Forecasting Apple's Q3 Using Its Guidance

| About: Apple Inc. (AAPL)

Summary

My forecast for Q2 was closer to actuals than the street.

Q3 Expenses - is Apple hinting at larger R&D spending?

On the path down to the 5 billion share mark.

I was going over the current analysts forecast for Apple's (NASDAQ: AAPL) Q3 (Source: Yahoo), and I was surprised to learn that at least one analyst is forecasting Apple's Q3 revenue to be below the guidance provided by Apple's management team during last quarter's earnings call. Readers of my previous articles on this subject should know that Apple has not had revenue below their low-end guidance (or guidance when they didn't provide a range) in the last 34 quarters. Strange but true. For those newcomers to this series, Apple's guidance has its share of interesting quirks, consistencies and inconsistencies. You can read my previous article regarding Q2 here and continue reading for my take on where Apple is headed for Q3.

Reading up on Apple became a little easier on SA this past quarter. For a few quarters, I have been conducting a rather informal gauge of Apple "frothiness" by calculating the actual numbers of Apple-related articles here on Seeking Alpha, a poor man's media "VIX" if you will. This quarter dropped dramatically. The graph below shows the average number of Apple-related articles per day on Seeking Alpha. The timeframe for these fiscal quarters' is earnings release to earnings release. The Q3 2017 number is through 7/18.

Quarter

Year

APD

Q3

2015

1.447

Q4

2015

1.582

Q1

2016

1.264

Q2

2016

1.824

Q3

2016

2.198

Q4

2016

2.000

Q1

2017

1.612

Q2

2017

2.725

Q3

2017

1.527

Well, as usual, it certainly appears we haven't run out of words on our subject yet. But, why the sudden drop back down to Q1 levels? Was last quarter the market top? Are we reaching an end to the discussion? Just a little food for thought and discussion. I'll let the readers be the judge. Still, more than an article each day is more than enough to absorb. Start reading the comments, though, and we're talking a full novel each quarter. To me, it is another indication of the fascination and compulsion we have to over-think and over-state this company like no other on the planet.

But that's not why you're here.

Apple continues to be all about iPhones. Indeed, other revenue generators such as iPads, MACs, and Services will be propped up with great words like "momentum", "strong demand" and my personal favorite, "we're happy with....". The plain and simple truth is iPhone revenue will not be replaced by any other product in the near future. Everything else is just supplementary. So what will happen when Apple reports their Q3 results? Let's look at the numbers and see what we can learn. First, a review of where Apple left us at the end of Q2.

Review of Q2 and my Q2 forecasts

In the following chart, I show the guidance, my forecast, and actual numbers for Apple's Q2. The guidance is from the earnings call on 1/31/17 (transcript can be found on Seeking Alpha). My forecast was from my last quarterly article (here). Actuals are taken from Apple's 10-Q.

Attribute

Q2 Guidance

My forecast

Actual

Revenue

$51.5-$53.5 billion

$52.851 billion

$52.896 billion

Gross Margin

38.0-39.0%

39.25%

38.93%

Operating Exp.

$6.5-$6.6 billion

$6.5 billion

$6.494 billion

Other Income

$400 million

$467 million

$587 million

Tax Rate

26.0%

26.0%

24.89%

Share count

No guidance

5,270,070,657

5,261,688,000

Earnings Per share

No guidance

$2.07 per share diluted

$2.10 per share diluted

My key miss, the tax rate, which came in a full 4.27% less than guidance. I guess even Apple's tax department pull a few surprises now and then. I got within 1.5% on EPS. Not bad considering consensus of the pros put EPS at just $2.02, a nickel lower. Moving on.

Q3 Apple Guidance

In the following table is the pertinent numbers that Apple provided guidance on during the Q2 earnings call on 5/2/17.

Attribute

Q2 Guidance

Revenue

$43.5-45.5 billion

Gross Margin

37.5-38.5%

Operating Exp.

$6.6-$6.7 billion

Other Income

$450 million

Tax Rate

25.5%

Share count

No guidance

Earnings Per share

No guidance

The thing that really jumps out is the change in expenses. Yes, things cost more in 2017, but I think this may actually portray a spike in R&D spending. Not that Apple will tell us anymore.

Q3 Guidance Analysis and Forecast - Revenue

Apple is guiding Q3 2017 to be $2.5 billion higher than the guidance for last year's Q3. This is 5.5% to 6.1% higher, but still 5.2% to 5.4% lower than the guidance for 2015's Q3. With no earth-shattering announcements during Q3, this $2 billion increase in guidance appears to be the growth level that Cook and company will "be pleased to announce".

Q3 has been the weakest quarter every year since 2011. The Q2 to Q3 drop since 2011 has been $8.368 billion. This average would put Q3 2017 right in line with guidance at $44.528 billion. Since reverting to high/low range format for revenue guidance in 2012, Q3 revenue has averaged 5.14% over the low estimate. Using that average would put revenue over the guidance range at $45.737 billion. This is something that has only happened once, the 2015 "monster" year, in Q3.

Looking a little further back, a total of seven years, the Q2 to Q3 revenue drop has averaged 15%. Applying that number to last quarter's revenue of $52.896 billion would yield quarterly revenue of $44.960 billion. This is within guidance towards the upper end and fits well with the reasoning of "no earth-shattering developments". This feels right and looks good to me from many angles. This will be my Q3 estimate for revenue.

Q3 Guidance Analysis and Forecast - Gross Margin

Seventeen quarters have passed since Apple reverted back to presenting their gross margin guidance as a range. During that time frame, gross margin has averaged 38.78% with Q3 coming in slightly lower at an average of 38.48%. Guidance for this quarter comes in between 37.5 and 38.5%. During these 17 quarters, the low guidance has always been met or exceeded. The high guidance has been exceeded 76.5% of the time.

Further, the average that high guidance has been exceeded is 0.31% per quarter with Q3 coming in at 0.38% above high guidance. That would put gross margin between 38.81% and 38.88%

But, looking at the last 4 quarters produces a more interesting trend with gross margin beating the high guidance in 3 out of 4 quarters but by a very slim margin. The trailing four quarters' average just under high guidance at 0.016% below. This puts an expectation of 38.484%, which is what I am forecasting for this quarter.

Q3 Guidance Analysis and Forecast - Expenses

Since reverting to providing ranges for some guidance items in Q2 of 2013, Apple has never exceeded the high-end guidance number for expenses. The low end of the range continues to be where the action is, with ten of the seventeen quarters coming in below the low end of guidance. But, the 17 quarter average comes in at just .01% over low guidance. Right on the money. The Q3 average during this time frame is similarly real close to the low guidance, coming in just 0.1% below low guidance.

Apple is guiding a range of $6.6 to $6.7 billion in expenses for Q3. Only the 14 week Q1 of this year has exceeded that guidance, ever. Although expenses continue to rise in general, expenses over this 17 quarter period have averaged just 10.46% of revenue. Q3 has averaged a bit more coming in at 12.04%. Even using the higher 12.04% Q3 average applied against Apple's high-end revenue guidance of $44.96 billion yields expenses of only $5.48 billion. That's a long way from the low end of guidance. Even the high water mark of expenses to revenue during this 17 quarter time frame, Q3 of 2016 gave us an expense to revenue ratio of 14.2%. 14.2% of Apple's revenue guidance gives us a range of $6.177 to 6.461 billion. Both ends are well below the guidance of 6.6 to 6.7 billion.

Apple breaks down the expense number into just two sub-categories, Research and Development and Selling, General, and Administrative. My money is on a larger than usual increase in R&D spending this quarter to fill those large guidance numbers. Or, perhaps, one of Trump's new US manufacturing plants! My forecast is for Apple to meet the low guidance number of 6.6 billion.

Q3 Guidance analysis and Forecast - Other Income & Expense

After Q1's shocker, Q2 was a still out of the ball park off. Q2 guidance was for OI&E to come in at $400 million. It was actually $187 million higher at $587 million. A 46.8% surprise. Breaking down the components of OI&E, Apple provides three sub categories: Interest Income, Interest expense and other income/expense. The chart below shows this breakdown over the last 17 quarters.

Quarter

Year

Interest Income ($millions)

Interest Expense ($millions)

Other Inc/Exp ($millions)

2

2013

420

0

-73

3

2013

385

-53

-98

4

2013

390

-83

-194

1

2014

427

-84

-97

2

2014

410

-85

-100

3

2014

439

-100

-137

4

2014

519

-115

-97

1

2015

654

-131

-353

2

2015

675

-163

-226

3

2015

766

-201

-175

4

2015

826

-238

-149

1

2016

941

-276

-263

2

2016

986

-321

-510

3

2016

1036

-409

-263

4

2016

1036

-450

-159

1

2017

1224

-525

122

2

2017

1282

-530

-165

The trends are very clear on the first two sub-categories. Interest income is rising by an average of $50.7 million a quarter. Interest expense is also rising but by a lesser average of $31.2 million. Applying these averages would get us to a OI&E of $771.6 million. Because there is a wide range for the sub category of other income and expense, applying the 17 quarter average of a $172.7 million expense would give us OI&E of $598.9 million. This is considerably higher than the guidance of $450 million but I think the historical trends will win out this quarter. I am going with $598.9 million for OI&E.

Q3 Guidance Analysis and Forecast - Tax Rate

I guess even Apple's tax team gets one wrong every now and then. Previously, I have written how consistent the tax team has been in nailing the guidance number quarter after quarter. Last quarter came in 1.11% lower than guidance. Enough to move the earnings number by an additional $.03 per share. This quarter, they moved their guidance lower, back to levels from Q4 of last year. It seems whatever event that occurred to cause the glitch in Q2 may still have some residual effects. But even when factoring in this drop from Q2, the 17 quarter average guidance versus the 17 quarter actual is 6/100ths of a per cent. Back to that consistency. For that reason, I will stick with Apple's guidance for this parameter's forecast. I am going with a tax rate of 25.5% for Q3.

Q3 Forecast - Share Count

As usual, Apple continues to strengthen its bottom line through continued massive spending on its share repurchases. Q2 was no exception. The chart below shows Apple's reported number of shares (weighted average diluted shares) used to calculate earnings per share (chart updated to show Q2 results). The time frame is since the 7:1 split.

Qtr

Year

Date

Diluted shares

3

2014

6/28/2014

6,051,711,000

4

2014

9/27/2014

5,963,984,255

1

2015

12/27/14

5,881,803,000

2

2015

3/28/15

5,834,858,000

3

2015

6/27/15

5,773,099,000

4

2015

9/26/15

5,675,179,388

1

2016

12/26/15

5,594,127,000

2

2016

3/26/16

5,540,886,000

3

2016

6/25/16

5,472,781,000

4

2016

9/24/16

5,396,157,464

1

2017

12/31/16

5,327,995,000

2

2017

4/1/17

5,261,688,000

In terms of slope, this equates to a 1.088% drop each quarter, up ever so slightly from 1.087% last quarter. Applying that number to estimate Q3 gives us a projected share count of 5,204,447,239 - a drop of another 57,240,761 shares. At this rate, Apple will drop below the 5 billion share mark in Q3 of 2018. For a Q3 forecast, I'm comfortable with 5,204,447,239 shares due to the consistency of the past history and the commitment by management to continue with these programs.

Q3 - Forecast Surprise

The average Q3 surprise of actual earnings versus earnings calculated from guidance over the last 8 years is 3.5%. The trailing twelve months have averaged just 0.5% per quarter. Clearly, the surprise is becoming less of a factor as the company matures. My gut feeling on surprise says I should stick closer to the recent trend, especially in a quarter where new products and large announcements were lacking. So for the surprise factor, I am going with 0.5%.

The following chart summarizes my predictions against Apple guidance. For share count, where Apple does not provide any guidance, I used my projected number to determine the projected range for its guidance. For general information purposes, the current "pro" consensus for Q3 earnings as of 7/27 is $1.57, down from $1.62 just 90 days ago. The high forecast is $1.64 and the low is $1.50 per share (Source: Yahoo)

Parameter

AAPL Guidance

Forecast

Revenue

$43.5-45.5 billion

$44.96 billion

Gross Margin

37.5-38.5%

38.484%

Operating Expenses

$6.6-6.7 billion

$6.6 billion

Other Income/Expense

$450 million

$598.9 million

Tax Rate

25.5%

25.5%

Share count

No guidance

5,204,447,239

Calculated EPS

$1.44-$1.63

$1.62

With Surprise

$1.45-$1.64

$1.63

Stock Price Reaction

As of this writing, Apple's stock price since the end of the last quarter has traded in a range between $140.45 and $155.98 and in a generally upward trend. With the forecast earnings from the above chart, I do not foresee any shockwave that would drive the stock higher other than the usual Apple being Apple forging ahead.

How do I define Apple being Apple? By revisiting the correlation between Apple's stock price and their earnings surprises. Over Apple's last 8+ years, 34 quarters, the average price change 1 week after the earnings announcements is an increase of 1.97%. This calculated result was up from last quarter's average of 1.89%. At the one month mark, the average price had risen 3.08% per quarter, up from last quarter's mark of 3.02%.

Over the Tim Cook era, the one-week gain after earnings announcement increased to 1.35% and to 4.46% after one month.

It might just be time to play these averages.....

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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