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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.

Saturday, January 10, 2009

Apple's FY09 EPS Estimate Too Low

Apple Inc (nasd: AAPL)- Apple’s FY09 EPS estimate continues to be revised downward and now stands at a $5.08, a level Apple should easily exceed. The consensus FY09 estimate represents a 5.2% decline from FY08 $5.36 EPS, although revenues are forecasted to increase 11.8%, or $3.8B to $36.3B. Thus, analysts are expecting significant margin compression. Specifically, the consensus estimates for EPS and revenue imply net margin will be 12.8% in FY09, a decline of 2.1% from 14.9% recorded in FY08.

It’s not that I don’t believe the recession will take a major toll on Apple, it will. Instead of achieving 35%-40% earnings growth likely to occur in a normal economy, Apple’s EPS should increase at least 5%-10% in FY09. Due to deferred revenue recognition and upward margin pressure, it’s very unlikely Apple’s earnings will decline, certainly not to the 20%-30% magnitude some analysts predict.

I believe there are two major factors being ignored with respect to FY09 estimates that suggest higher earnings. First, there are multiple factors in play that argue against margin deterioration. This includes lower product and overhead costs, and a more favorable sales mix towards high margin products. iPod revenue (as percentage of total sales) will be much lower in FY09 which is significant since iPod has the lowest margins. iPhone and software have the highest margins and will contribute a much larger portion of Apple’s total revenue.

Second, Apple will recognize a sizable amount of deferred revenue associated with high margin segments, such as iPhone and AppleCare. Also, Apple’s $25B cash position will produce a decent amount of income. Thus, without even having to make a single sale, Apple should still produce $2.67/share in incremental after-tax income.

Assuming 19M iPhone unit sales, incremental taxed EPS for iPhone segment would be $2.99/share. Combining deferred revenue, interest income, and iPhone sales; I estimate incremental EPS will be $4.04. Apple would only have to earn $1.04/share in its other segments to meet the FY09 consensus.

According to Yahoo Finance, the lowest estimate for FY09 is $3.70 (High- $6.00). I have been seeing many estimates being revised down to the mid-to-low $4 range. In my opinion, these estimates are ridiculously low. Canaccord Adams puts FY09 EPS @ $3.70 (31% decline) with an $80 price target and Morgan Stanley’s FY09 estimate is $4.37 (18.5% decline) with price target of $95.

I recently did a detailed analysis of Apple’s profit margin outlook and concluded that FY09 gross margin expectations are too low. I highlight some of my main points below.

-Favorable Cost Environment:
All of the factors listed below should lead to lower costs, hence higher margins. At the least, provide margin stability by eliminating upward pressure on costs. Considering most of FY08 was marked by a commodity bubble and $100-plus crude, FY09 should be a much more favorable cost environment.

1) Raw Material / Component Prices
2) Energy- Transportation / Overhead
3) Occupancy / Labor (stable)
4) Marketing
5) Scale Benefits & Shared Costs

-Margin Expansion From Increased iPhone Revenue:
The primary driver for higher margins for FY09 is iPhone revenue. The iPhone generates substantially higher margins than the Mac and iPod segments. Due to the subscription accounting whereby iPhone sales are recognized over 8 quarters, the margin effects were minor for FY08 since only $1.84 Billion of iPhone revenue was recognized. This equates to roughly 5.7% of Apple’s total FY08 revenue.

Most analysts and myself included, expect iPhone revenue to come in above $7B for FY09. Not only will the iPhone supply more than 20% of Apple’s total sales (FY09), the subsidy payment agreement of the new 3G model translates into even higher margins compared to the legacy iPhone. I calculated that the gross margin of the new 3G model was 55% in 4Q08.

If Apple recognized iPhone revenue in the period sold, instead of deferring, 4Q08 gross margin would have been 39% compared to GAAP 34.7%, net margin would have been 20.9% vs. 14.4%, and EPS $2.69 vs. $1.26. As deferred revenue continues to pile up on the balance sheet, the portion recognized in current quarterly revenue will continue to increase each quarter.

-Other Margin Drivers:
There are several other factors that could aid profitability this year. First, software revenue, which has huge margins, will be much higher in FY09. Apple is releasing new iWork and iLife editions, and it’s expected to release Mac OSX 10.6 “Snow Leopard” this year. MobileMe also carries high margins, yet even though revenue won’t be much, the yr/yr incremental will be sizable. Second, Apple will incur and recognize more of its high margin AppleCare revenue.

Looking at operational expenses, such as SG&A and R&D, these items should fall on a percentage basis (of total sales) due to leverage effects if sales continue to increase as expected. Looking at the table one can see the trend in declining operating expense and rising profit margins.

The other side of the margin equation is selling price. Margin compression can still occur even while costs are decreasing if selling prices drop more. Apple’s brand is unique and it products command premium prices. Apple’s products are highly differentiated which eliminates price competition. I don’t expect Apple to make drastic price reductions. I recently explained why Macs sell at premium ASPs.

The Street is expecting sales to increase 11.8%, or $3.8B to $36.3B (FY09) vs. $32.5B (FY08). By default, Apple’s sales will increase $3.5B from recognizing 4.85B in current deferred revenue. Apple will also take in around $400 million from iPhone carrier payments and $650 million in investment income. Thus, even with out making a single sale in FY09, Apple will still post nearly $6B in revenue.

Total FY09 iPhone revenue will likely increase by at least $5B, implying Apple’s other revenue is expected to decline if consensus sales growth is $4B. Most analysts expect iPod revenue to drop significantly, coupled with either a slight increase/decrease in Mac sales. I see iPod unit sales declining 25%-30%, but iPod revenue only dropping 15%-20% due to the shift towards the higher ASP touch model.

According to my estimates, Apple will report iPhone FY09 sales of $7.0B, $3.1B originating from new sales, and 3.9B from recognition of deferred revenue and carrier payments. This assumes Apple sells 19M units. With 56% gross margins, iPhone will contribute $2.99 in EPS. Hence, all other segments only need to earn $2.09/shr to meet the Street’s estimate.

I estimate only 60 cents of $5.36 FY08 EPS is associated with iPhone, which leaves $4.76 from all other segments. This means FY09 non-iPhone EPS could decline 55% or $2.67 to $2.09 and match the $5.08 consensus if iPhone can pull in $2.99/share.

With new MacBooks released in Q1, and new desktops expected in Q2/Q3, FY09 Mac sales should continue to grow despite the weak economy. MacBook hasn’t seen a redesign since being released in 2006. This has provided little reason to replace/upgrade. Looking at unit sales growth, it is evident that the product line had become very tired and in need of a refresh as growth began to lag desktops. There are probably 5M MacBooks that may be replaced in the coming year.

Mac revenue has grown roughly 40% for the past two years, and under favorable economic conditions, I would expect growth to continue if not exceed that pace. Given the harsh economic conditions, I expect single-digit unit growth for FY09.

Unit sales will probably see a sharp decline in FY09 due to the economic landscape and product saturation. The iPod touch model will be popular causing unit sales to exceed forecasts. In addition, the touch will boost ASPs, which will soften the decline in dollar sales.

-Music & Software/Services:
Music segment revenue increased 34% to $3.34B in FY08. Music sales will continue to demonstrate strong growth due to the direct placement of the iTunes music store on the iPhone and iPod touch allowing purchases/downloads in seconds over cellular and Wi-Fi network connections. The iTunes App store could add up to one billion in additional sales this year.

Software sales could get a billion dollar boost from iWork ’09, iLife ’09, Snow Leopard, and MobileMe plus other titles. Typically software delivers high profit margins, thus these software introductions should offer margin support.

When considering the amount of high margin deferred revenue and interest income Apple will recognize this year coupled with multiple drivers lending margin support, it’s unlikely Apple’s earnings will fall in FY09. Apple won’t earn $7 to $8 in EPS possible in a favorable economic climate, but EPS won’t decline as analysts predict.

Apple already has $2.67 in incremental EPS in the bag. Including my estimates for new iPhone sales, the incremental EPS effect is $4.04. Considering SG&A and R&D expense, I estimate that EPS from deferred revenue recognition, interest income, and iPhone sales will be $3.43. Adding Mac, iPod, and all other segments, EPS will easily top the $5.08 concensus.

Disclosure: Long AAPL

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