Monthly Archives: July 2010

Equity Market Ready to make a Massive Move

There are several key technical indicators suggesting that the market is ready to make a massive move one way or the other, and the evidence is pretty compelling on both sides of the tape – though I think the bears have an edge here. Yet, one thing is for sure. Whichever way the market goes, it will be a big move in the coming weeks. (QQQQ) (SPY) (DIA)

We’re either going to see a February to April type melt-up or another huge downdraft to at least test the correction lows. I suspect this move will begin within the next few trading sessions. I’m currently positioned on the short side of the trade, however, to take advantage of very overbought conditions as exhibited in the NYMO and cumulative tick.

The Bear Case
There are four central technical indicators suggesting that this current rally is on its last legs, and the market is about to see some major selling pressure starting within the next few trading sessions.

First, the $NYMO is simply way too high. In fact, its sitting at levels not seen since the bear market lows set over a year ago. An 80 on the $NYMO usually indicates that the market is getting a little over extended – it current sits at 97.25 set at yesterday’s close. You can see a very thorough analysis on the $NYMO at Cobra’s Market View.

Secondly, the cumulative tick on the NASDAQ has hit levels suggesting that a major sell-off sits on the horizon. The last 11 times we saw such overzealous buying on the NASDAQ a significant sell-off in the markets followed within a few days. See Cobra’s Market View or SentimenTrader for more on the cumulative tick indicator.

Thirdly, the last two trading sessions of the last nine or so months have generally been met with significant weakness. Those who have shorted the broader market at the close of the third to last trading session, and covered that position at the close of the last trading session has been very profitable for nearly every month of the past year. See here.

Finally, the volume on the market’s recent move up through several key technical levels of resistance has been very abysmal. This indicates a serious lack of conviction on the part of market participants taking this market higher. The S&P 500 closed above the 200-day moving average yesterday on very weak volume, and continues to flirt with that level today but without the necessary conviction to bring real buyers into this market.

The Bull Case
The bulls have some very compelling arguments of their own. First, recent weakening of the trend on the TLT (TLT) seems to indicate that there may be an impending flight from the safety of fixed income instruments to the higher risk assets in the equity markets. The TLT appears to have put in a double top at around $102 and is currently flirting with the 50-day moving average. There’s an inherent inverse relationship between the TLT, a 20+ Year Treasury Bond Fund, and the equity markets.

Secondly, the $TNX (10-Year Treasury Note Yield Index) seems to support this view as it appears the yield on the 10-year treasure note has put in a double bottom at the 29 level. Moreover, the $TNX is currently testing the upper trend line of the April to July downtrend suggesting that market participants are getting ready to shift to an equity strategy.

Thirdly, the $VIX is at the cusp of breaking down from the April to July bearish pennant, and appears that its set to close below the 200-day moving average for the second day in a row. A shift to an equity environment of lower volatility will clearly be conducive to much higher stock prices.

For a more detailed analysis of the equity markets, please see Cobra’s Market View – easily one of the best technitions I’ve had the pleasure to follow over the past several months.

Disclosure: At the time of this writing, the author holds August 2010 puts on the QQQQs. The information contained in this column 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.

Barron’s on Apple & Microsoft

One of my favorite columnists, Eric Savitz, published a well-balanced piece comparing Apple and Microsoft in Barron’s today. Its definitely worth a read. He captures, what I think, is a very key concept when assessing these two companies – that one is a value play and the other a growth stock. As I noted in an article I published at Fortune this past Monday, I’ll be running an in-depth comparative analysis of these two companies in the coming weeks.

While some regard Eric as generally bearish or skeptical on Apple, I’ve had a chance to follow a lot of his writing over the years and can attest that those concerns are relatively overstated. He’s actually very balanced and fair in his writing focusing on both the positive and negative aspects of the company.

As most of wall street and the media seems to place Apple on a pedestal, I think it’s important to keep in mind that there are always two sides to every story, and Eric does a excellent job of reminding us of this. You can read Eric’s article here.

Disclosure: At the time of this writing, the author holds August 2010 puts on the QQQQs. The information contained in this blog is not 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.

Apple to Surpass Microsoft in Revenue this Quarter?

After 30-years of living in the shadows of Microsoft, Steve Jobs and Co. will likely surpass its archenemies in Revenue this quarter. And as Apple’s staggering growth rate continues, its unlikely that Microsoft will be able to resume its dominance over the iPhone maker anytime soon.

While doubts as to whether Apple (AAPL) deserves to hold the second largest market cap in the U.S. continues to mount, one thing it is clear: Apple has closed the revenue gap on Microsoft (MSFT), and looks to assume full supremacy over the software giant going forward.

And though Apple still has a ways to go to compete with Microsoft in terms of net income due to Microsoft’s stunning operating margin, many will be surprised to learn that Apple will actually post more revenue than its rival in the 2010 and 2011 fiscal years.

In fact, when Microsoft reports second quarter calendar results after the bell this afternoon, its likely that Apple will have surpassed Microsoft in revenue for the first time in the company’s recent history – and that it will continue to do so in the future. Apple reported $3.25 billion in net income ($3.51) on a whopping $15.7 billion in revenue on Tuesday, smashing analyst expectations, and reporting more or less in line with my forecast.

Microsoft, on the other hand, is expected to earn $4.1 billion in net income ($0.46 in EPS) on $15.26 billion in revenue when it releases results after the bell today. That is nearly $500 million less than what Apple reported in revenue this quarter. And while Microsoft also regularly reports upside surprises making it very possible that it could edge out Apple in revenue, the gap between consensus estimates and Microsoft’s actual results is nowhere near as wide as it is with Apple’s results.

The chart below details a quarterly revenue comparison of Apple and Microsoft over the past few years. As one can see from the chart, Apple looks to surpass Microsoft’s quarterly revenue for the first time in recent history. More importantly, while Microsoft’s revenue growth appears to have slowed in recent years, Apple continues to post one record quarter after another. Since Microsoft and Apple are on a different fiscal year, the chart realigns their results to make them comparable on the calendar year.

So the big story in tech earnings this week is whether history will be made in the decades-long battle between Apple and Microsoft, or whether Microsoft will postpone the inevitable and maintain its dominance over Apple for at least one more quarter.

And even if Apple doesn’t beat Microsoft in sales this quarter, it will certainly do so next quarter and by quite a large margin. For the September quarter, analysts expect Apple to generate approximately $18 billion in revenue compared to a projected $15.16 billion expected out of Microsoft.

So even conservative analyst estimates already put Apple ahead of Microsoft by nearly $3 billion next quarter. My estimates put Apple ahead by $3.8 billion as I expect Apple to record nearly $18.9 billion in revenue. You can see my track record on Apple here.

What’s even more surprising is that Apple will likely far surpass Microsoft in revenue for the entire 2010 and 2011 fiscal year. In fact, I’m looking for Apple to record $81.6 billion in revenue in 2011 – that’s about $11.6 billion above the $70 billion I’m expecting out of Microsoft. Even the 2010 and 2011 conservative analyst consensus puts Apple well ahead of Microsoft. Thus, it’s looking increasingly likely that this quarter sets the beginning of a new age where Apple will regularly post higher revenue than Microsoft going forward.

The chart below compares Apple and Microsoft’s annual fiscal revenue for the past several years. While quarterly data must be compared on the calendar year to show a side by side comparison over a particular 3-month period, yearly data can be analyzed on the fiscal year.

Yet, when it comes to questions as to which company ought to have a larger market capitalization, total revenue is but a single of several factors that should be considered. Net income growth, total net income, total net cash, cash flow, book value, total assets and the economic sensitivity of each company’s primary operations are just a few of those other key factors.

So while Apple will be surpassing Microsoft in revenue in the near future, that in and of itself doesn’t necessarily mean that Apple automatically ‘ought’ to have a larger market capitalization.

Though under closer scrutiny one will find that within the next year or so, Apple will soon not only record more revenue than Microsoft, but will earn more in net income, generate a larger amount of cash, and out-pace Microsoft in terms of growth in net income and revenue.

Still, Apple does have a ways to go before it will surpass Microsoft in net income. Due to Microsoft’s extraordinarily high operating margin, the only way Apple can beat Microsoft in earnings is by simply outpacing it in sales. Since Microsoft pushes more of its revenue to the bottom line, Apple will have to significantly outpace Microsoft in revenue to win on the net income front – something that Apple will probably do in 2012. The chart below compares Apple and Microsoft’s net income for the last several fiscal years, and offers projections for 2011.

Though these two companies no longer really operate in the same space as they once did in the past, Apple turning its focus on the consumer and Microsoft on enterprise spending, both companies are dominating their respective industries. Yet, several Microsoft investors have argued that it’s somehow inappropriate to compare Apple to Microsoft since Apple is a device maker and Microsoft an enterprise software maker. Nothing can be further from the truth.

Such arguments not only reek of the highest level of financial irrationality, but they are also rooted in a dangerously mislead ideology. Any two companies that make money are automatically comparable.

For while the comparison may or may not be appropriate in a cross sector analysis, any two publically traded companies can in fact be compared on a fundamental return on equity basis. That much is clear. If a multi-trillionaire wanted to buy either of these companies, a fundamental comparison is not only appropriate, but required for sound due diligence.

Moreover, even in a cross sector analysis where an investor wishes to determine which company is best in breed, Apple and Microsoft do in fact participate in the technology sector despite little operational overlap between the two companies. It’s not as if Apple is a pharmaceutical company, and Microsoft an oil refiner. Such is a rudimentary concept of finance, and the average investor would do well to understand it.

Thus, what’s left to be decided is which of these two tech giants deserves to be crowned the supreme leader of the tech sector as a whole? The answer to that question will be addressed in future articles I’ll be writing over the next few weeks. Stay tuned.

See also:
Earnings Smackdown: The best and worst Apple Analysts
Apple Smashes Expectations in its Fiscal Q3 Earnings Report

Disclosure: At the time of this writing, the author holds no position in the equity markets. 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 thier own professional financial advisors before acting on any thoughts expressed in this publication.

Apple Smashes Expectations in its Fiscal Q3 Earnings Report

Apple absolutely demolished Wall Street estimates posting yet another $1 billion beat on the top line when it released its fiscal third quarter earnings results this afternoon. Shares of the tech giant moved up in after hours as investors welcomed strong results across the board. Apple reported $3.51 in EPS on $15.7 billion in revenue compared to analyst expectations of $3.10 in EPS on $14.74 billion in revenue. Apple also added $4 billion in cash to its war chest bringing the total just above $45 billions.
Apple’s earnings were driven largely by sales of 8.4 million iPhones, 9.4 million iPods, 3.27 million iPads, and 3.47 million Macintosh computers. And in spite of the law of large numbers, Apple posted a high flying 61.4% revenue growth and 74.6% EPS growth when compared to the year-ago quarter.
Yet, the big story in this report is Apple’s aggressively confident revenue guidance for the September quarter. I’ve never seen Apple provide guidance so far above the consensus in the several years I’ve followed the company.
Analysts were expecting Apple to guide for about $17 billion in revenue for Q4. I was actually expecting to see guidance in the range of $16.8 billion consistent with Apple’s habit of guiding below the street’s expectations. Yet, Apple came right out of left field and aggressively guided for $18 billion for the September quarter all but indicating that revenue will likely come in at the higher end of $19 to $20 billion. I’ll be exploring this issue in far more detail in a full review of the earnings release later this week.
Another big story in this report is whether Apple (AAPL) will surpass Microsoft (MSFT) on the top line for the first time in the company’s history. Analysts polled by Thomson Reuters expect Microsoft to report earnings of $0.47 a share on $15.27 billion in revenue. Unless Microsoft far surpasses analyst estimates, Apple’s $15.7 billion in revenue appears to have put Apple ahead of Microsoft for the quarter. You can read my full report of this story at CNN Fortune.
I’ll be doing a more detailed analysis of Apple’s earnings and what it means for Q4 later this week. Stay tuned.

See also:
Apple Fiscal Q3 2010 Earnings Preview
Apple Closes in on Microsoft in Revenue Race
How Apple Maintains Explosive Earnings Growth
Philip Elmer-DeWitt’s Apple Earnings Preview

Disclosure: At the time of this writing, the author holds Apple 2012 $300 call options purchased ahead of Apple’s fiscal third quarter results. 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.

Apple Fiscal Q3 2010 Earnings Preview

As shares of Apple (AAPL) continue to fall under pressure due to negative market reaction to “Antennagate” and disappointing results from IBM (IBM), investors will now look for earnings to pull Apple out of the doldrums. Analysts polled by Thomson Reuters expect Apple to report about $3.10 in EPS on approximately $14.74 billion in revenue. Furthermore, analysts are generally looking for Apple to sell 8.35 million iPhones, 9.8 million iPods, 3.2 million Macintosh computers, and 3.3 million iPads – see here.

Yet, a collection of nine financial bloggers polled by Fortune Columnist Philip Elmer-DeWitt, and who tend to regularly outperform Wall Street analysts are generally looking for far more impressive results than the street. The bloggers, according to Elmer-DeWitt, are looking for Apple to report about $3.64 in EPS on $15.67 billion in revenue (that’s a $1 billion beat on the Wall Street revenue consensus). The bloggers also expect Apple to report sales of 9 million iPhones, 9.9 million iPods, 3.33 million Macs and 3.32 million iPads.

Yet, based on the data I’ve analyzed over the course of the quarter, I’m looking for Apple to report closer in the neighborhood of $3.70 in EPS on $15.608 billion in revenue. I’m expecting Apple to sell 8.8 million iPhones, 10 million iPods, 3.363 million Macs, and 3.4 million iPads. The first table outlines my estimates relative to the consensus estimates and Apple’s forecast. The second table contains my revenue and unit sales estimates for Apple’s primary operations. Please click on the table for an enlarged image.

The big story this quarter, however, is whether Apple will surpass Microsoft in revenue for the first time in the company’s history. Analysts are generally expecting Microsoft (MSFT) to report $0.46 in EPS on $15.25 billion in revenue this quarter. That’s well below the $15.6 billion that the bloggers are expecting out of Apple when it reports this afternoon. If Apple does in fact report closer to what I’m expecting out of the quarter, then we’ll probably be watching history unfold when Microsoft reports this Thursday.

Though it appears this will be a strong report overall, there are still major risks of which investors should be aware. First, due to the collapse of the Euro this quarter, it’s possible that demand for Apple’s products overseas could have taken somewhat of a hit.

Secondly, it’s also likely that Apple will take a hit on the exchange rate leading to added margin pressure. Yet, Apple did note in its fiscal Q2 conference call that it is generally hedge for any potential future strength in the dollar. Still, it’s unclear whether Apple or any other company could have sufficiently anticipated the rather unusually sharp decline seen in the Euro this quarter due to the European sovereign debt crisis.

Another significant risk in this report is that Apple may potentially miss the street’s expectations on iPhone sales. Though the iPhone saw exceptional sell through in the quarter at the retail level indicating high demand for the device, Apple has been very slow at replenishing its channel inventory.

Financial Alchemist’s Turley Muller, who is generally known to be the most accurate analyst covering Apple, is modeling for an iPhone number well below the street. Muller expects Apple to report 7.8 million iPhones due in large part to stress in the channel – that’s 500,000 units below the street’s view. In fact, I’ve reduced my initial estimates from 9.3 million iPhones to 8.8 million units due to channel weakness.

If Apple does in fact miss on the iPhone number, it’s almost certain to lead to a major sell-off in the stock. It’s relatively easy to predict how the market will react to such news. The average fund manager, not fully understanding the difference between weakness in the channel and weakness in demand will see a low iPhone sales figure as simply being weakness in demand.

The market would likely dump the stock in spite of evidence suggesting that sales to the end user have actually been booming throughout the quarter clearly signifying robust demand for the device. The ongoing “antennagate” backlash also doesn’t help matters either. With Research in Motion (RIMM), Nokia (NOK), and Motorola (MOT) passionately attacking Steve Jobs’ attempt to deflect the reception problem of the iPhone 4 to the industry at large, the media is sure to keep this debate alive – and that’s exactly what these companies want.

Yet, though it’s possible that Apple might miss on the iPhone number due to weakness in the channel, I still think the weight of the evidence suggests that strong initial iPhone 4 sales will likely ameliorate the negative impact from weakness in the channel. And even if Apple does happen to miss on iPhone sales leading to short term weakness in the stock, it will present a good opportunity to dollar-cost average. Especially since weakness in the channel in this quarter will lead to stronger results in future quarters as that channel is replenished over the coming months.

Another story worth following in this report is the strength of Macintosh sales. My analysis of Gartner Research on worldwide computer sales seems to indicate that sales will fall between 3.3 and 3.4 million units. That far exceeds the 3.2 million Macs expected by the street. NPD data generally seems to confirm this view as well.

Finally, the most important issue worth following on the conference call is whether management will be able to provide any color on its plans to correct the current supply-demand imbalance going on with the iPhone 4. Apple is currently faced with major supply constrains not seen since the early days of the iPod Nano.

This is evidenced by Steve Jobs’ comments during antennagate that Apple has only sold “well over” 3 million iPhone 4s as of July 16 – that is tracking way behind analyst estimates for Q4. Apple sold 1.7 million iPhones in its first 3 days of sales, and only 1.3 million over the next 19 days. The run rate over that 19-day period is tracking far behind even the most conservative estimates.

In fact, if that run rate continues throughout the quarter, Apple would only sell 6.5 million units in Q4 – that’s well under the 11-12 million iPhone number expected by many analysts. In fact, I’m currently modeling for 11.5 million units. You can read more about this issue here.

Thus, it will be very important for Apple to address this issue head on in the conference call, and give some type of reassurance that it has plans to replenish its channel in a timely manner. For if this incredibly low run-rate continues for much longer, Apple may become at risk of missing Q4 iPhone sales estimates. As of now, this is merely an issue worth following, and I expect that it will be efficiently addressed given Apple’s incredible track record at problem solving. All in all, this should make for an interesting report.

See also:
Philip Elmer-DeWitt’s Very Exhaustive Earnings Preview
Apple Closes in on Microsoft in Revenue Race
2010: The Year Apple Enters a New Golden Age

Disclosure: At the time of this writing, the author holds no position in the equity markets. 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 thier own professional financial advisors before acting on any thoughts expressed in this publication.

Apple closes-in on Microsoft in Revenue Race

Whether it deserves it or not, Apple has held onto its lead over Microsoft in terms of market capitalization since it first surpassed it back in May. While it may be bigger in value thanks to a meteoric stock surge, Apple’s revenue and earnings still fall short compared to Microsoft. But that’s all about to change.

Apple will report second quarter earnings on Tuesday, and Microsoft will follow on Thursday. Though Apple still has a ways to go to compete with Microsoft in terms of net income due to Microsoft’s untouchable operating margin, many will be surprised to discover that Apple’s revenues are close to surpassing Microsoft’s. If it doesn’t happen this week, it will almost certainly come in the next quarterly announcement.

It’s important to step back and examine just how close each of these companies really are in terms of revenue and earnings. Analysts polled by Thomson Reuters expect Apple to report approximately $2.85 billion in net income ($3.07 in EPS) on about $14.62 billion in revenue when it releases results after the bell on Tuesday. (read more).

How the Overstated iPhone 4 Crisis forced Apple to Give away Free Bumpers

During the Apple (AAPL) press conference on Friday, CEO Steve Jobs made several very interesting observations about the iPhone 4 antenna crisis that I remember reading about in passing when the problem first surfaced.

That nearly every smart phone in the market today, including the Blackberry Bold and HTC Droid Eris, can lose its signal if handled in certain ways. That if the phone already has a weak signal, improper handling can push that weak signal over the precipice and lead to a dropped call.

So the question I have is if smart phones generally do in fact exhibit similar signal problems as Steve Jobs and others have suggested, then why is Apple being singled out for a seemingly ubiquitous issue exhibited in several other smart phones? More importantly, why has Apple agreed to give away free bumpers when this seems to be more of an industry-wide problem and not just an iPhone 4 problem?

Shouldn’t other smart phone makers such as Research in Motion (RIMM), Google (GOOG) and Nokia (NOK) be equally criticized and equally required to give away free cases? It seems to me that Apple was forced to give away free bumpers due to negative public opinion suggesting that this reception problem is a design flaw specific to Apple. That the free bumper solution was in essence the cost of negative public relations, and more importantly the cost to alter that negative perception. It also doesn’t help that Consumer Reports in one week, passes the iPhone with flying colors and then flip-flops the next week by essentially flunking the iPhone.

Yet, Apple by its own actions isn’t entirely innocent either. Steve Jobs conceded that the reason this whole problem even surfaced to begin with is because of how the iPhone would drop calls from the false appearance of full bars on the phone. That because of some flawed software algorithm, the iPhone 4 displayed more bars than the phone actually had. So when the average consumer would see their iPhone 4 go from full bars to dropped calls, complaints about a design flaw in the antenna logically followed. Apple, for its part, fixed this particular problem with the iPhone 4.0.1 patch released on Thursday evening.

Jobs also suggests that another reason this problem became front and center in the media was due to the iPhone 4 dropping slightly more calls than the iPhone 3GS. That because the iPhone 3GS had a similar design as the iPhone 3G, many people just used their old 3G cases on their new 3GS phones. This supposedly caused the iPhone 3GS to collectively drop less calls per 100 than the iPhone 4 at launch. So the idea here is because more people had cases on their iPhone 3GS, than they currently do on their iPhone 4, the problem became more apparent.

It seems to me that Apple really stands by this idea that the iPhone reception problem seems to be more of an industry wide problem, and far more overstated than suggested by the media. Steve Jobs also announced that Apple has already sold 3 million iPhone 4s since launch – that’s a million per week run rate or 12 million in Q4.

Jobs also noted that not more than one-half of one percent of complaints to Apple Customer Care concerns the iPhone 4 antenna problem and that in fact, it has received thousands of emails from customers indicating that they have no reception issues. I personally have an iPhone 4 without a bumper and have yet to drop a call. Then again, I don’t live in an area with a weak signal and I’m just one person. If Apple is in fact right that this seems to be a smart phone problem, and not just an iPhone 4 problem, then I can understand Steve Jobs’ frustration today. Then again, I have to ask myself: When is the last time the media has ever blown anything out of proportion?

Disclosure: At the time of this writing, the author holds no position in the equity markets. However, the author recently exited a short position he took at the close of yesterday’s trading for a large percentage gain on the QQQQ (August $44 Puts).

How Apple Maintains Explosive Earnings Growth

In the four years I’ve followed Apple (AAPL) as it’s grown from a mere mid-sized tech stock to becoming the second largest corporation in the United States in terms of market capitalization, I never imagined that it or any other company of its size would be able to consistently grow its earnings by well over 50% a year.

While Apple is now larger than Microsoft (MSFT), Google (GOOG), Cisco (CSCO), and Intel (INTC), it still enjoys the growth rate of small cap tech stocks. A few weeks ago I wrote an article entitled Apple’s $63.5 Billion Revenue Year where I offer comprehensive revenue estimates for Apple’s fiscal Q3 and Q4 of 2010. Picking up where that report left off, I’ll take a look at Apple’s potential 2010 earnings.

To get an idea of how deeply Apple continues to penetrate the market, Apple will likely produce 50% more in sales and 71% more in earnings in 2010 than it did last year. If this growth continues into 2011, Apple will surpass Exxon (XOM) to become the largest corporation in America. Not to mention that it already has more cash than any other company in the United States: $41 billion. (read more).

2010: The Year Apple Enters a New Golden Age

In the four years I’ve followed Apple (AAPL) grow from a mere mid-sized tech stock to becoming the second largest corporation in the United States in terms of market capitalization, I never imagined that it or any other company of its size would be able to consistently grow its earnings by well over 50% a year.

While Apple is now larger than Microsoft (MSFT), Google (GOOG), Cisco (CSCO), Hewlett Packard (HPQ) and Intel (INTC), Apple still enjoys the growth rate of small cap tech stocks. A few weeks ago I wrote a detailed article entitled Apple’s $63.5 Billion Revenue Year where I offer comprehensive revenue estimates for Apple’s fiscal Q3 and Q4 of 2010 – a must read for any Apple investor.

This article will pick up where that report left off, and take a look at Apple’s potential 2010 earnings. To get an idea of how deeply Apple continues to penetrate the market, Apple will produce 50% more in sales and 71% more in earnings in 2010 than it did last year. If this growth continues into 2011, Apple will surpass Exxon (XOM) to become the largest corporation in America. Not to mention that it already has more cash than any other company in the United States – $41 billion.

That is absolutely stunning when one considers that Apple recorded a whopping $43 billion in revenue during the 2009 reporting period – almost double the $24 billion it recorded in 2007. While the market continues to generally slobber over the financial prospects of the iPhone and Apple’s business, I think it’s important to step back and examine exactly where Apple’s business stands. We often hear about the strength of Apple’s stock in very general terms. Yet, we rarely get a broad picture of Apple’s past, present and future growth rates.

Not only is Apple accelerating its revenue, it’s pushing more of that revenue to the bottom line. For while its sales are accelerating, the growth in the cost to run the entire Apple operation is barely climbing. This means Apple is becoming increasingly efficient at printing money as it makes more revenue per dollar spent to run the operation. This is something that every company, big or small, could only wish to achieve. It is very difficult to accelerate sales as a large cap tech stock while tempering costs.

Based on the analysis presented below, I’m expecting Apple to report $15.51 in earnings per share (EPS) on an explosive $63.409 billion in revenue in 2010. That compares to $9.08 in EPS on $42.9 billion in revenue in the fiscal year ended 2009. The two tables below outline my revenue and earnings estimates for Apple’s 2010 fiscal year. For those who would like to see my track record on Apple, you can find that record at Philip Elmer-DeWitt’s quarterly analyst review published in his Fortune column ‘Apple 2.0.’


Again, this report will focus on Apple’s income statement based on the revenue estimates I’ve already published. For those who are interested on how I arrive at these revenue estimates, please refer to that article. I will also be publishing a detailed analysis of my Q3 2010 estimates in an earnings preview ahead of Apple’s numbers due out after the bell on Tuesday, July 20, 2010. Thus, to get a full picture of Apple’s 2010 fiscal year, I will present a detailed analysis of how, based on a projected revenue estimate of $18.9 billion for Q4, that a forecast of $4.90 in EPS logically follows.

Gross Margin Estimates: 41.9%
Anyone can draw relatively reliable quarterly estimates for Apple simply by analyzing the seasonal trends of consumer spending of Apple products. Once one arrives at rigorously thought out revenue estimates, he or she must then perform an analysis of each line item of Apple’s income statement starting with gross margin.

Gross margin is the amount of money Apple makes on each of its products less the cost it takes to make those products. The only costs considered are the manufacturing cost, the bill of materials, and the packaging cost. These costs are called the cost of goods sold or ‘COGS.’ Subtracting the total cost of goods sold from Apple’s overall revenue will give you Apple’s gross margin.

Determining what Apple’s total gross margin will be in any one of Apple’s fiscal quarters requires an understanding of which of Apple’s product tend to carry higher gross margins, a careful analysis of Apple’s guidance for gross margin, the seasonal trend, the strength of the U.S. Dollar relative to the Euro, and whether a newly introduced product carries a higher or lower gross margin relative to the company’s average.

For example, in Q2 Apple reported 41.67% in overall gross margin percentage. The relevant information required to forecast gross margin for Q3 is: (1) Apple’s comments where it guides down gross margin to 36% owing to supposed lower margins on the iPad; (2) the seasonal trend which suggests that Q3 is stronger than Q2 for the past 4 years; (3) the amount by which Apple generally beats its own forecast (its sizable), (4) the number of iPhones Apple sells as the iPhone possesses the highest gross margin of Apple’s products, (5) the collapse of the Euro which suggests that Apple will see some pressure on ASPs this quarter (though Apple has admitted to be hedged for this potential event) and (6) the lower ASP on the iPod and Macintosh this quarter.

Based on an analysis of these issues (which I will publish in my earnings preview), I arrive at a 40.3% gross margin estimate for Q3. For while Q3 generally outperforms Q2, the weakness in the dollar, and the introduction of the iPad will undoubtedly put margin pressure on Apple this quarter.

Yet, when looking at Q4 gross margin estimates, one must consider the fact that Apple will likely sell well over 11 million iPhones due to the introduction of the iPhone 4. Knowing the iPhone to enjoy higher gross margins than Apple’s other products, one should conclude that overall gross margins will strongly benefit from huge iPhone sales in Q4.

Moreover, since the introduction of the iPhone, Apple’s best quarter for gross margins has been Q4. In Q4 2008, gross margin jumped from 36.28% in Q3 to 38.57% in Q4. In 2009, Apple saw a 1% increase from 40.92% to 41.82%. As Apple is set to record explosive iPhone 4 sales in Q4, I’m expecting gross margin to rise to 41.9% from the projected 40.3% I’m expecting in Q3. The chart below outlines Apple’s gross margin percentage from 2006 to 2010, which include my estimates for Q3 and Q4 2010.

Operating Expenses: $2 Billion
Based on the gross margin percentage estimate of 41.9%, I’m looking for Apple to post $7.922 billion in overall gross margin. To arrive at operating income, one must project operating expenses. Operating expenses are all the expenses related to running the Apple operation. The geniuses at the Apple store, Steve Jobs’ $1 income, the rental cost of all of Apple’s retail stores, the employees, the paperwork, the Apple campus in Cupertino and all other money spent to run the company are all what is included in operating expenses. Based on the current trend in Apple’s guidance, one can produce almost exact estimates for operating expenses.

There are several quarters where I was able to forecast these expenses almost perfectly because Apple would regularly guide $40 million under the actual results. Picking up on this trend, it has been relatively easy to predict these expenses. Yet, one must also consider the growth trend of these expenses to help facilitate a strong forecast.

For Q3, I arrived at an estimate of $1.850 billion in operating expenses based on Apple’s guidance, and based on the trend. Knowing that Q4 tends to be one of the highest quarters in terms of operating expenses due to Apple mass hiring to meet consumer demand of the iPhone and back to school shopping season, I’m expecting a $150 million bump to $2 billion in Q4. The chart below outlines Apple’s operating expenses from 2006 to 2010. Q3 and Q4 are merely estimates and actual results may vary.



Operating Income, OI&E and Income before Taxes
To arrive at operating income, income that Apple generates from its primary operations, one must simply subtract operating expenses from gross margin. Remember operating expenses are those expenses that only include the costs to run the entire Apple operation. Gross margin, on the other hand, is the amount of money Apple makes on the sale of each of its goods (revenue) minus the cost it takes to bring those goods into existence i.e. to make those goods. Thus, for Q4 I’m forecasting an operating income of $5.922 billion, which is the difference of subtracting $2 billion in operating expenses from $7.922 billion in projected gross margin.

Yet, companies will regularly make and/or lose money on the sale of property, from interest on their cash deposits, or from investments. Good accounting requires that we keep that income or loss in a separate category because it would be inappropriate to suggest that income from an investment should be part of the income that Apple receives from the sale of its goods.

So under generally accepted accounting principles (GAAP) we have a line item in the income statement called “Other Income & Expenses” or OI&E. Though the dollar amount of OI&E is generally a small amount compared to Apple’s operating income, it can and will regularly affect EPS and so it should be taken seriously. Based on Apple’s guidance, which generally undercuts or overstates OI&E by $5 million, I’m projecting OI&E to come in at about $50 million for Q3 and $35 million for Q4.

Finally, to arrive at income before a provision for income taxes, one only needs to add operating income to OI&E. In this case, I’m expecting $5.922 billion in operating income, and $35 million in OI&E for Q4. Thus, we arrive at a net income before taxes of $5.957 billion.

Provision for Income Taxes & Net Income
Income taxes can greatly influence the outcome in earnings per share, and thus demands careful consideration. Evidence suggests that Apple will post some very favorable tax rates for Q3 and Q4 of 2010. In Q2, Apple already posted an unusual low tax rate of 23.7%, and looks to continue that rate, based on its guidance, in Q3 and probably in Q4. Q4 is generally Apple’s most favorable tax rate quarter but only slightly better than Q3.

For Q3, I’m estimating a tax rate of 23.4% based on Apple’s comments for the quarter. I’m also expecting a very favorable rate of 23.0% in Q4. Thus, based on a tax rate of 23.0% for Q4, I’m looking for Apple to record a post tax profit of $4.587 billion in fiscal Q4. The chart below outlines Apple’s tax rate, inclusive of my Q3 and Q4 estimates, from 2006 through 2010.



Earnings Per Share
Once you arrive at net income, the job is basically done. One only needs to divide net income by the number of projected outstanding diluted shares to arrive at Earnings Per Share or EPS. Based on a projection of 935 million shares outstanding at the end of Q4 2010, my estimates are calling for Apple to report $4.90 in EPS on $18.906 billion in revenue versus the current consensus of $3.73 in EPS on a conservative $16.54 billion in revenue. The chart below outlines Apple’s EPS growth from 2006 to 2010. This chart presents undeniable evidence that Apple has entered yet another golden age of growth. Apple is truly firing on all cylinders.



Apple’s Earnings History
The four tables below present Apple’s revenue and earnings history from 2006 to 2010. Due diligence begs the average investor to have at least a general working knowledge of these tables. These income statements have been amended to account for Apple’s new GAAP accounting measures. These new accounting measures were implemented in Q1 2010 resulting in dramatic amendments to each of Apple’s fiscal quarters between 2007 and 2010. These income statements can also be found on Apple’s website.



Apple’s Year over Year Growth Rates
The three tables below outline Apple’s (AAPL) year-over-year growth rates for the past 3 fiscal years. The first thing that should be noticed is how Apple’s growth rate decelerated in 2009, and then reaccelerated in 2010. These tables are a very useful guide for performing fundamental analysis and establishing price targets on Apple. Also note the 75% net income growth and the 70.8% EPS growth in fiscal 2010. If this type of growth continues into 2011, then Apple will likely see $350 sometime next year.

Disclosure: At the time of this writing, the author holds no position in the equity markets. 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.

The End of the iPod Era Part II: The Other Side of the Debate

I recently published an article arguing that the iPod’s importance to Apple’s overall quarterly revenue has diminished to the point of being almost irrelevant to Apple’s growth. Yet, this article seemed to hit the nerves of iPod aficionados who ardently contend that the iPhone is an iPod, and to say otherwise, would constitute the highest level of blasphemy to the Apple investment community. So I thought that in the interest of fairness and balanced reporting that I would present the other side of the debate, and let my readers decide which of these viewpoints makes the most sense.

In my previous article, I demonstrate how the facts according to Apple, suggests that the iPod is no longer that large of a revenue driver when compared to Apple’s other sources of revenue. I exhibit how the iPod as a percentage of Apple’s overall revenue has been on a consistent and steep decline since Q1 2006. This is due in part to the iPod’s maturing growth rate, and in large part, to the iPhone and Macintosh Computer taking the helm as Apple’s main source of revenue.

Apple’s fiscal year starts in October and ends in September. When it reports its quarterly earnings, Apple generally publishes a revenue breakdown for each of its six primary operations (iPhones, iPods, Macs, iTunes + music accessories, Software and Peripherals). It defines the general category of “iPod” to include sales from the iPod Touch, iPod Nano, iPod classic and iPod shuffle without reference to the iPhone.

So those four devices are what make up the revenue in Apple’s iPod category. While Apple doesn’t breakdown unit sales and revenue for each line of its iPods, Steve Jobs will from time to time let us know how many iPod touches it has sold during media events. Based on Apple’s definition of the term iPod revenue, the four charts below clearly and undeniably illustrate how the iPod as a percentage of Apple’s direct and recorded revenue has been on a steep and consistent decline since 2006.

If this isn’t already self-evident, here is exactly how the charts should be read. The first chart shows iPod revenue from 2006 to 2010. The second chart is of iPod unit sales. The third chart details iPod revenue as a PERCENTAGE of Apple’s overall revenue. This chart is important because it unmistakably illustrates how the iPod’s impact to Apple’s recorded revenue has been on a decline since 2006.

The fourth chart is of Apple’s recorded revenue from 2006 to 2010. This chart is important because it shows how Apple’s overall revenue has continued to demonstrate explosive growth despite the fact that iPod revenue (shown in chart #1) has posted either slightly positive or slightly negative growth over the past few years. Please note that Q3 and Q4 are merely estimates and that actual results may differ.



Misinterpreting the Analysis
My argument shouldn’t be construed, though I’m positive it will be, to suggest that I believe that Apple should somehow discontinue selling the iPod or that the iPod is doing poorly as a device. In fact, the iPod Touch is arguably one of Apple’s most important products as that device is a gateway drug to Apple’s other products, so to speak. It introduces those who don’t already own an iPhone to the iPhone OS making it the most proficient use of advertisement in the entire tech industry. That OS powers two of Apple’s most important product lines – the iPhone and iPad. And evidence suggests that this iPhone OS will power an all encompassing media hub being used in a flat screen TV that Apple is potentially developing.

Moreover, the iPod halo is still very much in full effect as each device gives consumers a broad introduction to the Apple ecosystem. So while the iPod isn’t as big of a player as is the iPhone or Macintosh when it comes to total revenue contribution, it still plays a key role in Apple’s overall business strategy. This much should be obvious as there still remains quite a large number of intangible benefits Apple derives from the iPod – a driver for revenue growth is just no longer one of those benefits.

One Alternative Viewpoint: iPhones are iPods, STUPID!
In January of 2007, Steve Jobs wowed his audience at Macworld, investors and the entire financial world with his introduction of the iPhone. During his keynote address, he called the iPhone “The best iPod Apple has ever made.” He began his introduction by saying, “Well today, we’re introducing THREE revolutionary new products. The first one is a widescreen iPod with touch controls, the second is a revolutionary new mobile phone and the third is a breakthrough internet communications device.” He continued, as the crowed held its breath, “An iPod, a phone, an internet mobile communicator. An iPod, a phone, an internet communicator…these are NOT three separate devices!” And to add a cheery on top, he went on to say: “we are calling it iPhone!”

This was huge news as the entire Apple world was convinced that due to legal constrains, Apple would be unable to name this new potential breakthrough device the “iPhone.” So it came as a great surprise to the entire financial community when he came out, gave the classic Steve Jobs’ finger to the term impossible (the reason everyone loves him), and called it the iPhone – I’m sure he told his lawyers to make it happen.

After reading the comments to my article published at Appleinsider, I discovered that quite a large number of people hold the view that the iPhone is an iPod. That even Steve Jobs made it perfectly clear that it’s an iPod (in fact the best iPod Apple has ever made), and that trying to characterize the iPod classic, iPod Touch, iPod Nano and iPod Shuffle as being Apple’s only iPods would patently misrepresent the facts. The “iPhone is an iPod, stupid” forms the basis of many of the arguments against the conclusion that the iPod (as defined in Apple’s financial statements) contributes an increasingly smaller portion of Apple’s overall revenue.

A lot would go on to argue that the only appropriate way to view and analyze iPod sales is by adding iPhone unit sales and revenue to iPod unit sales and revenue. Doing this, several have argued, will produce a true picture of the “real” iPod unit sales and revenue growth over the past 5 years. That the charts and tables outlining iPod sales above are inherently flawed because they unfairly breakdown iPod sales and revenue, as defined by Apple, without taking iPhone sales into account. The two charts below outline iPhone + iPod unit sales and iPhone + iPod revenue from 2006 to 2010. These charts form the basis of the iPhone is an iPod viewpoint. So without further ado, will the real iPod Category please stand up?

Thus, one will argue, that according to the two charts above, the “real” iPod unit sales, unlike iPod sales as defined by Apple and the rest of the financial world, shows that iPod unit sales are growing quite consistently. Sure, adding the two together dilutes the growth rate of iPhone standing alone; but who cares as long as we’ve shown that iPod sales are still growing right? “Real iPod” revenue growth is far more dramatic owing in large part to the $630 – $660 ASP that the iPhone normally enjoys versus the $150 to $170 ASP the iPod usually records. So while overall unit sales don’t look super impressive, revenue growth looks very strong. And we can’t get a true picture of how important the “real iPod” is to Apple’s revenue without looking at “real iPod” as a percentage of Apple’s revenue. The chart below outlines iPhone + iPod revenue i.e. “real iPod” revenue as a percentage of Apple’s overall revenue:

Notice how by Q4 2008, it appears that Apple gets about 50% of its business from the “Real iPod” making the company appear overly dependent on one of its primary operations for growth. While my argument shows that Apple is multi-dimensional and not overly dependent on the iPod, those in support of the iPhone is an iPod theory, makes it such that Apple is very dependent on this new category. Yet, the charts above do show how if the iPhone was characterized as an iPod, that iPod growth is alive and well. Of course it also demonstrates how important the iPod would become to the company’s financial well being.

Now here is why I think this is not only a very misguided, but dangerous viewpoint of the company from a financial perspective. First, the very last impression that any company wants to give investors, financial analysts and the financial media is that a company can only do a handful of things well, and that the company is too overly dependent on any one of its product lines.

In fact, Apple has worked very hard to demonstrate how well they are able to innovate by showing that they are not just a one or two dimensional company, but that they can make 4 separate and very successful products driving their overall revenue growth. By collapsing iPod and iPhone sales, it suggests that Apple is merely a two dimensional company. That the only thing they can do in terms of innovation is just make fancier iPods and sell Macintosh computers.

Apple has wisely chosen not to go this route. Instead, they break down their main revenue drivers into 4 distinct categories – iPods, iPhones, Macintosh Computers and now iPads. Over the past few years, iPod unit sales and revenue started to weaken. In the face of this weakness, Apple demonstrated their ability to innovate by introducing the iPhone and now the iPad. I’ve seen some arguments where some hold the view that iPads are merely iPods as well. This held belief is extremely counterproductive from a financial perspective.

Once again, no one is expecting that Apple or any company should be able to introduce a product that will grow from now into perpetuity. What money managers and analysts do expect is that Apple should able to make new fresh products that can take the helm of driving growth as some other product reaches maturity. In this case, Macintosh sales took over as Apple’s main revenue driver in 2007 followed by the iPhone in late 2008. The iPad will also drive future growth as the product sets to posts more revenue than the iPod in its inaugural quarter.

Fund managers are far more concerned with how well iPhone, iPad and Macintosh sales fare than they care about the archaic iPod. For the past few years, iPod sales have been slightly up to slightly down. Yet, no one seems to make a stink about it, because no institutional investor or analyst really gives a hoot about iPod sales anymore. Instead, the central focus of Apple’s financial picture is on the explosive growth the iPhone posted in Q1 and Q2 of this year.

What these two articles demonstrate is how Apple can innovate in the face of slower growth from its former main revenue driver, the iPod. These articles get ahead of future debates about whether Apple can continue to grow given the law of large numbers. Is Apple getting too big for its own good tends to be the general question posed among money managers and analysts these days. Not whether the iPod can continue to drive future growth. An argument that the iPhone is an iPod is definitely not the best way to view the company or its future growth prospects.

Instead, view the iPod for what it is. It’s a device that helped Apple escape the brink of bankruptcy. It’s a device that helped drive Apple’s growth for much of the past decade. It’s a device that produces quite a substantial halo effect for nearly everything Apple and introduces droves to the Apple ecosystem. The iPod Touch is very crucial in terms of introducing those who don’t own an iPhone to the iPhone OS. The iPhone OS has made its way in 3 separate devices, and evidence indicates that it will find itself in new and future products. The iPod is still very much important to Apple in these particular ways. But in terms of direct revenue, by the end of 2011, the iPod will barely make a dent in Apple’s overall revenue.

Another Alternative Viewpoint: Like Intel Chips, iPods are in All Apple Devices There’s another relatively strong argument put forth by a message board poster named Chano at Appleinsider. Chano contends that my article “misses the point” because iPods are embedded in several of Apple’s devices, and that this value should be counted in the analysis. Chano offers the following:

“Apple is selling more iPods today than all other products combined. Most of them are buried in the value proposition of the devices they are embedded in. I buy an iPhone because I want an iPod too. Without the iPod built in, how well would sales go? They still contribute to revenue. Embedded value is ADDED value. Intel’s chips are all embedded in something. They’re still counted in the sales value of the products they’re embedded in. It’s possible to break out a notional sales value for the embedded iPods as part of the selling price of the host device. It may be notional value but the embedded iPod is real. It should be counted.”

This is not a bad argument, and presents a stronger viewpoint than the iPhone is an iPod analysis. In fact, one can extract the added value of the iPod from each iPhone sale by simply subtracting iPod ASP from iPhone ASP, and add that value to iPod revenue. Basically, one could shift a portion of iPhone revenue and add it to overall iPod revenue. This would dramatically increase overall iPod revenue thereby indicating that iPod sales are in fact significantly stronger than my article suggests.

Yet, obviously one could counter-argue that it isn’t entirely obvious just how much added value the iPod actually contributes. That unlike Intel chips which are actually sold to a device manufacturer, actually used by every consumer of the device and make up a portion of the cost of goods sold, the iPod is simply embedded as an unquantifiable software feature that may or may not be used by the consumer of the iPhone.

In this sense, unlike Intel chips which are necessarily used by the consumer by virtue of using the device, the value proposition of the iPod depends largely on the varying needs of the consumer. My parents, for example, while they own iPhones, don’t use the iPod application. For them, the value is zero. For another person, that value might be $450 – higher than the iPod ASP. So in this sense, the quantifiable value in terms of a precise dollar amount is very arbitrary making the analysis upon which the value proposition is based, equally arbitrary. Thus, this viewpoint really has no value from a financial statement analysis perspective, but should be added as a sub-analytical argument suggesting that there’s an intangible benefit of the iPod to each of Apple’s portal devices (iPhones and iPads).

Secondly, while one could try to arbitrarily break out the added revenue value from those devices, it also would be very difficult to quantify this value in terms of unit sales. It would be a gross overestimation of iPod unit sales to suggest that each iPhone or iPad sold is an iPod sale as well. Because it isn’t entirely clear how many iPods would sell if Apple only introduced the iPod Touch. In other words, there are definitely a large number of people who buy the iPhone for features other than the iPod capability. Some may like the iPhone for the applications. Some might simply like the interface. Still, others might buy the iPhone for enterprise. Thus, it isn’t clear exactly how much value is added from a unit sales perspective.

So while this viewpoint is really more of a complimentary analysis that should be added to the overall iPod analysis, the fact still remains that total iPod revenue, as defined and recorded by Apple, continues to make up an increasingly smaller portion of Apple’s overall revenue.

Disclosure: At the time of this writing, the author holds no position 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.