Why I'm Shorting Apple Ahead of Earnings

I will preface this report by stating that I am not bearish on Apple (AAPL) long-term, and while I consider myself (in Graham’s terms) much more of an investor than a speculator, I am willing to make a significant bet that on a short-term basis, Apple’s share price will deteriorate. 

Since the market's slight recovery in May and sequential downturn through June, the S&P has given up 15% while Apple has significantly outperformed the market. shedding less than 8%.  During these past months, multiple analysts have upped price targets, most citing 3G iPhone sales, and expectations have become overly optimistic in today’s slow-growth environment. 

What follows is a comprehensive analysis of Apple's Fiscal 3Q ending on June 30, 2008 due to be released July 21^st.  The three main factors I expect to contribute to a short-term drop in AAPL shares are:

1. Perceived disappointing numbers in iPod, iPhone, and Mac revenue,
2. Disappointing gross margin and Net Profit Margin, consistent with decline seen in Q2 (see conference call transcript), and
3. Apple’s emotional impact on its investors.  

Rev Streams

iPod

Where I see the greatest weakness in Apple’s current quarter and future is related to their heavy reliance on iPod sales.  In Q3, I expect iPod revenue to represent around 25% of total revenue, a percentage that will become exponentially smaller as iPhone revenue grows and iPod sales decline. 

The iPod is quickly becoming a nonessential product as more and more phones come with mp3 capabilities.  Granted, these competing products pale in comparison to the user friendliness of the iPod, but consumers will continue to look for multi-use devices as apposed to purchasing two separate devices.  While this consumer shift dampens the future of the iPod, it also brightens the future of the iPhone. 

What I expect to see in the future, but most importantly what I believe will already be evident in this quarter, is heavy cannibalization of iPod sales from the iPhone.  I still expect iPod shuffles to sell well because of their extremely low price mark and their clear distinction as a workout device, but shuffle margins are much lower than Apple’s other products and the heavier distribution of shuffle sales will weigh on gross margins.  I expect iPod classic sales to slump this quarter and more severely in the future with iPod nano sales decreasing at a slower rate. 

While I realize the iPod touch is a distinctly different product, I foresee a similarly disappoint quarter and future as more user friendly phones are introduced with capabilities similar to the iPhone.  With what I believe will be disappointing unit sales at a lower ASP (due to high shuffle sales) I am expecting $1.72 billion in revenue from iPod sales (10.1 mil units at $170).

iPhone

The iPhone revenue is by far the easiest to predict.  Although it is easy to estimate, some analysts will get it wrong because they simply don’t recognize or understand Apple’s smoothing revenue recognition strategy and the delayed recognition from sales made from March 6^th through the end of the quarter.  In Q2 Apple reported $378 million in iPhone revenue.  I expect $380 million in revenue from the iPhone for Q3 due to the delayed start of recognition.  Although the minimal growth in nominal revenue from the iPhone is expected, some analysts/investors will misunderstand the $380 million as disappointing.

Mac

The greatest strength of Apple lies in Mac sales and market share growth.  While I foresee an extremely strong future for Mac computers, I expect Q3 numbers to slightly disappoint analysts.  As noted by Apple COO Cook in the Q2 call, Q3 is a big K-12 quarter.  This reliance on state and local government spending will hurt Mac sales as states look to cut spending as they deal with increased food and gas prices (remember busing?).  Already over 20% of states have cut K-12 budgets and even more have reduced spending on replacing Mac computers that still perform adequately. 

I also believe that we will finally begin to see economic headwinds affect Mac sales in Q3.  Based on NPD data, Mac currently owns 66% of the over $1,000 computer market.  While consumers will continue to buy computers, Mac computers are treading the line between necessary and discretionary spending and consumers’ discretionary cash has been cut significantly with the downturn in the economy. 

Finally, with Apple due to release new lines of redesigned MacBooks, MacBook Pros and more MacBook Airs, I believe more consumers will delay purchases until the fourth quarter of 2008 when back to school spending really heats up.  Based on these factors, I am expecting $3.6 billion in revenue on 2.4 million Macs. 

Based on these numbers and when combining them with general analyst estimates for iTunes, Software, and Peripheral revenue, I am expecting Apple to report $7.51 billion in Revenue, beating their $7.2 billion estimate by 4.3% the lowest percentage amount in over six quarters. 

Margin Compression

Gross margin was by far the biggest surprise from Apple in Q2 earnings.  Although the company beat GM guidance for the quarter by 90 bps by reporting 32.9%, the number was significantly lower than what the street expected. 

Based on the conditions seen during Q2 related to lower commodity and NAND flash memory prices, distribution of higher margin product sales, and Apple’s tendency to beat guidance by 300 – 500 bps, most analysts had projected 36% GM and an upside surprise in EPS.  Obviously we didn’t see this GM beat and this led to the smallest EPS beat in 6 quarters.  Realize the importance of GM for bottom line earnings, approximately every 1% of additional GM in Q2 would have added 7.3 cents to the bottom line EPS. 

So, the question that is on most analysts' minds now, is whether this was an aberration or if GM pressure will continue into Q3.  I believe that Q3 will show similarly disappointing GM and an even more disappointing Net Profit Margin.  For reasons listed above, especially those related to Apple’s continual movement away from the higher margin traditional iPod to the cheap, lower margin, $50 iPod shuffle, iPod unit growth will slowly plot along as GM takes the hit.  Lower than expected unit sales at lower than expected gross margin per unit can only result in a significant hit on GM similar to that seen in Q2. 

Unfortunately for Apple, the problem with margin contraction does not stop there.  With the continual growth of revenue derived from iTunes, a business arm that Apple says they run at break-even, GM are sure to be under further pressure.  Also, additional expenses incurred and recognized immediately related to the launch of the 3G iPhone will show up in Q3 Operating Expenses.  Apple guided for $1.185 billion in Q3 OpEx expenses, but OpEx is a number that Apple consistently underestimates by $30 million and I expect this aggressive trend to be amplified as Apple overspends in preparation for the 3G launch. 

Based on this trend and in light of Apple’s $39 million underestimate in 07’s Q3 iPhone launch, I’m modeling in 1.235 in OpEx. I don’t expect to see any major differences in tax rates which have stayed constant around 31-32% or in Other Income and Expenses which Apple has guided at $115 million. 

Based on these estimates, the following is a pro forma income statement of Apple’s Q3 with GM variation shown in GM which I believe will be somewhere between 33-34.5%.   

 

You can see the importance of GM in the chart above.  Based on these estimates, I estimate Apple will report GM of 33.7% and EPS of 1.08. 

Emotions

Every investment book that I have ever read tells investors over and over again not to invest based on emotions but rather on pure valuation.  I, on the other hand, encourage anyone I talk to to invest based on emotions; it gives me the opportunity to make more money.  In fact, I love it when investors make decisions based on emotions; it is why I bought Apple over a year ago after investors had emotionally sold off and it is why I doubled my stake in February when investors beat down the stock on “bad earnings” and Steve Job’s lacking keynote.  I have rarely come across a stock that trades with such volatile characteristics on relatively stable, be it impressive, growth. 

Based on Apple investors’ characteristics, the current market sentiment, and my EPS projections I expect a significant selloff of AAPL on the 21^st.  Although Apple has continued to beat estimates, they have done it at a declining rate going from a 55.4% beat in Q4, to 23.9%, to 23.4% last quarter.  The two most recent quarters I believe have signified a new trend in slightly more aggressive guidance from Apple, guidance that will be a bit more difficult to destroy in this tough economy.  Rest assured, Apple will beat their $1.00 in EPS and they just might beat my 1.08 EPS but the stock will get beaten down based on the specifics of their earnings, the non-rational emotional high that a lot of Apple investors are on with the 3G iPhone, and guidance that, while a bit more aggressive than in the past, is still considerably lower than the street. 

Don’t buy Apple, it will get cheap...remember, when investing its not about lowering your standards for stocks, it’s about increasing your patience. 

Disclosure:  Author is short AAPL and long NOK, TWM

Comments

[ChiGuy2008]

I think your analysis is way off mark. The results will be exceed analyst expectations. The question is guidance. With the success of the 3G iPhone and the back-to-school season upon us, I expect Apple to continue momentum next quarter and through year-end.

As for cannibalization, you are probably right to a degree. However, many people are locked into phone contracts or, frankly, use a Blackberry smart-phone for work and may not want to invest in another phone.

I don't have any statistics to back this up, by my hunch is the Blackberry users still use iPods. And that trend will continue.

Moreover, you seem to be looking at this as solely an American phenomenon. I don't see too much cannibalization of iPod sales overseas even if that might be true in the U.S.

[finance ninja]

hey buddy,

historically apple inc. has fell after earnings. just look at all the earnings dates and do your research. you are definitely correct about evaluation and with AAPL at a peg of 1.21 + 3rd leader in computer market share and people in lines waiting out their door to buy the iPhone. this shows apple continual success. i agree and love it also when people sell off and make my money off puts and my calls.

-fn
financeninja.wordpress...

[bjmc]

I wonder just how many folks will bookmark your comments and rub your nose in those which do not materialize, particularly the iPod story.

Classic analysis such as yours rarely works out in practice simply because of over simplistic assumptions.

We shall see?

[mrtaxx]

Last quarter Apple earned $1.16 however if you add in the defered/delayed revenue it earned $1.45 which significantly beat the earnings projection and would have considerably increased gross margins. This is something most writers and analysts fail to adjust for understand. Gartner yesterday (7/16/2008) estimated Mac sales at 3.2 mil for the coming quarter where the writer estimates 2.4 mil a considerable difference (almost a 38% difference) ouch. I suspect that Gartner, not the writer of this article, would be more accurate since it is their business Since the writer is short Apple's stock he may be trying to manipulate the stock. A writer of stock articles should not own a stock they write about, somehow it does not seem ethical. Seeking-alpha shame on you for letting your writers write about a stock they are invested in, how unethical.

[NobodyKnowsWhatTheyAreTlkinabout]

Do you even know what the term "exponential"... means? For the iPod revenues to decline in a truly exponential sense they would have to be cut by a FACTOR of 2 one or more times. Do you really think the numbers will be cut to a QUARTER of their current value in so short a time, if ever?

Really?

[tuskagee]

Good luck with the short.
I hope it's not your mortgage money on the line.

[Andy Zaky]

7.51 Billion in Revenue? You're out of your mind. Read:

seekingalpha.com/artic...

[tuskagee]

"...May and sequential downturn through June, the S&P has given up 15% while Apple has significantly outperformed the market. shedding less than 8%..."

Go back a bit further than May, and the picture changes:

Jan 2008: $202.00

So, where is the stock right now?

Current Analyst's consensus: $218.00
Currently: $172.81

How exactly has the stock not suffered the slings and arrows of the downturn?

Guess you see what you want to see.

Selective vision?

Blinders?

Strong possibility.

[tuskagee]

Jan 2008: $202.00
Estimates: $218.00
Currently: $172.81

I'd say undervalued.

[jkeller]

Careful. Are you sure you are accounting for Apple's deferred revenue accounting? They book the revenue for each sale over 24 months. The deferred revenue is on their balance sheet and will grow by $8 billion in 2008. Apple is still booking revenue from the first iPhone they ever sold.

[buyitcheap]

Rather than just one side of the trade - why not a strangle of some kind - a put/call at $195/$205 or something along those lines?

[michiganjake]

The writer is short Apple says it all--no need to comment any further!

[michiganjake]

The writer is short Apple says it all--no need to comment any further!

[Toni]

APPLE will sell off after earnings. It's sad but it's true. It's evident by the fact it didn't follow the market rally yesterday.

You all are invited back here after earnings.

[Defendant]

Ben,

Appreciate your willingness to go against the grain and take the heat from all the pro apple posters and readers out there. I know that must be hard since so many people immediately and sometimes irrationally come to the defense of Apple no matter what.

I think you do, however, that if Apple does go down, it will either be because of general market bearishness or irrational emotionality that will correct quickly. On the other hand, if the market is bullish on the day they release and they have predictably stellar guidance, wouldn't the short hurt a bit? Just seems risky given that you have no idea what kind of guidance they will be giving.

[Toni]

@mrtaxx

Much fate on Gartner uh ?

These are the same people, in 2006

"Gartner: Apple should quit hardware business"

news.zdnet.co.uk/emerg...

[Hardhead]

It is your money - well WAS. My condolences to your account!

HH

[Toni]

Really don't know why some stupid people here is showing so much hate, he have every right to have a different opinion and do what he like with his money.

Well, live as you can.

And I say again, come back here after earnings, in any case.

[friedrich engels]

i think the writer underestimates the increase in mac computer sales and the taking away of share from msft. that this number is now quite significant is a relatively new development. plus, with their new products i wouldn't go against aapl now.

i habe no position in aapl

[User 227576]

Good effort, Rev. Streams.

It's good to see intelligent, timely, market sensitive analysis we can read, consider, & draw our own conclusions abt.

Well appreciated. Keep it up!

We'll be praying for you, and for ourselves...

[tom1234]

now is a good time to hedge your position by selling oct 175 calls ----

[JW, PhD]

Ben, I'll enjoy watching you lose money on your AAPL short.

[Shorting Should be Banned]

I hope you are not borrowing my stock to short it.
Wait, a minute, I haven't got a say in the matter; my broker does.
This is why Shorting Should be Banned!

[David Lentz]

The AAPL longs should be glad for the AAPL shorts -- otherwise who would they buy from?

(confession: I am a long-term AAPL long, and I fully expect a post-earnings buying opportunity)

[Titan100]

With everyone so sure that Apple will be sold off after the earnings I just have a feeling that the masses are wrong. No matter to myself, I will stay long.

What is different this time id that the price has not spiked with all the positive news. If this was last years market we would be looking at Apple in the $225 range. Then I agree that it would sell off.

[Ben S.]

First off, I am not YET short AAPL like the article says...so this isn't a case of purely manipulating the price, in fact I would love it to go higher prior to earnings.

My belief is that Apple will beat earnings (like they always do and are expected to do) at a smaller % than in prior quarters due to somewhat disappointing numbers in iPod, iPhone, Mac sales, and Gross Margin. Guidance will once again be below the street and the stock will fall, creating a BUYING OPPORTUNITY.

The mass of responses is great and it only further proves my point about the emotional attachment of Apple investors. Do the research and maybe you will or maybe you won't stumble upon similar numbers that I have; but either way, most of you are the type of investors that will buy Apple with a PEG of 2.5 and in six months wonder why you just lost half your money.

[JW, PhD]

Ben, I'll bet whatever amount of money you've got invested in the market right now that I've made more on Apple since the turn of the century than you have. That's the "type of investor" I am. People who have been in the stock as long as I have have watched "analysts" like you "do the research" and wind up wrong over and over and over again. But good luck with your short, be sure and let us know in six months how you're doing.

[AnonAlso]

@JW
Wow, Mr. Big Balls. I've made more money than you. I'll bet whatever you want. Shove it Mr. PhD.

The challenge in gambling (yes I said gambling) on earnings is not only do you need to accurately predict the earnings number and guidance, but more importantly, you need to predict the market's reaction to those numbers. That is impossible.

Also, a market rally won't start until the last of the mohicans, AAPL, is somewhat taken to the woodshed. I expect that to occur Mon/Tues. So PhD, take all your money and hope it to the wind.

Good luck

[JW, PhD]

No one is impressed Mr. Anonymous. I could buy and sell you 10x over I'll bet.

[Partners in Grime]

He didn't say he wasn't going to buy AAPL back after the drop.

Perhaps he's just going to pick up a few dollars in earnings after he sells higher and buys back lower.

Could turn out to be a buying opportunity indeed. Historically, he's right about the stock price dropping after earnings reports.

[AnonAlso]

Uh, no you can't.

[Shorting Should be Banned]

For people who short stocks or those who defending shorting; investors hold stock and are prepared for accept rewards and risks associated the investment. Short selling is not investing, it is a trading action which increases volatility and distorts the true value of the stock. I still do not understand why the SEC allows this. If people want to bet that a stock will go down, they should have the courage to front the cash to buy put options.

[JW, PhD]

Uh, yes...I really can. I'd love to keep having this scintillating debate with you all morning long, but my Continental GT is due for a service interval. Ta-ta.

[bobthenoob]

The timing could be right on AAPL side for earnings... coinciding with oil prices coming down could mean AAPL going way up.

[AnonAlso]

Put some money in an escrow account. How about 10k? We'll draw up some paperwork of which loser will pick up the tab on. 10x over. Deal?

10k should be enough to pay for service on the emblem you drive that shows you are centrally challenged?

[bobthenoob]

@Apple Heavy
Why blame the short sellers, there would be nothing for them to take advantage of if there were no rumors. I'd rather have the SEC go after rumor mongers, like Cramer. Or at least have the reporter or blogger accountable for their posts.

[JW, PhD]

Dude, don't hate on the guy just because you probably drive a Chrysler minivan. Jealousy is ugly.

[JW, PhD]

I hope shorts are living in alleys soon.

[AnonAlso]

Guy said he wants to bet. I've taken him up on his offer. We'll see if he responds.
I doubt it.

[AnonAlso]

Ha, multiple names JW? Or is it Richard L. You messed up there. I hope you don't mess up on your 10x figure. Could be costly.