Our community’s reaction to the ER call

AAPL, Quarterly Forecasts, Earnings & Guidance

On April 24, 2008, TechStock2000 posted the following:

Now that the dust is beginning to settle after the earnings call, let’s take a moment to pause, catch our breath, and see where we are.

I believe that our community has a deeper knowledge of AAPL and of Apple Inc. than is available in the general investment community (including many professional analysts).  Also, we are highly skewed toward viewing Apple favorably (long on AAPL) rather than unfavorably (short on AAPL).

If you look at the numbers that were reported yesterday, Q2 was a blow-out quarter.  Even with the revenue from a month of iPhone sales being deferred from Q2 to Q3, revenue beat expectations, with more macs, more iPods, and more iPhones sold than were expected.  Even though gross margins were lower than expected, the operating margin was significantly better than expected and EPS blew away the guidance and consensus.

For a little while, I was puzzling over the gross margin drop, but figured it out with the help of Kylobbyist and howlongtoretire (thanks again to you both).  Apple’s overall gross margin is a blend of the gross margin for software sales (very high) and the gross margin for hardware sales (much lower).  By selling so many more macs than expected, there is a higher percentage of the hardware gross margin included in the blended overall gross margin - which brings the overall gross margin down.  If this were due to lower than expected software sales, it would be a bad signal.  Since the software sales were as expected but hardware sales were more than expectations, the resulting lower gross margin is a good signal.

On our board, we published our expectations for the EPS for the quarter, and the majority of our expectations were significantly higher than the actual $1.16 that was reported.  This has happened quarter after quarter with our group, and also applies to our expectations of product sales.  Does everyone remember our “consensus opinion” of the number of iPhones sold during the first weekend of sales last year, and how we came back to earth only by tracking the IMEI numbers?  Like I wrote above, we are heavily skewed toward being favorable toward Apple, and I believe that we naturally are more likely to believe a “strong” interpretation of data than a “weak” interpretation of data.

And the result of being so bullish on Apple?  When the company reports EPS of $1.16, which I believe is a stellar number, some of our group expresses disappointment that the number was not $1.24, $1.30, or even higher.  It must be frustrating for the hardworking people that have made Apple the success that it currently is when they announce numbers of which they are justifiably proud, only to be told that those numbers are not good enough.  Kind of like bringing home an “A” on a big test only to have your parents berate you for not getting an “A+” on the test. I have to admit that my daughters have known this frustration on occasion.

Imagine the situation for AAPL stockholders if this were the prevailing attitude of the investor community, not just our little group.  The wild swings that we have experienced in AAPL’s price over the past few years would seem like molehills compared to the gyrations that I believe would result.

So, how does a management team keep expectations from getting so far ahead of the rate at which the company can maintain sustainable growth?  One way is to NOTdeliver results in any one quarter that will lead to higher expectations for future quarters.  There is no doubt in my mind that this is the reason for deferring revenue from all sales of iPhones after March 6 until the 2.0 software is delivered.  Sales of macs were so far ahead of expectations that the company needed to report a lower revenue number than they otherwise would have reported, and this was a creative way to shave some revenue off of the quarter (while still collecting the cash).  As an aside, my opinion is that this is the strongest reason for implementing subscription accounting for iPhone generally - the company did not want to have a huge increase in revenue with the introduction of the iPhone, but rather a more gradual increase, which allows for easier management of expectations.

Another way that a company can rein in runaway expectations in the analyst community is through the signals in its guidance.  When analysts generally are moving to expectations that might be difficult for the company to reach, the company has added risk and uses lower guidance to bring those expectations down.  As with everything, there are both long-term and short-term results from using lower guidance.  No question that the short-term result is a lower short-term stock price.  We saw the AH price drop from $171 to $154 almost immediately yesterday afternoon when the guidance number became public.

The long-term result of lower guidance is to place the trajectory of expectations for growth on a path that the company believes it can meet quarter after quarter for a long time.  If it succeeds, the company can avoid ever having a true miss, with the result that the long-range stock price will be higher that it would be with blow-outs and misses.

This is an area in which the incentives of company management and investors in the stock (especially short-term traders) diverge.  It is and will always be in the best interest of the management to have steady, sustained, uninterrupted long-term growth.  Management is at the company for the long term.  It is often in the best interest of an individual stockholder to have peaks and valleys in the stock price, which will provide an opportunity for talented traders to buy the valleys and sell the peaks.

So, it is natural for our community to be frustrated with low guidance, and to express that frustration.  It is also natural for the company to provide that low guidance - and I fully expect them to continue to do so.  The executive team has very few tools with which to guide expectations for the future, and I would certainly not expect them to voluntarily give up one of those tools or to cease using it aggressively.

techstock2000 @ April 24, 2008