Read Between The Lines Of The Apple Downgrade

| About: Apple Inc. (AAPL)
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As of Monday, analysts expect Apple (NASDAQ:AAPL) to post a year-over-year earnings decline in the current quarter (Q1FY13). EPS is projected to drop to $13.31 from $13.87 last year; for next quarter, analysts are predicting a negligible 6 cent increase from $12.30 to $12.36. As best I can tell, analysts have never predicted a year-over-year earnings decline for Apple since the launch of the iPhone more than five years ago. (However, I should point out that last year's Q1 benefited from an extra week of sales.) While other factors have also factored into Apple's three month slide, I believe that this projection for a sudden end (or hiatus) to profit growth has been a major cause of the stock's rapid drop.

Apple has produced reliable and quick earnings growth over the past ten years, as can be easily seen from the following graph (courtesy of YCharts):

What could cause a sudden end to this long track record of profit growth? There are two major business risks for Apple: a drop in sales (due to low demand for Apple products) and margin compression (from rising costs or a loss of pricing power due to heavy competition from Amazon (NASDAQ:AMZN), Samsung (OTC:SSNLF) and others). Interestingly enough, analysts' pessimism is almost wholly derived from concerns on the second issue: margin compression. The worst analysts are willing to say about Apple's sales is that sales growth is good but not great (the consensus is for revenue growth of more than 20% this quarter).

It is true that margin erosion could hurt Apple's profits this quarter, due to the concentrated costs of launching multiple new form factors in just a few months. However, as I discussed in another recent article, concerns about Apple's Q1 (and full year) margins have become overblown. The biggest threat to margins for the current quarter was low yields for iPhone 5 components. Yields appear to have improved faster than expected, providing significant upside to management's guidance of 36% gross margins. Apple regularly beats its gross margin guidance by 2-4%, and it seems likely that Q1 will fall at the upper end of that range.

Moreover, recent evidence seems to be pointing to higher than expected sales in Q1. As one example, the analyst team at Citi made news on Monday by downgrading Apple from buy to hold (most analysts have been content to keep buy ratings while cutting their Apple price targets). The Citi analysts reiterated a concern raised by various other analysts that Apple has drastically cut iPhone 5 component orders for next quarter. But at the same time, the Citi research team mentioned that monthly iPhone 5 output has increased by 45-50% from October to December! Given the conservative nature of Apple projections, it is highly unlikely that management projected such a rapid production ramp when releasing Q1 guidance for revenue of $52 billion.

Therefore, while the Citi research note was bearish in tone, it actually suggests that Q1 revenue is likely to be very strong. Due to the nature of an iPhone launch, Apple will be able to sell as many units as it produces this quarter because it needs to "fill the channel" in addition to meeting end demand. If Citi is correct about the rapid increase in production through the quarter, then Q1 iPhone sales may come in above 50 million, versus my previous estimate of 45-47 million iPhone sales (these figures include iPhone 4 and 4S sales as well). This could drive revenue to $60 billion or above, compared to a current consensus of $54.56 billion.

Combining this with my expectation for gross margins of 39%-41% this quarter, I actually think Apple is setting up for a big earnings beat, similar to last year's Q1. Wall Street is "fighting the last war" by reining in expectations after Apple missed analyst estimates for the last two quarters. However, we only have to look back as far as Q1 and Q2 of FY12 to find analysts routinely underestimating profit potential by 20-30%. If Apple posts EPS better than $15 next month, which I now estimate as at least 50/50, there will be a sharp reversal in sentiment (barring a very weak forecast) as the "earnings growth has stalled" story will be shelved for at least a few months. As long as Apple remains below $550, buying the dips is likely to pay off next month. Moreover, with the company still investing heavily in R&D and producing products that people want to buy, Apple remains a very sound investment for the long term. Apple is therefore one of my top three picks for 2013.

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.

Additional disclosure: I am also short AMZN.