Digging Deeper Into Apple Q3 Guidance

| About: Apple Inc. (AAPL)

Summary

Q2 by the numbers - Apple's guidance nails the results.

Big drops expected in revenue and gross margin.

What happened to the Apple surprise factor?

Since Apple's (NASDAQ:AAPL) last earnings announcement on 4/26, Seeking Alpha readers have had an average of four articles to read each and every day on the merits or shortcomings of this behemoth. It's a lot to absorb. With hundreds of comments on some of the articles, the opinions and dialogue that go along with the articles make for some pretty interesting reading. Rather than get lost in the conjecture and opinion, I try to rely on facts and numbers to formulate my own opinion. Over the past few quarters I have presented an in-depth look into the guidance numbers presented at each of Apple's earnings announcements, comparing them to the actual to determine where the patterns and problems might show up. This article is an ongoing continuation of that analysis. The past articles are (Q1 2016 guidance) and (Q2 2016 guidance).

Apple only gives us factors that we must formulate to come up with the all important earnings per share. If we make assumptions regarding outstanding share count, they give us just enough information to come up with a number. But there's history in those guidance numbers. History to learn from. That is why I dig deeper to ascertain. First, let's review the Q2 results related to guidance and a few side notes that may be pertinent as we review the Q3 guidance and my expectations later in this article.

Q2 Results - Revenue

For fiscal Q2, ending 3/26/16, Apple's revenue came in at $50.557 billion. This number was down 12.8% from a year ago but was within the range of guidance provided for this quarter ($50.0-$53.0 billion) back in January's announcement. (transcript of this announcement is here). Over the last 30 quarters, Apple has never "missed" on revenue. The Revenue has never been below their low guidance. Not once in 30 quarters.

Q2 Results - Gross Margin

Like revenue, Apple's Q2 gross margin fell within the guided range at 39.4%. The guided range was between 39.0% to 39.5%. This is the first time since Q3-2013 that the actual gross margin is within the range of guidance. That's 10 straight quarters of missing guidance. And now they hit it. Even more spectacular, like revenue, actual gross margin has never missed on the low side of guidance.

Q2 Results - Expenses

Beginning with guidance for Q2 of 2013, Apple provides a range for expenses. During this 13-quarter timeframe, Apple results have never exceeded the high end of the guided range. In fact eight out of the 13 quarters were below the low end guided number including the last two quarters. Q2 actual was $5.934 billion. Guidance was given to be a range between $6.0 to $6.1 billion. For the 13 quarters they have provided a guidance range for expenses, the average actual is just 0.11% over the low guidance number.

Q2 Results - Other Income

Other Income came in at $155 million for the quarter. This was significantly below the projected/guided number of $325 million, breaking the trend of the last three quarters. It was the lowest Other Income for any quarter since Q4 of 2013.

Q2 Results - Tax Rate

The tax rate for Q2 was 25.64%, 0.5% higher than the guided rate of 25.5%. This is only the fifth time in the last 15 quarters where the actual rate was higher than the guidance.

Q2 Results - Share count

As pointed out in previous articles, there are three share counts Apple reports in their 10-Q. The header of the 10-Q includes the share count at the time they complete (internally) their 10-Q. This number was reported as of 4/8/16 and was 5,477,425,000. This was down 67,158,000 (1.2%) from the previous quarter, which is in line with the average post-split quarterly drop of 1.3%. The share count used to determine earnings per share, which is a weighted average (see Note 1 of the 10-Q's notes to condensed consolidated financial statements (unaudited)) fell 1.0% (53,241,000 shares) to 5,540,886 (fully diluted). The third share count reported by Apple is the one used to determine shareholder's equity as of the close of the quarter. This was reported as 5,478,446,000, down 1.2% from the previous quarter, a drop of 66,041,000 shares.

Q2 Results - EPS

Apple's Q2 guidance with all of its permutations averaged an expected earnings per share of $1.93. They came in at $1.90 per share. Well within the guided range extrapolated from the various factors between $1.83 and $2.03, so I would give them praise for hitting it so well.

Examining These Trends, Projections Q3 Report Next Week

With revenue, gross margin and expense guidance pretty much always on the money, the tax rate guidance correct two-thirds of the time, and Other Income providing less than a nickel of EPS (<2.5%), you would think that the guidance numbers can be pretty much taken at face value. But that's where Apple gets interesting. With major share buybacks ongoing, and a historical propensity for surprise, analyzing the trends can provide insight into the future of Apple's earnings.

Revenue

The analysis provided in last quarter's article projected the range of revenue to be between $52.0 and $53.985 billion. The average revenue estimate from the 35 analysts providing an estimate for the quarter (source: Yahoo) was $52.0 billion just a week before the announcement. Looks like everyone missed it. For the 13 quarters since returning to a guided revenue range, actual revenue has averaged 7.447% over the low end of guidance. This is down from last quarter's 12 quarter average of 7.974%. However the last four quarters have averaged just 3.637% over the low guidance.

In previous articles I had projected revenue to be 4.0% over low guidance. Moving forward, I think this projection condition should be lowered to the current one year average of 3.637%. Apple has guided revenue to be between $41.0 and $43.0 billion. Applying the one-year average, I'm projecting revenue to be $42.49 billion.

Gross Margin

Based on the historic data, Apple's gross margin factor was anticipated to be 2.4% over the low end guidance of 39.0%, or 39.936%. Apple's high guidance was 39.5%. Q2 results, coming within the guided range at 39.4%, moves the 13 quarter actual average slightly lower (3.639% over the low guidance), moving toward my anticipated 2.4% over low guidance which I maintain for third quarter calculations. Apple has guided a range of 37.5% to 38.0% for Q3. My number comes in higher at 38.4%. I think someone may be covering their butt a little too much on this guidance as it is a fairly significant drop of nearly 5% to get to the low end of guidance from where they were at the end of Q2. There hasn't been that much of a decline in GM since early 2012.

Expenses

Since Apple reformatted their guidance back at the beginning of 2013, providing a high and low range of expenses, the actual expenses have yet to exceed the high guidance. Would there be any reason to expect a change in that expectation? I doubt it as well. Last quarter I expected the expenses to be 0.78% off the high guidance of $6.1 billion. For Q3 I expect that to be a little lower, 0.98% below the high guidance, or $6.04 billion.

Other Income

This parameter is one that fluctuates wildly. Last quarter saw the actual number come in 52.3% off of the guidance. Last quarter's dip moved the rolling four quarter average from guidance back to within a couple of tenths of a percent of the overall average. With this in mind, I expect the number to come in 7.81% below the guidance, or $276 million. But, in the larger scheme of things, this isn't a large enough number to move the meters on stock price or P/E.

Tax Rate

This quarter's tax rate of 25.64% was only 0.55% over the guidance. The 13 quarter average guidance remains slightly less than guidance at 99.84%. That said, you'd have to go back to 2012 before seeing tax rates consistently lower than this quarter's guidance of 25.5%. The 13-quarter average tax rate is 26.13%, 63 basis points higher than the guidance. Based on these divergent facts, I will continue to accept the guidance as a "good" number.

Share count

This is one factor where there is no guidance. But, yet, Apple's financial engineering team continues to "add value" for their shareholders through stock buybacks. Since Q3 of 2014, when the 7:1 split came into play, Apple has seen an 8.66% decline in weighted average shares used to calculate earnings per share. This is an average of 1.24% per quarter. As the actual share count was already down to 5,477,425,000 on 4.8, I believe this quarter could see the weighted average share count fall to 5,470,000,000 for Q3.

Q3 expected numbers

So we have the numbers. I've summarized Apple's guidance and my projection of the numbers in the chart below to determine where earnings should fall. The EPS projected using Apple's guidance numbers reflects use of Q2's share count.

Parameter

Q2 Actual

Q3 Guidance

Q3 Projection

Revenue

$50.557 Billion

$41.0-$43.0 Billion

$42.49 Billion

Gross Margin

39.40%

37.5%-38.0%

38.4%

Expenses

$5.934 Billion

$6.0-$6.1 Billion

$6.04 Billion

Other Income

$155 Million

$300 Million

$276 Million

Tax Rate

25.64%

25.5%

25.5%

Share count

5,540,886,000

No Guidance

5,470,000,000

EPS

$1.90

$1.29-$1.43

$1.42

Click to enlarge

The Surprise Factor

Anyone who has followed Apple over the years is well aware of some of the surprises found during the earnings announcement calls. Beginning with Q1 of 2009, for 14 straight quarters, earnings surpassed guidance by greater than 14% each quarter. In fact the average "surprise" over this period was 41.51%. Since then, 16 quarters are in the books. The average surprise over these 16 quarters, just 7.19%. The last four quarters have averaged just a 1.9% surprise. applying this to my projection of $1.42 per share puts my current Q3 estimate at $1.45 per share.

Potential Effect on Stock Price

The million-dollar question. Earnings of $1.45 per share would put the trailing 12-month earnings at $8.59 per share. With Apple's P/E ratio being more comparable to that of a bank than a tech company, I think we could see a retreat back to early May levels (low 90s).

It's always important to listen to guidance. These facts over time reflect a significant change toward better guidance and quite possibly a statement on the state of the product pipeline. Or, it's just plain harder for a company whose average revenue has leaped from $21.1 billion per quarter from Q1 2009 through Q2 of 2012 to over $49.0 billion per quarter from Q3 2012 through the last quarter. To have that kind of hidden increase or changes in factors may not be possible at this size. Maybe like all of us, it's getting old. Maybe it's just a sign of maturity.

Disclosure: I/we 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.