Dissecting Apple's (AAPL) Consensus Estimates for FY19

As depicted in the graphs below,  Apple's revenue and EPS consensus estimates have come way down.  The first sharp drop occurred in the beginning of January when Apple warned it would not meet guidance and issued a revised revenue forecast that was $7B lower than its initial guidance. The stock bottomed around $142, and gradually rose through the rest of January to the mid $150's- even as consensus estimates were still falling. After Apple reported Q1 results at the end of January, estimates took another leg down, but Apple's stock price jumped to over $170. Apple's stock price has anticipated decreases to consensus estimates as analyst revisions have lagged stock price movements. Apple's stock began its decline when it reported Q4 results at the beginning of November. Apple issued weak guidance and announced it would no longer report unit sales. The stock took a steep dive, but estimates only decreased slightly. And while estimates have dropped significantly in recent weeks, Apple's stock has rallied. This suggests that the bad news has been priced in, and that the market expects revisions to stabilize or perhaps even rise.

The table below highlights what appears to be a disconnect between revenue and EPS estimates. Revenues are expected to fall mid-low single-digits, but EPS is forecasted to decrease much more, as much as double-digit declines for Q2 and Q3. If we assume that Apple repurchases 125M shares each quarter, then net income based on those share counts coupled with consensus EPS estimates points to even a much larger Y/Y decline in net income. Those net income levels imply 300-plus basis point drop in net margin. Does this make sense? 

As we saw in Q1, sales dropped 4.5%, but EPS rose 7.5% due to two factors. 1) EPS benefited from a lower share count. 2) Net income only fell 0.5% due to a lower tax rate boosting net margin by 100 basis points.  Thus, with Apple expected to buyback considerable amount of stock, one would expect EPS to perform better than revenue as seen in Q1. However, upon closer analysis the forecasted relationship between sales and EPS appear to be reasonable. 

There are 3 factors or headwinds that could offset the benefit of a lower share count. 1) Lower revenue causes a loss of operating leverage as fixed costs are spread over a smaller revenue base resulting in margin compression. Gross margins are pressured by depreciation expense that is independent of sales volume. Aside from depreciation, there are other fixed costs that affect gross margins. 2) Operating margins are affected by the levels of SG&A and R&D expense which are relatively fixed. R&D has been rising at a much faster pace than revenue for several years. With an expected smaller revenue base, these expenses will compress operating margins if they are at levels equal to or higher than last year's. 3) Higher tax rates will compress net margins thus negatively impacting net income. Apple is guiding to a tax rate of 17% for Q2 vs. 14.5% for the year-ago quarter. Apple's tax rates for Q3 and Q4 last year were 13.3% and 14%, respectively. If 17% is the norm for the remainder of FY19, then net margin will be negatively impacted.

Investors should keep an eye on the trends affecting these 3 factors- gross margins, operating expenses, and tax rates as they will be the primary drivers behind net margins which drives net income. Since EPS is net income divided by the share count, net income should be the primary focus since it can be safely assumed the share count will fall. We just don't have much visibility for what net income will do.