Apple Misses and Guides Lower

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In an extremely unusual development, Apple reported revenues and earnings well below the Street’s estimates. More normally, the company guided earnings for the September quarter below estimates. However, the gap to analyst estimates was unusually large, effectively making this quarter and a “miss and lower.” In response Apple shares are trading down 5%.
Given the magnitude of the shortfalls in revenue, earnings, margins, and iPhone and Mac shipments, a 5% decline is quite modest. This is due to two factors. First, the news is not a shock. Most of the shortfall is probably related to a pause in iPhone demand ahead of the expected October launch of iPhone 5. Foreign exchange also played a factor along with some product mix shifts that cut average selling prices. Second, by all indications including many surveys, demand for the iPhone 5 is going to be extraordinary. Intent to buy measures are at all time highs among current and potentially new iPhone users. As a result, Wall Street is willing to cut Apple a lot of slack as it assumes that any shortfalls will be made up in the December 2012 and March 2013 quarters when iPhone 5 is released around the world.
I remain very optimistic about Apple shares. The stock is very cheap. After backing out over $120 in cash earning little with interest rates at 0%, the stock trades at just 10 times earnings. Even with the six month pause in iPhone demand (when the company will ship about 50 million phones!), Apple is growing at a rate of more than 20% a year, a growth rate that will accelerate later this year. I still see the shares having one more good run based on the current product lineup (Mac, iPhone, iPad, iPod, and integrated software) with a target of $750 easily achievable.
All that said, there were some troubling issues in the quarter not present in prior quarters where Apple disappointed the street. The product mix shift could be a sign that Apple’s newer products are facing increased competition and losing market share. It is hard to tell if lower average selling prices were due solely to the fewer high end iPhones sold or if a clear customer preference for older models was responsible.
ASPs may also be feeling pressure from tighter upgrade and subsidy policies from wireless service providers around the globe. This impact will cycle through over three more quarters. I was surprised to hear minimal questions on this topic on the conference call. Follow-up analyst reports also touched on upgrades policies less than I expected.
Another issue was much lower margin guidance. Apple usually guides margins conservatively but the guide for the September quarter is still surprisingly low. Apple’s margins are incredibly high on hardware, 3-4 times the best other hardware manufacturers. This is the result of Apple’s tight integration of its best in breed software. However, as competitors catch up — Samsung phones and Google tablets, in particular — the long feared margin compression could be coming sooner than expected.
While I respect the greater competition argument, I suspect other things are at work. The global economy has weakened and this impacts even companies as strong as Apple. The company specifically pointed to negligible growth in Europe. Foreign exchange also took a bigger bite out of financial performance. The street should have figured this out given the massive overseas growth the company has enjoyed. It was unusual to hear Apple management discuss macroeconomic impact in such great detail. It is likely legitimate but still raises a caution flag.
Misunderstood inventory shifts as new products rolled out over the last year also may be at work. As Apple’s market share has grown ever larger and its products have reached around the entire globe, the impact of a single new product on the company has also risen. Quarter-to-quarter volatility is going to be greater and even with Apple’s regular discussion of channel inventories forecasting inventory shifts and thus shipments is going to be more difficult. I think that was the case in the most recently reported quarter.
To repeat, I still see Apple shares heading comfortably north of $700 within the twelve months based on the current product lineup and the still massive growth in penetration of smartphones and tablets. Less than 20% of mobile phones currently in use around the world are smartphones. To move significantly above that, I believe the company will have to find another new product that opens up a huge market opportunity. TV seems the most likely. Innovation in new product categories has brought Apple this far.
The next innovation will determine if Apple can be the first trillion dollar market cap company. That requires almost another doubling in the share price. I think the odds are in Apple’s favor. Fortunately, as is, there remains 30% upside in the shares.
Disclosure: Apple and Google are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an Illinois-registered investment advisor. Filings can be found at www.sec.gov. Apple and Google are net long positions in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds.

Earnings from Google, Qualcomm, and EMC Greeted Warmly

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The early part of each quarterly earnings season is focused on technology companies as far as Northlake Capital Management’s strategies are concerned. Thus far, we have heard from Google (GOOG), Qualcomm (QCOM), and EMC Corporation (EMC). All three stocks reacted well to their earnings announcement, recovering a significant portion of recent share price declines. Heading into this earnings period, technology stocks sold off sharply on concerns about demand given weaker economic data around the globe. Foreign exchange was also a big worry. Technology companies are global as the language and use of technology crosses borders with ease. Furthermore, mega trends toward mobile broadband, smartphones, and big data are global.
GOOG, QCOM, and EMC each reported results that were very close to expectations. Wall Street was prepared for much worse. Guidance commentary was similar. QCOM guided lower although not as bad as feared. GOOG does not provide guidance but comments on business trends indicate no deceleration beyond the impact of foreign exchange. EMC reaffirmed its guidance, confirming the power of data storage trends. In the short-term, stocks react to news based on expectations. Expectations were low for GOOG, QCOM, and EMC due to macroeconomic fears. As it turned out, good operating execution and powerful long-term business trends allowed each company to beat the lowered expectations. In turn, the stocks rallied sharply. Let’s take a brief, closer look at each company.
The major takeaway from GOOG is that investors are growing more comfortable with the transition to mobile search. The big controversy in 2012 has been the balance between much lower average prices for search advertisements and much higher volume of searches. Both factors are due to the shift toward mobile computing. Additional influences are more searches in lower priced emerging markets, changes to Google’s ad serving technology, and foreign exchange. In the most quarter, the number of paid searches rose by 42%, while the average price per paid search advertisement fell 16%. In prior quarters, this sort of mix was greeted rudely by investors despite the company continuing to produce 20-25% revenue growth. This quarter the street reacted positively to the results. I think GOOG shares reached a positive tipping point with this quarterly report. The stock remains about % lower in 2012 and has plenty of room to make up.
QCOM actually slightly missed earnings and revenue estimates and issued guidance below current street estimates for the September quarter. Normally, this would have punished the stock. However, expectations were for even worse results and guidance. The stock had already fallen from the upper $60s in April, reflecting a summer slowdown in smartphone sales ahead of the iPhone 5 introduction this fall and supply constraints that leave QCOM short of inventory to meet current demand. The quarter proved to be a relief after a string of bad news. All of this is timing related. QCOM remains perfectly positioned to play the mobile broadband trend by providing the key semiconductor technology for smartphones and tablets. Relief and improved sentiment is a welcome change after a few tough months. I do not think the near-term is as bullish for QCOM as GOOG but beyond the next few months the investment thesis remains very good.
EMC preannounced its June quarter earnings and maintained full year guidance. The stock had pulled back from $30 to $23 since April as macroeconomic worries built and many other enterprise-focused technology companies reported shortfalls or cut guidance. I was remained confident in EMC for a couple of reasons. First, the trend toward management of data is as important as the trend toward broadband internet. Cloud computing is raising the demand for hardware and software solutions as requirements for data retrieval and management grow rapidly. This trend supports EMC’s business fundamentals even against the grain of a tough macroeconomic environment. Second, EMC announced upgraded products across most its product line in the spring. This was always part of the business plan but analysts apparently missed the positive impact. When the industry leader offers new products into a market with heavy demand the results can come quickly. This is the case at EMC and the upgrade cycle is protecting the company’s revenues against the deceleration in global economic growth. EMC is a boring stock compared to GOOG and QCOM but the long-term outlook is equally strong as “big data” and cloud computing are powerful and irreversible technology trends.
Disclosure: Google, Qualcomm, and EMC are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an Illinois-registered investment advisor. Filings can be found at www.sec.gov. Google and Qualcomm are net long positions in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds.

Mid Cap and Growth Survive for Another Month

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There were no changes to Northlake’s Market Cap and Style model signals for June. Mid Cap and Growth continue to be favored. As a result, client positions in the S&P 400 Mid Cap (MDY) and the Russell 100 Growth (IWF) will be maintained for at least another month.
It does appear likely that the growth signal that has been place all year could shift to value for July. Weak performance by growth stocks last month shifted the trend indicators to value. Along with weakening growth signals from a few other indicators, the one month only reading of the Style model is in value territory. The models use a two month smoothing to determine the final reading so barring a quick shift back in favor of growth emanating from July data inputs it seems that a value signal may be in the cards for July.
Growth stocks are dominated by technology companies many of which are multinational. Technology has no language or cultural barriers. Several technology companies have noted weak demand from Europe which is being multiplied on the income statement by the weak Euro. A softening in the domestic economy is also at work impacting the indicators.
In May the models were off target as Mid Cap rose almost 2% but lagged the 3% plus gains in large cap and small cap. As noted, technology dragged down growth indices in May leading to a gain of just over 2% against an almost 5% gain for value stocks. With half the year done, the Style model — growth all year — has matched the S&P 500 return of over 9%. The Market Cap model is lagging the S&P 500, up 6%, as investors have been cautious about taking on the added risk of small and mid cap stocks with the Europe crisis simmering and slowing GDP growth in China and the US.
Disclosure: MDY and IWF are widely by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an Illinois-registered investment advisor. Regulatory and disclousre filings can be found at www.sec.gov.