Seeking Alpha
Profile| Send Message|
( followers)  

Apple's (AAPL) third fiscal quarter results came as a major disappointment despite setting records for the June quarter in revenue and earnings. The primary detractor, lower than expected iPhone sales, led to both lower total revenue and lower margins than analysts estimated. But Apple's leadership was not responsible for these lofty expectations; CFO Peter Oppenheimer and CEO Tim Cook repeatedly warned during their second quarter earnings call that changes in the timing of channel builds and country rollouts would significantly impact sequential and YOY comparisons for the third fiscal quarter. Although the company notoriously presents conservative guidance, they demonstrated the best insight into future sales.

Revenue for the quarter was $35 billion, while analysts' average expectation was for over $37 billion. The shortfall, relative to expectations, came in the iPhone segment. Apple reported selling 26 million iPhones during the quarter. Of major analysts and independents, none predicted less than 27 million iPhones sold. In fact, the average prediction was 29 million. It is worth noting that the 26 million phones sold are the most ever in the June quarter. The iPhone segment is a key to Apple's revenue and profit, with handset and accessory sales representing roughly half of revenue and having the highest margins among main products. Note: Sales of iPads, the second largest segment, met or beat analysts' expectations.

iPhone Sales in Millions

Jan-MarApr-JunJul-SepOct-Dec
20108.88.414.116.2
201118.620.317.137
201235.126

(Apple Transcripts, seekingalpha.com)

The Warning

During their second fiscal quarter conference call, Apple gave guidance for the third fiscal quarter of $34 billion in revenue on gross margins of 41.5%. Analysts were quick to question this guidance. During the question and answer session, Katy Huberty of Morgan Stanley characterized the guidance as implying "a sequential downtick that is worse than the guidance message you provided over the last 3 years." Oppenheimer was ready with five points that actually supported Huberty's conclusion. And the first two points he raised related to iPhone sales:

The first, the iPhone channel inventory changes. As I discussed in my prepared remarks, we increased our iPhone channel inventory by about 2.6 million units in the March quarter this year, and we exited within our target inventory range of about 4 to 6 weeks. Last year, we continued to add new countries into the June quarter, and we built an additional 700,000 units of iPhone channel inventory last year in the June quarter. So the combination of these channel builds in the March quarter of this year and the June quarter of last year will impact the sequential comparisons from this year to last.

The second factor: fabulous iPhone 4S execution. As we told you in January, we exited December with significant iPhone 4S backlog, which led to a huge January. We launched China and 20 other countries also in January, which completed the rollout of the iPhone 4S into all the countries where iPhone is currently shipping. And as I said before, we exited the quarter within a supply and demand balance.

Late in the question and answer session Chris Whitmore of Deutsche Bank, using the sales and margin guidance given earlier in the call, predicted "iPhone unit sales to be down about 10 million units quarter-on-quarter." Again, Oppenheimer accepts the conclusion and restates the aforementioned reasons.

...we do expect a sequential decline in iPhone sales driven by the fact that we built 2.6 million units of channel inventory in the March quarter, which we needed to do. We're now within our target range of 4 to 6 weeks, and we entered the March quarter with significant backlog, as we talked about, in January. And we're able to fulfill that and launch 20 countries in the month of January.

("Apple's CEO Discusses Q2 2012 Results - Earnings Call", seekingalpha.com)

Takeaways

The past year has brought is a new paradigm of rapid sales growth highlighted by increased seasonality around new product rollouts. While the new paradigm makes YOY and sequential quarter comparisons difficult, company executives provide a good feel for product sales during the question and answer session of their results conference. Apple's channel inventory comments give color on supply/demand dynamics for each product. The company also provides solid insight into major rollout factors and timelines. Using their margin guidance one can also deduce generalities about the expected product mix.

Oppenheimer, during the fiscal third quarter conference call, gave guidance for the September quarter of $34 billion in revenue and gross margins of 38.5 percent. This lowered gross margin expectation indicates we will see a lower percentage of high margin iPhones in the product mix and we predict 25 million phones sold, a sequential decline of 1 million phones. This estimate is based on the following conjectures:

  1. Apple gave conservative guidance (both revenue and margin) which is "reasonably certain" to be met. It remains unclear how many, if any, iPhone 5 units were included in the guidance.
  2. All of the margin decline will not be attributable to lower iPhone unit sales; in past quarters Apple has attributed as low as one quarter of the margin decline to lower iPhone unit sales.
  3. The attributable decline will be approximately two thirds of what it was in the June quarter; this is based on Apple's guidance.
  4. iPhone segment revenue declined $6.5 billion in the June quarter on 9 million less units (26 million sold). The trend of customers putting off a purchase until the iPhone 5 released continued during July and August.
  5. Though it is not nearly this simple, two thirds of 9 million units equals 6 million units.
  6. Apple will recognize non-GAAP revenue for 5 million iPhone 5 units. We believe recognizable units are those sold at Apple stores, retail partners, and ordered units that arrive at the customer prior to the end of September. (see Apple's press release)
  7. 26 - 6 + 5 = 25

These lower margins are also indicative of the lower average sell price of both the iPhone (older versions are on sale) and iPad. Oppenheimer stated:

The current iPad lineup that we're selling includes the very successful $399 price point, which we did not have in the year-ago quarter. So this, along with mix in the line will impact the ASPs in the September quarter.

The second key takeaway from the most recent call is the iPad inventory builds.

…..we're able to increase our iPad channel inventory in the June quarter by 1.2 million units and we ended the June quarter just within our four to six week channel inventory target and we increased last year by 1.5 million units in the September quarter, which also put us in our four to six week inventory target. These increases in channel inventory will impact both the year-over-year and sequential compares for iPad.

("Apple's CEO Discusses Q3 2012 Results - Earnings Call")

Conclusion

It is hard to see how there will be a significant beat of revenue guidance of $34 billion with the decrease in iPhone sales, lower average selling prices, and relative decrease in the iPad channel inventory. While long Apple, we could see a near term pull back if revenues actually miss estimates for the current quarter or guidance for the holiday quarter is very light on the upcoming results call. However, because of the imminent announcement of the iPad Mini, there is also a near-term cushion. While expectations remain elevated, valuations also provide a floor. Consider the January 2013 $675 or $700 strike calls if the reversal continues and the share price falls below $650.

For additional information please see our pre-Q3 earnings Instablog: "No Big Beat From Apple This Quarter".

Source: Lessons From Apple's Fiscal Q3 Instructive For Current Quarter Predictions