One of the most interesting earnings release was issued by Apple last night – while the company reported blowout results in its Q3/F08, but the fact that its guidance for Q4/F08 is well below analyst expectations was a principal reason for the stock dropping 10% in the after market. Post the company’s conference call, I can’t recall a situation where such a big mystery remains afterwards – to be specific, Apple’s CFO Peter Oppenheimer (with no Jobs to be seen anywhere) referred to an upcoming product introduction that will materially decrease margins over the coming quarters. This was certainly unexpected, and the big question is what should be done about the stock in light of this news.
To recap, Apple’s results in Q3/F08 were excellent. Apple beat by 11 cents with an EPS of $1.17, while revenue of $7.46B was up 38% YoY, ahead of consensus of $7.37B. Cash generation was particularly impressive, and year-to-date, the company was $5.4B on $3.7B of net income – and this gap will increase as iPhone ramps because of the subscription accounting used for the product (product costs and revenues are spread out over the length of a consumer’s subscription while the cash is received up-front).
iPhone shipments in the quarter were 717k, ahead of 270k last year, which doesn’t include any 3G iPhones. Apple has seen “staggering” demand for the 3G iPhone, with the product selling now in 22 countries and expected to launch in 20 more in August.
On the PC side, Apple sold 2.5M Macs, up 41% YoY, with desktops up 49% YoY due to iMac demand and notebooks up 37% driven by MacBook sales including Air. iPod sales were solid as well, up 12% to 11M.
A positive for Apple should have been their view that “it’s hard to see any obvious impact of the economy” – a factor that other companies have started to use to explain their lack of performance in recent quarters.
The gross margin in the quarter of 34.8% was positive, with a one-time 70 bp boost due to a manufacturing margin adjustment and a 110 bp boost due to a good commodity environment, especially with falling DRAM and NAND flash prices.
The guidance going forward was a huge disappointment to the street, with Apple guiding to $7.8B (up 25% YoY) and EPS of $1.00, below expectations of $1.24 and $8.32B in sales. The key factors behind this shortfall are:
- On the topline, a mysterious new product introduction will hit the gross margin line but may also serve to cannibalize or diminish sales in other areas.
- Gross margin will be down to 31.5%, as Apple will see a full quarter of back-to-school promotions (a free iPod with a Mac sale) as well as the expectation that certain commodity prices may be higher, particularly DRAM as demand tightens up.
- On the profit side, I would expect the near-term operating margin to come down as iPhone sales really ramp up – recall that with subscription accounting, the opex costs for engineering and SG&A are incurred up front (along with the cash), leading to near-term margin compression.
Personally, this new product introduction is the biggest wildcard in all of this, and Apple is keeping pretty tight-lipped about it. As noted by CFO Oppenheimer, “We have some investments in front of us that I can’t discuss with you today, where we are going to be delivering state of the art new products that our competitors just aren’t going to be able to match and as a result, I would see gross margins being about 30%, and that’s all I can tell you at this point.” From the margin guidance and the relatively light revenue expectation, we can surmise that the product is likely a low-cost product in a segment familiar to Apple, and that it may be cannibalizing to some degree. Moreover, Moreover, based on Oppenheimer’s discussion during the conference call, Apple may be looking for huge volumes of these products to be sold in 2009. What could this new product be?
An obvious guess is a mini notebook product – a tweener of sorts. With netbooks selling very well and Apple now no longer wishing to be relegated to the “niche product” manufacturer that it once was, an entry here would make sense, though Apple does understand that it will hurt its PC sales significantly. To maintain differentiation, Apple might roll a long rumoured product like a tablet PC – a larger version of the iPhone in a sense. If this product were also able to run BOTH Mac and iPhone applications, this could be a killer product in my view.
Could a new iPhone be in the making? While Apple has reportedly been demoing a keyboard-enabled iphone to U.S. carriers, I would expect that margins on this product would still be very good, so at least this quarter, this is not the new product introduction that Apple is talking about. I think it would be reasonable to expect more iPhone versions over the coming 12 months because the smartphone market is heating up and Apple has demonstrated that it s a master at market segmentation.And with Apple noting that one-third of Fortune 500 companies are in its beta program, this is as good a time as any to strike at RIM in the enterprise, though a keyboard may be the sticking point for many at present.
Bottom line, with Apple doing very very well in all of its product segments, a sudden reversal of fortunes seems unlikely. This may be just a case of Apple guiding conservatively to allow it rein in overly ambitious analyst expectations, and with near-term operating margin compression the case as the 3G iPhone exceeds expectations, the mid-term picture for Apple looks bright.
