Apple to Report an Unprecedented $2.5B Top-Line Beat in Fiscal Q3

| About: Apple Inc. (AAPL)

While Wall Street continues its 7-month bear clawing of Apple's (NASDAQ:AAPL) stock price, the company is about to report the largest top-line beat in its 35-year history -- and quite possibly one of the biggest top-line beats in the market's history. Apple's stock price has been far underperforming the NASDAQ, S&P and Dow Industrials over the past 8 months, despite repeatedly posting outrageously high growth-rates.

Last quarter, for instance, Apple's earnings per share grew 92%, higher than the vast majority of stocks trading in the S&P 500. Yet, in spite of this ridiculously strong growth for a company of Apple's size, the stock's P/E ratio continues to fall quite dramatically due to the company's simultaneous explosive earnings and the underlying stock's underperformance. In fact, if Apple continues its sideways trading even after it reports earnings in July, Apple's P/E ratio will fall to the lowest level in nearly 10-years -- eclipsing the lows of the financial crisis.

According to the most recent poll taken by the Thomson Financial Network, Wall Street analysts are expecting Apple to report revenues of $24.49 billion on the quarter. This compares to Apple's revenue guidance of $23 billion on the top-line. Notice that for the past two quarters, Apple eclipsed its own revenue guidance by $3.7 billion in fiscal Q1 and by $2.7 billion in fiscal Q2, despite missing on iPads.

The table below (click to enlarge) contains the details of my $27.053 billion top-line estimate for Apple's fiscal Q3 -- that's $2.5 billion above Wall Street's expectations. I'll be providing an income statement analysis for Apple's fiscal Q3 in a follow up to this sales and revenue analysis.

Click to enlarge

iPad sales to top a record 10 million units in fiscal Q3

Here are the factors that will likely contribute to Apple's massive top-line beat. First we have iPads. Wall Street analysts are significantly underestimating the amount of iPads Apple expects to sell and will sell in fiscal Q3. A big part of that underestimation is due to the fact that several analysts are over-estimating the financial impact of the Foxconn explosion in late May.

Mike Abramsky -- the RBC capital analyst who famously had a sell-rating and $70 price target on Apple in March 2009 before the stock bottomed and doubled in just three months time -- expects that Apple may lose as many as 1.8 to 2.8 million iPads on the quarter. Due to this loss in production, Abramsky is expecting that iPad sales will fall 22-36% short of his already unreliable 8 million iPad estimate on the quarter. He thinks the revenue impact could be as high as $1.1 to $1.7 billion in fiscal Q3.

On a side note, even in April 2009, Abramsky stubbornly kept his $70 price target and sell-rating on the stock. Only once the stock had moved over 100% off the lows did he finally chase the company higher. He chased the stock down during the financial crisis and chased it back up during the recovery. While other journalists might ignore this, I think these analysts who get paid hundreds and thousands of dollars a year should demonstrate why we actually need them.

What he should have done was put a buy rating on a stock trading at only 2.5 times cash when it was trading between $80-$90 a share. What kind of a moron puts a sell-rating on a stock growing its earnings at 100% a year when it's trading at only 2.5 times its cash? Notice, he put this $70 price target and sell rating on Apple even after it reported 155% earnings growth in fiscal Q1 2008.

Great advice to your clients! Chase a stock all the down by lowering price targets once the stock has already lost 60% of its value, and then chase it back up by placing buy ratings once the stock has moved 100% off the lows. I find that whatever anyone decides to do for a living, they should at least try to do it well.

But I digress. Where were we? Oh yeah. Before getting lost in Mike Abramsky's ineptitude as an analyst, we were talking about iPads. Here is what investors should expect with iPads this quarter. Apple will probably sell between 9 and 10 million units with a much higher average selling price than what we saw in fiscal Q2.

I believe the production constrains as a result of the Foxconn explosion are largely overstated because not only did the explosion take place far too late in the quarter to have more than a marginal impact in fiscal Q3, the language used by Apple's management in the conference call suggests that Apple planned to overproduce rather than underproduce iPads in Q3.

Apple probably planned to have more iPads than is necessary to meet fiscal Q3 demand head on. To see a full analysis of the comments by Apple's management, you can read my full take on iPads here. But here is one key comment from Apple's management in the conference call (emphasis added):

Well, the demand on iPad 2 has been staggering. And we're still amazed that we are still heavily backlogged not only at the end of the quarter but also up to date. However, I can tell you that I'm extremely pleased with the progress of the manufacturing ramp, and we were so confident that we rolled out to 25 additional countries at the end of last month. And we are shipping to an additional 13 countries next week, and we're planning to add even more countries through the quarter. And so I'm very confident that we can produce a very large number of iPads for the quarter.

I'm estimating that Apple will report about $6.4 billion in iPad revenue on sales of 10 million units with an average selling price of $640 in fiscal Q3. The most difficult thing to predict this quarter, however, are iPad sale and iPad ASPs. There really isn't all too much to go on when it comes to making iPad predictions. Yet, those in the best position to make iPad predictions is Apple's management. Thus, what they have to say about the iPad is probably of the highest importance on the quarter.

iPhone sales to drop sequentially to 16.5 million units

iPhone sales will like see a marginal sequential decline in fiscal Q3 to 16.5 million units on the quarter. This represents a very impressive 96.5% year-over-year growth rate over the 8.4 million units Apple sold in fiscal Q3 2010. The reason for the decline will be largely due to Apple increasing its channel inventory by 1.7 million units on the quarter. This will cause some overhead pressure on iPhone sales in fiscal Q3.

Moreover, based on Apple's revenue guidance in conjunction with its iPad comments, Apple's own internal estimates do not call for sales of both 10 million iPads and more than 16.5 million iPhones. That would yield a revenue number that is far beyond the normal variance seen in Apple's historical guidance beats.

While Apple is in fact almost always conservative, it is for the most part consistently so. In other words, Apple is not going to give a guidance number that is 30% or 40% below what they expect to actually report. That would fall outside its normal range.

Thus, Apple's guidance is helpful in giving the outer boundaries one can expect to see in terms of revenue. $4 billion above its $23 billion revenue guidance is already stretched to the limit. If Apple were to sell 10 million iPads and the 18.6 million iPhones it sold last quarter, it would report well above $28 billion on the quarter -- or $5 billion above its guidance.

This simply will not happen. Again, in fiscal Q1, Apple reported a record $3.7 billion guidance beat. In fiscal Q2, it was $2.7 billion. For fiscal Q3, I'm calling for a $4 billion revenue beat which would be the highest in the companies history. That beat is also more or less consistent with Apple's comments regarding its gross margin estimate decline, and iPhone channel inventory increase.

Notice that the iPad carries far less favorable gross margins than the iPhone. So a higher mix of iPad sales to iPhone sales will result in a much lower sequential gross margin percentage than in a quarter where Apple reports a higher more favorable mix of iPhones to iPads. According to Apple's guidance for gross margin this quarter, Apple is expecting a significantly higher ratio of iPad sales to iPhone sales than in Q2.

In realty, truth be told, Apple has basically told us that it expect a mix of 9 million iPads and 16.5 million iPhones. This is very obvious to anyone who has experience with understanding the link between Apple's comments in any given quarter regarding its iPhone channel inventory, iPad channel inventory, production capacity, gross margin guidance, and revenue guidance. This tells the whole story and is a remarkably accurate methodology used for forecasting.

The only reason that I'm at a 10 million iPad estimate is because I think Apple might be providing an even more conservative outlook given its internal miss on iPads in fiscal Q2. I think this is evidenced by the fact that Apple warned ahead of Q2 earnings with its Samsung lawsuit one week before it reported earnings.

The lawsuit basically indicated that Apple sold more iPhones than expected and less iPads than expected in fiscal Q2. I think this was very intentional on Apple's part. It was a very impressive and elegant way for Apple to warn about the iPad shortfall and iPhone increase without issuing an official warning. Obviously, they would never warn given the fact their revenue is coming in billions above Wall Street expectations.

After dealing with production issues with the iPad, I'm sure Apple decided to increase its iPhone channel inventory in order to make up for the loss in revenue which resulted in Apple beating its earnings estimates by the customary margin. Selling 1 million iPhones produces, more or less, the same result as selling 1 million iPads from a revenue perspective.

From an earnings perspective, obviously Apple would rather sell 1 million iPhone than 1 million iPads given the far more favorable gross margins with iPhones. And so what we got in fiscal Q2 was a significant earnings beat even though Apple posted lower revenue than the most optimistic estimates and a much higher gross margin percentage as a result of the more favorable mix.

Thus, I'm expecting Apple to report iPhone revenue of $10.7 billion on sales of 16.5 million iPhones at an average selling price of $647 in fiscal Q3. You can see more on my fiscal Q3 iPhone analysis here and you can read more about my 2012 iPhone sales expectations here.

Apple to report record Mac sales of 4.267 units

The seasonal trend in Macintosh sales suggests a Mac number somewhere above 4.134 million units. Apple's fiscal Q3 Macintosh unit sales has surpassed Apple's fiscal Q1 every year since 2005. Yet, the key question is not whether Apple's fiscal Q3 will surpass its fiscal Q1 in unit sales, the question is: by how much? The data below lays out the growth rate between Apple's fiscal Q1 and Q3 in terms of unit sales:

  • 2010: 3.27%
  • 2009: 3.13%
  • 2008: 7.63%
  • 2007: 9.84%
  • 2006: 5.82%
  • 2005: 13.0%

Notice that over the past two years the growth rate between fiscal Q3 and fiscal Q1 has slowed to about 3.2% on average. If we get that same 3.2% growth this year, unit sales would come in at about 4.267 million or 133,000 units higher than in fiscal Q1.

The year-over-year growth trend

Yet, the sequential and seasonal trend is only one part of the story. We also have to look at what the year-over-year growth rate has been over the past few quarters to get confirmation of the seasonal trend. How do we know that this isn't an 8% seasonal growth year like in 2008 and not a 3% growth year like last year? That is largely determined by what the year-over-year growth has looked like this year.

Macintosh unit sales grew to 4.134 million units or 23.0% in fiscal Q1 2011 over the 3.362 million Macs Apple sold in 2010. We saw much of the same in Apple's recently reported fiscal Q2. Mac sales grew to 3.76 million or 27.8% over the 2.943 million Macs Apple sold in Q2 2010. If Apple were to sell 4.267 million Macs in fiscal Q3, that would represent a 22.9% year-over-year growth rate which is more or less directly in-line with the year-over-year growth trend in 2011.

There are also a wide-variety of intangible reason why I think this 4.267 million Mac number makes the most sense. Apple's management has pointed out there is no noticeable cannibalization of Mac sales from the iPad. I think that for the most part Apple's management is probably correct on this end. But there will probably be at least a few thousand lost purchases to iPads this quarter notwithstanding.

Thus, based on a $1,300 average selling price, Apple should report around $5.55 billion in Macintosh revenue this quarter. I'll make some very slight revisions to this estimate once I get a chance to analyze some Gartner data. You can read more on my 2011-2012 Mac sales outlook here.

Apple's other $4.430 billion in revenue

I'm expecting Apple to report about $4.4 billion in revenue drawn from iPods, iTunes, Software and Peripherals. None of these categories individually make up enough of Apple's revenue for me to spend a lot of time justifying my estimates. I expect iPod sales to continues its downward contraction as a results of the smashing success of the iPhone.

iPod sales should come in at around 8.8-9 million units leading to about $1.5 billion in revenue. This is more less consistent with the seasonal, sequential and year-over-year growth trend as well as other intangible factors. iTunes revenue should come in at about $1.540 billion dollars which is also consistent with the seasonality. I expect Apple to report about $530 million in revenue drawn from peripherals and $810 million from software sales.

I'll publish an income statement analysis and earnings preview for fiscal Q3 shortly.

Disclosure: I am long AAPL.