Mixed Bag of Apples

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Apple reported decent September quarter results against low expectations following lots of worry about demand trends and recent data that revealed iPad sales would be below expectations. Revenues of $36 billion were up 12% year over year and in line with consensus forecasts. EPS of $8.67 rose 23% vs. a year ago but slightly missed consensus estimate of $8.81. EPS would have been about 20 cents higher except for an unexpected and unusual negative swing in other expense related to foreign exchange hedging that should reverse next quarter.
At the product level, Mac sales of 4.9 million units were right on target. iPhone sales of 26.9 million units were ahead of expectations indicating that demand remained reasonable for the 4S even ahead of the launch of iPhone5. iPads came in at a disappointing 14 million units. An iPad shortfall was expected after Apple announced that it had sold its 100 millionth iPad earlier this week. iPad inventories were unchanged and management indicated that it saw a slowdown in demand in August and September as rumors mounted about the iPad mini. iPods, no long an important product at just 2% of revenue, were slightly below estimates at 5.3 million units.
Overall, the quarter was solid against low expectations by Apple standards. The much bigger news concerned guidance for the September quarter. Management forecast revenue of $52 billion and EPS of $11.75 against consensus estimates of $55 billion and $15.50. By Apple standards, the revenue guide was actually pretty good. However, EPS are way below estimates even by Apple’s usual conservative standard. The issue is gross margins, which Apple forecast at 36% against 40% in the September quarter.
Gross margins have not been below 40% since the December quarter of 2010 and have averaged 42.1% in the past eight quarters. Management noted that newly introduced products would make up over 80% of December quarter sales and that costs are highest in the first quarter a product is introduced before economies of scale kick in. This is a legitimate point although it has not been as obvious of an issue in past quarters with heavy new products flow.
Apple shares are barely changed following the report after a 15% pullback over the past month. I think there are several takeaways from the quarter. First, the stock price action indicates that the stock already reflects the lower expectations. At $610, the shares seem to have discounted the weak EPS guidance. Second, I think we should start to accept that Tim Cook provides realistic guidance. Most of the quarters since he took over have been closer to company guidance than to analyst estimates. Analysts have been trained to view Apple guidance as extremely conservative. Maybe that is changing under Cook’s leadership. Whether this is because Apple’s financial momentum is waning is a key question.
Most importantly to me, Apple may have finally reset growth expectations (or the market have reset growth expectations for Apple). Trailing twelve month earnings growth over the past eight quarters has varied from 60% to 96%. If guidance proves correct, earnings growth in calendar 2012 will be just 20%. For a long time, Apple shares have traded at what seems like a very low P-E multiple relative to the growth rate of its earnings and to its product and market share momentum. This is because investors had long anticipated that the growth rate would slow if for no other reason than the law of large numbers. Apple sold 37 million iPhones in the December quarter a year ago. The guidance implies around 46 million this year. To sustain 20% growth means next year they must sell 55 million. At some point, the end market and Apple’s market becomes mature.
Investors are smart and realized this was coming and kept Apple’s valuation in check. Current controversy over iPad demand and corporate gross margins is likely to be what determines whether Apple shares get their upside mojo back. Management discussed the huge opportunity for iPads against 300 million PCs still sold each year (Apple has sold 100 million iPads in 18 months). iPhones still have growth as smartphone penetration continues to grow on a global basis but the sheer size of iPhone revenue ($29 billion in the most recent quarter representing 55% of sales) means that iPads have to pick up the slack. Broadening the product line with iPad mini makes sense in this regard.
Gross margins also have to firm up. Another key question is whether Apple has to accept lower margins to drive product sales. Maybe the competition is catching up? This is a fair interpretation of the guidance. Management indicated that margins should rise as production ramps and products mature. Apple does usually guide gross margins conservatively. If that proves to be the case this quarter then investors will be comfortable in the company’s competitive position and the likelihood that future growth is sustained at 20% or even re-accelerates.
I believe that the combination of recent worries, the reported guidance, the acknowledgment of the slowing growth rate, and the 15% pullback in the shares have effectively reset the investment case for Apple. Backing out cash, the shares trade for less than 10 times forward earnings. Against 20% growth in FY13, this is a very reasonable valuation with much lower expectations on the part of investors.
A new catalyst will have to emerge to get the shares back on track. Signals of strong demand this holiday season and easing of supply constraints are the most likely until the company reports earnings again in January. I think both of those things will occur. If they do, then it will be clear that guidance is going to be comfortably exceeded. This is the bull case for the near-term. It is also the case I believe will occur. And never forget that as the largest market cap stock on the planet, Apple shares are going to be heavily influenced by sentiment and direction of the overall market.
Apple is widely held by Northlake Capital Management LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a long only registered investment adviser. Apple is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, communications and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the funds’ investment management company and has personal monies invested in the funds.

EMC Misses But Remains Well Positioned

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EMC reported results that were slightly below Wall Street expectations and management’s prior guidance. In addition, management lowered full year guidance. Interestingly, the stock is down barely over 1% today, a good performance given the huge drops at other tech companies after reporting earnings. Many stocks that have yet to report dropped a lot more than EMC in anticipation of poor reports and weak guidance.
I think EMC is taking the quarter reasonably well because it is quite clear that the primary problem the company is facing is a weak IT spending environment at major enterprises. EMC’s results and guidance indicate that it is growing faster than other major IT suppliers as its focus on big data, cloud computing, flash solutions, and virtualization provides insulation against weak spending in more mature, legacy technologies. Storage and virtualization are gaining share and sit in the sweet spot of the major trends in enterprise computing.
Given EMC’s excellent positioning in growth markets and a strong product cycle across most its storage solutions, I think it will pay to ride out the near-term weakness in stock. Should spending patterns actually improve or Wall Street begin to anticipate better IT spending, EMC shares are likely to reassert their leadership role we saw earlier in 2012.
Catching the timing of these sort of changes is difficult. In the meantime, EMC’s strong execution and attractive end markets should prove defensive if the market or technology environment worsens. On the other hand, a lesson learned here is not to be greedy when the stock rallies again as even the best positioned companies face cyclical risks in the highly competitive and mature enterprise technology market. I am highly confident Northlake will get a chance to sell EMC at 2012 highs around $30, good for a 25% gain against today’s prices.
EMC is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake regulatory filings can be found at www.sec.gov.

Just When It Looked in the Clear, Google Misses

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Google’s results and the negative stock price action are a good chance for me to reflect. In my Entermedia hedge fund, Google is the second largest long position. At Northlake, my long only registered investment advisor, Google is widely owned but a slightly below average position. As a generally long-term investor, my initial thought is today’s results are not a game changer. However, I can’t ignore the short-term either and that could be a little rough.
Standalone Google results were worse than expected. It’s not an excuse but it is worth remembering that Google provides minimal guidance. Let’s look at the estimates and reported figures for this quarter in the core Google (ex-Motorola). Google sites revenue was $7.73 billion vs. a consensus of $8.12, about a 5% miss but up 15% vs. a year ago. Google networks revenue was $3.13 billion vs. an estimate of $3.09 billion, about 1% ahead of expectations and up 21% vs. last year. Sites grew 2% sequentially with network up 5% sequentially. Google indicated that foreign exchange cost the company several hundred million dollars, a figure that is hard to compare to street estimates and hard for the street to calculate. Operating margins at the core were about 36%, approximately 1% less than expected and down 1% from a year ago. Paid clicks (volume of searches) rose 33% against an expectation of 34%. Cost per click (price of an ad) fell 15% against an estimate of down 11.3%. Clearly, there was an overall miss vs. Street expectations. Given that Google does not provide specific guidance, however, the miss seems within the margin of error. And not to be lost is the growth rate of the core business is still almost 20%.
One takeaway is that that Google’s lack of guidance results in more volatility of reported results relative to estimates than for most companies. More quarters than not over the last few years, analysts have been too optimistic. However, that does not mean that Google does not maintain a superior growth and investment profile for the long-term.
As noted, core growth this quarter was just under 20% and showed mid-single digit sequential growth. This is for a company that just reported almost $9 billion in quarterly net revenue, a $36 billion annual run rate. How many really large companies can grow anywhere near this rate? Google’s core search product is also being used more and more — paid clicks up 33%. Sure, the transition to mobile means the cost per click or price of an ad is falling. Yet, it still nets out to stellar growth.
By any measure, Google appears to be gaining share and maintaining a very strong competitive position. It’s a position that is hard to attack. In mobile, you can argue that Google search is the only player. iOS and Android devices default to Google search. Bing and Yahoo are nowhere to be found in mobile.
Of course, momentum and short-term results matter on Wall Street. This quarter’s negative surprise, even if only modestly negative, is going to break the momentum the shares had finally gathered after a rough few years. Sentiment that had been improving is going to sour.
I suspect I’ll be looking to add to Google over the next days and weeks but it may be at lower prices than $687 (-9%) where it was halted after the earnings were accidentally released early. If the game hasn’t changed, Google can double its earnings in about four years. It seems to me that should lead to a much higher stock price eventually. How many large cap companies do you own or follow with that type of potential and with what appears to a very strong competitive position?
Google is widely held by clients of Northlake Capital Management, LLC, including in Steve’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Regulatory filings can be found at www.sec.gov.Google and Yahoo are net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, communications, and related technologies. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the funds.

Large Cap and Value Still Favored for October

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There were no changes to the signals from Northlake’s Market Cap and Style models for October. The new large cap signal remains in place for a second month and the value signal is now entering its fourth month. With no changes for October, clients will continue to own the S&P 500 (SPY) representing large cap and the Russell 1000 Value (IWD) representing value.
The underlying indicators in the Market Cap model shifted in favor of small caps based on the latest data but not far enough to change the signal. However, another similar month in October would move the model back to mid cap territory. The main shift in favor of small cap occurred in the trend indicators which picked up a better month for small and mid caps during September’s market rally.
A similar situation exists in the Style model. There was a shift toward growth from value but not enough to cause the overall model to change for October. Once again, if the model were unchanged in in October, the following month would see a change. In the Style model, the U.S. dollar indicator moved from value to growth reflecting the weak performance of the dollar in September a the Euroe rallied strongly.
Overall, the models indicate that the economy is growing slowly and the market is trending consistently with a high degree of correlation among various market themes. This type of environment often sees more volatility in the model signals as has been the cause in recent months.
During October, the shift form mid cap to large cap worked well. Mid cap, as represented by the S&P 400 Mid Cap (MDY) rose just 1.9% while the S&P 500 (SPY) gained 2.3%. The Style model also had a good month with Value gaining 2.5% against just 1.1% for Growth. For all of 2012, the Market Cap model has struggled and lags the benchmark S&P 500, while the Style model is beating the market. The Market Cap model has struggled with an environment that historically has favored small caps while investors focused on large caps instead. I think the many risks apparent in the investment landscape have bullish investors looking at presumably safer large companies.
Disclosure: IWD and SPY are widely held by clients of Northlake Capital Management, including in Steve Birenberg’s personal accounts. MDY is held in selected Northlake-managed accounts. Steve Birenberg is sole proprietor of Northlake, a registered investment advisor. Regulatory filings can be found at www.sec.gov.