Where Is The Upside In Apple?

| About: Apple Inc. (AAPL)

Shares of Apple (NASDAQ:AAPL) fell modestly on Friday, the first day after the company's Q4FY12 earnings report. The company reported EPS of $8.67 on revenue of $36 billion, beating analyst estimates for revenue but falling slightly short on earnings. As Apple used to be consistent in blowing away the market's earnings expectations, this could be viewed as a slight negative for the stock. Apple's EPS guidance for the upcoming quarter (Q1FY13) was also restrained, at $11.75 (down roughly 15% year-over-year), though the revenue outlook was fairly strong at $52 billion.

Analysts still do expect Apple to outperform its guidance. Although gross margin concerns have led a number of analysts to revise their estimates downward, the average estimate for the current quarter is for EPS of $13.59 on revenue of $54.4 billion. However, while Q1 last year was boosted by a 14th week, that would still represent the first year over year EPS decline for any single quarter in more than ten years. Does that suggest that Apple is finally reaching its peak? If not, then why aren't analysts more bullish?

In large part, the problem is Wall Street psychology. Analysts don't want to stray too far from the overall consensus, and they don't want to stray too far from management's guidance. This practice was taken to the extreme by Katy Huberty of Morgan Stanley, who wrote, "Apple handed investors a perfect combination of a bullish demand view and an EPS reset that sets up for the return to a 'beat and raise' story," and then promptly slashed her EPS estimate for CY13 from $60 to $51. So while Huberty thinks that Apple will beat expectations, she apparently also wants to be among those "surprised" when that occurs.

This problem is multiplied by a combination of supply constraints and start-up costs all being concentrated in the fall quarter. Even though many analysts are bullish about Apple's long-term future and recommend buying the stock, they recognize that Q1 could be disappointing. Gross margins will decline significantly because of price cuts on older merchandise, the introduction of a cheaper iPad mini, and the higher production costs for redesigned products such as the iPhone 5 and iMac. Management accordingly forecast a gross margin of 36% for the quarter, whereas gross margins were 43.9% last year and 40.5% the year before.

The result is that forecasts for the new fiscal year heavily depend on analysts' assumptions about 1) the strength of underlying demand (how many units can Apple sell once it gets sufficient supply?) and 2) the new "normal" for gross margins. With the average full year EPS estimate barely over $50, it appears that most analysts are concerned about one or both factors.

The real upside for Apple is therefore not in the coming quarter (though I do expect an EPS beat in the range of $14-$16), but in the rest of the fiscal year. In FY12, Apple had an exaggerated seasonality to earnings, as Apple rapidly satisfied early demand for the iPhone 4S and filled the channel. Sell-through dropped off in the spring, and earnings followed. By contrast, even though Apple is launching more devices than ever this fall, FY13 seasonality is likely to be muted because supply constraints will probably prevent Apple from fully filling the iPhone channel by the end of Q2 (especially if a China Mobile (NYSE:CHL) deal is announced in the next six months). Moreover, somewhat lower volumes in the spring and summer will most likely be offset by rising margins as component costs drop and yields rise.

The real upside in Apple won't be known for sure until the market gets better clarity on Apple's ability to return to gross margins above 40% and the full extent of iPhone demand. Apple shares may thus remain range-bound for the next few months. But when Apple reports Q1 results in January, I expect to hear good news on the margin and demand fronts, which could propel shares toward $800. Whereas the iPhone 4S was a relatively modest upgrade over the iPhone 4, the iPhone 5 boasts a larger screen, which will please many consumers (in addition to other hardware and software upgrades). I believe that this will drive much higher and more sustained demand, from new customers (including conquests from Google's (NASDAQ:GOOG) Android OS and RIM's (RIMM) Blackberry OS) as well as devoted iPhone fans. I think there is a good chance that Apple could sell more than 40 million iPhones in each quarter of FY13 (a feat it has not accomplished in any quarter to date). From a gross margin perspective, sales growth in the high-margin iPhone will more or less offset the iPad mini's dilutive impact, keeping these around 40%-41% for the full year.

One implication of this outlook is that EPS may actually grow sequentially from Q1 to Q2, breaking the traditional seasonal pattern. This could lead to a very nice run in the stock early next year. Nevertheless, I think that the price today is attractive enough that it is not worth waiting any longer to try to "time" Apple's rise. I therefore rate Apple a buy, and expect the price to reach $800 by next spring.

Disclosure: I am long AAPL. 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.