Apple Shares Set For A Major Move

| About: Apple Inc. (AAPL)

Summary

During the past 30 days, Apple forward P/E ratios have expanded without justification, as earnings estimates were lowered, and long term interest rates remained unchanged.

Apple may have to beat earnings estimates by 6 cents or more to appreciate.

We favor an options position ahead of earnings that can benefit from a substantial move in Apple stock price in either direction, with a bearish bias.

Apple Inc. (NASDAQ:AAPL) will be reporting its quarterly earnings for the quarter ending June 2016 on Tuesday July 26 after the market closes. Consensus estimates are calling for $1.38/share for net earnings, and $42.11 billion for revenues. Last quarter, Apple missed consensus estimates for net earnings by 10 cents, reporting net earnings of $1.90/share vs. consensus estimates of $2.00/share, and revenues of $50.56 billion vs. consensus estimates of $51.87 billion.

In the 30-day period (4/13/2016 to 5/12/2016) straddling last quarter's earnings release date (4/26/2016), Apple shares traded between 112.30 (intraday high on 4/15/2016) and 89.47 (intraday low on 5/12/2016). That's a sizable range of 23 dollars, while currently Apple shares last closed at 98.66 on 7/22/2016.

Click to enlarge Apple stock 6-month chart - Source: Yahoo Finance

As a result of last quarter's earnings miss, as well as multiple factors provided below, Apple shares are at an important crossroad, with a high likelihood for a pending sizable move, as well as additional volatility in the upcoming months.

Apple Earnings Surprises

During the past 7 years, as per below table, Apple missed consensus earnings estimates in only 5 out of 28 releases, by an average of about 5.6 cents (with a range of -1 cent to -15 cents). On the other hand, estimate beats averaged 14.65 cents (with a range of +3 cents to +54 cents).

Apple earnings estimates vs. actual - Source: Zacks

As per below table, on every occasion where Apple missed its earnings estimates, Apple shares dropped the following day, by an average of 3.45%. In addition, Apple shares also dropped on the day following earnings release on another 8 occasions (out of 23) where Apple actually beat consensus, and yet shares dropped by an average of 4.8%. On the other 15 occasions, Apple shares rallied by an average of 4.34%.

Most interestingly, for the past 6 years since October 2010, where there had been 18 earnings beat, Apple shares dropped in 4 out of 5 such beats whereby earnings exceeded expectations by less than 6 cents. Furthermore, during the past 7 years, for earnings released in July for Q2, actual earnings never exceeded expectations by more than 6 cents with the exception of 2011, with resulting average stock price move in excess of 3.3%, although Apple shares did trade higher in 5 out of 7 such occasions.

Earnings Stock Price Stock Price Price Percent EPS Percent
Date Before Release 1 day after release Change Change Surprise Surprise
4/26/2016 104.35 97.82 -6.53 -6.26% -0.07 -3.55%
1/26/2016 99.99 93.42 -6.57 -6.57% 0.04 1.23%
10/27/2015 114.55 119.27 4.72 4.12% 0.08 4.26%
7/21/2015 130.75 125.22 -5.53 -4.23% 0.05 2.78%
4/27/2015 132.65 130.56 -2.09 -1.58% 0.14 6.39%
1/27/2015 109.14 115.31 6.17 5.65% 0.46 17.69%
10/20/2014 99.76 102.47 2.71 2.72% 0.12 9.23%
7/22/2014 94.72 97.19 2.47 2.61% 0.06 4.92%
4/23/2014 74.96 81.11 6.15 8.20% 0.2 13.70%
1/27/2014 78.64 72.36 -6.28 -7.99% 0.06 2.99%
10/28/2013 75.7 73.81 -1.89 -2.50% 0.05 4.42%
7/23/2013 59.86 62.93 3.07 5.13% 0.03 2.88%
4/23/2013 58.02 57.92 -0.1 -0.17% -0.01 -69.00%
1/23/2013 73.43 64.36 -9.07 -12.35% 0.05 2.60%
10/25/2012 87.08 86.29 -0.79 -0.91% -0.02 -1.59%
7/24/2012 85.85 82.14 -3.71 -4.32% -0.15 -10.14%
4/24/2012 80.04 87.14 7.1 8.87% 0.33 23.08%
1/24/2012 60.06 63.81 3.75 6.24% 0.54 37.50%
10/18/2011 60.32 56.95 -3.37 -5.59% -0.03 -2.88%
7/19/2011 53.84 55.27 1.43 2.66% 0.28 33.73%
4/20/2011 48.92 50.1 1.18 2.41% 0.15 19.74%
1/18/2011 48.66 48.41 -0.25 -0.51% 0.15 19.48%
10/18/2010 45.43 44.21 -1.22 -2.69% 0.08 13.79%
7/20/2010 35.98 36.32 0.34 0.94% 0.06 13.64%
4/20/2010 34.94 37.03 2.09 5.98% 0.13 37.14%
1/25/2010 29.01 29.42 0.41 1.41% 0.22 73.33%
10/19/2009 27.12 28.39 1.27 4.68% 0.06 30.00%
7/21/2009 21.64 22.39 0.75 3.47% 0.03 18.75%
Click to enlarge

Apple stock price change following earnings release - Source: Yahoo Finance (historical stock prices) , Zacks (earnings data)

Although past history is not necessarily indicative of future performance, we believe that strictly from a seasonal perspective, there is a high likelihood that unless Apple net earnings beat estimates by 6 cents or more, hence coming in at $1.44 per share or higher, there is a high likelihood that Apple shares would trade lower following earnings release (and assuming Apple does not provide a strongly upbeat credible outlook for the next quarter and beyond). In either case, from a seasonal perspective, we expect Apple shares to move by a minimum of 3.2% in the day following earnings.

Apple stock price vs. quarterly earnings surprise - Source: Y-Charts

Apple suppliers

Two of Apple's suppliers, Skyworks (NASDAQ:SWKS) and Qualcomm (NASDAQ:QCOM), have recently reported divergent results. Qualcomm shares rose by over 7.3% after they announced Q2 2016 net earnings of $1.16 per share vs. consensus estimates of $0.97 per share, and revenues of $6.03 billion vs. consensus estimates of $5.58 billion. However, as we already discussed in our prior article, Qualcomm's positive performance was triggered both by cost cutting, as well as China's migration to LTE. Both such factors do not necessarily imply improvement in current smart phone demand, and hence is not an early indicator for Apple iPhone sales.

On the other hand, following Skyworks' earnings announcement on 7/20/2016, its shares dropped by as much as 12.5% at one point on 7/21/2016 as Skyworks revenues of $751.7 million missed revenue estimates of $756 million. Given that Skyworks is estimated to derive about 44% of its business from Apple, smart phone driven weakness for Skyworks could provide unfavorable indication for Apple's earnings. This is further demonstrated by Skyworks' inventory build of over $100 million; as reported by Investors Business Daily:

Skyworks Solutions' inventory spiked to $100 million-plus in fiscal Q3, indicating key customer Apple will likely see a 25% year-over-year sales decline in September amid its iPhone 7 ramp, Pacific Crest analyst John Vinh said Friday.

Another report was equally worrying, as BidnessEtc reported:

In fact, many research reports are now supporting the down thesis. The two reports - one by The Nikkei and another by IDC - reflects that Apple is preparing for another disappointing quarter, which should cause a further decline in its market cap.

According to The Nikkei, vending orders at six prominent Japanese manufacturers of electronic components descended for the third consecutive quarter in the period ended June, which indicates tumbling sales of Apple's iPhone units and a stronger yen. Combined orders at these suppliers totaled $11.7 billion during the second quarter of calendar year 2016 (2QCY16). The 7% year-over-year (YoY) slump was sharper than 4% decline in the prior quarter....

Separately, IDC issued its report on the global smartwatch market in 2QCY16, which it said declined 32% YoY. Smartwatch vendors delivered 3.5 million units in the outgoing quarter, down from 5.1 million shipped a year ago. Apple dispatched 1.6 million units, down 55% YoY from a whopping 3.6 million....

Headwinds & Valuation

In an article we published on June 30, 2016, "Apple Stock: Still Too Risky", we examined multiple factors related to the challenging macro environment, including strong dollar and Brexit jitters, as well as pessimism surrounding upcoming iPhone 7 release, and potential for lower future cash reserves for Apple. We concluded that risks persisted for Apple for the next several months, and although Apple shares have appreciated by over 4% since then, we believe such risks continue to persist today and are not reflected in Apple's stock price.

Meanwhile, Apple's earnings estimates have actually dropped since our June article. Analysts' previous average earnings estimates of $8.25 per share for the current year have been revised lower to $8.22, while those for next year have been revised lower from $9.04 per share to $8.91. When compounded with Apple's stock price increase, previously reported forward P/E ratios of 11.44 and 10.44 respectively have expanded further to 12.0 and 11.1 respectively. Meanwhile, since June 30, long term interest rates have not changed much, still around 2.3% for the 30-year U.S. treasury bond.

Conclusion

Substantial uncertainty remains about the current state of the weakening smartphone market, and its effect on iPhone sales and Apple. Such weakness has resulted in lower earnings expectations for Apple, hence lowering the bar for Apple to provide an earnings positive surprise. However, it also seems that valuations have also increased, for no apparent reason, other than optimism about Apple potentially beating lowered earnings expectations (strange circular logic equivalent to unjustified hype...). Meanwhile, from an earnings seasonal perspective, we believe the odds may be stacked against Apple.

What will matter more than current earnings results will be Apple's outlook for the future. Given the challenging macro environment, we cannot see how Apple can possibly provide a very upbeat future outlook for the next quarter or two. Any such optimism will be balanced by cautionary statements at best.

Meanwhile, it seems that traders and investors interested in Apple shares are polarized at two extremes; those who believe that Apple will be able to ride the current weak smartphone environment, vs. others (probably a minority including ourselves) who believe that a combination of a challenging macro environment and weakening smartphone market does not justify the current share price for the next several months. We are indeed a minority as out of 47 analysts, 22 have a strong buy indication, 17 have a buy indication, 7 have a hold indication and 1 has a sell indication, with average price target of 122.73.

Given such uncertainty about the factors discussed throughout the article, we believe that Apple's upcoming earnings release will act as a catalyst to possibly cause a major move in Apple's stock price. Although we are biased to the downside, investors could opt to purchase Apple calls expiring October 21, 2016, with a strike price of 100, for a premium of about $3.34, as well as Apple puts with same expiration, with a strike of 95, for a premium of about $2.88. We would favor purchasing 2 puts for every 1 call, due to our bearish outlook, although a substantial move in either direction can result in a profitable trade, with breakeven level of 109.10 to the upside, and 90.45 to the downside.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in AAPL, SWKS over 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.