Apple: The Storm Before The Calm

| About: Apple Inc. (AAPL)


Apple could see a rough patch before the waters calm.

Earnings reports always contain disappointments. Will iPhone sales disappoint again?

Fiscal Q3 guidance seems likely to disappoint, just like last year.

Dividend raise is expected, but a buyback increase too?

Don't panic. Use pullbacks as opportunities to accumulate.

Earnings season is quickly approaching. In just over two weeks, Apple (NASDAQ:AAPL) will report its fiscal second quarter results. While every Apple earnings report is important, there are two special items that separate this report from prior ones. This article today will be a primer for Apple's earnings report, but it is not my official one, which will come a few days before Apple reports. Today, I'll examine some higher level items when it comes to Apple, instead of drilling down into the nuts and bolts of the quarterly report. I believe the next few weeks are going to be a bit intense for Apple, but once this month ends things will start to calm down a bit. Here's why:

There will be a disappointment:

No, I'm not saying that Apple will wildly miss on revenues and earnings here. But like all earnings reports, some number or item will disappoint. The key question for this quarter is what is that disappointment, and what is actually priced into the stock.

Let's take last quarter's report as a great example. Apple had a tremendous miss in terms of iPod sales. While that did hurt revenue and earnings a little, this wasn't a major issue overall. The iPod line is an extremely small part of Apple's business, so holding all else equal, the importance here was really low. On the flip side, you had Apple missing iPhone sales estimates as well as the company issuing guidance a bit below street expectations. These were major issues because the iPhone is Apple's number one product line, and fiscal Q2 guidance basically called for flat or declining revenues.

So this time around, the two items that Apple missed on last quarter are really big items to focus on. The iPhone number is critical because of the China Mobile (NYSE:CHL) launch during fiscal Q2. China Mobile had 1.2 million pre-registrations by January 15th, and added another roughly 1 million iPhone users in February. Apple probably won't release specifics on China Mobile in the press release, but I'm guessing at least one analyst will ask on the call. We'll see if an answer is given. I'd guess maybe about 4 million sales would be a reasonable expectation for the quarter. That number will be offset a little by the fact that China's other carriers got the iPhones in September, a few months earlier than usual. Apple had 37.4 million iPhone sales in last year's Q2. For the street to be happy, 38-40 million would probably be a lot nicer than 35-37 million.

The second issue will be guidance. I've been detailing for a number of weeks that fiscal Q3 analyst estimates seem a bit high, unless a new product will be launched in the quarter. We saw a minor launch of a cheaper iPhone 5C in Europe a few weeks ago, but that's not going to move the needle tremendously. Current estimates still call for more than 9% revenue growth in the quarter. That probably means that Apple needs a double digit jump in its "core" business, since the iPod will probably show a sizable decline. In fact, a recent analyst note, which was an estimate and price target hike, echoed similar thoughts. The BMO analyst is projecting fiscal Q3 revenues of $36.6 billion, two billion below the current street forecast. As I continue to state, Apple is likely to issue a guidance midpoint below estimates unless estimates come down a bit in the next few weeks or the company is launching a new product in the quarter.

Also, there is a high probability that Apple will announce a year over year decline in net income for Q2. While analyst estimates call for a slight increase in EPS, Apple's diluted share count is expected to be around 870 to 880 million for the period. Last year's Q2 had a diluted share count of more than 946 million. The buyback will provide a significant boost to EPS, but net income will probably decline slightly. Don't let the bear camp tell you this is a surprise, because simple math shows it probably is coming. It will only be a surprise if it is a much larger drop than expected.

The other item that comes into play here, and I'll discuss this more in my official preview, is where Apple stands going into earnings. Obviously, the higher Apple is going into earnings, the higher expectations will be. If Apple is in the $550 to $575 range going into earnings, Apple can't have one of these "major" disappointments. But if Apple is in the $500 to $525 range, the street probably can digest a mid level or even one major disappointment, as long as everything else looks alright.

A capital return update:

It was at last year's April report that Apple announced a large increase in its capital return plan. Management has stated that an update will be provided in the early stages of 2014, so this earnings report seems to be the proper time for an announcement. The general feeling is that Apple will raise its dividend up to 20%, and this would still be part of the current $100 billion return plan. If Apple only announced a dividend raise, it really wouldn't be an increase to the overall total, unless Apple specifically says so. A true increase to the plan would be in the form of an increased buyback, with current estimates in the $25 billion to $50 billion range.

I recently laid out my reasoning for a 15% raise in Apple's dividend to $3.50 per quarter. I still feel confident in that prediction, and I don't plan on changing it before the report. Apple had about $32 billion left on the buyback going into this quarter, and we know at least $14 billion has been bought back in the quarter. With up to $18 billion still available on the current plan, Apple is not in a position where it has to announce an increase at this report. The company could easily wait until it gets closer to finishing the current plan to announce a raise. Remember, the original plan was expected to finish by the end of calendar 2015, more than a year and a half from now.

Obviously, the company can look at a financial website like Yahoo! Finance and see where estimates are. If Apple is going to report a weak Q2 or hand in light Q3 guidance, management might decide a buyback announcement is necessary to offset some disappointments. I would expect a potential raise announcement to be in the $20 billion to $40 billion range. I think Apple would go with the $20 billion number if it expects the buyback (along with the increase) to be completed in the next year or two. However, if Apple is targeting a longer time frame, the $40 billion number would allow the company to boost the current plan to $100 billion in total. Remember, for Apple to continue buying back a large amount each year, the company will need to either issue more debt or repatriate funds from outside the US. The company's US cash pile has come down a lot in recent years thanks to the buyback and dividend. Only those US funds can be used.

It's the second half of 2014 that's more important:

Last year's report in April had weak Q3 guidance but the huge capital return plan announcement. The market was able to shake off some of that weakness, because everyone was waiting for the new line of iPhones and iPads coming later in the year. That process could repeat this year. Later this year, Apple is expected to launch the iPhone 6, which is expected to have a larger screen, with the potential for a second model with an even larger screen.

Internal Apple documents show that the company's sales force is worrying about the growth of the iPhone. The iPhone is losing out to larger screen devices and much cheaper devices. Apple will look to deal with at least one of those two issues this year. But everyone seems to agree that Apple needs to do more. Just updating the iPhone and iPad again won't be enough. The China Mobile deal obviously will help Apple's growth numbers a bit, but Apple needs something for the future.

The smartwatch is what's on most people's minds, but it may not come just yet. Some sort of TV product is also rumored, but we've been waiting for it for years. Many eyes will be on the second half of this year, and hopefully Apple does more than just a larger screen iPhone and perhaps a larger iPad as well.

Final thoughts:

Things may get a bit rough for Apple before they get better in the second half of this year. There is likely to be some disappointment in this quarter's report. In the April report last year, guidance was terrible but a huge capital return plan sent shares higher. I do think guidance will be light here, but I also expect a dividend raise and perhaps a buyback increase announcement. The key question is will there be any other disappointments in the Q2 report, and are they minor or major? Apple may be able to shake off some disappointment if shares are low enough.

So what should investors do? Well, I still believe in Apple as a good long-term investment. The company does offer some growth, but investors can't expect tremendous growth. At the same time, a decent dividend is being paid out, and the company's tremendous buyback is working. The best time to buy Apple is on pullbacks, like the one we got after last quarter's earnings report. Apple has started pulling back a little lately along with the market, so investors should start to watch Apple. As this name gets closer to $500, it will be a stronger buy. That's when management decided to buy back a lot of Apple shares, and I think that is a good reference point for investors as well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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.