Why Apple Will Beat Estimates Next Quarter

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Mr. Market has a warped sense of what is disappointing. When Apple (NASDAQ: AAPL) released earnings recently, they were dubbed  disappointing and led many to question if the company was going to make a habit of missing estimates. While it's true that Apple is running into tough comparisons, long-term investors are actually getting exactly what analysts have been predicting. For the last few years analysts have pegged Apple's EPS growth rate at around 20%; but when the company delivers on this expectation, investors are disappointed? The key to understanding Apple's earnings is knowing that consumers behave in a certain way. Those who understand the cycle of Apple's products can benefit from the drop in the stock when the company “disappoints,” and this is why I believe Apple will easily beat estimates next quarter.

Current Quarter Results For The Big Two Products Were Mixed:

Before we get to next quarter, let's look at the last three months to see just what happened. Apple reported sales up 27.21%, and EPS was up 22.98%. When you consider during the same quarter that competitors Google (NASDAQ: GOOG) and Microsoft (NASDAQ: MSFT) reported revenue growth of 18.58%, and a decline of 7.85%, respectively, the numbers look pretty darn good. The company's two major growth drivers are the iPhone and the iPad, and there were very specific dynamics that affected each.

iPhone sales increased 56%, with unit growth of 58%. I'm sure a big part of the reason for this huge increase was the benefit of the end of quarter shipments of the iPhone 5. The quarter ended Sept. 29, and the iPhone 5 was introduced on Sept. 12. While recent IDC research suggests that Android is running about 75% of smartphones, this operating system is open-source and doesn't generate significant cash flow for Google. In fact, it has been rumored that Microsoft makes more on licensing from Android than Google does, and as open-source software this isn't likely to change. iPad sales were a bit muted, showing an increase of 9%, but unit growth was much stronger, with a 26% increase.

Laptops Dominate And iPod Sales Are Being Cannibalized:

Total sales of Mac computers were up 6%, primarily driven by laptop sales. The fact that desktop sales decreased by 26%, and units declined by 24% is really no surprise, as Apple has put a lot of money into their laptop lineup. Sales of laptops increased 17%, and unit sales were up 9%. In fact, 81% of Mac sales were from laptops. With recent updates to the iMac, Mac Mini, Macbook, and more, this trend will probably continue, but the desktop refresh might help those sales a little. IPod sales continued to decline, with sales down 26% and units down 19%. However, the company just refreshed the whole iPod lineup, and this may slow the decline in these sales somewhat. iTunes continued to perform well, with sales up 37%.

Margins Generate Huge Cash Flow And An Ever Increasing Cash Pile:

Apple is well known for its cash generating capabilities, and the company's results over the last twelve months would make most companies green with envy. Though Apple primarily is a mobile device manufacturer, the company's gross margin is astounding. In the recent quarter, Apple's gross margin was about 40%. Think about this: Google, which is more reliant on advertising, had a gross margin of almost 59%, and Microsoft's gross margin is nearly 74%. For Apple to even be in the same ballpark as these two companies is amazing, considering the lower margins that comes with hardware sales.

This relatively high margin allows the company to generate an almost ridiculous amount of cash flow. In the last twelve months, Apple grew operating cash flow by 35.51%, and generated over $42 billion in free cash flow. Cash and investments increased from $81.57 billion last year to over $121 billion this year. The company's huge free cash flow meant their new dividend used just 23.38% of free cash flow on an annualized basis. Looking at Microsoft, they have almost the same free cash flow payout ratio (21.27%), but on an annualized basis, the company is generating less free cash flow than Apple.

So How Do I Know Apple Will Beat Earnings Next Quarter?

It's actually just a matter of some logical thinking about how consumers behave. First, you have to consider that the company's most important product, the iPhone, was updated just a few weeks before the end of the quarter. There was a lot of pent up demand for the iPhone 5, and there is no way this was extinguished in just the last two weeks of September. It is highly likely that many people will be upgrading to the iPhone 5 during the last three months of the year, and in particular this device will be given as a holiday present. Almost the same phenomenon played out last year when Apple beat estimates by 22.27%.

The second reason Apple should outperform is due to a mis-step by Microsoft. Theoretically, the introduction of the Microsoft Surface tablet could have slowed down the adoption rate of the iPad. However, Microsoft chose to make only the RT version of the tablet available at launch, and the Pro version won't be available until closer to the end of the year. It seems very unlikely that the RT version will see large adoption given its lack of native Windows program support and lack of apps. Customers may have waited to see what the Surface would be like, before deciding which tablet to choose.

In addition, the iPad mini has been rumored for months, and when it wasn't introduced along with the iPhone 5, customers probably waited to see when it would come out. Since the iPad mini wasn't introduced until the beginning of the 4th quarter 2012, many customers may choose to make this their tablet of choice. The fact that Apple refreshed almost their entire iPod and Mac product line recently also argues that customers who waited to upgrade will probably do so during the last three months of the year. It's much easier to justify buying a $329 iPad mini or spending $199 on the iPhone 5 as a holiday present than to just buy one during the year.

Conclusion:

Long story short, Apple is set to blow away earnings expectations for the last three months of the year. The iPhone 5, the iPad with Retina Display, and the iPad mini are likely to be hot gift items this year, and they will drive higher earnings. While the iPad mini I'm sure will cannibalize some iPad sales, this will also likely steal some sales from the Nexus and Kindle Fire lineups as well. Investors looking for a short-term play on Apple might consider buying today, and riding the wave to an earnings beat for the quarter. For longer-term investors, Apple keeps updating and introducing new products, and next quarter should calm fears that the company is done growing.


MHenage owns shares of Apple. The Motley Fool owns shares of Apple, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus

Compare Brokers

Fool Disclosure