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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Tuesday, October 28, 2008

Apple's FY09 Gross Margin Expectations Too Low

Apple Inc (nasd: AAPL) - Apple’s FY09 gross margin should well-exceed management’s guidance of 30%. There are multiple factors that will support FY09 gross margins. 1) As iPhone’s revenue contribution to total company sales increases, overall gross margins will rise since the iPhone carries a very high GM. 2) There will be a more favorable component price environment created by plunging commodity and energy prices. 3) As production volume rises for the iPhone and MacBooks, scale effects and cost efficiencies will benefit drive down product costs. 4) Higher revenues supply leverage by spreading fixed costs across a higher revenue base.

Apple’s guidance is way too conservative; yet considering the economic landscape, management is exercising prudence. This cushion should help Apple exceed earnings expectations even if the economy adversely affects its business. With gross margin expectations so low, Apple’s revenue growth could turn out worse than expected and still match/beat EPS estimates. Alternatively, Apple could use the gross margin cushion for lowering prices to boost demand if warranted.

Market Reaction to Lowered Guidance:
On the Q3 2008 earnings call back in July, Apple guided Q4(Dec) gross margin down to 31.5% which concerned investors after reporting a healthy 34.8% for Q3 (June). Much more troubling was the 30% GM guidance for FY09, down significantly from FY07 average of 34.2% and 34.1% average for FY08’s first 3 quarters. Apple’s shares had an ugly reaction. The weak GM guidance was shocking surprise for Wall Street. Management didn’t provide a clear explanation for the reduced GM guidance. The general perception in the investment community was that Apple was planning to drastically lower its prices which was seen has having negative implications. The popular belief was that Apple must have started to see a dramatic slowdown in demand at higher price points. A few examples being mentioned- competition will intensify, other firms will introduce alternative products at much lower prices, consumers won’t be able to afford or willing to pay premium prices. Many dismissed the possibility that Apple could be providing overly conservative guidance. In addition, many were overlooking the possibility that Apple would only cut prices and accept a lower gross margin because there would be a positive impact on the bottom line.

Gross Margin Guidance Historical Overview:
Management developed the reputation for repeatedly low-balling its gross margin estimates. For the 5 quarters- 1Q07 to 1Q08, Apple exceeded its gross margin guidance by an average of 14.1%. Yet, that trend ended for 2Q08 & 3Q08, when Apple only beat GM guidance by 2.8% & 5.5%, respectively (4.1% avg). Therefore, when Apple provided that week guidance for Q4 on the July call, investors reacted very negatively since the guidance for Q2 & Q3 had been relatively accurate.

In 3Q08 (June) Apple reported its gross margin was 34.8%, which exceeded guidance by about 180 basis points. Management stated that several factors contributed to better than expected margins. First, the one-time true-up of contract manufacturer deferred margin added 70 bps. Second, the remaining 110 basis points resulted primarily from lower commodity prices, a more favorable product mix with respect to margins, and the leverage effect of higher-than-expected revenue.

For the reduced gross margin guidance for Q4, Apple gave three primary factors for the expected sequential GM decline. 1) The full quarter impact of the back-to-school promotion 2) A future product transition 3) The one-time true-up of contract manufacturer deferred margin realized in Q3 (June).



Q4 2008 Gross Margin Exceeds Expectations
:
Apple beat management’s GM estimates by a sizable margin (320 bps): 34.7% actual vs. 31.5% guidance. I was surprised because I had been expecting GM to come in at 32% with a possible upside of 50-100 bps. I expected the back-to-school promotion would have a larger impact on overall margin.

Apple offered students a full price rebate for 8GB iPod Touch ($299) purchased along with a Mac. The iPod sale is recorded, and then once it’s rebated, the sales price is applied as a reduction to sales for both iPod and Mac, in proportion of the iPod and Mac sale. This probably results in about 80% of the rebate being applied to Mac revenue and 20% to iPod revenue. This noticeably impacted Macbook ASP which fell $93 sequentially, from $1,440 in Q3 down to $1,347 for Q4. The decline year/year was $69.

The iPod ASP fell to $150, its lowest ever. However, the sequential decline was only $2 and $9 year/year. In September, Apple introduced new iPods carrying lower price tags. The 16GB & 32GB Touch dropped $100, and the 8GB model saw a $70 reduction. Even though the lowered prices only prevailed for roughly 3 weeks of the quarter, Apple shipped a good number of units into the channel before quarter-end to alleviate the wide-spread shortage Thus, the amount of units sold with the new pricing was larger than what one would expect given the short length of time.

4Q08 Gross Margin Analysis:
Management stated that improved component pricing was primarily responsible for GM exceeding guidance. I believe that component pricing will only get more favorable and should even have a more robust impact going forward. It’s likely that most products sold in Q4 contained inputs procured months back at higher prices, especially given Apple uses FIFO accounting method. In the coming quarters, components will have be acquired at significantly cheaper prices, and those price will likely continue to fall.

Apple said that higher carrier payments on legacy iPhones was a secondary factor contributing to higher-than-expected GM. This is perplexing. No 2.5G iPhone units were sold in the September quarter. Only 717K units were sold in the June quarter; the majority of sales likely occurred during the early half since supply was virtually gone by the end of May. In addition, a decent number of the June quarter sales were unlocked and exported. Therefore, the number of units generating carrier payments would have not materially increased in the September qtr versus the June qtr. Thus, if anything, payment revenue would be slightly better than flat. Yet, total revenue increased by $431M which would have diluted the impact on gross margin.

Actually, the population of first generation iPhones with revenue payments decreased in Q4. With no additional 2.5G units were sold during the period, the number fell since 2.5G units were replaced with 3G models. My understanding is that this would curtail the carrier payments on those units. I estimate over 3M units had attached carrier payments and by end of Q4, 500K to 1M legacy iPhones were replaced by 3G. Unless there is some huge one-time payout, or a similar agreement, payments from wireless providers should have decreased. Due to the massive subsidy being paid by AT&T on 3G models coupled with the fact that legacy iPhone customers could upgrade without penalty, It seems very unlikely that there would be any such payments that would materially affect GM. Another interpretation is that management expected higher fallout of original iPhones carrying shared revenue payments, thus the actual revenue decline was less than expected.

I believe robust sales of the new 3G model (that resulted in a near doubling of recognized Q4 iPhone revenue) had a meaningful impact.

Due to massive 3G iPhone unit sales, revenue recognized in Q4 almost doubled sequentially. iPhone revenue reported in Q2 & Q3 amounted to roughly 5% of total sales. Yet, Q4 iPhone revenue constituted over 10% of total sales. With iPhone margins around 50%, the impact is noticeable. Assuming GM for non-iPhone segments was 33.1% and iPhone GM was 49%, Q4 GM would have been 33.9%, or 80 bps lower is iPhone was 5% of total sales instead of 10%.

Gross Margin Outlook Q1 2009:
Gross margins might see a slight to moderate decline sequentially in the December quarter due to the reduced prices for iPods and the higher manufacturing cost associated with the new generation of MacBooks. Apple guided GM to 30%-31%; taking the midpoint of 30.5%, GM would decline 420 bps Q/Q. That’s a significant decrease which is tough to grasp because of the multiple factors that should benefit gross margin.

Positives-
1) There will not be the negative impact of the back-to-school promotion.
2) Commodity and energy prices continue to fall, and the drop-off in component demand is improving Apple’s product cost. I don’t foresee this trend reversing in the near-term.
3) Q1 iPhone revenue will increase (larger % of total sales) providing further GM support since iPhone margins are much higher than overall company GM.

Unknown-
1) How much higher production costs are for the MacBooks.
2) How conservative the guidance is.

Given the mix of favorable factors at play, product costs for new MacBooks would have to be very large to counteract the upward margin pressure AND drive GM down 420 bps. That doesn’t appear likely.



Financial Alchemist FY09 GM Outlook:
In addition to the items discussed above, the primary GM driver in FY09 will be the iPhone.

Using regular accounting, whereby all revenue/expense are recognized in period incurred, the 4Q08 GM was 39% compared to 34.7% reported using the subscription method. The non-GAAP figures Apple provided take out iPhone amortized revenue/product cost reported under GAAP, then adds total revenue/product expense for the units shipped during the quarter. This highlights the huge disconnect between accounting earnings and cash earnings. The subscription method, whereby revenues and product expense are amortized over 24 month period, causes the reported GAAP numbers to be highly misleading.

iPhone revenue would have increased by 3.79B, from 806M to 4.59B. This represents nearly 40% of total revenue. Granted, this includes AppleTV revenue, but its contribution is believed to be insignificant.

Also impressive is the leverage effect- operating margin is 27.9% vs 18.3% under GAAP. Apple expenses associated operating costs as incurred, and defers the product cost and revenue. This weighs on operating margin because only a portion of the revenue related to the expense is recognized. Theoretically, this benefits margins in the next period since the deferred revenue to be recognized will have had its associated SG&A fully expensed in the prior period. However, SG&A costs are necessary to operate the business, thus there will be new non-product expenses arising in every period. As deferred revenue builds, the amount recognized increases by quarter offsetting the related operating expenses. Selling and advertising costs associated with the iPhone should be the highest in the months following the launch. This creates a favorable situation where recognized revenue is rising coupled with falling non-product costs.

First: With subscription accounting, operating margins should improve as the amount of revenue recognized flowing from deferred revenue increases. Second: Overall gross margins will rise as the high-margin iPhone revenue becomes a greater percentage of total sales. Thus, going forward, the iPhone should lift margins.

I believe the low GM guidance for FY09 is overly conservative. The iPhone GM is likely higher than 50%. Q4 GM was 39% sales in the period fully recognized. We can see the upward trend. Thus, GM somewhere else has to sharply decline. The new MacBooks are likely to create some pressure, but how much? Hard to say until we get Q1 numbers. Even so, those costs should moderate with increasing production volume along with lower component prices.

Apple could also trade margin for volume if demand elasticity appears to be favorable. Hence, keep GM in low 30’s by using iPhone margin to subsidize price reductions on other products to drive volume. Apple consumers are not very price sensitive, therefore something Apple is not likely to do. Considering the economic backdrop, it’s not a bad alternative to have on the table.

Conclusion:
FY09 gross margins will come in way above management’s guidance of 30%. The iPhone, with it’s staggering margins, will become a larger contributer to overall revenue, thus it will drive GM higher. Management is being excessively conservative, and the ultra-low GM guidance provides a cushion in the event that Apple’s business considerably deteriorates. A more favorable commodity and component price environment will also lend support to margins. As management stated, costs from the iPod and MacBook transition should also decreases from volume manufacturing and cost engineering as the firm moves along the cost curve. AAPL shares are pricing in lower margins as analysts are looking for FY09 EPS to be flat versus FY08. Even in a tough economic environment, I foresee better results.


Disclosure: Long Apple

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