Apple: More Earnings Risk

We wrote we were below the Street ahead of Apple’s (AAPL) recent pre-announcement which hit the stock. Using the same method, we’re still below the Street for earnings.

Margins Are The Issue

We’ll get into revenues in a little bit, but margins are the new issue. The company said that business improved in January when they dropped prices in China.

China and emerging markets had been weak for Apple because as local currencies dropped, Apple reacted by raising prices. That reduced demand. But it cushioned the blow to some extent when translating back those foreign revenues.

If they didn’t raise prices, their foreign revenues would have dropped further in translation.

In January, Apple decided to drop prices in China to offset the unit weakness.

But look at their margin guide as a repercussion.

They guided to 37-38% gross margins for next quarter.

Dec.
Mar.
June
Sept.
Dec.
Mar.

Q1
Q2
Q3
Q4
Q1
Q2E
Fiscal
2018
2018
2018
2018
2019
2019
Calendar
2017
2018
2018
2018
2018
2019
Gross Margins
33912.0
23422.0
20421.0
24084.0
32031.0
21375.0
Gross Margins
38.4%
38.3%
38.3%
38.3%
38.0%
37.5%
bp chg
-0.11%
-0.64%
-0.17%
0.38%
-0.42%
-0.81%
2yr%
-1.69%
-1.09%
0.31%
0.26%
-0.52%
-1.45%

Source: Elazar Advisors, LLC model with data sourced from Apple earnings reports

Look at the one- and two-year drop off in year-over-year gross margins.

The December quarter was down 50bp (basis points) on a two-year and their guide implies -1.45% on a two-year. (The « two year » adds up this year’s quarter with last year’s same quarter giving you an underlying trend.)

So, while business may have picked up in January, it’s at the expense of margins.

Now, for modeling purposes, this trend is getting worse, right?

The two-year went from +.31% to +.26% to -.52% to -1.45%.

They already guided for the March quarter. Which way should the June and September quarters go? If anything, the two-year trend just got worse, so we should model it to continue to worsen.

Here are our numbers.

Dec.
Mar.
June
Sept.
Dec.
Mar.
June
Sept.

Q1
Q2
Q3
Q4
Q1
Q2E
Q3E
Q4E
Fiscal
2018
2018
2018
2018
2019
2019
2019
2019
Calendar
2017
2018
2018
2018
2018
2019
2019
2019
Gross Margins
33912.0
23422.0
20421.0
24084.0
32031.0
21375.0
17929.2
20292.3
Gross Margins
38.4%
38.3%
38.3%
38.3%
38.0%
37.5%
37.1%
36.5%
bp chg
-0.11%
-0.64%
-0.17%
0.38%
-0.42%
-0.81%
-1.23%
-1.78%
2yr%
-1.69%
-1.09%
0.31%
0.26%
-0.52%
-1.45%
-1.40%
-1.40%

Source: Elazar Advisors, LLC model with data sourced from Apple earnings reports

Above is our future quarters. We may actually be a little aggressive by not slowing the trend further. Still, our earnings end up below the Street as we’ll show further on. I don’t think the Street is focused on the « out quarters » which adds further risk to Apple shares.

Revenues: Street Too High

Dec
Mar
Jun
Sept
Dec
Mar
Jun

Q1
Q2
Q3
Q4
Q1
Q2E
Q3E
Fiscal
2018
2018
2018
2018
2019
2019
2019
Calendar
2017
2018
2018
2018
2018
2019
2019
Co Revs
88293
61137
53265
62900
84310
57000
48310
Growth
12.7%
15.6%
17.3%
19.6%
-4.5%
-6.8%
-9.3%
2 Year Gr
16.0%
20.2%
24.5%
31.9%
8.2%
8.9%
8.0%

Source: Elazar Advisors, LLC model with data sourced from Apple earnings reports

Look at the two-year revenue trend drop off a cliff in December from 31.9% to 8.2%. That tells you the trend is down and the March and June quarters can have even slower two-year revenue growth trends.

But Apple did not guide for that. They guided to $55-59B for the March quarter. That assumes the two-year growth trend will not slow further. But it probably should, right? That tells me the guide is not conservative.

If you notice, Apple gave a $4B range for the quarter which is historically huge for Apple in a « small » quarter. I think that shows the risk surrounding the quarter. The wider the range, the more the company’s telling you ‘we’re not sure.’ Add to that the non-conservative slight acceleration and you see some risk building.

If trends are falling off a cliff, I would think that the guide should have been lower ‘just in case.’ It’s not.

Let’s Add It Up

Why do they have higher revenues on a two-year basis? Because of the dropping of price in China to make up for lost unit sales. We saw above the gross margin hit they were accepting with this move.

You also see our estimates only assume a straight-line of the same trend they guided to in the March quarter for both revenues and margins. But, as we mentioned, you can just have easily assumed a continued slowdown after December fell off a cliff. Our numbers are not conservative.

Here’s our EPS versus the Street (Paywall: See full model) for coming quarters. Our numbers assume straight-lining their underlying (two-year) trends they gave for a guide in the March quarter.

Mar.
June
Sept.
Dec.

Q2E
Q3E
Q4E
Q1E
Street EPS
2.38
2.10
2.69
4.50
Our Upside
-0.05
-0.39
-0.52
0.44

Source: Elazar Advisors, LLC model versus Street estimates.

So, the Street has not brought down their future quarters enough, so it seems. Implied in Street numbers is a re-acceleration of revenues and margins. That adds risk once again to the Apple story.

You Want Proof Apple’s Concerned About Forward Quarters?

Sept.
Dec.
Mar.
June
Sept.
Dec.

Q4
Q1
Q2
Q3
Q4
Q1
Fiscal
2017
2018
2018
2018
2018
2019
Calendar
2017
2017
2018
2018
2018
2018
R&D
2997.0
3407.0
3378.0
3701.0
3750.0
3902.0
Growth
16.61%
18.67%
21.69%
26.01%
25.13%
14.53%

Source: Elazar Advisors, LLC model with data sourced from Apple earnings reports

Above, you have R&D (Research and Development). You see when they were doing well, they were accelerating the pace of R&D spend. But look at what happened in the December quarter.

They pulled R&D spending. R&D growth went from 25.13% in the September quarter to 14.53% in the December quarter.

They happened to beat Street estimates in the December quarter by a penny. But how’d they get there? They cut R&D big-time to get there.

I would guess they are going to continue to cut R&D.

But R&D is for the future health of the company. It shouldn’t be tampered with, generally. Nonetheless, I think Apple is concerned and showing you that by reducing R&D to meet forecasts.

What To Watch

China

Source

You see above what’s going on in China. This is a big swing factor. Growth rates of the consumer in China are slowing.

As long as this happens, Apple has a headwind. China also has spillover effects to other emerging margins.

Between emerging markets and China, we think that makes up about half of the company’s revenues. It very much matters.

The Dollar

Source

As long as the dollar (above) keeps moving up, it adds an extra headwind to Apple’s reported numbers. As the dollar goes up, they have to decide to either raise prices, hold revenues, and lose share or drop prices, hold share, and hit margins.

You saw the negative impact on margins above.

Conclusion

There’s no arguing that Apple is a great company. But everything’s relative, and for now, it looks like there’s continued earnings risk versus what the Street has out there. Earnings drive stock prices. Caution warranted.

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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.

Additional disclosure: Additional disclosure: All investments have many risks and can lose principal in the short and long term. The information provided is for information purposes only and can be wrong. By reading this you agree, understand and accept that you take upon yourself all responsibility for all of your investment decisions and to do your own work and hold Elazar Advisors, LLC, and their related parties harmless. Elazar and its employees do not take individual stock positions to avoid front running and other potential customer related issues.

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