Monday, December 12, 2011, 08:24 am
How to properly use Apple's guidance to accurately forecast earnings
1. Revenue Tells the Whole Story
Over the past several years, and especially after undergoing a major accounting change in fiscal Q1 2010, Apple has consistently reported a quarterly revenue number that was precisely 12-18 percent above its revenue guidance. Regardless of how rosy or conservative the Wall Street consensus happens to be, regardless of what Business Insider has to say about the Android destroying iPhone sales, regardless of all of the channel checks, Gartner & IDC research data, Comscore, NPD data, and the supply chain.
Regardless of rumors of Apple cutting manufacturing orders by 90 percent as falsely reported every quarter by the Chinese equivalent of the National Enquirer, Digitimes. Regardless of all of these reports that Apple has cut iPhone production by 75 percent, regardless of reports, and rumors of reports of Apple's untimely death. Regardless of everything you hear from analysts, fund managers CNBC or anyone else for that matter. The fact remains that Apple consistently beats its own revenue guidance by the same exact 12-18 percent every single quarter. The rest is all noise intended to do nothing else but to distract you.
Half the time Apple beats its revenue guidance by 12-13 percent and half the time Apple beats its revenue guidance by 16-18 percent. The only exception came in fiscal Q3 2011 when Apple beat its revenue guidance by 24.22 percent. The charts below show the difference between Apple's actual revenue and Apple's guidance.
The reason Apple regularly beats its revenue guidance so consistently between 12-18 percent every quarter is the fact that of any entity, research group, analyst or fund manager, Apple's management is by far the best positioned to know exactly how the company will perform in any given quarter. In fact, Apple probably possesses on the order of 20-30 times more information than everyone else put together.
Being so well positioned, what Apple does before offering it's sales guidance is it formulates a conservative internal outlook. After doing so, Apple then offers a guidance number that is just about 10 percent below that internal sales expectation.
Good conservative accounting practices dictates that if and when a company decides to offer guidance on its sales expectations, the company must provide an outlook that is reasonably conservative, consistent and comparable across quarters. The expectation set by the company must allow the average analyst to reasonably infer what is likely to unfold. Both reported financial statements and unaudited financial forecasts must be reported consistently across quarters, comparable across quarters and conservative across quarters.
Thus, Apple ultimately ends up offering a guidance number that is 12-18 percent below what it ends up reporting. The reason for this is simple. As with any other company, Apple's internal expectations tend to be slightly conservative. So when the company offers a sales estimate that is roughly 10 percent below its internal expectations, those internal expectations are already slightly conservative leading to the ultimate 12-18 percent beat.
Consequently, any good analyst doing even a modicum of research would understand immediately that when Apple offers revenue guidance, it is essentially telling the Street that it should expect sales to come in around 12-18 percent above that estimate. An analyst that forecasts a sales estimate higher than 16-17 percent above Apple's guidance is being overly optimistic and setting Apple up to fail. An analyst publishing a revenue estimate lower than 10 percent below Apple's guidance is setting the bar too low.
Good conservative forecasting practices dictate that a sales forecast should fall between 12-14 percent. Any lower and you're being unrealistic. Any higher and Apple will generally fall short of your expectations on a regular basis.
Apple guided revenue to $37 billion for fiscal Q1 2012 which is expected to be released sometime in the third week of January. Based on Apple's history of offering revenue guidance that is 12-18 percent below what it generally reports, that would suggest that Apple will report between $41.5 billion and $43.7 billion in revenue.
Bullish Cross expects Apple to report $42 billion in revenue in fiscal Q1 2012. That is precisely 13.51 percent above Apple's revenue guidance for the quarter and based partly on the extrapolation of certain inferences derived by analyzing Apple's gross margin guidance.
If Apple reports on the higher end of its range, it will result in Apple exceeding our expectations by 4.01 percent. If Apple reports at the lowest end of our expectation, we will have missed Apple's revenue by $500 million or just about 1.19 percent. So that puts us in a position to forecast Apple's revenue almost perfectly in a range of -1.2 percent to 4.0 percent. That's a very reasonable margin of error for a forecast on sales.
Finally, as a side-note, some people believe that the reason Apple missed on revenue expectations in fiscal Q4 was either due to a slowdown in sales or due to the fact that Apple somehow was more aggressive with its guidance. Yet, I find that interesting given that Apple reported a 13.08 percent beat on its revenue guidance which falls right within the normal range. The only thing out of the ordinary in fiscal Q4 was the fact that the Wall Street consensus was nearly 20 percent above Apple's guidance. That would have amounted to a miss in 7 out of the last 8 quarters. Moreover, what was very odd about that consensus estimate is the fact that it was more than two times higher than usual. It seems like Apple was set-up to miss pretty much no matter what. See the chart below:
I also find it quite fascinating that people try to argue that Apple's guidance has become more aggressive for fiscal Q1 just because Apple guided above the street on revenue. Well this isn't the first time that Apple has guided above the street. In fact, Apple has guided above the street on revenue in 6 out of the last 8 quarters. Since Apple underwent its accounting change in fiscal Q1 2010, the company has steadily offered revenue guidance way above the street. And in four out of the last six quarters, Apple has offered revenue guidance that was either very close to $1 billion above the street, or far more than $1 billion above the street. Moral of the story. Stop listening to morons that don't know jack about Apple's guidance i.e. the financial press and the SA average contributor:
We're going to spend a lot of time on this issue of Apple supposedly getting aggressive with its guidance in article we will be publishing later on in the week. For now, we're going to continue discussing how to properly use Apple's guidance to accurately forecast its earnings and why EPS guidance is meaningless.
2. Gross Margin Tells the Story of the Sales Breakdown
One thing that Apple doesn't really tell you in its guidance is how many iPhones, iPads, Macs and iPods the company expects to sell. At least not directly. While Wall Street analysts pretty much waste a lot time on the conference call trying to get Apple to give up information about how the company feels about iPhone sales or iPad sales or Mac sales etc., the company has already indirectly told anyone intelligent enough to understand the subtleties in Apple's gross margin guidance.
This is probably one of the most complex, subtle and intriguing things in financial accounting and analysis. It is the reason Bullish Cross has been far more accurate than Wall Street in forecasting Apple's earnings over the years and it is the reason Bullish Cross is able to consistently forecast Apple's unit sales.
What you have to understand about Apple's gross margin guidance is that Apple almost always guides at least 200 basis-points below what it actually expects to report. In fact, in the last 14 quarters, Apple's guidance came in less than 200 basis-points above Apple's guidance a whopping one time out of fourteen quarters. In fiscal Q4 2010, Apple's gross margin percentage came in at exactly 190 basis points above Apple's guidance. See below:
Yet, normally what you tend to see is Apple guides between 250 and 300 basis points below what it actually reports. In fact, in 8 out of the last 10 quarters i.e. since Apple underwent its major accounting change the company has reported a gross margin percentage number that was at least 250 basis points above its revenue guidance one quarter came in at 230 basis points and the other was 190 basis points above. See the table above.
So what you can conservatively infer here is that Apple will probably report a gross margin percentage that is just about 250 basis points above its guidance. In fact, if you look at the seasonality, here's what Apple has done in previous fiscal Q1′s. In fiscal Q1 2011, Apple reported a gross margin percentage that was exactly 250 basis points above its guidance. In fiscal Q1 2010, Apple reported a gross margin percentage that was exactly 250 basis points above its guidance. In fiscal Q1 2009, Apple reported a gross margin percentage that was 424 basis points above its guidance and in fiscal Q1 2008, it reported a gross margin percentage that was 368 basis points above its guidance.
From analyzing these numbers, a very strong case can be made that Apple will report a gross margin percentage that is at least 250 basis-points above its guidance if not slightly more. For fiscal Q1 2012, Apple guided for a 40.0 percent gross margin percentage. Thus, Bullish Cross holds the expectations that Apple will report a gross margin percentage of exactly 42.5 percent on the quarter.
That means taken together with our revenue expectations of $42 billion, it gives us three different line items in our forecast for Apple's fiscal Q1. It gives us (1) Revenue at $42 billion, (2) the Cost of Goods Sold or COGS at $24.15 billion; and (3) Gross Margin at $17.85 billion or 42.5 percent of revenues.
Bullish Cross Fiscal Q1 2012 Earnings Forecast for Apple, Inc (in Millions except for EPS)
Cost of Goods Sold (COGS): $24,150
Gross Margin: $17,850 (42.5 percent)
Now the next thing every good analyst should understand immediately is that the iPhone carries the highest gross margin percentage by far. The more Apple's revenue is driven by iPhone sales, the higher Apple's gross margin percentage will be.
Apple's two main revenue drivers are iPhones and iPads. While iPads do carry a pretty solid gross margin percentage, it is nowhere near as profitable as the iPhone. Apple's third biggest revenue driver is Macintosh sales. Everything else is nonsense.
Thus, using some relatively basic algebra, it is very possible to determine how Apple envisions the product mix between iPhones and iPads to look like simply by analyzing the gross margin percentage on the quarters. Now if Apple does in fact report a 42.5 percent gross margin number, that would the highest gross margin percentage in the company's history by far.
And no one should be shocked by this fact for at least three major reasons. First, Apple is giving the most aggressive gross margin percentage guidance it has ever given in its history. Just for comparison's sake, in fiscal Q4 Apple guided gross margin to 38 percent. In fiscal Q1 of 2011, it guided gross margin to 36 percent.
So just from Apple's gross margin guidance alone, no one should be shocked when Apple reports a record high gross margin percentage. The second big reason that no one should be shocked by Apple's gross margin percentage guidance is the fact that Apple just guided revenue to $37 billion. You know how freaking high that is? That's $10 billion above what it just reported in fiscal Q4 2011 and 50 percent higher on a year over year basis. So it shouldn't be surprising to see Apple report a 42.5 percent 43.5 percent gross margin number.
Thirdly, with the iPhone 4S just being released, it is obvious this quarter's revenue is largely driven by iPhone sales. As revenue increase and as the distribution of revenue is attributed more proportionately to iPhone sales than iPad or Mac sales, Apple's gross margin increases.
What Apple basically told us with its revenue guidance + gross margin guidance is that the company expects to report a huge revenue number and it expects that revenue number to be driven primarily by iPhone sales. In fact, while I don't want to spend the time explaining the math in this particular article, Apple's guidance suggests sales of 32 35 million iPhones, 13.5 14.5 million iPads and 4.9 million Macintosh Computers. For those who want to see our completely methodology, you can do so by visiting some past earnings previews published at Bullish Cross. But this article is supposed to be all about forecasting an income statement using nothing but guidance and historical data.
So we're not going to have a detailed discussion about the breakdown in terms of sales. Though I will post the sales breakdown, and how we arrive at our revenue expectation below. For now, what you should take from Apple's gross margin guidance is that (1) Apple tends to report a gross margin number that is about 250 basis-points or above its guidance which suggests Apple report a 42.5 percent gross margin percentage; (2) Apple's gross margin guidance is the highest in the companies history which suggests Apple should report a record revenue number and a record gross margin percentage number; (3) Apple's gross margin guidance suggests Apple is very dead serious about its revenue guidance. If Apple was even slightly hesitant about its sales expectations, it wouldn't have guided gross margin to 40 percent. It means Apple stands squarely behind its revenue guidance.
Wall Street believes Apple has become conservative with its guidance for the dumbest f'ing reasons you could ever imagine. After getting overly aggressive with its guidance in fiscal Q4, now Wall Street has turned the wheel just as hard in the opposite direction and has guided only 2.68 percent above Apple's revenue guidance. This is going to lead to the largest blowout in company history. We will discuss why in an article later this week.
But now let's turn to operating expenses which will give us the next two line items in our income statement forecast.
On page three, how operating expenses are only a small fraction of Apple's revenue.
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