MorningWord 7/23/14: Think Different This Time? – $AAPL

by Dan July 23, 2014 9:29 am • Commentary

Two years ago this week, Apple reported fiscal Q3 results that disappointed the street, missing on sales, earnings and saw an almost 5 point sequential gross margin decline from an all time high of 47.3%.  The stock sold off 4.3% the next day (see the 3rd to last column below, last row) That was despite the street’s enthusiasm about the upcoming iPhone 5 launch, which I bulls were suggesting would be the mother of all upgrade cycles.

AAPL Quarterly results from fiscal Q3 2012 to FQ3 2014 from Bloomberg
AAPL Quarterly results from fiscal Q3 2012 to FQ3 2014 from Bloomberg

Whats also interesting is that in the last 2 years, the stock has only risen two times on the day after earnings, on avg about 6.5%, vs the 6 times the stock has declined, with an average decline of about 4.7%.   Heading into last night’s report, the options market was implying about a 4.7% one day move today, or put another way, a $27 billion move in market cap in either direction.  With the stock basically flat in the pre-market, it suggests that expectations were not particularly high, and the slight miss in iPad units and inline-ish iPhone sales were offset by better cost controls helping gross margins to come in slightly better than expected.

Looking back though at fiscal Q3 2012, it is interesting to note that despite AAPL’s unexpected miss, the company offered fairly aggressive guidance, for a quarter that would mark the all time top.  Summarized by Bernstein’s Apple analyst Tony Sacconaghi Jr (emphasis mine) in 2012:

Apple’s Q4 guidance appears aggressive, which is atypical for the company (it has beaten its own revenue and EPS guidance by an average of 17% and 39% respectively over the last 10 quarters). We see two possible explanations – one is that Apple may be providing less conservative guidance than history, or the other is that the company is planning to introduce a new product this quarter, which we believe would most likely be the iPad Mini. That said, unless the new product is the iPhone 5, we still believe Q4 revenue guidance is not a slam dunk.

The company did introduce the iPad Mini the following quarter, and the company ended up missing on their gross margin guide, and margins have remained below 40% since:

AAPL gross margins by qtr from Bloomberg
AAPL gross margins by qtr from Bloomberg

Last night the company issued better-than-expected gross margins for the quarter just reported, flat sequentially, but guided them down sequentially.  This makes sense when you consider the expectations for two new large form factors to be introduced in the quarter, but one would expect a much lower guide if in fact Apple were about to introduce a new category like an iWatch?

Here is the thing, all seems fine in Cupertino. There is no doubt in anyone’s mind that there isn’t serious pent up demand for a larger iPhone, but I am not certain there is a ton of demand (at least in the developed world) for a 5.5 inch iPhone, and how much will it cannibalize the 7 inch iPad Mini? And for a company that has not introduced a new category since the iPad launch in April of 2010, what is the likelihood for a runaway hit that can actually move the needle in the wearable space? Does a iWatch introduction that seems more a hobby (think AppleTV or Google Glass) pose risk to the story for those who firmly believe the stock’s performance is largely related to the company’s ability to continue to create (or re-create depending on how you look at things) new innovative product categories?

I obviously have no magic eight ball for those questions.  What I do know is that once again, as the stock approaches the prior high (just above $100) it is important to note that the all-time high was put in on the very morning that the iPhone 5 went on sale.  The stock saw a fairly epic slide of nearly 45% over the next 9 months, losing $275 billion in market capitalization.

So it’s a matter of sentiment. As it was in 2012 prior to the high. While expectations are not for the 30, 40, 50% growth the company had been displaying, the law of large numbers can have the same sort of effect in a slower growth period as it can at the end of a hyper growth period.  The sell off in the stock from Sept 2012 to the summer of 2013 was likely an investor shift from growth to value, but as the company will struggle to achieve greater than 10% sales growth on a $185 billion base they will also need to continue to manage earnings through cost controls and buybacks to achieve double digit growth as competitors will likely exact whatever toll they can on Apple’s industry high margins.  To sum up, it’s never different this time.  The stock is cheap, they have an amazing balance sheet, great management, a fantastic suite of products and they are very likely to be the ones who get the wearables thing right.  But in the short run, as the investment community is convinced that the stock will make a new all time high (I agree), I am not certain we see a runaway breakout up 20% from here on the heels of new iPhones.  It is going to take something else, a very innovative product or a suite of services.

Lastly here is a rundown of the analysts headlines from seems that all share a theme:

Gene Munster, Piper Jaffray: All Clear To Fall New Products.

Katy Huberty, Morgan Stanley: Gross Margin Guide Dilutes Bear Case.

Tony Sacconaghi Jr, Bernstein: No Fireworks or Blowups; Still Waiting on the Product Cycle Gravy Train

Brian Marshall, ISI: Just Waiting for the “Mother Lode” of all Upgrade Cycles to Occur…

Walter Piecyk, BTIG: Apple’s R&D Hits Levels Not Seen Since The Year Before The iPhone’s Initial Launch.

Brian White, Cantor Fitzgerald: We Shrug and Look Forward to the Fall Launch

When everyone is looking one way, it may be time to start looking the other. I am not saying Apple is a screaming sale here, just seems that sentiment is getting a bit frothy and rallies from here may be good spots to lighten up on longs or start to think about some trades from the short side (defined risk).  As we said in our quarterly preview yesterday:

we don’t view a breakout or a breakdown as likely, and expect the stock to trade between $85 and $100 in the coming months.  Of course, implied volatility is not at an extreme, so no great structure stands out to us to capitalize on that view.  However, if AAPL approaches either end of that range, we would likely be more inclined to buy weakness than sell strength as history has shown trying to pick a top in Apple can be a fools errand.

I’ll stick with that for now.