Apple Bulls Win This Quarter

Updated from April 22 with earnings results.

Apple (AAPL - commentary - Cramer's Take) reported excellent second-quarter 2008 results, with revenue and EPS exceeding estimates. Guidance is good by Apple standards, with revenue above street estimates and EPS just 10 cents below the Street.

Analysts and investors will pick apart the numbers and conference call commentary, but the bottom line is that this quarter, the conference call and the guidance provide little to no ammunition for the bears. While there is similarly little for the bulls, especially in the short run, the fact that the bears can take away little makes this a win for the bulls -- of which I count myself one.

This commentary and what follows is very consistent with my first impressions, which I posted as soon as the numbers were released but before the call started here and here. The bottom line, for the short-term, is what I noted in my first comment: "this stock is not going back to $120 but it isn't going to see $200 either."

Revenue of $7.5 billion easily beat street estimates of $7 billion. EPS of $1.16 beat street estimates of $1.07. The quarter lacked the huge upside to estimates because of less upside in gross margins than analysts estimated. EPS were helped by a lower-than-expected tax rate, which boosted EPS by 4 cents.

The tax rate will stay below prior levels, so this may not be a one-time item. The lower tax rate resulted from more non-U.S. profits and lower-than-expected interest income due to the very low short-term interest rates (this was below management guidance by about $40 million and should really be considered if someone complains about the 4 cent tax rate boost). It is also possible that a decision to forgo revenue recognition on iPhones sold after March 6 -- the day of the iPhone 2.0 software announcement -- until iPhone 2.0 software starts to ship in late June cost a very small amount on the EPS line.

Mac sales were stellar, led by a 61% increase in notebook units. Desktops were no slouch, growing by 30%. Education sales were the best in eight years. Management seemed very confident in current momentum, and the Air appears to be developing as more than just a niche product.

iPod sales rose 1% to 10.6 million units, ahead of expectations. ASPs were up, but not as much I expected. Shuffles sales were down again but rose after the price cut, probably impacting the mix and the ASPs. iPod revenue grew 8%. Some investors will still worry about slowing growth in iPods, but the touch still has upside and I continue to believe that old iPod numbers should be compared with iPod-plus-iPhone numbers today.

iPhones came in at 1.7 million, which is the low end of expectations. Nevertheless, management very firmly reiterated 10 million in 2008 as guidance.

The revenue recognition change mentioned above was the source of a lot questions on the call, but I didn't get the impression that management felt it was material. However, I'll admit I didn't understand the accounting implications completely. For what it's worth, the shares came off their after-hours lows when management stated that they beat their internal unit target on iPhones in the quarter, which was the cause of the stock outs and missing iPhones late in the quarter. This suggests that we should have more confidence in the 10 million guidance.

The biggest source of questions on the call surrounded the gross margin, which came in at 33% in the quarter, vs. guidance of 32% and analysts' estimates of 34% to 36%. The reason that EPS were not the usual blowout vs. estimates was this "shortfall" in gross margin.

Management said that, relative to its guidance, higher-than-expected revenues, the weak dollar, and lower-than-expected commodity costs led to the upside. Via Q&A, it also became apparent that analysts may have underestimated the positive impact of Leopard on the prior quarter's gross margin.

One analyst perceptively asked if the decline in commodity costs in the quarter -- evident in published pricing by suppliers -- may not have fully flowed through, due to prior commitments by Apple to buy inventory. The analyst did not get a clear answer, which leaves open the possibility that gross margins may surprise to the upside in the current quarter. I am modeling flat gross margins on a sequential basis.

It is worth noting that ever since gross margins exploded upward a year ago, management has consistently guided analysts not to assume it was all permanent. Maybe this quarter proves the point. Maybe not.

I've adjusted my spreadsheet for the June quarter. I am now targeting revenue of $7.3 billion and EPS of $1.09, roughly in line with current analyst estimates but above guidance. The big swing factor is going to be gross margins. One hundred basis points are worth 6 cents a share.

Furthermore, gross margins reached an all-time record of 37% in the June quarter a year ago, setting up a very difficult comparison that will limit the year-over-year growth in EPS. It's nothing to worry about but worth noting, as that is something bears will seize upon. I've got Mac units at 2.3 million, up slightly sequentially. Sequential history would suggest a larger uptick. My estimate assumes unit growth at the low end of the recent range, thus implying a deceleration that is not supported by current trends or buzz. I am assuming a 3% year-over-year decline in iPod units but a 5% revenue gain thanks to improved ASPs. I have iPhone units at 2.2 million, assuming that the 3G phone ships late this quarter.

As noted, I think the bulls won this quarter because the bears lost, but I don't see a quick upward move in the stock. What I do see is upside as new products are announced/anticipated because the bear case is not very strong thanks to second-quarter fundamentals and the relatively solid guidance.

In the brief press release, Jobs says there are "some terrific new products in coming quarters." I think the stock works higher in May and June on investor enthusiasm for those products, especially the 3G iPhone.

Preview

Before Tuesday's shellacking I was planning to say that the sharp upward move in Apple (AAPL - commentary - Cramer's Take) shares had raised the bar unrealistically high heading into the second-quarter earnings report. With some steam out of the stock, I think it is now a coin flip as to which way the stock trades off the report. One good adage passed along to me by my friend and institutional salesman JK is "Macs drive earnings, iPhone drives the multiple." Keep that in mind as you analyze the results and guidance.

One thing we know for sure is what will determine how the stock responds: guidance. Analysts are looking for a flat outlook for the June period, in line with recent sequential patterns for the June quarter. Current consensus for the third quarter is EPS of $1.10 on revenue of $7.15 billion. Apple probably needs to guide within 5 cents and $100 million of these figures to clear the way for the shares to move higher.

One thing that could provide upside in the third quarter is laptop sales. These have shown a strong uptick in June quarters in the past, and if the multiquarter run of 40% unit gains holds, Mac sales could drive higher-than-expected guidance. If management guides to flattish sequential revenue, a good question would be, Doesn't this imply a slowing in the growth rate of laptops? If not, then what else would offset the rising revenue from laptops?

Also likely to have a big impact on guidance is the gross-margin assumption. Apple has been very conservative about gross-margin guidance since the huge jump in second quarter 2007 from about 30% to 35%. Since then, guidance has generally been for low 30s, but the actual quarters have ranged from 33.6% to 36.9%. I see little reason to assume that gross margins would contract from second quarter to third quarter based on current evidence, so keep an eye on the second-quarter gross margin, which analysts expect to be around 34%.

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At the time of publication, Birenberg was long Apple, although holdings can change at any time.

Steven Birenberg is president and chief investment officer of Northlake Capital Management, LLC. Northlake specializes in managing equity portfolios using a combination of exchange-traded funds and special situation stocks. Birenberg appreciates your feedback; click here to send him an email.