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April 24, 2008

Apple Earnings Set The Stage For More Share Price Upside

Apple reported excellent 2Q08 results with revenues and EPS exceeding estimates. Guidance is good by Apple standards with revenues above street estimates and EPS just 10 cents below the street. Analysts and investors will pick apart the numbers and conference call commentary but the bottom line is that this quarter, the conference call, and the guidance provide little to no ammunition for the bears. While there is similarly little for the bulls, especially in the short run, the fact that the bears can take away little makes this a win for the bulls – of which I count myself one.

This commentary and what follows is very consistent with my first impressions which I posted as soon as the numbers were released but before the call started. The bottom line, for the short-term, is what I noted in my first comment, "this stock is not going back to $120 but it isn’t going to see $200 either." Here's all the details in four times the number of words Apple used in their press release....

....Revenues of $7.5 billion easily beat street estimates of $7 billion. EPS of $1.16 beat street estimates of $1.07. The quarter lacked the huge upside to estimates because of less upside in gross margins than analysts estimated. EPS were helped by a lower than expected tax rate which boosted EPS by 4 cents. The tax rate will stay below prior levels so this may not be a one-time item. The lower tax rate resulted from more non-US profits and lower than expected interest income due to the very low short-term interest rates (this was below management guidance by about $40 million and should really be considered if someone complains about the 4 cent tax rate boost). It is also possible that a decision to forgo revenue recognition on iPhones sold after March 6th, the day of the iPhone 2.0 software announcement, until iPhone 2.0 software starts to ship in late June cost a very small amount on the EPS line.

Mac sales were stellar led by a 61% increase in notebook units. Desktops were no slouch, growing by 30%. Education sales were the best in eight years. Management seemed very confident in current momentum and the Air appears to be developing as more than just a niche product.

iPod sales rose 1% to 10.6 million units, ahead of expectations. ASPs were up but not as much I expected. Shuffles sales were down again but rose after the price cut probably impacting the mix and the ASPs. iPod revenue grew 8%. Some investors will still worry about slowing growth in iPods but touch still has upside and I continue to believe that old iPod numbers should be compared to iPod plus iPhone numbers today.

iPhones came in at 1.7 million which is the low end of expectations. Nevertheless, management very firmly reiterated 10 million in 2008 as guidance. The revenue recognition change mentioned above was the source of a lot question on the call but I didn’t get the impression that management felt it was material although I'll admit I didn’t understand the accounting implications completely. For what it's worth, the shares came off their after hours lows when management stated that they beat their internal unit target on iPhone sin the quarter which was the cause of the stock outs and missing iPhones late in the quarter. This suggests that we should have more confidence in the 10 million guidance.

The biggest source of questions on the call surrounded the gross margin which came in at 32.9% in the quarter versus guidance of 32% and analysts estimates of 34-36%. The reason that EPS were not the usual blowout vs. estimates was due to this "shortfall" in gross margin. Management said that relative to its guidance higher than expected revenues, the weak dollar, and lower than expected commodity costs led to the upside. Via Q&A it also became apparent that analysts may have underestimated the positive impact of Leopard on the prior quarter's gross margin. One analyst perceptively asked if the decline in commodity costs in the quarter evident in published pricing by suppliers may not have fully flowed through due to prior commitments made by Apple to buy inventory. The analyst did not get a clear answer which leaves open the possibility that gross margins may surprise to the upside in the current quarter. I am modeling flat gross margins on a sequential basis. It is worth noting that ever since gross margins exploded upward a year ago management has consistently guided analysts not to assume it was all permanent. Maybe this quarter proves the point. Maybe not.

I've adjusted my spreadsheet for the June quarter. I am now targeting revenues of $7.3 billion and EPS of $1.09, roughly in line with current analyst estimates but above guidance. The big swing factor is going to be gross margins. 100 basis points is worth 6 cents per share. Furthermore, gross margins reached an all-time record of 36.9% in the June quarter a year ago setting up a very difficult comparison that will limit the year over year growth in EPS. Nothing to worry about but worth noting as that is something bears will seize upon. I've got Mac units at 2.3 million up slightly sequentially. Sequential history would suggest a larger uptick. My estimate assumes unit growth at the low end of the recent range thus implying a deceleration that is not supported by current trends or buzz. I am assuming a 3% year over year decline in iPod units but a 5% revenue gain thanks to improved ASPs. I have iPhone units at 2.2 million assuming that the 3G phone ships late this quarter.

As noted, I think the bulls won this quarter because the bears lost but I don't see quick upward move in the stock. What I do see is upside as new products are announced/anticipated because the bear case is not very strong thanks to 2Q08 fundamentals and the relatively solid guidance. In the brief, Jobs says there are "some terrific new products in coming quarters." I think the stock works higher in May and June on investor enthusiasm for those products, especially the 3G iPhone.

Posted by Steve Birenberg at April 24, 2008 03:38 PM in AAPL