Apple: Some Cause For Concern?

| About: Apple Inc. (AAPL)

Last week, Apple (NASDAQ:AAPL) reported its fiscal second quarter earnings report, and from all accounts, it was a very good one. Since the report came out, Apple has subsequently filed it's quarterly 10-Q statement, and I've had some time to comb over the data. Now, there are a few things that I've found that concern me a little. And while I'm not here today to claim the Apple run is over or that the stock is going lower, there are some issues that need to be discussed. Yes, I am still recommending you be long Apple here, but I want to explain why selected expectations may need to come down slightly for the company's next quarterly report, which is its fiscal third quarter.

I can give you a brief overview of where I am going just by looking at Apple's guidance. When Apple guided for Q2 (the quarter the company just reported), it stated that it expected revenues of $32.5 billion and EPS of about $8.50. When Apple guided for the current quarter, Q3, it gave a revenue number of $34 billion, and said earnings per share would be at least $8.68. I'm not questioning the guidance Apple gave, as we know the company has always been extremely conservative when giving guidance. In that guidance, it appears to me that Apple hinted that margins could tick down a little from Q2, so I don't want everyone thinking that margins will continue to explode as they have in the past two quarters.

Just think logically. Quarter over Quarter guidance was up $1.5 billion for revenues, an increase of 4.61%, but earnings per share guidance was up just 18 cents, or 2.12%. There is a slight disconnect there because Apple's diluted share count is rising quarter over quarter, but at most, the share count will rise 0.25% in the next quarter. That's not enough to really impact earnings per share by that much. I will get to my margin explanation later in this article, but first, I am going to focus on Apple's performance by geographic region.

Regional Performance:

For the quarter, Apple reported revenues of $39.186 billion, up from $24.667 billion in the prior year, an increase of 58.86%. That was a good increase. Now, for the following tables I will provide, I am giving you the information on revenues and that segment's percentage of revenues in relation to the company whole.

Americas Q2 2011 Q2 2012 Change
Net Sales $9,323 $13,182 41.39%
% of Revenues 37.80% 33.64% -4.16%
Europe Q2 2011 Q2 2012 Change
Net Sales $6,027 $8,807 46.13%
% of Revenues 24.43% 22.47% -1.96%
Japan Q2 2011 Q2 2012 Change
Net Sales $1,383 $2,645 91.25%
% of Revenues 5.61% 6.75% 1.14%
Asia-Pacific Q2 2011 Q2 2012 Change
Net Sales $4,743 $10,153 114.06%
% of Revenues 19.23% 25.91% 6.68%
Retail Q2 2011 Q2 2012 Change
Net Sales $3,191 $4,399 37.86%
% of Revenues 12.94% 11.23% -1.71%
Click to enlarge

The new iPad only went on sale in select countries in the Asia-Pacific region during Q2, so expect some boost to iPad sales in that region during Q3. However, I don't think we will see that 114% sales growth in the Asia-Pacific region for Q3, just because of simple math. Last year's Q3 for Asia-Pacific saw sales of $6.332 billion, so we would have to see more than $13.5 billion in revenues from that region to match the percentage gain from Q2. It isn't likely. Apple saw total revenues rise by nearly 59% year over year for Q2, but I expect that number to come down a little for Q3. Expect somewhere in the 40% to 45% range, with my current expectation at around 43.5%.

Average Selling Prices:

This is where the numbers start to get a little worrisome. If you look at the "average selling price" for each product line, the numbers all declined in Q2. Apple's margins did so well only because the company was able to keep costs in check, but that might not work going forward (more on that later).

Now I'm going to show how the average selling price has trended in recent times. A couple of notes: This number is calculated by taking the revenues from the product line divided by the number of units sold. For instance, for the iPhone, revenues are counted as "iPhone and related products and services". In that, Apple includes revenues from sales of iPhones, iPhone services, and Apple-branded and third party iPhone accessories.

Selling Prices Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012
Desktops $1,410.76 $1,428.15 $1,367.97 $1,320.03 $1,308.99 $1,303.59
Portables $1,272.45 $1,284.99 $1,262.54 $1,267.98 $1,253.56 $1,245.56
Total Mac $1,313.50 $1,323.40 $1,293.39 $1,281.57 $1,269.33 $1,262.88
iPod $176.13 $177.44 $175.85 $166.57 $164.19 $157.30
iPhone $644.78 $659.52 $654.49 $643.12 $659.14 $647.10
iPad $628.56 $604.18 $653.90 $617.46 $593.04 $558.57
Click to enlarge

All product lines saw a quarter over quarter decrease, but that isn't the worst part. Just look at the year over year numbers. The average desktop price was down $125, a loss of 8.7%. Portables were down about 3.07%, meaning the total Mac drop was more than 4.5%. iPods saw the worst decline, at 11.35%, but we know that segment is the smallest and is headed lower. Even iPhone averages ticked down year over year, and I'm wondering if that is due to the high amount sold in the Asia-Pacific region. Even the new iPad numbers took a 7.55% decline year over year, which is very worrisome.

Margin Contraction:

We know that new Macs will be coming out soon, potentially in Q3. If Apple comes out with cheaper versions, the average price might continue to decline. In that case, the company better hope that it can keep the costs of those down, because lower prices could impact margins. The curious one is the iPad. Estimates have said that the new version of the iPad costs 7% to 10% more. If that is the case, Apple needs to get that average selling price back up to around $600 if possible, or we will definitely see margins contract.

So what does that mean for Q3? Well, I think it is highly likely, almost definite, that we will see some margin contraction for Apple. Why? Well, take a look at the following table, which shows Apple's three primary margins, and the percentage of revenues that came from the iPhone that quarter.

Margins Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012
iPhone Sales % 39.15% 49.86% 46.59% 38.84% 52.70% 57.90%
Gross 38.51% 41.42% 41.73% 40.25% 44.68% 47.37%
Operating 29.27% 31.92% 32.83% 30.81% 37.42% 39.26%
Profit 22.45% 24.27% 25.58% 23.43% 28.20% 29.66%
Click to enlarge

iPhone sales accounted for nearly 58% of Apple's revenues in Q2, an amazing amount compared to recent quarters. Now let's do the math. We expect that Apple's revenues might increase from Q2 to Q3 (based on the guidance numbers I gave above). I expect those revenue gains to be from increases in iPad revenues and Mac revenues. I think that iPhone sales might tick down a little, or even be flat. The iPhone is the highest margin product, so with less iPhone sales as a percentage of the total, margins will come down. I haven't run any formal numbers or projections yet, but I think Q3 could be comparable to Q1 in terms of iPhone sales percentage and margins, and that is a very rough estimate at this point. The numbers could easily change, especially if we get new Mac versions in this quarter.

A new version of the iPhone is expected out sometime this year. That could be another key to Apple's margins. If the new phone costs even a few dollars more, it will have an impact on margins. Just think about it, a $3 increase in phone costs equals $100 million in extra cost of goods sold when you are selling 33 million plus phones a quarter. One hundred million dollars doesn't seem like much for a company with $40 billion in quarterly revenues, but I'm just throwing that number out there. What if the increase is $5, $10, or more? We've already seen iPad costs go up, phone prices could easily do the same.

Other Factors to Consider:

There are two other factors to think about here, and neither have anything to do with any of Apple's products, but they are important factors to consider. Later this year, Apple will start paying a dividend and purchasing some of its outstanding shares to negate the impact of executive options dilution.

So what, you say? Well, first, at the end of Q2, Apple had more than $110 billion in cash, equivalents, and marketable securities. That includes both short- and long-term investments. That money does generate some interest, which flows down into Apple's bottom line. When Apple starts paying the dividend, and buying some stock, some of that money pile could go away, or, it just won't increase as much as it could have. Yes, the overall impact may be small, but a few million here, a lower selling price there, some extra costs on the iPad over there, and eventually, you are talking about real money. It is something that I felt I must note.

When it comes to the share purchase plan, that will help earnings per share. Apple's diluted share count (used to calculate EPS) rose from 935.94 million to 944.89 million, just in the past year alone. Just a few years ago, the share count was under 900 million. It may not seem like much, but take the Q2 net income number of $11.622 billion. Apple's earnings per share were $12.30, based on the 944 million + share count. Had Apple's share count stayed the same over the past year, earnings per share would have been 12 cents higher, at $12.42. That doesn't seem like much, but you could be talking about 50 cents a share or more over a full year. Is that not meaningful?

Given Apple's decision to stop expanding the share count, something I advised the company to do last November, earnings per share will be somewhat inflated going forward. Now, at this time, Apple has only decided to stop the increase in share count. At this point, it is not going to buy enough shares to start reducing it. Once that happens, earnings per share will rise even more. But again, that is only the bottom line number. The only impact on margins is on the net profit margin, which will be slightly lower from the less interest revenues Apple will generate. There is no impact on gross or operating margins.

Conclusion: Don't Expect Too Much In Q3

If you are crazy enough to think after the great second quarter that Apple will perhaps hit any margin milestones (50% gross, 40% operating, 30% profit), you might want to step back a little. Apple should see increased sales of iPads and Macs in the quarter, and that will take down margins a little if iPhone sales stay at Q2 levels. Should iPhone sales decline quarter over quarter, margins will contract even further. Apple's selling prices have been coming down in recent quarters, and I expect, or hope, that some might rebound in Q3.

I'm not calling a top in Apple stock, or telling you to sell the stock or short it. At this point, I'm not calling a margin top forever. Margins should rebound, but for the factors listed above, I do expect them to decline in Q3 (over Q2). Also, I would like to see some of those selling price numbers turn around. The trend has not been Apple's friend, especially as of late.

In fact, I'm still saying to be long Apple. However, when expectations get too high, disappointment will occur. Q3 is not likely to see the same margin numbers as Q2, and that probably is just due to seasonality. It's not the end of the world for Apple. This happens. You don't see record snow shovel sales in July, and that's just the way things are.

As for my Apple targets. Given the Q2 numbers, I am raising my revenue forecast for fiscal year 2012 (ending in September) from $162 to $165 billion. I am maintaining my $48 earnings per share number on Apple for now, only based on the timing of the iPhone 5. My current expectation (until proven otherwise) is for a similar early October release, like the 4S. Should the 5 come out pre-October, I will raise my estimates accordingly. Given the Q2 report, I will increase my valuation on Apple from 14 to 15 times this year's earnings, giving a current fiscal year target of $720. I will keep my $55 EPS number for fiscal 2013, and with the increase in multiple (14 to 15), I am giving a target of $825 for Apple's next fiscal year.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours.