Apple Is Likely To Beat Earnings

| July 16, 2017 | 0 Comments

Thesis Apple (AAPL ) is likely to beat earnings when it reports on August the first. While many are considered about China declining, it is actually China’s slowing decline that will help the company produce an earnings beat. China to drag on earnings Investors are also concerned about revenue declines in Greater China, but Tim Cook sees reason for improvement: “On the flip side, currency devalued by 5%, and so that’s not an insignificant headwind. And our performance continued to be weak in Hong Kong, which has been hit a bit harder as the tourism market continues to slump. Also, where the iPhone 7 Plus did well, we didn’t perform as well on some of the previous generation iPhones. And so that’s the set of things on the plus and minus side.” And.. “We did perform about where I thought we would. At least I thought it would be similar to the previous quarter, and it was. What I now believe is that we’ll improve a bit more during this current quarter, not back to growth, but improve – but make more progress.” We know that China declined about 14% year over year. What exactly “improve a bit” means is hard to estimate. But I’m guessing this puts the decline in China at about 12%, or perhaps 4% if we want to be really optimistic. I’d caution against interpreting “improve a bit” as anything above low single range of 1% – 4%. Pause in purchases Beyond declines in China, we’ll also have to factor in the effects of seasonality on iPhone sales. In the last quarter, Apple reported a bigger than expected seasonal decline. Typically, 2Q seasonality results in a decline of about 25%. Unfortunately for investors, the 2Q sequential decline came in at 35%. This appears to be a trend. Below is a chart of the historical decline rates of the second quarter.

Source: Author’s Excel spreadsheet One explanation is the pause in purchases. One of the analysts on the conference call cited a survey that observed two interesting developments: 1) Consumers are waiting for the longest period of time to purchase an iPhone in nine years. 2) More people in the US are switching over as measured by Apple’s retention rate declining of about 80%. When the analyst asked Tim Cook about it, he pretty much conceded these points. However, he does provide an interesting rationale: “I only glanced at it, and so I haven’t had time to study it. But in general, what we are seeing, we’re seeing what we believe to be a pause in purchases on iPhone, which we believe are due to the earlier and much more frequent reports about future iPhones. And so that part is clearly going on, and it could be what’s behind the data. I don’t know, but we are seeing that in full transparency.” I don’t know if this rationale holds up to scrutiny. In my opinion, this seems like a very fragile argument, at least on the surface. However, it would be an extremely time consuming and tedious endeavor to try and measure the amount of rumors that Apple normally experiences. Is the third quarter seasonality trending down as well? Luckily, for the purpose of estimating earnings, the rationale is not as important. No matter the rationale, the findings are the findings, whether this is due to diminished brand loyalty or heightened rumors. The point here is that I will be forecasting a higher than seasonal decline in 3Q17. First, I should figure out what a good base rate is. I will use a three year average for these purposes.

2014 As we can see from this slide, iPhone sales declined 19%. This is also the lowest decline rate in three years as we can see from the following two slides.

2015 The sequential decline accelerated by about 16% to 22% as compared with 2014.

2016 In 2016, the decline rate slowed by roughly 5% to 21%. This means that the average decline rate for the third quarter in the last three years was 20.66% or 21% rounded up. There is no clear acceleration, or trend, to be found here. Also important is looking at the sequential behavior of the revenues. For the third quarter, the average sequential revenue decline is about 16%. Not surprisingly, the decline in 2016 was also 16%. However, this came on the back of a close to 25% sequential decline in Asia. We know that China’s decline is actually set to slow. Incorporating my findings So, we know a couple of things now. 1) China is declining, but at a lesser rate than previously experienced declines. 2) Survey shows a declining retention rate. 3) Customer patience has increased to its highest level in nine years. 4) Average iPhone seasonality is 21%. 5) Average revenue seasonality is 16%. We also know Apple’s guidance , which is as follows: “Our outlook, which includes the types of forward-looking information that Nancy referred to at the beginning of the call. We expect revenue to be between $43.5 billion and $45.5 billion. We expect gross margin to be between 37.5% and 38.5%. We expect OpEx to be between $6.6 billion and $6.7 billion. We expect OI&E to be about $450 million, and we expect the tax rate to be about 25.5%.”
Note: For those who are wondering how the Qualcomm (NASDAQ:QCOM ) dispute fits in here, it doesn’t. Apple accrues the payments it is withholding which means that there is no effect on or boost to the P&L statement. Given that we have an outlook and our own estimates on how unit sales will behave, we can now produce an estimate. After decreasing the sequential decline of China and incorporating lower iPhone retentions and applying my sequential decline rate, I get a revenue of $45 billion. Final estimate That puts my estimate decidedly on the high end of Apple’s guidance. Analysts are also predicting Apple to come in at the high end range with consensus estimates being $44.92 billion. To get to the EPS, we apply this guidance to the high end of the ranges – meaning that gross margin of 37.5%, and opex of $6.7B. This produces an EPS of $1.39, which is above Wall Street’s $1.38 estimate. What is interesting to note is that if you take Wall Street’s estimate and apply the high end of the range, EPS comes in at $1.38. In other words, Wall Street has also applied the high end of the ranges wherever they have a negative impact. I did this to make a point: that Apple will quite probably beat on EPS. But there is one estimate that I do not agree with: that of the gross margin. I don’t think it too unreasonable to increase that by 200 basis points, which puts my EPS estimate at $1.40. We can add to that whatever buyback number we feel is appropriate, but that would be irrelevant at this point. Apple will beat on revenue and on EPS on the back of slowing declines in China. Final words on some buyback fantasizing For perspective, here are some numbers: $210B in buybacks authorized to be spend by the end of March 2019. So that’s 7 quarters, or $30B per quarter, if we assume buybacks are spread evenly. This would reduce the share count by 193 million and would boost the EPS to $1.45 per share if we assume an average buyback price of $155 per share. An average share price of $155 is unrealistic since this is more or less the company’s all-time high. In other words, if Apple did indeed spend $30B on share buybacks this quarter, it will have reduced the share count by more than my estimated 193 million.
However, there is considerable discretion involved in share buybacks and this makes it quite pointless to fantasize about a $30B spend at an all-time high or near it. I am pretty confident that the company did not spend anywhere close to $30B.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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