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Monday, December 12, 2011, 05:24 am PT (08:24 am ET)

How to properly use Apple's guidance to accurately forecast earnings



3. Operating Expenses: Only a Small Fraction of Apple's Revenue
Like with other line-items in Apple's guidance, there is a very consistent trend here. Apple pretty much always tends to deliver an operating expense number that is just about $50-$60 million above or below its forecast. For example, in fiscal Q4 2011, Apple guided operating expenses to $2.725 billion and came in at $2.67 billion which was $55 million below its forecast. It's a pretty negligible number overall.

Because of the holiday shopping season, there has been a historical tendency for Apple to actually overshoot on expenses. What we've seen happen is Apple report an OpEx number that is about $50 million above what guided. Yet, in the last 20-quarters, there is only 1 instance where Apple's operating expenses fell outside of this $50 million +/- range. For whatever reason, Apple reported operating expenses of $146 million above its guidance in fiscal Q1 2011. But if you go back to previous fiscal Q1′s, it was $46 million in Q1 2010, -$34 million in Q1 2009 and +$41 million in 2008.

Zaky


If one wanted to be very conservative, he or she would forecast operating expenses to come in about $100 million above Apple's forecast. But I think a very strong case can be made that Apple really intends to come in above $50 million above what its guiding. That fiscal Q1 2011 is truly just an outlier. And in fact it is given that it's only happened once in twenty quarters or 5-years.

For fiscal Q1 2011, Apple's guiding for $3.250 billion in operating expenses. Bullish Cross expects Apple to report that operating expenses rose to $3.3 billion versus $2.471 billion in the year ago quarter.

Now let's add this line item to our developing forecast. In fact, we can add two line items. Operating Expenses are those expenses that are necessary for the running of the business. They include things like selling, general and administrative expenses and the cost to do research. Anything related to running the Apple operating falls under this expense category.

In order to get operating income, one needs only to merely subtract operating expenses from gross profit/gross margin. Remember gross margin is the profit Apple makes on each device it sells before taking out expenses to run the operation. So for example, if it costs $200 to make an iPhone and Apple is selling that iPhone for $600, then Apple is making a gross profit or gross margin of $400. Operating expenses are those expenses needed to take the iPhone and put it in the hands of the consumer by hiring people, renting retail stores etc. etc. Ok. So we have two line-items to add to our income statement forecast. (1) Operating Expenses and (2) Operating Income. In this case, operating income is $14.55 billion.

Bullish Cross Fiscal Q1 2012 Earnings Forecast for Apple, Inc (in Millions except for EPS)
Revenue: $42,000
Cost of Goods Sold (COGS): $24,150
Gross Margin: $17,850 (42.5 percent)
Operating Expenses: $3,300
Operating Income: $14,550

4. OI&E: A sleeper in buffing EPS
In the past, OI&E used to dramatically impact EPS in a pretty significant way. Sometimes you would see a 10 percent increase in EPS just as a result of OI&E. In fact, I remember times where Apple decimating Wall Street expectations only because OI&E came in a lot higher than anyone expected. It's not so big of a deal these days even though Apple could make it a big deal if it wanted to with those trillions of dollars it has sitting there in its coffers.

In the typical quarter, Apple tends to beat its OI&E guidance by between $5 million and $20 million. There is one outlier in fiscal Q3 2011 where Apple reported $127 million which was a big contributor to the huge EPS beat it delivered. But in most cases, it's a $5 – $15 million difference. Recently, however, we've seen a bigger trend. For example, in four out of the last five quarters, Apple has delivered an OI&E number that was $15 million or more above its guidance. It also offering the most aggressive OI&E guidance in nearly two years this quarter.

Zaky


For this reason, we're expecting Apple to deliver a $15 million beat on its OI&E guidance this quarter. Apple guided OI&E to $85 million for fiscal Q1 and Bullish Cross is expecting OI&E to come in at an even-Steven $100 million.

For those who are curious, OI&E stands for “Other Income & Expenditures.” The reason Apple breaks this income off into its own category is very simple. It would be deceiving for any company to include that number in their revenue.

The reason for that is the fact that OI&E is income received from its secondary operations. Apple is in the business of selling iPhones, iPads, Macs and iPods. It's not in the business of investing. At least not primarily. If Apple were to make a windfall one quarter, it would be unfair to investors to flaunt that number around as part of its revenue if Apple didn't derive that revenue from the things it normally sells. So OI&E under GAAP-accounting is generally broken off into its own category.

Now when you add OI&E to operating income, we get net income. Hurray we're almost there! So we have two line-item to add to our forecast and we're almost done. We have to add OI&E and Net Income before Taxes.

Bullish Cross Fiscal Q1 2012 Earnings Forecast for Apple, Inc (in Millions except for EPS)
Revenue: $42,000
Cost of Goods Sold (COGS): $24,150
Gross Margin: $17,850 (42.5 percent)
Operating Expenses: $3,300
Operating Income: $14,550
Other Income & Expenditures: $100
Net Income, Before Taxes: $14,650

5. The Tax Rate: Apple Pays Like No Taxes
One of the largest companies in the world, and Apple pays half the tax-rate that I pay to Uncle Scam. Pretty amazing isn't it? Now I don't want to spend an incredible amount of time explaining the historical trend when it comes to the tax rate. Suffice it to say that there is consistent trend when it comes to Apple's tax-rate guidance.

Generally speaking, Apple tends to report a tax-rate that is about 250 to 500 basis points below its guidance. Yet, very recently, Apple just started getting very realistic with its guidance. For the longest time, I had an edge on Wall Street on this issue. The tax rate does have a huge impact on EPS too so if you had an edge in being able to accurately forecast the tax rate, you were generally at a massive advantage on everyone else.

Zaky


This quarter, I think Apple is pretty much guiding in-line with what it will actually report in terms of the tax-rate. Apple guided the tax rate to 24.25 percent and I expect the company to report roughly 24.0 percent in taxes this quarter. Though I should note that in fiscal Q3 Apple reported a 23.5 percent tax rate and in fiscal Q2 it reported a 23.7 percent tax rate. And Apple does indeed have a tendency to sandbag on the tax rate. So we could very easily see a 23.5 percent tax rate for fiscal Q1 since Apple pays taxes at the poverty level.

And there you have it. Bullish Cross expects Apple to report a 24.0 percent tax rate for fiscal Q1 2012. Thus, we can add two more line items to our developing income statement. First we can add the amount Apple will pay in taxes which is nothing more than multiplying 24 percent to $14.65 billion in net income before taxes. That number happens to be $3.516 billion. If you subtract the tax rate from Net Income before Taxes, you get the bottom-line i.e. Net Income. Thus, Bullish Cross expects Apple to report $11.134 billion in net income for fiscal Q1 2012. See below:

Bullish Cross Fiscal Q1 2012 Earnings Forecast for Apple, Inc (in Millions except for EPS)
Revenue: $42,000
Cost of Goods Sold (COGS): $24,150
Gross Margin: $17,850 (42.5 percent)
Operating Expenses: $3,300
Operating Income: $14,550
Other Income & Expenditures: $100
Net Income, Before Taxes: $14,650
Taxes: $3,516 (24.0 percent)
Net Income: $11,134

6. Earnings Per Share Guidance: Why it is completely meaningless, random and useless
The only thing that Apple's EPS guidance is good for at all is being able to infer the number of shares that will be outstanding in fiscal Q1 2012. What you have to understand is that Apple introduces new shares all of the time which leads to a quarterly increase in the number of shares used in the calculation of diluted EPS. Based on Apple's EPS guidance this quarter, we are able to infer with a very high level of accuracy the number of outstanding shares Apple will have in fiscal Q1 2012. That number happens to be 947,000,000 shares.

In order to arrive at our final line-item, all we have to do is divide net income by the number of diluted shares that will be outstanding in fiscal Q1 2012. In this case, that means dividing $11.134 billion in net income by 947 million shares. Doing so will give us $11.75 in earnings per share (EPS).

Currently, Apple guided that it will report $9.30 in EPS, Wall Street expects Apple to report $9.73 in EPS, and Bullish Cross expects Apple to report $11.75 in EPS. That EPS number would match the largest EPS blowout of Wall Street estimates in Apple's history.

The table below outlines the Bullish Cross Outlook for Apple's Fiscal Q1 2012. Notice that this table also displays a product breakdown which we arrived at only after doing an analysis that was on the order of 3-4 times greater that what we've outlined in this article. It's an entirely different type of analysis only based in part on this guidance analysis. Yet, the difference between Bullish Cross and Wall Street is that we're not guessing what Apple reported in sales. We know that the revenue number will be around $42 billion. It's just a matter of doing the requisite analysis necessary to know precisely how that revenue will be derived.

Zaky


As a side note, I think it is also very important to note that based on our earnings forecast, Apple's trailing 12-months of earnings will rise very dramatically to $33.00 in fiscal Q1 which is 19.18 percent higher than it is today. If you're an Apple investor, I hope you understand the gravity of what that means. What this means precisely is that in order for the stock to maintain its current very depressed valuation, the stock would have to rise 19.18 percent after earnings. Notice that is merely just to maintain the current crap-valuation it has been getting.

As of the close of trading on Thursday, Apple trades at a 14.11 P/E ratio. In order for the stock to maintain that 14.11 P/E ratio, the stock will have to rise $465.63. That's just to maintain a 14.11 P/E ratio. If the stock trades at $390 a share after earnings, the stock's P/E ratio will collapse to 11.82. Apple's P/E ratio can only contract so far before it gets to 0. This pace of minute 2-points every quarter on the P/E ratio is unsustainable. Something is going to give and soon. You don't want to be short like Steve Cortez when it does. He's going to get massively blindsided like Whitney Tilson on the Netflix short. The difference is that Whitney Tilson is actually a smart guy.

Now that we've demonstrated how one can build a net-income statement forecast using each element of Apple's guidance except for EPS, let's now discuss why EPS guidance is entirely random, meaningless and useless

As we demonstrated above, each item in Apple's guidance has a level of intentionality to it. Apple intentionally guides gross margin about 250 basis points below what it actually reports. It guides revenue between 12-18 percent below what it actually reports. Intentionally as we demonstrated above. It intentionally guides operating expenses +/- $50 million above or below its guidance. It guides OI&E just about $15 million below what it actually reports. It guides the tax rate in-line.

But notice that Apple's EPS guidance is a sum amalgamation of the different line-items in the overall guidance. Just as Apple doesn't give guidance for operating income, cost of goods sold, net income before taxes and net income, it really shouldn't give guidance for EPS. EPS is just a result. It's not an intentional number.

If you gave me each element in Apple's guidance including its shares outstanding, I can tell you exactly what it's EPS guidance is. And that's because Apple's guidance has to be internally consistent. Meaning, it can't give an EPS that doesn't compute mathematically with the other line items. In that sense, the EPS guidance is dependent on the other line items.

That is PRECISELY why Apple tends to beat its EPS guidance by an outrageously large range. If you look at Apple's EPS beats on its guidance, it's been anywhere from 20 percent to 60 percent. That's because Apple isn't intentionally giving you that guidance number. Unlike every other line item, there is no consistent pattern to Apple's EPS guidance. One quarter Apple beats EPS guidance by 54.9 percent and in the very next quarter it beats EPS guidance by 28.2 percent.

If Apple guided gross margin to 43 percent this quarter, Apple's EPS guidance would be much higher. If it guided gross margin guidance to 41 percent, Apple's EPS guidance would be much lower. As you saw in the analysis we outlined above, Apple's EPS guidance is highly dependent on how each of these different line-items in the income statement work together.

It's all about proportions. But rest assured, Apple could deliver a 28.2 percent beat on its EPS guidance in one quarter which results in a massive miss and it can do so in a different quarter which would result in a huge blowout. In fact, that's precisely what's going to happen in here.

In fiscal Q4, Apple beat its own EPS guidance by 28.2 percent. For fiscal Q1, Bullish Cross is expecting Apple to beat its EPS guidance by a lower 26.3 percent. Yet, we believe that in fiscal Q1 it will amount to one of the biggest if not the biggest earnings blowout in company history whereas in fiscal Q4 it resulted in a huge earnings miss.

That's because what matters here is not how much Apple beats its own EPS guidance but how much it beats Wall Street expectation. Now the reason I went through all of the trouble to point out that Apple's EPS guidance is meaningless is because too many people in the financial press have been recently spreading some very piss-poor research that is starting to mislead the public at large. Hopefully this report will help clear up this issue.

Andy M. Zaky is a fund manager at Bullish Cross Capital and the editor of the Bullish Cross Financial Newsletter. Bullish Cross Capital owns a significant long position in Apple, Inc.