Bullish Cross Beats the Street in Predicting Apple’s Second Quarter Earnings Results

In early April, Bullish Cross offered its own earnings forecasts and estimates for Apple's (Nasdaq: AAPL) 2008 fiscal second quarter reported on April 23, 2008. Bullish Cross is proud to report that its forecasts generally beat the street, and several of its prominent financial analysts in giving one of the most accurate earnings predictions on Wall Street. The data below provides a comparison between Bullish Cross' published earnings forecast and Apple's actual results for its recently reported fiscal second quarter of 2008:

Apple's Q2 2008 Statement of Operations

(In millions except per share data)

Line Item	Apple's Numbers	Bullish Cross' Forecast	Difference
Revenue	$7,512	$7,449	$63
Cost of Goods Sold	$5,038	$4,767	$271
Gross Margin	(32.9%) $2,474	(36.0%) $2,682	$208
OpEx	$1,159	$1,160	$1
Operating Income	$1,315	$1,522	$207
OI&E	$162	$200	$38
Net, before taxes	$1,477	$1,722	$245
Taxes	(29.3%) $432	(32%) $551	$119
Net Income	$1,045	$1,171	$126
Earnings Per Share	$1.16	$1.31	$0.15
Outstanding Shares	899,329,000	900,000,000	671,000

As indicated in the chart above, the main difference between Apple's actual results and Bullish Cross' forecast is gross margin percentage, and as a direct result, EPS. Going line item by line item, Bullish Cross' forecast for revenue came with .08% within the actual results missing the target by a mere $63 million. This forecast came closer to actual result than any other analyst's forecast on Wall Street. Leaving the cost of goods sold and gross margin for a discussion below, Bullish Cross estimated operating expenses within $1 million or .008% of actual results. Basically, one could not have given a better OpEx estimate without hitting the number dead on. Yet, there are at least two line items that are quite perplexing given Apple's history in offering conservative guidance, and given what was going on in the market place during the quarter. These items were Gross Margin and OI&E, which will be discussed at some length below:

Gross Margin Percentage

Apple reporting 32.9% in gross margin percentage this quarter was one of the most unanticipated results I have personally witnessed in the three years that I have analyzed Apple's quarterly earnings, and I think that many of the more astute analysts, such as Richard Gardner from Citigroup, would agree. As a matter of fact, the first question on Apple's conference call was regarding Apple's way lower than expected gross margin percentage. There are an overwhelming number of reasons why Apple should have reported anywhere from 35.5% to 37% in gross margin percentage this quarter.

First, Apple generally guides between 3.5% to 4% lower than what they actually report in gross margins. They have done this for at least the past five (5) quarters. The reason why guidance history is such an important indicator is due to the fact that Apple's management is in the best position to offer estimates for gross margin since they are the most involved in the inner workings of Apple's operations. Only Apple's management knows the gross margin percentage of each of its individual products, which they have never released to the public. Thus, it is the job of the analyst to try and determine what Apple's management really thinks Apple will post in gross margins by following the historical trend. Apple's management is bound under GAAP to offer conservative guidance. Management must offer guidance that they think they will easily accomplish instead of guidance they think they will accomplish. Thus, the best information the analyst has to draw on is her interpretation of management's guidance based on comparing the earnings history with the associated guidance history. As noted in the trends below, Apple tends to beat its own gross margin estimates by an average of 3.5-5% 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)

Secondly, one should expect Apple to enjoy better gross margins in a quarter where the revenue is dominated by Mac sales than in a quarter where the revenue is dominated by iPod sales. Macs generally tends to carry higher gross margins than do iPod sales. This is why Apple has historically reported significantly higher gross margins in Q2 and Q3 than in Q1. In 2007, Apple saw a 400 basis point increase in gross margins sequentially in Q2 over Q1. Why? Because Q1 was highly dominated by iPod sales whereas Q2 was dominated by Mac sales. This year was no different. In Q1 2008, 41.6% of Apple's revenue was derived from iPod sales whereas 36.9% was derived from Mac sales. In contrast with Q2 2008, a mere 24.2% of Apple's total revenue was derived from iPod sales whereas a whopping 46.5% of revenue was derived from Mac sales in the quarter. Thus, based on this shift in ratio, Apple should have easily been able to beat the 34.68% in gross margins it reported in Q1. The fact that it did not do so, is quite perplexing.

Thirdly, Apple should have seen significantly better component pricing in the quarter than in previous quarters which tends to support a conclusion for better gross margins. Reports have surfaced indicating that the price for NAND flash memory, the storage chips found in Apple's iPod Nano, iPod Shuffle and iPod Touch have been falling quite significantly in the quarter. It has been suggested that NAND flash memory has fallen by 73 percent during the period from August to February. Declines in the component pricing for the iPod obviously indicated that Apple should have seen better gross margins in the quarter. Yet, gross margins were weaker than expected.

Fourthly, in September, Apple offered $100 in store credits to nearly 1 million iPhone customers to help with its public relations fumble, which had a cumulative impact of at least a 1% in gross margins during Q4 0f 2007 and Q1 of 2008. The $100 million in store credits were charged directly to the cost of goods sold, thus significantly impacting overall gross margins during the quarters in which those store credits were redeemed. Just to demonstrate how big of impact those store credits had on gross margins, one need only consider how Apple's results would change in Q1 if it had not recorded the $50 million it had charged to COGS i.e. if there was no store credit. In Q1, a $50 million increase in gross margins would have result in a 51 basis point increase to gross margins from 34.68% to 35.20%. That's quite an increase in gross margins for a quarter that produce $9.6 billion in revenue. According to Apple, the vast majority or nearly all of those store credits were redeemed by the end of Q1 which suggested that gross margins should have seen at least a 50 basis point lift in Q2 as a result of not having to deal with this added expense.

These four reasons, among others, highly suggested, to any analyst doing their due diligence, that Apple would report between 35.5% to 37% in gross margins for Q2. The data tends to only support this conclusion. The fact that Apple reported 32.9% is irrelevant as hindsight to the available data. Those who offered estimates that were significnatly lower than 35.5% either did not perform the analysis and just guessed, had alterior motives for offering their estimates (which I leave to the reader to speculate), or were providing conservative estimates with 35-37% in mind. Prominent analysts such as Gene Munster of Piper Jaffray and Richard Gardner of Citigroup offered estimates of 36% and 36.5% respectively. These analysts have been known to closely follow Apple and to perform solid analysis before providing their estimates. As for other anlaysts, I do not quite know what they were thinking. Katy Huberty of Morgan Stanley also offered above 35% in gross margins, but she has been known to simply guess without providing supporting analysis.

OI&E

OI&E is normally easy to predict as Apple has consistently beat its OI&E guidance by $5-10 million each quarter. Yet, this quarter, Apple missed its OI&E guidance by $28 when as it posted actual earnings of $162 million in other income and expense. This caused Bullish Cross to miss its estimate of $200 million in OI&E by $38 millon on the quarter. Apple noted that the reason for the miss in OI&E was due to lower than expected interest rates. This abberition in Apple's misguidance on OI&E will likely not be repeated as Apple's management will probably give even more conservative guidance in anticipation of this possibility in the future. It would have been difficult, but not entirely impossible, to predict that Apple would miss its OI&E guidance given what had been going on with interest rates in the quarter. Yet, it would not have been imprudent for the analyst to entrust Apple's management with being able to anticipate price fluctuations in interest rates given how effective Apple's management has been in being able to predict its OI&E within such a small margin of error. 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)

Earnings Per Share

Bullish Cross' forecasted estimates for EPS missed Apple's actual results by $0.15 due largely to Apple's lower than expected gross margin percentage of 32.9%. Bullish Cross estimated EPS to be $1.31 and Apple reported earnigns of $1.16. Yet, it should be noted that if Apple had reported 36% in gross margins as expected, Apple would have earned exactly $1.34 in EPS. It would have beaten Bullish Cross' forecast by $0.03. Each 1% miss in gross margin percentage amounted to nearly 7.3 cents in EPS.

Breakdown of Revenue

(In millions)

Item of Revenue	Apple's Numbers	Bullish Cross' Forecast	Difference
Macintosh Revenue	$3,494	$3,643	149
iPod Revenue	$1,816	$1,806	(10)
iTunes Plus	$881	$600	(281)
iPhone Revenue	$378	$400	22
Peripherals	$412	$420	8
Software	$529	$580	51
Total Revenue	$7,512	$7,449	(63)

Bullish Cross had, by far, the closest revenue estimate of any prominant Wall Street analyst polled by Thomson Financial. Bullish Cross estimated that Apple would record $7.449 billion in Q2 and Apple reported $7.512 billion. That's a margin of error of 8/10 of a percent or $63 million. The next best forecast for total revenue was given by Mike Abramsky of RBC Capital who estimated $7.2 billion. He was off by a full $312 million or 4.1%. The average Wall Street analyst missed revenue estimates by 7.5% whereas Bullish Cross came within 0.8% of hitting the exact revenue number. Also of note, Bullish Cross came within $10 million of calling iPod sales revenue. Bullish Cross forecasted $1.806 billion and Apple reported $1.816 billion in total iPod revenue.

Breakdown of Units Sales Data

Product	Apple's Numbers	Bullish Cross' Forecast	Difference
Macintosh Sales	2,289,000	2,350,000	61,000
iPod Sales	10,644,000	10,500,000	(144,000)
iPhone Sales	1,703,000	1,700,000	(3,000)

Bullish Cross came within 2.5 days of sales of making a near perfect call in Macintosh sales. There were a total of 91-days in the quarter and Apple sold nearly 25,154 computers a day. As noted above, Bullish Cross missed estimates by 61,000 total units or 2.43 days of sales. Bullish Cross also came within 1.4% of hitting the iPod number missing by a mere 1-day of sales. Finally, in likely the best call in the quarter, Bullish cross came within 3,000 units of perfectly calling the iPhone sales number - that's a miss of a mere 4 hours of sales.

Comparison between Bullish Cross & Wall Street Firms

(Best Estimate Highlighted in Blue; Worst Highlighted in Red)

Analyst	Revenue	EPS	G.M.	iPhones	iPods	Macs
Apple, Inc.	$7.512b	$1.16	32.9%	1.703m	10.644m	2.289m
Andy Zaky, Bullish Cross	$7.449b	$1.31	36.0%	1.700m	10.5m	2.350m
Gene Munster, Piper Jaffray	$6.900b	$1.19	36.0%	1.6-2.0m	10.5m	2.100m
Shaw Wu, AmTech	$7.000b	$1.10	33.5%	1.5m	10m	2.150m
Richard Gardner, Citigroup	$7.000b	$1.23	36.5%	1.5m	9.5m	2.100m
Ben Reitzes, Lehman Bros.	$6.950b	$1.05	33.2%	1.5m	10.3m	2.090m
Mike Abramsky, RBC Capt.	$7.200b	$1.11	34.0%	1.8m	10.0m	2.200m
Katy Huberty, Morgan Stan.	$6.634b	$1.10	35.8%	1.0m	8.5m	2.020m
Scott Craig, BofA	$6.900b	$1.07	n/a	1.22m	10.0m	2.021m

As noted in the table above, Bullish Cross beat Wall Street analysts in predicting Apple's second quarter earnings results almost across the board. In terms of revenue, Bullish Cross made the best call in forecasting $7.449 billion - a mere 63 million or 0.8% within the actual numbers. The next best analyst, Mike Abramsky, forecasted $7.2 billion - a $312 million or 4.1% miss. By far the worst call on Wall Street came from none other than Katy Huberty of Morgan Stanley who's revenue estimates missed the number by almost a cool billion. She estimated sales of $6.634 billion and Apple reported $7.512 billion or nearly $878 million (11.7%) above Ms. Huberty's estimates.

Gene Munster of Piper Jaffray made the best call in predicting EPS. Though, with a little luck at his side. Munster was looking for 36% in gross margins and $6.9 billion in revenue to help him reach his $1.19 in EPS. Yet, Apple reported nowhere close to either $6.9 billion or 36% in gross margins. Munster was lucky in calling EPS because his revenue estimates were $612 million below what Apple actually reported. Under those circumstances, one's EPS estimates would normally miss as well.

Ben Reitzes wins in calling gross margins but misses big time in both EPS and revenue estimates. How Reitzes made such a call in gross margins is anyone's guess as I noted extensively above. Maybe he estimated gross margins in the same way he estimated revenue and EPS. By sheer dumb luck. His estimates missed revenue by $562 million - that's more than 1/2 billion!

Andy Zaky of Bullish Cross wins in calling iPhone unit sales. Bullish Cross estimated 1.7 million units and Apple reported unit sales of 1.703 million units. The next best call was by RBC Capital analyst Mike Abramsky who's estimates missed by 100,000. Yet, worthy of note is the idiotic call made by Katy Huberty of Morgan Stanley. She estimated that Apple would only sell 1 million iPhone units on the quarter despite the fact that Steve Jobs, during MacWorld, all but admitted that Apple sold 300,000 iPhones in the first two weeks of the quarter! This suggests that Apple enjoyed a run-rate of nearly 150,000 units a week. According to Katy Huberty, either Apple's iPhone run-rate should have dramatically collapsed during the quarter or Apple's quarter should have had a duration 6.5 weeks or 1.5 months. Still, I have to hand it to Morgan Stanely for indefatigably continuing to employ Ms. Huberty despite her clear and obvious shortcoming as a financial analyst.

Andy Zaky of Bullish Cross and Gene Munster of Piper Jaffray made the best calls in estimating total iPod unit sales. Yet, I think credit should go to Gene Munster as Bullish Cross' estimates of iPod unit sales generally track Gene Munster's estimates based on his readings of NPD data. I note in a previous artical how Gene Munster has been unusally accurate in being able to predict Apple's iPod unit sales. Both Gene Munster and I were looking for 10.5 million iPod units and Apple reported 10.644 million. Ms. Huberty, once again, demonstrated her shrewdness as an analyst with her great call of estimating sales of 8.5 million iPod units - she only missed by 2.1 million units (being facetious). Why anyone should listen to word Katy Huberty says is beyond me.

Andy Zaky of Bullish Cross made the best call in estimating total Mac sales. Bullish Cross estimated sales of 2.350 million Macs and Apple reported sales of 2.289 million macs - that's a 61,000 unit difference or about 2.4 days of sales as noted above. The next best call came from Mike Abramsky of RBC Capital who estimated unit sales of 2.2 million macs or nearly 89,000 units below what Apple actually reported. The worst call obviously came from none other than Katy Huberty of Morgan Stanley. She continues to impress with her estimates. Katy Huberty estimated unit sales of 2.020 million Macs, missing estimates by a full 269,000 Macs! If I were running things at Morgan Stanley, I would consider firing Ms. Huberty. That's a recommendation. Finally, it's intersting to note that Morgan Stanley made the worst call in four out of the six categories and Bullish Cross made the best call in four out of the six categories.

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.