Apple Fiscal Q2 Earnings Preview

Event:  Apple is scheduled to report their fiscal Q2 earnings Wednesday after the close.  The options market is implying about a 3.5% one day move which is shy of the 4 qtr avg of about 4% and the 8 qtr avg of about 5.3%.  Over the last 7 qtrs, the stock has only risen once the day after results, and that was on July 24th 2013 following their fiscal Q3.

Sentiment:  Wall Street analysts remain infatuated with Apple’s stock with 44 Buys, 16 Holds and only 3 sells, with an average 12 month price target of $597, or about 12.5% above current levels.  Short interest sits at 12 month highs at about 2.5% of the float.

Options Open Interest:  The eight of the top ten largest lines of open interest are all in Jan15, while only one of the top 10 are puts: 41k of the Jan15 500 calls, 31,500 of the Jan15 700 calls, 30k of the Jan15 600 calls, 19,000 Jan15 500 puts, and 19k of the Jan15 550 calls.  Total open interest is skewed towards calls over puts 947k to 700k. One month average volumes have also been skewed to calls 195k to 147k.

Price Action / Technicals:  Apple’s ytd under-performance does not look that glaring, down about 6% vs the Nasdaq which is down about 2% in 2014, but Apple has actually mildly outperformed the Nasdaq over the last 12 months by a few % points.

The one year chart below shows a fairly range-bound stock for the last six months, with the stock spending much of its time between $500 and $550.   I had flagged the potential for the stock forming a head and shoulders top formation in a chart of the day a couple weeks ago (here). Last week the stock held its 200 day moving average (yellow), a momentum indicator which it has not been below since last September, which is encouraging:

Apple 1yr chart from Bloomberg
Apple 1yr chart from Bloomberg

On the flipside, the stock has spent most of 2014 below the uptrend that has been in place since the stock’s double bottom made last summer.  Below $550, the chart looks broken, and that’s the big level to watch on the upside.  On the downside, the lows just below $500 (purple) from late January, which also happens to be near the level where the company started buying stock in an accelerated buyback, will remain an important psychological support level.

Volatility: Trading in a range in 2014 has had a pretty devastating effect on implied volatility in AAPL. The IV is higher recently going into earnings but is nothing compared to where it normally trades over the past 2 years ahead of the event:

Screen Shot 2014-04-21 at 9.10.32 AM

30 Day IV from Livevol Pro

May vol is about 25 going into the report and will likely fall to about 20 afterwards.  The company’s massive share repurchase, plus the late January/early February $14 billion accelerated buyback were vol dampening to say the least.  Investors and options traders now expect the company to serve as the buyer of last resort, thus lower vol for the stock is implied in the options market.

Fundamentals/Valuation:  For investors and analysts that recently got excited about the product rumor mill that suggested larger iPhones in September, and the possibility of a health monitoring wearable device, they will not get any confirmation, hint or benefit from such talk in Wednesday’s release or guidance.  The highlight of the report will likely be the company’s replenishment of their existing capital allocation plan.

In a note to clients dated April 16th, highly ranked Bernstein Research analyst Tony Sacconaghi, detailed his AAPL estimates relative to consensus:

  • iPhone: We forecast iPhone sales of 38.8M (we estimate consensus is ~38M). Our estimate is a 24% sequential decrease from FQ1 on a reported sell-in basis and -22% sequentially on a sell-through basis, which is in-line with the iPhone 5 cycle, and for 4% YoY growth.
  • iPad: We forecast 19.5M units (we believe consensus is ~20M), down 25% QoQ and flat YoY. Apple has been losing meaningful market share to cheaper Android competition (34% in CY13 vs. 46% unit share 2012 and 33% in CQ413 versus 38% in CQ412) and while we believe the market for tablets comparable to the Mini and full size iPad may grow in the double digits for a few years, we ultimately believe the Mini has cannibalized demand for the full size iPad
  • Mac: While global PC demand remains weak, with Gartner and IDC indicating a 2%-4% YoY unit decline in CQ1, PC demand does show signs of stabilizing. We model unit growth of 3% YoY.
  • iPod: We expect a 60% YoY decline in unit sales versus 51% previously. Apple has not refreshed the iPod since September 2012 and we expect a more precipitous drop without a refresh.
  • Gross Margins: We are slightly ahead of Apple’s gross margin guidance range for the current quarter and consensus due to higher iTunes, software, services margins than in our previous model We believe gross margins will ultimately depend on iPhone demand and iPhone mix.  We model 38.1% overall company gross margins, up 20 bps sequentially compared to consensus of 37.6% and guidance of 37%-38%
  • Q3 Guidance: Expectations for the June quarter appear a bit high on revenue compared to our estimates, and we believe there is downside risk to both our numbers and guidance. That said, strong buyback may help buoy EPS. We forecast that Apple may guide to FYQ3 revenue and EPS to ~$37B and ~$8.15vs. consensus of $38.5B and $8.58, respectively.

On the Valuation front, stating you want to own AAPL because it is “cheap” is about lame as stating you want to short AMZN because it is expensive.  We get it, the company has one third of their market cap in cash, they generate upwards of $5 billion in cash a qtr, has a dividend yield of 2.3%, the largest share repurchase program ever known and trades a steep discount to the broad market, with or without their cash.  Problem with just owning it cause it is cheap is that it can stay cheap without a massive product cycle (see MSFT since the early 200os).

Our View:  We have been pretty straightforward this year that we see Apple as dead money, and likely to remain range-bound (with risk to the downside) until the company can introduce a new product line, or suite of services that have a prayer of moving the needle on their expected $180 billion revenue base, without cannibalizing existing product lines (iPhone and iPad account for almost 70% of their total sales).

We think that “wearables” will be a big deal for AAPL, and they are very likely the ones to get the category right out of the gate (Why Apple’s Wearable is a BFD), but we are hard pressed to see a device in the $200 – $300 range that will sell single digit millions on the first iteration as having much of an impact on sales or earnings – unless of course it is married with a service offering that could be tied into their existing iTunes payments infrastructure (Through the Wormhole?).  Obviously we have no clue what they come up with, but we are hard-pressed to think that large screen iPhones will drive the sort of incremental demand to help AAPL re-accelerate earnings in a way that would once again show double digit growth.

The big question for AAPL over the next year is how will they create a new category or suite of services that will help bridge the growing market share gap between iOS and Android?  History appears to be repeating itself with AAPL, as Android is the PC of the 1980s and 90s.  It is my view that the larger the market share gap between AAPL and Android, the greater likelihood that AAPL’s margins come under massive attack as their growing competition just whittles away at their profitability by competing on price. If new iPhone’s receive a similar reception to that of iPhone 5s and 5c, Tim Cook will be fighting for his life as CEO and be forced to make some hard game-changing decisions for the company.

If this is the case, activists will once again be swarming and for good reason.  Think MSFT of the last decade, think of Cook as Ballmer, the successor who never quite filled the founder’s shoes, but worst of all, think of a stock that could be range-bound for years.  Not to put too fine a point on this, but the balance of 2014 could be the most crucial 8 months the company has faced since Jobs’ return to the company in 1997.  If we get to the September iPhone launch and there has not been a new product category introduced (in addition of iPhone), the stock is likely to be much lower, possibly back towards last September’s lows, post iPhone 5s/5c launch.

We are not buyers in front of the print.

Bloomberg Estimates/Guidance:

  • 2Q EPS est. $10.16 (range $9.66-$10.69)
  • 2Q rev. est. $43.6b (range $41.8b-$44.5b) / AAPL forecast 2Q rev. $42b-$44b
  • 2Q gross margin est. 37.7% (range 36.8%-38.1%) / AAPL forecast 2Q gross margin 37%-38%
  • 3Q EPS est. $8.52 (range $7.36-$10.47); avg. est. down 1.4% over past four weeks
  • 3Q rev. est. $38.1b (range $34.9b-$44.1b); avg. est. down 1.6% over past four weeks
  • 3Q gross margin est. 37.3% (range 35.9%-39.1%)

Unit Breakdown:

  • 2Q iPhone unit est. 37.7m (14 ests., compiled by Bloomberg First Word)
  • iPhone ASP $610 (6 ests.)
  • 2Q iPad unit est. 19.7m (14 ests.)
  • iPad ASP $430 (6 ests.)
  • 2Q Mac unit est. 4.03m (9 ests.)
  • 2Q iPod unit est. 2.99m (9 ests.
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