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Apple (AAPL) launched a series of new products yesterday, Oct. 23, just ahead of its Thursday earnings release. For Q3, the market is expecting sales of $36.02 and EPS of $8.82. We believe the company will report sales of $33.1 billion and EPS of $8.13. That's because we believe the company has sold 21.5 million iPhones (26% year over year) in this quarter, as compared to the Street's estimates of 27 million. The sales and margins of the iPad Mini can have a significant impact on the price as it contributes approximately $7.5 to annual EPS estimates. We believe the company will miss earnings estimates, taking the stock price below $600. Therefore, we are offering a sell recommendation on Apple.

A Look at Q4 2012

The biggest company in the world plans to release its fourth-quarter earnings tomorrow after the market close. Sell-side research estimates sales of $36.02 billion and EPS of $8.82. The estimates of independent analysts are more bullish, with EPS estimates of $10.14 on earnings of $38.08 billion. There is a wide discrepancy in earnings, which is shown in a survey by Forbes. The revenue estimates range from $34.26 billion to $42.83 billion. The gap is even more significant in EPS estimates, which range from $7.09 to $11.32. If we look at the past record, the company has missed analyst estimates in two of the last four quarters.

Earnings History

11-Sep

11-Dec

12-Mar

12-Jun

EPS Est

7.39

10.16

10.04

10.37

EPS Actual

7.05

13.87

12.3

9.32

Difference

-0.34

3.71

2.26

-1.05

Surprise %

-4.60%

36.50%

22.50%

-10.10%

Source: Yahoo Finance.

We are expecting an EPS target of $8.13 on sales of approximately $33.1 billion. We are assuming that the company will sell 21.5 million iPhones in the current quarter, and that the data released by Verizon (VZ) and AT&T (T) justifies our sales estimates. According to Verizon, it sold 3.1 million iPhones during the quarter and AT&T reported activation of 4.7 million iPhones, lower than what the sell side was expecting.

We are assuming that the company will sell approximately 18 million iPads in this quarter. Going forward, there will be cannibalization of the iPad by the newly announced iPad Mini. The lower priced product should have lower margins, and that will further erode the $7.3 EPS contribution of the iPad to Apple's estimated EPS of $44.04 for 2012E.

Going forward, we expect 140 million iPhone sales in the next financial year. The amount of iPad sales that are cannibalized by the iPad Mini are hard to estimate at this moment. Therefore, we are still assuming 87 million (62 million 2012E) iPad sales for 2013. Investors should expect higher sales due to a large demand for the iPad Mini, but lower margins on the product should bring EPS contribution down to our current estimates of $7.5. A higher than anticipated margin or sales can significantly improve these estimates.

We have calculated a share price target using the sum-of-parts valuation for 2012 and 2013. A detailed discussion on the calculation of an average industry multiple is available here. We have calculated a PT of $518 for 2012 and $579 for 2013 earnings forecast. The argument that average multiples are not relevant to Apple as it shows more growth than the industry is not valid because that growth is already incorporated into the earnings estimates.

2012E

2013E

Average P/E Multiple

PT2012

PT 2013

$

EPS E

EPS

Desktop

$ 1.1

$ 0.9

4.40

$ 4.8

$ 4.1

Notebook

$ 2.9

$ 2.8

4.40

$ 12.8

$ 12.5

iPod

$ 1.0

$ 0.7

12.00

$ 12.1

$ 8.9

iPhone

$ 28.7

$30.5

8.70

$ 249.6

$ 265.3

iPad

$ 7.3

$ 7.5

10.00

$ 72.6

$ 75.1

Peripherals & iTunes

$ 1.9

$ 2.0

12.00

$ 23.3

$ 23.5

Software, Service & Other Revenue

$ 1.1

$ 1.1

12.00

$ 13.5

$ 13.8

Cash Per Share

$ 128.9

$ 175.6

$518

$579

Source: Qineqt calculations.

iPad Mini

These days, rumors and speculations about Apple products are usually true. Just as most people were expecting, Apple announced its iPad Mini yesterday. The hardware specifications of the new product were also almost what everyone had expected. The thing the market didn't expect was the upgrades to the iPad and the Mac. The new iPad Mini is priced at $329, $429, and $529 (add $130 to each for cellular functionality). The internal memory doubles as you move from one price point to the next. The display is 7.9 inches and it weighs 0.68 pounds. There is still little information on the margins of the new product. The low price range will, in our opinion, result in lower margins. Another uncharacteristic part of the presentation was the direct slamming of the Nexus 7 by Apple executives. The new product is beautiful, but still approximately 30% more expensive than Google's (GOOG) Nexus 7.

Verizon

The recent iPhone sale disclosure by Verizon pushed the shares under $610. According to the second-largest carrier in the U.S., it has sold 651,000 Apple iPhone 5s in the third quarter. The company reported that in total, it has activated 3.1 million iPhones as compared to 3.4 million Android phones. According to Verizon, it faced supply constraints for the iPhone 5. The market reacted negatively to these numbers, which shows the over estimates of iPhone sales estimates.

Conclusion

Our calculations show that Apple will not be able to meet consensus estimates for the current quarter. The key catalysts from the quarter results are sales figures for the iPhone 5. In other significant news, Samsung has decided to reduce LCD panel supplies to Apple. The reason cited behind this move is extremely low margins on Apple sales. This has been a problem for vendors supplying to Apple. The tough competition in the handheld market not only gives consumers more choice, but vendors have more choice as well. We believe the market is moving toward "specification-based differentiation" from "brand-based differentiation." The slamming of the Nexus 7 and its side-by-side comparison with the iPad Mini are indicators of this eventuality. We believe this shift in dynamics will eventually increase vendor margins and limit manufacturer profits.

The estimates above show that Apple can miss consensus earnings for the current quarter, and can fall below $600. Therefore, we are offering a sell recommendation on Apple.

Source: Why Apple Will Miss Earnings And Trade Below $600