Apple Set to Significantly Beat Analysts Q2 2008 Earnings Estimates

Many of the financial analysts covering Apple, Inc. (Nasdaq: AAPL) have become so increasingly bearish on both the technology sector and the economy as a whole that they have lost complete touch with any degree of financial reality. Analysts such as Kathryn Huberty of Morgan Stanley actually believe that Apple will only sell 1 million iPhones and 8.5 million iPods this quarter - way below consensus estimates and the current iPhone run rates.

Other bearish analysts include BMO Capital analysts Keith Bachman who recently cut his price target on shares of Apple from $160 to $140 citing relative weakness in revenue upside for the year, Bernstein Research analyst Toni Sacconaghi who has been quite vocal of his belief that Apple will miss its 10 million calendar 2008 iPhone target by as much as 2.1 million units despite reassurance by Apple's own Steve Jobs (CEO), Tim Cook (COO) and Peter Oppenhiemer (CFO), and finally, Friedman Billings Ramsey chip analyst Craig Berger who believes Apple has significantly reduced its build orders for its Macintosh computers by 50% for the quarter despite evidence suggesting that Mac sales are up 60% in the month of February alone.

Each of these deluded analysts have led to significant pullbacks in shares of Apple over the past few months, and in this article, I set to demonstrate just how wrong these overpaid analysts can be. While I do not work at Morgan Stanley, BMO Capital or Bank of America as a high flying analysts, I am going to publicly parade just how much better I am at this job than they are.

According to analysts polled by Thomson Financial, the street is forecasting an earnings per share gain of $1.06 on $6.95 billion in revenue for the quarter (Fiscal Q2 2008). The highest estimate on the street is calling for $1.18 in EPS on $7.20 billion in revenue while the lowest estimate is for $0.94 in EPS on $6.65 billion in revenue. Furthermore, the street is generally looking for Mac sales to fall from 2.3 million units in Q1 to 1.9 million units in Q2 as a reflection of both a slowdown in consumer spending and normal seasonality. Finally, the street is generally looking for sales of 1.5 million iPhones and 9.7-10.5 million iPods for the quarter.

Apple, Inc. Q2 2008 Earnings Estimates

Despite the general bearish outlook exhibited on Wall Street, I am looking for Apple to significantly beat both its quarterly guidance and analyst expectations. I am forecasting earnings of $1.33 in EPS on $7.587 billion in revenue. I am looking for Apple to sell 2.350 million macs, 11.3 million iPods and 1.7 million iPhones. I am expecting gross margins to rise to 36%, operating expenses to be $1.160 billion, OI&E to be $200 million, COGS to be $4.856 billion and I am looking for $1.204 billion in net income after provisions for income taxes of $567 million (32%).

In terms of Apple's operating segment information, I expect Apple to produce $3.643 billion in revenue from Mac sales (2.350 million macs at $1,550 ASP), $1.9436 billion in iPod sales (11.3 million iPods at $172 ASP), and a total of $2 billion derived from its other operating segments (this includes revenue Apple recognizes through its other music related products and services, iPhone and related products & services, peripherals & other hardware, and software, service and other sales).

Pro Forma Financial Statement (in Millions except per share data)

Revenue............................................................................................$7,587

Cost of Goods Sold...............................................................................$4,856

Gross Margin......................................................................................$2,731 (36%)

OpEx.................................................................................................$1,160

Operating Income................................................................................$1,571

OI&E...................................................................................................$200

Net, Before Taxes................................................................................$1,771

Taxes.................................................................................................$567 (32%)

Net Income.........................................................................................$1,204

EPS.....................................................................................................$1.33

Segment Information & Product Summary

Macintosh Sales: $3.643 billion

iPods: $1.9436 billion

Other Music Related Products & Services: $600 million

iPhone: $400 million

Peripherals: $420 million

Software: $580 million

Total Revenue: $7.587 billion

Supporting Arguments

The basis of my forecast is rooted both in comparison trends between how Apple has guided in the past as compared to what it has actually earned over the past several quarters as well as the currently available data regarding each of Apple's operating segments. The analysis on the historical guidance trend, set out below, should be viewed as merely supportive of the operating segment conclusions and not as leading to the conclusions, laid out in this article, in and of itself. In other words, the guidance data trends merely provides further evidence in support of the conclusion that Apple will report sales of 2.35 million macs and 11.3 million iPods rather than being conclusory of those results.

The historical data suggests that Apple is ultra-conservative in its guidance on some of the line items of its income statement and actually a little overly aggressive on others. I will first walk us through the various trends in Apple's guidance compared to its earnings on each line item, and will then discuss how the available data tends to support my earnings forecast.

Revenue

On average, over the past five quarters, Apple tends to beat its own revenue estimates by 8.50%. Considering the fact that Apple is known to be a very conservative company when it comes to offering guidance, it is likely the case that it will guide even more conservatively this quarter due to the fact that it has probably built into its guidance, the possibility of a slowdown in consumer spending. As economists continue to forecast recession for the first half of 2008, Apple's management has likely conservatively calculated this possibility into its guidance even though it might believe that a slowdown in consumer spending will have a marginal impact on its earnings. Based on the trends below, and the supporting arguments for the segment data, Apple should probably see close to $7.5-$7.6 billion in revenue for the quarter. The figures below compare Apple's revenue guidance with its actual results for the past five quarters (in millions):

Q1 2008: $9,200 v. $9,608 ($408 or 4.4% beat)

Q4 2007: $5,700 v. $6,217 ($517 or 9.0% beat)

Q3 2007: $5,100 v. $5,410 ($310 0r 6.0% beat)

Q2 2007: $4,850 v. $5,264 ($414 or 8.5% beat)

Q1 2007: $6,200 v. $7,115 ($915 or 15% beat)

Gross Margin

Sandbagging. This is exactly where Apple's reputation of giving conservative guidance has been created. By giving ultra conservative gross margin guidance, Apple is able to continuously beat its EPS expectations by the staggering 47% margin we have seen over the past five quarters. The trends in Apple's conservative gross margin guidance coupled with reports that Apple is seeing better than expected component pricing for the quarter supports my forecasted 36% gross margin percentage stated above. Moreover, Apple offered $100 in store credits to nearly 1 million iPhone customers at the end its fiscal third quarter which undoubtedly put some pressure on overall gross margins during Q4 of 2007 and Q1 of 2008. According to Apple, the vast majority or nearly all of those store credits have been redeemed which suggests that gross margins should see a lift in the quarter. Also, as noted below, Apple tends to have its best quarter in terms of gross margin percentage in the middle of the year. Finally, and most importantly, Apple has guided for 32% gross margins for the quarter. The only other time Apple has guided for 32% in gross margins was in Q3 2007 where it reported a mind-numbing 36.88% in gross margins. As noted in the trends below, Apple tends to beat its own gross margin estimates by an average of 4% thus allowing them to regularly beat EPS expectations:

Q1 2008: 31.0% v. 34.68% (368 basis point beat)

Q4 2007: 29.5% v. 33.61% (411 basis point beat)

Q3 2007: 32.0% v. 36.88% (488 basis point beat)

Q2 2007: 29.5% v. 35.13% (563 basis point beat)

Q1 2007: 28.3% v. 31.20% (290 basis point beat)

First, notice how Apple tends to produce better margins in Q2 and Q3 over Q1 and Q4. This is due mainly to two factors. One, Apple tends to get better component pricing in the spring and summer quarters due to pricing pressures caused by seasonality in demand. Two, Apple gets a better product mix in the spring and summer i.e. a larger portion of its sales are high margin products such as Macs while the winter and fall quarters are met by large quantities of low margin iPods - Christmas gifts in the winter and new generation iPods in the fall. Secondly, notice Apple's guidance. This quarter Apple is guiding for 32% in gross margins - this matches the highest estimates it has given over the past 5 quarters. Finally, to reiterate, favorable component pricing, high sales of the MacBook Air, elimination of the iPhone store credit, and Apple's trend in guidance support a 36% gross margin percentage - probably conservatively so.

Operating Expenses (OpEx)

In terms of operating expenses, Apple is pretty consistent in guiding $40 million less than what it actually reports. In other words, Apple tends to be on the aggressive side when it provides guidance on OpEx. My forecast is consistent with this trend of under-performing when it comes to OpEx. Apple is guiding for $1.120 billion in operating expenses for its fiscal second quarter. Yet, based on the current trend, Apple should see closer to $1.140 billion in OpEx for the quarter. It remains to be seen whether Apple will break out of its trend of over-promising and under-delivering on OpEx. Until they do, I think it's prudent to be conservative on the estimates. Below is the trend of Apple missing on its operating expense guidance by $40 million (in millions).

Q1 2008: $1,165 v. $1,206 ($41 million miss)

Q4 2007: $990 v. $1,030 ($40 million miss)

Q3 2007: $915 v. $954 ($39 million miss)

Q2 2007: $800 v. $863 ($63 million miss)

Q1 2007: $920 v. $898 ($22 million beat)

OI&E and Taxes

OI&E is relatively easy to predict as Apple consistently beats its OI&E guidance by $5-10 million each quarter. As Apple continues to pile up its cash ($18 billion), it will continue to collect larger amounts of interest on its war-chest. For the quarter, Apple is guiding for $190 million in OI&E which basically means it will report between $195-$200 million. I am looking for $200 million due to the recent pile up of cash in Q1. In terms of taxes, Apple consistently records a 32% tax rate with the occasional favorable quarter helping earnings to the upside. The data below marks the trend in Apple's consistent conservative guidance in OI&E to the tune of $5-10 million (in millions):

Q1 2008: $190 v. $200 ($10 million beat)

Q4 2007: $165 v. $170 ($5 million beat)

Q3 2007: $150 v. $155 ($5 million beat)

Q2 2007: $143 v. $148 ($5 million beat)

Q1 2007: $120 v. $126 ($6 million beat)

Earning Per Share (EPS)

The historical trend in Apple's guidance versus actual earnings tends to suggest that Apple will earn over $1.30 in EPS this quarter. The trends in the data also tends to support my forecast of $1.33 in EPS. First, Apple tends to beat its own EPS guidance by an average of 47% over the past five quarters. Secondly, the trend in quarter over quarter seasonality between Q1 and Q2 of 2007 suggests that Apple should see a 23.7% decline in EPS between Q1 and Q2 of this year.

As a matter of fact, Apple should see better seasonality this year considering the fact that Apple released the new MacBook Air, a 16 GB iPhone, and a 32 GB iPod Touch during Q2 of this year while Apple released no new products for sale in Q2 last year. Yet, assuming that Apple sees the same degree of seasonality, earnings should decline from $1.76 in Q1 to $1.34 in Q2 (a 23.8% decline). Alternatively, if Apple beats by the same margin it did in Q2 of last year (58%), it would earn $1.49. Yet, that number is too steep because it is not supported by the current predictions in the segment sales data. Still, the general trend of Apple smashing its conservative guidance tends to support the forecast of $1.33 for the quarter. The data below exhibits the trend of Apple's tendency to offer and significantly beat its conservative guidance:

Q1 2008: $1.42 v. $1.76 (23.9% beat)

Q4 2007: $0.65 v. $1.01 (55.4% beat)

Q3 2007: $0.66 v. $0.92 (39.4% beat)

Q2 2007: $0.55 v. $0.87 (58% beat)

Q1 2007: $0.73 v. $1.14 (56% beat)

iPod Estimates

As noted above, I am looking for Apple to sell 11.3 million iPods at an average selling price of $172. The basis of my forecast is routed in tracking the accuracy of Piper Jaffray senior analyst Gene Munster's iPod predictions based on his analysis of NPD data. Gene Munster has been unusually accurate and has the uncanny ability of being able to predict the number of iPods Apple will sell in any given quarter. He is able to analyze NPD data better than most which results in his ability to predict iPod sales within the few thousands of sales.

For example, in Q1 2008, when other analysts were expecting 25-26 million iPods, Munster forecasted 23.5 million iPods - just 5% above what Apple actually reported. In Q4 2007, Munster accurately forecasted that Apple would sell exactly 10.2 million iPods. Apple reported exactly 10.2 million iPods on the dot. For Q3 2007, Munster forecasted that Apple would see 9.5-10 million iPods on the quarter. Apple reported exactly 9.8 million iPods. Thus, Munster has obviously proven his ability to accurately predict iPod sales far better than Wall Street. The current consensus estimates for iPods falls between 10-10.5 million with several analysts predicting between 8.5-9.5 million. Munster's estimates are based on NPD data while many of these other estimates are based on pure conjecture and nonsense. Kathy Huberty just predicts sales of 8.5 million iPods without any underlying data, logic or reason in support of her conclusion. Munster basis his data on channel checks and NPD data. Who are you going to believe? Based on estimates from Gene Munster on iPod data, Apple would see sales of 11.3 million iPods at an ASP of $172 and record segment revenue of $1.9436 billion.

Mac Estimates

My earnings forecast is based on estimated sales of 2.350 million macs. The basis of this forecast is based on evidence suggests that Mac sales were up 60% year over year for the month February. Moreover, the Mac experiences significantly less seasonality than does the iPod. For example, in 2007, Apple experienced a mere 100,000 unit decline sequentially between Q1 and Q2 from 1.6 million units to 1.5 million units. Yet, as noted above, Apple released no new desktop or notebook computers in Q2 of 2007. In Q2 of 2008, Apple released not only the new MacBook Air, but it also released highly anticipated updates to the MacBook and MacBook Pro lines. This suggests that Apple should see much better seasonality this year than it did last year. This much is clear. Yet, even more importantly is the clear success of the MacBook Air. Since its release, the MacBook Air has held the number one spot, overtaking the MacBook, on Apple's on-line website in terms of best sellers. Last quarter, Apple sold 2.319 million Macs in a relatively slower than expected holiday shopping season. Given that Apple should see better seasonality this year than it did last year, and given the fact that the MacBook Air is selling phenomenally according to several analysts, I am forecasting sales of 2.350 million macs. This number might prove conservative if MacBook Airs end up selling way better than expected.

Disclosure: I own long term 2009 and 2010 call options in Apple. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.