Wednesday, August 11, 2010, 04:05 pm
A detailed look at Apple's September quarterAs the market continues to fully digest Apples recently reported fiscal Q3 earnings, I would like to take a look at whats in store for the September quarter.
Since theres very little concrete data in the form of research reports, channel checks, and order tracking being that its so early on in the quarter, Ive analyzed Apples (AAPL) guidance and the general seasonal and yearly growth trends to form a pretty reliable picture of what investors should expect to see when Apple releases results this October.
The biggest highlight in Apples fiscal Q3 earnings report was its uncharacteristically aggressive revenue guidance. The street was generally looking for Apple to provide guidance in the range of $16 to $16.5 billion, and Apple far exceeded those estimates with their incredible $18 billion estimate. Everyone knows Apples management to be overly conservatively when providing forward looking statements. So to see an $18 billion estimate come out of Apple was clearly the biggest surprise Ive witnessed in a long time.
Yet, as many Wall Street analysts have noted in their estimates, theres reason to breathe caution into the air when relying on Apples guidance this quarter. I believe Apples management has become slightly more aggressive with its estimates simply because I dont see where Apple will be able to derive the revenue to far exceed its own expectations this time around. The street is generally modeling for Apple report $3.95 in EPS on $18.29 billion in revenue. While I think the street is a tad bit low in its forecast, I dont believe Apple will beat estimates by quite as wide of margin as it has in recent quarters. Im currently modeling for Apple to report $4.45 in EPS on $19.1 billion in revenue.
Philip Elmer-DeWitt at Fortune puts forth a very interesting theory as to what might explain Apples seemingly aggressive $18 billion guidance this quarter. He notes, Wall Street is either betting that apple was hyping its revenue forecast, perhaps to send a message about the death grip flap. Or the analysts, in a time-honored sell-side ploy, were doing some low-balling of their own so clients who follow their advice and buy Apple shares might be pleasantly surprised come the end of the quarter.
Both of these theories are quite plausible though I think I buy into the former explanation that Apple was trying to send a message about the negligible financial impact of antennagate. Based on Apples guidance in conjunction with the seasonal and yearly growth trends, the tables below outline my forecast for Apples fiscal Q4. Please be advised that actual results may vary. You can review my track-record on Apple published at Fortune. Philip-Elmer DeWitt keeps an ongoing score of analyst accuracy in his column, Apple 2.0.
For those who care to swim in the minutia, the detailed analysis below forms the basis of my initial estimates. Starting with unit sales and revenue, whenever one draws estimates its important to keep Apples guidance squarely in mind. If the seasonal and yearly growth trends suggest a revenue number that is far below or beyond the range that Apple tends to beat on its own guidance, then either the estimates arent fairly stated or theres something uncharacteristic about Apples guidance.
Most of the time, estimates that fall outside of the normal variance will likely be the result of an error in the methodology rather than a change in Apples guidance behavior. Though as I noted above, I think that for this particular quarter, Apple is in fact guiding slightly more aggressive than usual. This much is clear. Ive drawn up some rather aggressive estimates for Q4 that I think will be pretty difficult for Apple to achieve. And even if Apple meets or slightly exceeds my expectations, it will be a much lower beat than what weve seen in the past few quarters. Note: If you dont want to get too bogged down with detail, stop reading here.
I. UNIT SALES & REVENUE
In the sections below, I lay out the details of my revenue model for Apples September quarter. The issue of Apples income statement will be taken up in section II of this report.
iPhone Unit Sales & Revenue
It has been somewhat difficult to gauge demand for the iPhone 4 beyond what Apple seems to be telling us with its guidance. Since Apple, as recently as mid-July, has been suffering from iPhone 4 supply constraints, we have very little data in terms of the full potential run-rate for the iPhone. That being said, what we can analyze is the current seasonal and sequential growth trend, and come to a number that is commensurate with Apples aggressive revenue guidance.
In fact, knowing that its much easier to predict Apples other product categories, Ive determined that Apple must sell about 11.5 million iPhones this quarter to meet the implications of its revenue guidance. Analyst estimates seem to range between 10 and 12 million units, but 11.5 seems to be more consistent with Apples guidance. Moreover, an 11.5 million iPhone estimate is more or less in harmony with the seasonal, yearly, and sequential growth trends as well.
Starting with the sequential growth trend, last year Apple saw a 41% quarter over quarter increase in iPhone unit sales between fiscal Q3 and Q4. The September quarter tends to see a significant uptick in unit sales due to Apples practice of releasing new iterations of the device at the end of June quarter. Based on last years sequential growth trend, Apple could sell about 11.8 million iPhones compared to the 8.4 million it sold in Q3.
The current yearly growth trend also seems to support this thesis. For the past few quarters, Apple has enjoyed some rather staggering iPhone growth rates. For Q1, Apple recorded 100.2% unit growth, for Q2 it recorded 131% and for the recently reported Q3, Apple saw 61.3% year over year growth. Thus, an estimate calling for 11.5 million iPhones would suggest a 56% yearly growth rate, which is more or less consistent with the growth rate seen in Apples previous three quarters.
The average selling price of the iPhone and its related products and services is much easier to gauge. The trend has been more or less consistent across the previous four quarters. Apple has generally reported an iPhone ASP range of $620 to $635 over the last several periods. Im conservatively estimating an ASP of about $620 on the quarter to partly account for the slight hit Apple will take for the free bumper program. Thus, based on sales of 11.5 million units at average selling price of $620, Im expecting Apple to report about $7.13 billion in iPhone revenue on the quarter. See the charts below.
Macintosh Unit Sales & Revenue
Macintosh unit sales and revenue is significantly easier to predict for the September quarter, and once Gartner data is released, well get a clear idea of what one should expect to see in Q4. Again, the sequential and yearly growth trends both suggest that we should see unit sales fall somewhere in the range of 3.8 to 4.0 million units.
Taking a look at the sequential seasonal growth rate between Q3 and Q4, Apple generally tends to post significant percentage gains largely due to the back to school shopping season. Last year, for example, Apple reported a 17.3% sequential rise between fiscal Q3 and Q4. Yet, in 2008, Apple saw a much lower sequential rise of 4.6% due largely to slower sales as a result of the impact of the financial crisis. However, I think last years sequential growth rate provides a more reliable basis for forecast in light of the more stable economic environment. Thus, based on the 17.3% sequential rise between fiscal Q3 and Q4, it is possible that Apple may ship around 4.1 million units this quarter.
Moreover, the current yearly growth rates of Apples most recently report three quarters seems to support this view. For Q1 2010, Apple posted Macintosh unit sales growth of 33.2%. For Q2, it reported 32.8% and for Apples recently reported fiscal Q3, it recorded sales of 33.4%. Notice how the year over year growth rate has consistently fallen within a range of 32% to 33% for each quarter this year. Thus, if the trend continues and Apple sees a 33.4% year over year rise in Macintosh sales, its probable that Apple can post sales of approximately 4.06 million Macintosh computers this quarter.
So while Im currently modeling for sales of 3.8 million Macs, I believe that once Garter and NPD data is released in October, I will likely be upgrading my assessment of Macintosh unit sales before Apple reports its results. Its also prudent to be somewhat conservative with initial forecasts in order to leave room to raise estimates in the future.
Using the same methodology to forecast unit sales growth, one can easily predict Macintosh ASP. In fact, its even easier to forecast average selling prices than it is to forecast unit sales. When forecasting the September quarter, its important to understand that two key issues will likely negatively impact Macintosh average selling prices. First, that Apple offers rather aggressive discount incentives and promotions to students buying a Mac during the back to school shopping season. Secondly, theres a general shift from sales of Apples higher end offerings to lower priced Macs during the quarter. So what we generally witness is a slight decline in ASP between fiscal Q3 and fiscal Q4.
Yet this isnt always the case. Often times well see Q4 Macintosh ASPs be flat to slightly up on the quarter. The strength of the dollar or Euro weakness also tends to have a big impact on the sequential comparison of Macintosh ASP. In fact, recent weakness in the dollar during the month of July portends a potentially stronger Macintosh ASP than what Apple reported in fiscal Q3. Still, for the sake of conservatism, its not a bad idea to model for a slightly lower average selling price than what might be suggested by the weaker dollar. If the dollar continues to weaken throughout the quarter, then I could easily upgrade my assessment of the average selling price.
Based on these considerations, Im modeling for an average selling price of $1,250 on the quarter. Thats just $17 lower than what Apple reported in fiscal Q3. Thus, based on a forecast of 3.8 million unit shipped at a $1,250 ASP, Im generally looking for Apple report about $4.75 billion in Macintosh revenue this quarter. Yet, as we noted above, its possible that once we get all the relevant data, a forecast of over $5 billion in Macintosh revenue might be more appropriate. The two charts below outline Macintosh unit sales and average selling prices from 2006 to the present.
iPod Unit Sales & Revenue
iPod unit sales were very disappointing in Q3, and it makes it difficult to gauge how well they will sell in Q4. Yet, I did note in two different articles that iPod sales as a percentage of Apples total revenue has been on a consistent decline since 2006. That the market doesnt give much of a crap about how iPod unit sales fare anymore (this was proven true by the mere fact that the market brushed aside the huge miss in unit sales during Q3), and that Apples reliance on the device as a driver of revenue isnt as important as it once was in the past. See here and here.
In fact, revenue from the device formed only a tiny portion of Apples total revenue in Q3 as it only accounted for merely 9.8% of the business. Moreover, iPod fell to the fourth largest contributor of Apples overall revenue for the first time in the devices history in Q3. In its inaugural quarter, even iPad revenue far surpassed iPod revenue in Q3, and iTunes revenue seems to be closing in to push iPod unit sales to fifth place.
Yet, this debate aside, Im modeling for sales to come in at 10 million units in Q4 as the September iPod refresh looks to revitalized sales on the quarter. Its not uncommon to see unusually weak iPod unit sales in Q3 from time to time. In fact, Apple reported a similar plunge in unit sales between Q2 and Q3 of 2007 and 2009. Yet, sales did in fact rebound quite significantly in Q4 once Apple released its new lineup of iPods during the last month of the quarter. Thus, well have to wait for NPD data to get a rough idea of what we can expect to see on the quarter.
iPod average selling prices are a much easier variable to forecast. I expect iPod ASP to come in at $158 based on the current seasonal and sequential trend. Thus, based on sales of 10 million iPods at an average selling price of $158, Im expecting to see roughly $1.58 billion in iPod revenue - just a fraction of what Apple will likely report in iPad, iPhone and Macintosh revenue this quarter. The two charts display iPod unit sales growth and average selling prices over the past several years.
iPad Unit Sales & Revenue
I expect iPad sales to pick up quite a bit over the 3.3 million units Apple reported in Q3. As Apple works to meet the current supply-demand imbalance over the next month or so, well probably see a strong run rate in the second half of the quarter. Also, Apples newest products tend to do a lot better in terms of sales after their inaugural quarters. Add the benefit of the back to school shopping season and we should expect to see sales come in at around 4.5 to 5 million units. We have very little data in terms of the seasonality for the iPad, but the fourth quarter is generally a strong quarter for Apple indicating that we should see a strong uptick in sales. Thus, based on $650 ASP, Im looking for Apple to post about $3.25 billion in iPad revenue this quarter.
iTunes revenue continues to consistently grow over the quarters making it relatively easy to forecast. Usually, iTunes revenue tends to be flat sequentially between Q3 and Q4 yet I think Apple will benefit from higher activity from strong sales of the iPad on iPhone 4. Im modeling for a slightly higher sequential rise in iTunes revenue than what Apple has seen in the past. Moreover, though iTunes revenue growth has tended to be flat from Q3 to Q4 in the past, in 2009 we did see quite a bump in revenue despite the prior trend. Thus, Im expecting iTunes revenue to come in at $1.275 billion or slightly above the $1.214 billion apple reported in Q3. See the chart below.
In terms of peripherals revenue, what we tend to see over the past two years is a steep decline in peripherals during Q3 followed by a steep rebound in the September quarter. Im basically looking for that same seasonal trend to continue, and Im modeling for revenue to jump to $450 million this quarter. That compares to the $396 million Apple reported in Q3.
Software revenue is slightly easier to forecast than peripherals. What we get is nice consistent software revenue growth and a peaking in fiscal Q4. With the exception of the occasional operating system release, Apples Q4 software revenue has tended to slightly outperform the previous three quarters. See the chart below. Thus, based on the trend in software revenue, Im modeling for Apple to report $670 million in fiscal Q4 versus the $646 it reported in Q3.
II. THE INCOME STATEMENT
Now that Ive laid out the details of how I arrive at my $19.1 billion revenue estimate for Apples September quarter, the sections below will go through and discuss line items in my income statement model to arrive at $4.45 in EPS.
Revenue, Gross Margin & the Cost of Goods Sold
Gross margin is the amount of money Apple makes on each of its products less the cost it takes to make those products. The only costs considered are the manufacturing cost, the bill of materials, and the packaging cost. These costs are called the cost of goods sold or COGS. Subtracting the total cost of goods sold from Apples overall revenue will give you Apples gross margin.
Determining what Apples total gross margin will be in any one of Apples fiscal quarters requires an understanding of which of Apples product tend to carry higher gross margins, a careful analysis of Apples guidance for gross margin, the seasonal trend, the strength of the U.S. Dollar relative to the Euro, and whether a newly introduced product carries a higher or lower gross margin relative to the companys average.
Apples management has repeatedly noted that the iPad tends to carry a lower gross margin due to the companys strategy to aggressively price the product in a way that is very competitive relative to the industry. Based on this and other considerations, Apple guided gross margins down to 35% from the 39% it reported in fiscal Q3. Yet, its important to note that Apple tends to be overly conservative with its gross margin guidance. In fact, Apple beat its gross margin guidance by over 300 basis points last quarter.
The table below compares Apples gross margin guidance to its actual results. Please keep in mind that in order to get an accurate reading of Apples guidance behavior, its important to refer to Apples pre-amended quarterly results. Starting in Q1 2010, Apple changed its GAAP revenue accounting system for the iPhone and has thus amended every quarterly report since fiscal Q3 2007 to reflect this change. Yet, theres no point in comparing Apples guidance to amended results because in order to analyze Apples guidance behavior, one has to compare their guidance to the original results for which their guidance was originally intended. Any time I analyze Apples guidance behavior, Ill be referring to pre-amended results for any quarter that was eventually amended. Obviously this doesnt apply to fiscal Q2 Q4 of 2010.
Moreover, for the past two years, Apples September quarter has tended to outperform its fiscal Q3 on the gross margin front. This is largely due to the sizable uptick in iPhone sales which tends to carry a larger overall gross margin than Apples other products. Yet, at the same time, with an expected rise in iPad sales on the quarter, Im expecting to see a slight decline in overall gross margin sequentially. Even Apples gross margin guidance for Q4 was 100 basis points less than its gross margin guidance for fiscal Q3. Thus, based on all of this data, Im modeling gross margin percentage to come in at around 38.75% versus the 39.08% Apple reported in fiscal Q3. Thus, Im looking for Apple to report about $19.105 billion in revenue, 11.702 billion in the cost of goods sold and $7.403 billion in gross margin.
Operating Expenses & Operating Income
Operating expenses include those expenses related to running the Apple operation. The geniuses at the Apple store, Steve Jobs $1 income, the rental cost of all of Apples retail stores, the employees, the paperwork, the Apple campus in Cupertino and all other money spent to run the company are operating expenses. Based on the current trend in Apples guidance, one can produce a pretty reliable picture of what Apple will probably report in the September quarter.
There were several quarters where I was able to forecast these expenses almost perfectly because Apple would regularly guide $40 million under the actual results. Picking up on this trend, it has been relatively easy to predict these expenses. Yet, one must also consider the growth trend of these expenses to help facilitate a strong forecast. The chart below compares Apples guidance for operating expense to actual results.
For Q4, Im modeling for an estimate of $2.050 billion in operating expenses based on Apples guidance, and based on the trend. Knowing that Q4 tends to be one of the highest quarters in terms of operating expenses due to Apple mass hiring to meet consumer demand of the iPhone and back to school shopping season, Im expecting a $150 million bump to $2 billion in Q4. The chart below outlines Apples operating expenses from 2006 to 2010.
To arrive at operating income, income that Apple generates from its primary operations, one must simply subtract operating expenses from gross margin. Remember operating expenses are those expenses that only include the costs to run the entire Apple operation. Gross margin, on the other hand, is the amount of money Apple makes on the sale of each of its goods (revenue) minus the cost it takes to bring those goods into existence i.e. to make those goods. Thus, for Q4 Im forecasting an operating income of $5.353 billion, which is the difference of subtracting $2.050 billion in operating expenses from $7.403 billion in projected gross margin.
Other Income & Expenditures
Companies will regularly make and/or lose money on the sale of property, from interest on their cash deposits, or from investments. Good accounting requires that we keep that income or loss in a separate category because it would be inappropriate to suggest that income from an investment should be part of the income that Apple receives from the sale of its goods.
So under generally accepted accounting principles (GAAP) we have a line item in the income statement called Other Income & Expenses or OI&E. Though the dollar amount of OI&E is generally a small amount compared to Apples operating income, it can and will regularly affect EPS and so it should be taken seriously. Based on Apples guidance, which generally undercuts or overstates OI&E by about $5 - 10 million, Im projecting OI&E to come in at about $55 million for Q4. The table below compares Apples OI&E guidance to actual results for the past several years.
Net Income, before appropriations for income taxes
Finally, to arrive at income before a provision for income taxes, one only needs to add operating income to OI&E. In this case, Im expecting $5.922 billion in operating income, and $35 million in OI&E for Q4. Thus, we arrive at a net income before taxes of $5.957 billion.
The Tax Rate
Last quarter many of my readers were quick to criticize my tax rate estimate despite my long history and track record following Apple. I had a tax rate guidance of 23.6%, which while slightly lower than the reported 24.2% tax rate, was far more in-line than the 27% suggested by many of those criticizing my aggressive tax forecast. Some of my readers even harped on Apples comments that fiscal Q2s low tax rate was just a one-time thing, and that it was nuts to model for an aggressively low tax rate for Apple fiscal Q3 and Q4 in my analysis.
Well if theres one thing I learned from following Apples guidance over the years, its that rarely is any benefit just a one-time thing and thats Apples fiscal Q4 tax rate is generally lower than that of Q3. Thats why I had a low tax rate in my initial Q4 estimates when I published them about a month ago. And as I expected, Apples tax rate guidance for Q4 is the lowest in the companys history! In the future, I would appreciate it if my readers would just trust me so I dont have to write a dissertation explaining my methodology every time I draw up estimates for Apple. In fact, this will be the last time I go into such detail. In the future Ill just publish the estimates and refer to this article for the methodology.
The table below compares Apples guidance to their actual results over the past several years. Notice how Apple generally guides way above what it tends to report in taxes. Based on the trend in Apples tax guidance, Im modeling for a 23% tax rate on the quarter.
Thus, based on a tax rate of 23.0% for Q4, Im looking for Apple to record a post tax profit of $4.164 billion in fiscal Q4. Apple will also probably generate more or less that amount in cash.
Earnings per Share
Once you arrive at net income, the job is basically done. One only needs to divide net income by the number of projected outstanding diluted shares to arrive at Earnings Per Share or EPS. Based on a projection of 930 million shares outstanding at the end of Q4 2010, my estimates are calling for Apple to report $4.45 in EPS on $19.105 billion in revenue versus the current consensus of $3.95 in EPS on a conservative $18.29 billion in revenue.
Andy Zaky is a graduate from the UCLA School of Law, an AppleInsider contributor and the founder and author of Bullish Cross -- an online publication that provides in-depth analysis of Apple's financial health.
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