase in Q3.

Increased capital returns:

Earlier this month, I discussed some of the prospects related to a potential dividend raise for Apple. Apple's share count has come down in a significant manner thanks to the buyback program. For the same total dividend payout, that will allow for a dividend raise. Apple used that buyback to help support shares after the post-earnings fall thanks to weak Q2 guidance. My personal opinion was that Apple would raise the dividend to $3.50 per quarter.

There seems to be growing speculation that Apple will announce an increase to its capital return at this next earnings report, and I'm not just talking about a dividend raise. Since Apple has already used more than two-thirds of the $60 billion buyback up, some are expecting a buyback raise. Analysts have discussed the shareholder-friendliness of new CFO Luca Maestri, and his favoring of buybacks.

At this point, how Apple would go after these higher capital returns is unclear, as it would depend on the time frame. As I've stated in the past, Apple could announce a trillion-dollar buyback today. But if the company only expects it to occur over 200 years, the math is rather simple. The amount is important here, but so is the timing. If Apple expects to buy back a lot of stock quickly, the company probably will need to raise more cash through debt or the repatriation of foreign funds. The $14 billion buyback earlier this quarter put Apple's domestic cash at around $20 billion. Apple should produce some level of cash this quarter, but there also is a dividend payment and perhaps more buybacks.

Additionally, the debate will rage on about what increased capital returns will mean for Apple going forward. The argument over Apple as a growth or value name will only increase with a raised dividend and buyback. Apple is no longer growing at Google (NASDAQ:GOOG)-like rates, and investors shouldn't expect that. The problem is that when you have quarters like this one with basically no growth, investors start to panic. Value-type tech names like Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT) are getting low teen P/E multiples, whereas growth names like Google are getting P/E multiples in the 20s or higher.

Lower margins versus higher revenues:

It seems like every day, there is a new rumor in regard to Apple launching something. Obviously, the biggest launch will be the new set of iPhones later this year. A larger-screen iPhone, 4.7 inches, is the most expected. A 5.5-inch phone may also be launched, but the probability of that phone is less, or it could come at a later time. One thing is clear. When Apple launches new form phones, of which these large phones would be, gross margins are hit. Generally speaking, gross margins dip by a little more than 200 basis points with these new form phones, then come back up about that much with the "S" line in between. These larger phones are expected to sell well, and pricing will be key, but don't be surprised when gross margins come down.

A large recent rumor is the potential launch of a streaming music service. These rumors sent shares of Pandora (NYSE:P) lower by almost 8% on Monday. One important item to consider here is that Pandora's GAAP gross margins were about 32% in the latest fiscal year, according to the 10-K filing. That's a few hundred basis points below Apple's current gross margins. Additionally, Pandora lost money on an operating basis. A streaming music service could help Apple's revenues a little, but would hurt margins a bit.

We also heard Monday about rumors involving Apple and Comcast (NASDAQ:CMCSA) in a streaming service-type deal, although skepticism later prevailed. We've heard past rumors about another Apple set-top device launching this year, so a streaming service could go along with that. Rumors of Apple entering this space helped to send Netflix (NASDAQ:NFLX) shares down more than 9% at one point Monday, leading to a momentum-based sell-off. Since I cover Netflix a lot, I can tell you that Apple launching a Netflix-like service would hurt margins. Netflix's domestic streaming gross margins were less than 31% in Q4 2013, and that was after more than 400 basis points of improvement over the prior-year period. Operating and net margins are even worse for Netflix, when compared to Apple's numbers currently. I would think Apple needs to look at something slightly more profitable here.

So when you hear about all these rumors, remember that it is a key balancing act. Apple could increase revenues overnight by buying other businesses or entering new lines of business. But, at the same time, would Apple buy a supermarket chain to get an extra billion in revenues that have much lower margins? Probably not. In the table below, I've shown how this margin/revenue story works for gross margins, with revenues across the top in billions and gross margin percentages across the left.

Apple could have $70 billion in gross profit, with 40% gross margins on $175 billion in revenues. The company could also have $70 billion in gross profits, with 33.33% (repeating) gross margins on $210 billion in revenues. The key here is not only to increase revenues, but to maintain a solid level of margins. If Apple was just interested in boosting revenues, the company could have bought Netflix when shares were in the $50s, or a Tesla (NASDAQ:TSLA) when it was in the $30s. But that's not how Apple works. Investors need to be patient and also realize that there will be some margin declines with these new products. The hope is that revenues increase at a faster rate to make sure gross profits continue higher.

Final thoughts:

While I still believe Apple will head higher throughout the rest of 2014, I do see reasons to be cautious in the short term. Fiscal Q3 guidance might be light, potentially overshadowing a larger capital return plan. Will an increased dividend or buyback help to overcome growth concerns? It will be tough, if we look what happened at Apple's last report, and Apple probably won't be coming in with $14 billion or so after this report. Additionally, while new products and or services may be coming, this round of new iPhones will put a dent into Apple's margins. I'm sure the bear camp will love that.

Apple closed Monday around $540. Shares recently have traded around or slightly above the mid-point of the $500 to $560 broad range. I continue to encourage buying Apple on pullbacks, like the post-earnings one we saw two months ago. Just like last year, Apple seems to be a second half of the calendar year story. Until we get through April or even May, I believe some caution is justified.

Source: Apple: Short-Term Caution Is Justified

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.