Even the most basic financial accounting course teaches analysts an important concept called cost-volume profit analysis. Technology analysts, in drawing their 2009 earnings forecast for Apple, Inc. (Nasdaq: AAPL), have seemingly, and for some reason, failed to contemplate this basic tool of financial analysis. Cost-volume profit analysis is the intuitive concept that a company’s ability to increase its profit margins will depend partly on its capacity to increase its total gross margin while keeping its operating expenses fixed within a relative range. For those who are unfamiliar with the concept of cost-volume profit analysis, and would like a simple explanation, see my comments, posted to this thread (below), where I offer a thorough example to help illuminate this important idea.
According to analysts polled by Thomson Financial, Apple is expected to earn $6.28 in EPS on $38.10 billion in revenue for the fiscal year ending in 2009. That's an expected increase of 21.9% in EPS and 20.4% increase in revenue for the year. The analysts expect EPS to rise proportionately to increases in revenue. Yet, this idea fails to contemplate cost-volume profit analysis. EPS does not necessarily rise in proportion to revenue as you shall soon see. As a matter of fact, EPS does not even commonly rise in proportion to revenue and it would be a grave mistake to make forecasts based on such a ludicrous assumption.
The reason why it is inadvisable to think that EPS will necessarily rise in proportion to revenue is because Apple's fixed costs or operating expenses are increasing at a relatively lower rate than its revenue. Moreover, Apple's gross margin contribution is increasing in dramatic fashion as it purchases large volumes of component parts at significantly lower prices. NAND flash memory, one of Apple's main commodity costs, continues to fall at alarming rates, thus benefiting Apple's overall gross margins. As Apple's revenue and gross margin continue to climb, and as Apple's operating expenses remain relatively at bay, Apple continues to produce more in EPS per dollar in revenue it recognizes. In other words, it takes Apple increasingly less in revenue to produce $0.01 in EPS. Why? Because the rate of increase in Apple's gross margin is outpacing the rate of increase in its operating expenses. It is very important that analysts and investors understand this concept. The example below will illustrate just how important this concept will be to Apple's earnings in the future:
Suppose that Widget Co., in year 1, recognizes revenue of $15 billion, gross margin of $10 billion and operating expenses of $3 billion. In year 1, Widget Co. would recognize net profit of $7 billion. In year 2, suppose that Widget Co. recognizes revenue of $20 billion, gross margin of $15 billion and operating expenses of $4 billion. In year 2, Widget Co. would recognize net profit of $11 billion. Notice that while Widget Co. had a mere 33% increase in revenue from year 1 to 2, it had a 57% increase in net profit. The analyst might ask, why is there such a disparity between the increase in revenue and the increase in profit? It's quite simple really. It's because Widget Co.'s percentage increase in gross margin outpaced the net increase of its operating expenses. In so doing, Widget Co. made more money per dollar that it produced in revenue in year two than it did in year one. This is what Apple has experienced in the past and will probably experience in a huge way in the future. The data below outlines how much revenue it takes Apple to produce $0.01 in EPS. The less revenue it takes to produce $0.01 in EPS, the more Apple earns in EPS in proportion to the revenue it recognizes. As I noted above, this is a function of the growth in gross margin (gross profit) outpacing the growth in operating expenses:
Q1 2008: $54.59 million in Revenue = $0.01 in EPS
Q4 2007: $61.55 million in Revenue = $0.01 in EPS
Q3 2007: $59.45 million in Revenue = $0.01 in EPS
Q2 2007: $60.51 million in Revenue = $0.01 in EPS
Q1 2007: $62.41 million in Revenue = $0.01 in EPS
Q4 2006: $78.02 million in Revenue = $0.01 in EPS
Q3 2006: $80.90 million in Revenue = $0.01 in EPS
Q2 2006: $92.80 million in Revenue = $0.01 in EPS
Q1 2006: $88.50 million in Revenue = $0.01 in EPS
Notice, in the data above, how it is taking Apple increasingly less revenue to produce a penny in EPS. This is due to the fact that the growth in Apple's gross profit and gross margin percentage is outpacing its growth in operating expenses. As Apple produces more in sales revenue, it produces more in gross margin. Unless Apple experiences a dramatic jump in operating expenses in the next few years, it should be able to produce more in EPS with less revenue dollars. What should be quite striking about this analysis is that if Apple's iPhone sells anywhere close to the 45 million units that Piper Jaffray analyst Gene Munster expects, deferred iPhone revenue could catapult Apple above the $10.00 EPS range in 2010. As Apple's revenue growth significantly outpaces the growth rate of its operating expenses, then not only will Apple produce large amounts of revenue, it will produce more in EPS per dollar of revenue recognized for the year. The data below compares the year over year growth rates for Apple's revenue, gross margin, operating expenses and EPS over a couple of periods. This data should reveal how Apple has been able to produce more in EPS with less revenue dollars and why it's obnoxious to assume that EPS growth trails revenue growth:
Q1 2008 v. Q1 2007
Revenue: 35% growth
Gross Margin: 50% growth
Operating Expense: 34% growth
Earnings Per Share: 54.4%
Revenue grew 35% & EPS grew 54.4%
Q4 2007 v. Q4 2006
Revenue: 28.5% growth
Gross Margin: 48% growth
Operating Expense: 28.1%
Earnings Per Share: 62.9%
Revenue grew 28.5% & EPS grew 62.9%
Q3 2007 v. Q3 2006
Revenue: 23.8% growth
Gross Margin: 50.6% growth
Operating Expense: 25.7% growth
Earnings Per Share: 70.4%
Revenue grew 23.8% & EPS grew 70.4%
Fiscal 2007 v. Fiscal 2006
Revenue: 24.3% growth
Gross Margin: 45.7% growth
Operating Expense: 19.1% growth
Earnings Per Share: 73.1% growth
Revenue grew 23.8% & EPS grew 73.1%
The data above seems to indicate that Apple does an excellent job controlling its operating expenses. They do it so efficiently that a mere 23.8% growth in revenue resulted in a 73.1% growth rate in EPS in 2007 when compared to 2006. This is due in large part to (1) the revenue growth outpacing the growth rate in operating expenses and (2) gross margin percentage increases that resulted in huge increases in overall gross profit (gross margin). Gross margin increased 45.7% year over year despite the fact that revenue only grew 23.8%. This is the result of very favorable component pricing due to technological advancements without a corresponding decrease in the sales price of Apple's catalogue offerings. As the iPhone, being a high gross margin product, begins to contribute its deferred revenue to future earnings reports, Apple should see even better gross margin percentages during those periods. This suggests that gross margin growth should further outpace operating expenses to such a degree that Apple's EPS growth is going to once again significantly outpace its revenue growth. The bottom line here is, the analysts couldn't be more wrong in predicting that a 20.4% increase in revenue will result in a mere 21.9% increase in EPS. They need to go back and recalculate their estimates. Below are my tentative earnings estimates and expectations for Apple for the fiscal year ending 2009 (in billions except for per share data):
Fiscal Year Ending 2009 (Pro Forma)
Revenue: $45.540
COGS: $29.146
Gross Margin: $16.394
Operating Expenses: $6.357
Operating Income: $10.037
OI&E: $1.2
Net Before Taxes: $11.237
Taxes: $3.596
Net Income: $7.641
EPS: $8.55
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.
7 comments:
Suppose 10-year old Jack runs a lemonade stand in his neighborhood where he sells a cup of lemonade to his customers for $1.00. Jack’s profit will depend on his ability to manage both his gross margin and operating expenses. Gross margin is the amount of money that Jack makes on each cup of lemonade (revenue) minus any direct costs associated with the production of the cup of lemonade (cost of goods sold). Jack’s product costs might include the lemons, the plastic cups, the bag of ice, and the sugar. Suppose Jack, after doing the math, discovers that its costs him $0.40 to make one cup of lemonade. His gross margin would be $0.60 per cup ($1.00 - $0.40). If Jack sells 100 cups, Jack will earn $100.00 in revenue, and $60.00 in gross margin.
Operating expenses, on the other hand, are expenses associated with the running of the lemonade business. For example, Jack will need to buy a table, a red and white plaid table cloth, and a dispensing container to serve his customers. Jack might also need to hire his friends Tom and Bill to help him meet customer demand. Suppose Jack, after doing the math, discovers that it costs him $40.00 to pay Tom and Bill, and to buy the table, table cloth and dispensing container. This $40.00 cost is what the financial world, in its common nomenclature, refers to as operating expenses or fixed costs. The costs are fixed because whether Jack sells 100 or 500 cups lemonades, it still costs Jack $40.00 to hire Tom and Bill, to pay for the table, table cloth and dispensing container. Now obviously, operating expenses are only fixed within a relative range. If customers really love his lemonade, Jack might have to open another lemonade stand, thus increasing his fixed costs.
Jack’s profit margin is nothing more than the sum of subtracting his operating expenses, the $40.00 it costs to run the business, from his gross margin of $60.00. Jack’s net profit would thus be $20.00 in EPS as he is a 100% shareholder of his little operation. Here is where cost-volume profit analysis becomes very important. Notice that Jack made nearly $0.20 on every dollar of revenue he produced from his lemonade business. What if Jack sold 200 cups of lemonade instead? Jack would have made $200.00 in revenue. Gross margin would be $120 and operating expenses would be $40.00. Jack would have made $80.00 in net profit. For every dollar in revenue, Jack would have made nearly $0.40. This is the impact of cost-volume profit analysis. As jack sells more lemonade i.e. increases his volume of sales, he makes more in profit per dollar in revenue. He makes more, because the $40.00 fixed cost doesn’t increase or vary with the level of sales within a relative range.
Apple's manufacturing labor and overhead costs are tied to the dollar (China) while almost 40% of revenues are tied to stronger currencies. Apple is profiting from the weak dollar because its products can maintain high average sales prices overseas.
Apple does not have to hire manufacturing employees and invest in large new facilities to grow sales.
As deferred revenues come on-line and cash reserves earn more interest income, future earnings will have a high base without any new sales.
Analysts are like deer in headlights, fixated by Apples low guidance and the lack of quantitative information for their own estimates. We profit by this very conservative uncertainty in the market.
I only have one thing to say:
Crispy Green Positives!!!
"Anonymous said...
I only have one thing to say:
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Indeed. Crispy Green Positives for everyone!
Do you really think Apple's subscription accounting methodology for iPhones will hold up after the 3G iPhone launches and the phones' revenues aren't actually received over 24 months any more, but are received up front from carriers in the form of bulk-payment subsidies?
The idea that deferred revenue might accumulate until it dwarfs the revenue being recognized from current operations seems threatened by the new payment scheme. Sure, delaying taxes by deferring revenue recognition would be nice -- and it'd certainly help smooth the recognized revenue reported each quarter, reducing the impact of, for example, the holiday season -- but I wonder how much practical support for this accounting position exists after the revenue-split dies later this month.
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