$AAPL FQ3 2016 Home Game Earnings Preview: The Quarter About “Nothing”

(IMPORTANT NOTE: Please refer to this About + Disclaimer message from my old blog. You won’t ever find actionable investing/trading advice here, just a humble home gamer in his corner of the Web trying to understand Apple and tech a bit better. As you know, no one has any clue what AAPL stock will do from day to day, quarter to quarter, year to year, even if earnings “seem good enough”. Performing your own due diligence is an absolute must. Also, hi there, Medium readers! I’ve “cross-posted” this on Apple News.)

A fiscal quarter most blasé

iPhone and Watch, still presumptive decay

As SE and iPad Pro enter the fray

Will Services, too, help offset dismay?

Hello and welcome to my 13th consecutive (no, really!) home game AAPL earnings preview, where I try to understand the world’s most (formerly, heh) consequential and (not so much lately) profitable tech company just that little bit better.

My goal, as it’s been since ($)55 (7-to-1 split-adjusted), is to “compare numbers to narratives in what small measure I can”, for those new readers (hey there!) who haven’t stopped by my WordPress blog before.

That little quatrain there? Just me trying to keep a droll subject fresh. It’s a one time deal — probably. 😂

Something that I think bears repeating from last quarter: There’s a gulf of difference between Apple disappointing Wall Street and Apple actually beginning to show signs of failure in an objective sense, whatever any hyperventilating members of the analyst/media/blogger class might tell you. Still, even the most ardent Apple bulls should (in my opinion) agree that a negative growth year, or even fiscal quarter (as FQ3 2016 is certain to be), is one worth watching — and doing additional research about — to check against the ol’ investment/trading thesis.

Let’s get right to it, shall we?

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Apple’s Lowered-Still-Further Guidance Bar, Plus the Formalistic-But-Somewhat-Meaningless “Stating of the Analyst Consensus for To-Be-Reported FQ3 2016” [as of July 23, 2016]

Here’s the FQ3 guidance from Apple:

• revenue between $41 billion and $43 billion

• gross margin between 37.5 percent and 38 percent

• operating expenses between $6 billion and $6.1 billion

• other income/(expense) of $300 million

• tax rate of 25.5 percent

Yes, that’s quite a drop from year-ago actual, where Apple brought in $49.6B in revenue and 39.7% gross margin. Then again, revenues in FQ3 2014 were $37.4B, albeit with a similar-to-FQ3 2015 39.4% gross margin. Then again again, ForEx headwinds didn’t start to be mentioned by Apple until FY15.

Anyway, run the numbers and Apple’s guiding to a net income range of around $7.13 to $7.93B. A sharp drop from $10.7B for FQ3 2015, and a possible drop from FQ3 2014’s $7.75B, though it’s no small sidenote that OpEx for FQ3 2016 is projected to be $1.55B or so higher than FQ3 2014’s “mere” $4.45B.

Yep, another bummer quarter inbound (Wall Street mostly prepared for the disappointment, seeing how AAPL’s bounced between around mostly 90 and 100 the past three months). The gross-outlier FY15, plus macroeconomic jitters, plus a still-very-strong US dollar vs. other foreign currencies (Apple’s done the majority of its business internationally for some time now), with a side of smartphone slowdown worries all contribute to some degree. Nothing we didn’t already know, except for Watch being the first iOS/iOS derivative product outside of iPod touch to not be on a (fairly) strict annual update cadence. The impact of a second-generation Watch won’t be measurable just yet.

Here’s what the 35-analyst consensus polled by Yahoo! Finance (not an endorsement per se, it’s just where I’ve always surfed to get the information) thinks about the FQ3 numbers: $42.11B (down about 15% YOY), and EPS of $1.38 (vs. $1.85 in the year-ago quarter)

And now, my “entertainment purposes only” complete wild guess for FQ3, with quick “commentary” on the major revenue categories.

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The AAPL Tree “I Bet Mav’s Overcorrecting This Time Around Because He Guessed High for FQ2 2016 Too” Horseshoe Toss for Apple’s Reported FQ3 2016 Numbers

And maybe I am overcorrecting in more than few ways, but you’ll get a decent sense of my overall “thinking” a little ways down the road.

We’ll start with iPhone and end with Services.

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iPhone

Last 10 fiscal quarters of year-over-year unit growth/decline, GAAP sell-in reporting basis (FQ1 2014 — FQ2 2016): 7%, 17%, 13%, 16%, 46%, 40%, 35%, 22%, 0.42%, -16%

Part I: Intro

If iPhone will continue decaying at around 15%-ish units year-on-year, even with iPhone SE being apparently fairly popular for a “boring” (heh) device (I had something to say about that elsewhere)…

…then maybe Apple really is doomed? 😱

Not quite.

First, let me bring your attention to the bolded percentages. That’s the profound iPhone 6 “unit sales nova”, collectively bringing iPhone sales from an already enormous 169.2M units in FY 2014 to a head-spinning 231.7M units for FY 2015. Has there ever been a time something of this volume ever achieved 37% year-on-year growth?

I’ve already mea culpa-ed my inability to see the “sales nova” + continuing macroeconomic jitters ‘round the world (which I suppose the ForEx headwinds should have been a significant clue of) + slowing global smartphone growth trends contributing to a negative growth year during an “iPhone S” cycle — but hey, I’m not an economist/industry analyst, I don’t get paid to do my home gamer’s work, and I’ve been warning (existing) readers practically every other post to never rely on anything I say. 😄

Related topic, notwithstanding my last sentence — I also happen to have a humble trio of metrics (Apple News format; I’ll post to Medium sometime soon, I hope) to better assess the overall strength of Apple’s 2-year iPhone campaigns…until the cadence established since iPhone 3G changes, but for now we’ll focus on FQ3.

Maestri cited, among other things such as relatively greater weakness in the Hong Kong market, a $2 billion (“plus”) channel inventory drawdown [FQ2 2016 conference call podcast, 23:25](from mostly iPhone) for FQ3 — which, depending on your ASP/iPhone-specific assumptions, could account for around 3M units on a GAAP basis. That alone, on a year-ago-compare basis, accounts for around 6% of FQ3 2015’s unit sales of around 47.5M units. Perhaps less, if higher-priced iPhones are “disproportionately” targeted for drawdown.

This isn’t to say, however, that the channel inventory drawdown is being done by Apple out of an abundance of sandbagging — not in this climate. After all, Apple guided to $50B-53B for FQ2, only to report at $50.6B. In any case, sellthrough units, which Apple should provide, will be more instructive. And that FQ3 2015 sellthrough compare is apparently around 48.1M units.

Part II: Units and ASP assumptions

So, units and ASP.

We’ll start with iPhone units. Where to begin?

Well, how about the arguably strongest component of the iPhone lineup— the new-in-April 2016 iPhone SE.

The stockouts sure seemed to imply iPhone SE was a decently strong seller.

If you, as I do, believe (theorize, whatever) that iPhone SE will grow the 4-inch iPhone market from 30M units (or more) back in CY/FY 2015, then you’d probably also believe that the SE will be one of the few tailwinds for the category in FQ3. A positive growth driver at least until iPhone 7 shows what it’s able to do in terms of reviving sales.

If you don’t agree? As a practical matter, if small-iPhone-segment unit decline is less bad than rest-of-iPhone (c’mon, it’s launch quarter), it still “helps” the overall average.

Of course, iPhone SE is just getting started, and 4-inch iPhone mix has been, well, not very significant since the iPhone 6 era (possibly as low as 13% of all iPhones sold in 2015). We’ll need more quarters to get more indirect hints on SE’s relative unit mix, though the trend could — should? — be upward for this year and next. Combine that with the sizable channel inventory shift in iPhone (unlikely to repeat for FQ4?), and my mental blender came up with a fairly gloomy rate-of-decline similar to the -16% seen in FQ2.

Why not lower? There’s a bear case to be made, sure, in the sense that Apple saw that -16% growth rate on a smaller channel inventory drawdown (450k units, call it around $300M) for FQ2. I reserve the right to be hilariously wrong, but after the FQ2 “shock”, I think Apple management decided to take their conservatism to new levels, especially as seen in this quote from Maestri: “The guidance also reflects a range of possible scenarios related to how quickly we can get into supply/demand balance for iPhone SE … our expected demand is greater than our revenue range implies.” [FQ2 2016 conference call podcast, 23:30-ish] Maybe they will be caught flat-footed a second time, but this is Apple we’re talking about. A world leader in sandbagging. I “suspect” they’ve recalibrated sufficiently this go-around.

That leaves iPhone ASP. Here’s where’s it’s been since FY 2012:

ASP had a substantial sequential drop vs. FQ1. On the other hand, the FQ2 2016 number is still the 7th highest ASP of those 18 data points — and if you adjust for ForEx, it’s probably in 6th.

Will ASP drop sequentially again? Well, a lot of iPhones are involved in that channel inventory drawdown. It’s logical, at least, to draw down inventory of a considerable amount of higher-end iPhones in a weaker consumer market. Plus, ASP sequential declines have happened often, though not always, in recent FQ2-to-FQ3 intervals.

SE will also lower ASP, but until Apple turns in a really “abysmal” number that it “blames” SE for, I’ll just wait and see, since no one really knows how many SE units Apple was able to produce for FQ3.

Given all this, might my ASP guess of $617 (a drop of about $25) still be too high? Quite possibly, but you know what? I’m comfortable with having an outlier data point or two. If I have to adjust assumptions, so be it. Non-iPhone unit sales mix, mix of channel inventory drawdown, and ForEx are all big question marks, even as one could reasonably presume all three would exert downward pressure on iPhone ASP.

Next up, iPad.

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iPad

Last 10 fiscal quarters of year-over-year unit growth/decline: 14%, -16%, -8%, -13%, -18%, -23%, -18%, -20%, -25%, -19%.

The YOY growth numbers look just awful. No question.

So, how much stock “should” one put into Tim Cook’s comment about having the “best iPad revenue compare in quite some time”? [FQ2 2016 conference call podcast, 43:40-ish]

Well, it’s certainly good to have iPad Pro 9.7 join the lineup, from that perspective. It’s an iPad two fiscal quarters delayed, given that the iPad Air 2 did not get a “formal successor” until the March event. Yes, pent-up demand still exists, heh — it’s just a matter of how much given Apple’s continuous negative growth trajectory for the past two-plus years. And having iPad Air 2 finally get a price drop (which was anticipated for late 2015, per the “usual” cadence) should help as well.

Since some of “iPad’s holiday quarter” was actually pushed out to FQ3, I’m theorizing (on fairly solid, obvious ground) it has the twin impact of (1) making the first half of FY16 look somewhat worse for the iPad segment, and (2) making the second half of FY16 look somewhat better, given that the “seasonality clock” for new product has been reset for Apple’s new “mainstream” tablet offering. If my complete wild guess of iPad Pro 9.7 demand being in the range of 15M units for an anticipated 12-month “full-price” sales cycle holds, I’d figure the maybe-3.5-to-4M or so iPad Pro 9.7s sold in FQ3 should at least offset unit decline as well as revenue decline. And that’s part of why I decided on a unit growth rate horseshoe toss of -7% YOY (10.2M) — which is apparently on the (very) bullish side.

In terms of ASP, I “split the difference” — guessing an iPad ASP of $422, which is up YOY (from $415), but down sequentially (about $430). Maybe iPad Pro unit sales continue to cool as the anticipated refresh approaches, and the “general rule” of ASP trending downward outweighs ASP uplift from iPad Pro 9.7? Who knows? Hey, management will clue us in very shortly anyway — so we move on to Mac.

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Mac

Last 10 fiscal quarters of year-over-year unit growth/decline: 19%, 5%, 13%, 21%, 14%, 10%, 9%, 3%, -4%, -12%

It’s been a very quiet year for Mac. Apple’s Mac of the future — the 12-inch MacBook — did get a nice update in mid-April. Beyond that, Apple boosted 13-inch MacBook Air RAM to 8GB — welcome, but no huge change by any means.

Apple had more for consumers in the first half of 2015: Updates to the 13-inch MacBook Pro and Air (along with the all-new 12-inch MacBook) in early March; a Force Touch + speed bump 15-inch MacBook Pro update and significantly price-dropped iMac 5K models in May.

Aside from the March update and retina iMac updates in October 2015, there’s really nothing to boost interest in Mac for the fiscal year — particularly not in Apple’s mainline MacBook Air or Pro models. So, it might be that a -10% YOY unit decline guess is too optimistic. Personally, I think it’s at least sober, considering that there is some level of interest in the USB-C Mac laptops that Apple’s trying to turn into “the next MacBook Air”.

The MacBook Pros certainly seem “overdue” for their next redesign. Can’t be more than a year away, or even half a year at this point, right?

As for Mac ASP, it’s been steady at around $1265 in FQ2 2016, and $1257 in FQ3 2015 — so I’ll just go with a slight decline to $1245 for now. A “traditional computing” ASP so many companies would [insert ad lib here] to have.

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Watch

Apple’s given consumers plenty of reason to set their *ahem* watch to annual reminders for iOS-type products — and since Watch has been hyped to iPad and iPhone-like levels, it was more than reasonable to expect some Spring 2016 announcement.

Nope.

Sure, there was a price drop, and watchOS 3 looks nice, but I can’t see Watch “doing well” on a units basis now that the expected 12-month sales cycle has “gone into overtime”. And here, I may well be too dour — guessing slightly less than 1M units at an ASP of $375.

Whatever the case (no pun intended), there’s a decent chance “rest of Other Products” (which is now “impossibly blended” with Watch and related product) is significantly higher than Watch revenues. But it’s not a revenue line Apple is keen on giving any real insight into, and odds are low that Cook and Maestri will say anything particularly illuminating about Watch or Other Products tomorrow.

Watch’s “true test” begins when the second generation launches. Whether that’s this year or next is anyone’s guess.

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Services

Last 10 fiscal quarters of year-over-year unit growth: 19%, 11%, 12%, 8%, 9%, 9%, 12%, 10%, 26%, 20%.

Here’s another part of my horseshoe toss where I’m probably too bearish — even though I’m “projecting” (exaggerated air quotes) a YOY revenue increase of around 10%. Apple Music alone might account for a large portion of that 10% growth.

My pet theory, which seems reasonably close to the mainstream (having some basis in “common sense”) is that as long as Apple adds new customers — which also means expanding the installed base, still happening as far as I know — that tends to positively impact Services revenue.

And, repeating a paragraph from last quarter’s preview — as long as Apple adds loyal customers who take an increasing liking to Apple over time, that creates its own sub-demand curve for existing users, and especially new users. Read: New customers in FY 2015 aren’t about to stop spending in FY 2016 — I’d think spending will increase overall.

Maybe the percentage growth number is closer to high-10s. Even 20%. But the general aim of my earnings “estimate” “methodology” (more exaggerated air quotes) is relative sobriety, especially in this jittery macroeconomic climate. We’ll see the effects of my restraint shortly.

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Gross Margin

Why am I guessing 38.1% (10 basis points over top-end guide), when

• Actual vs. guidance for FQ2 2016 was 39.4% (vs. guidance of 39–39.5%), and

• Well, Apple’s blatantly signalled this would be a pretty crappy quarter?

That’s actually kind of it, really. Apple had a perhaps-below-their-own-expectations FQ2, but gross margin remained strong, despite the margin pressures that come with, among other things, reduced revenue leverage (read: lower revenues).

My tinfoil theory? FQ3-guided gross margin, like Apple’s $41–43B FQ3 revenue guide, was built to be “world-economy-proof” (actual would not undercut guidance in Apple’s planning). And despite the macroeconomic uncertainty, Apple’s gross margin range was still just 50 basis points, when it could’ve easily been 100. It reflects a calm certainty in Apple’s business model despite the choppy “business waters”, so to speak.

If Apple’s saying gross margin won’t drop sequentially more than around 200 basis points, even with a big sequential drop in revenues (guided to around $7–9B reduction), even with a GAAP-affecting drawdown of high-margin iPhone channel inventory…then I’ll dare to be a little different, and say gross margin turns out slightly better than “feared”.

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Buybacks

Not much to say here. Apple repurchased $7B in stock for FQ2 2016, if memory serves. That’s usually their baseline, give or take a billion. So, I straight-line-projected a similar repurchase amount for FQ3 2016 (good for around 70M shares). Apple “should” report share-weighted-average diluted share count of under 5.5B (I call 5.47B) in any case tomorrow, if recent trends hold.

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Quick Note on FQ4 2016 — a.k.a., can this “lousy” fiscal year be over already?

Finally, just a few words on FQ4, while we wait on iPhone 7 and any new revenue-assisting new product from Apple before an “unmemorable” FY 2016 wraps up.

Analysts polled by Yahoo! Finance, as of July 25, 2016, expect Apple to ring in “meager” sales of $45.84B, which is a sequential improvement (absent a FQ3 blowout), but is still quite a drop (11%) from Apple’s year-ago actual result of $51.5B.

Oddly enough, analysts, at this point, do see Apple picking itself off the floor, so to speak, returning to revenue growth (of about 4%) in FY 2017, though their consensus estimate of about $224B remains about $10B shy of Apple’s all-time FY 2015 record of $233.72B.

Oh, will Apple ever see such heights again? Well, as of the here and now, analysts apparently see some combination of (1) continued strength in Services revenue, (2) presumptive growth courtesy of a second-gen Watch, and (3) maybe not totally disappointing iPhone 7 sales with a side of SE momentum reversing the slide of FY 2016. I can’t really see analysts being bullish on Mac and iPad, after all.

This concludes my thirteenth consecutive home game earnings preview for Apple — hope you didn’t mind reading! The wait’s nearly over. Let’s see what cards Apple shows in less than 24 hours.