Wednesday, April 23, 2008

Psychology of the Apple Inc. (AAPL) Q2 2008 Call

Most recent notable analyst changes
April 22th, Lehman initiated coverage with an overweight..
April 22th, AmTech Research downgraded from buy to neutral.
April 8th, Morgan Keegan downgraded from market perform to underperform.
April 7th, Thomas Weisel upgraded from market weight to overweight.
Jan. 23rd, Needham & Co upgraded from buy to strong buy.
Jan. 23rd, Caris & Company downgraded from buy to above average.
Jan. 3rd, Needham initiated with a buy.

The Psychology of the Call team (POTC) will pay close attention to all analysts, but particularly Needham's, as he initiated a buy rating on Jan. 3rd and then 20 days later upgraded to a strong buy, perhaps his questions will be the most insightful due to his aggressive and optimistic rating change. We hope you enjoy what we hope to be a fruitful exchange and presentation of perhaps the best hardware company in the world, Apple Inc. (AAPL). All hats to Steve Jobs, please.

First, here's some brief insight on AAPL from a piece we wrote in the "Psychology in the Upcoming Week's Earnings Data" specifically related to Wednesday's APPL release: We expect AAPL to have a downward bias due to the psychological ramifications of iPhone shortages and questions on a new iPhone launch. Although both events are positive from a numbers stand point, here's where "psychological financial fusion" applies. It's never a matter of quantifiable data only; it's more a matter of perception/sentiment/psychology. Here's the scoop from an analyst our team follows and respect:

The CC started at 5:00 PM ET with Nancy director of IR reading safe harbor statement and announcing the executives.
6m Peter CFO excitedly read the disseminated public press release.
7m Healthy growth in all regions, 200 retail stores extremely strong, 50% of customers sold to were new.
9m Ended quarter with 3-4 weeks of channel inventory; 10.6M iPods sold, late June new software will be released for iPod.
10m Objectives continued to be achieved; 10m recently surpassed Wal-Mart.
11m Very pleased with iPhone momentum.
11m 1.7M iPhones sold; 12m developer software has been TREMENDOUS (with emphasis) in new iPhone software.
13m AAPL retail stores momentum explained.
14m Personal training sessions in Macs is growing in retail stores.
15m Tax rate 29% below expected 32%, second half tax expected to be 31%.
15m June Q OUTLOOK: $7.2B or 33% growth, gross margins 33% expected; EPS of about $1.00; very excited in late June new iPhone software delivery.

Q/A began at 17m

17m Ben from Lehman Q about gross margins, and why confident in 33% gross margin next quarter? A: Commodity pricing hit historically low levels in latest quarter, we do see coming back to historical levels; 20m Gross margin declines explained, stumbling through excuses in POTC's opinion.
21m Still Ben from Lehman Q about iPhone growth going forward, shortages etc. A: Inventories are currently low and believe more phones are bought with the intentions of wanted to be unlocked.
22m SIGNIFICANT unlocking.
23m Q color on product mix and Best Buy A: 53%, up from 49% in previous quarter, Best Buy by 600 by summer.
24m Follow up Q on education sales A: Can't predict exact numbers but 38% is highest number ever; 25m SURPASSED DELL; POTC readers should note that DELL has now been called out by INTC and AAPL; a good reason to be SHORT DELL.
25m Mike RBC Q on the reasons in delay in iPhone 2.0 release A: Stumbling through answer again.
27m Follow up Q on 3G and iPhone: A: We don't comment on new products but confident we will hit 10M units.
28m Follow up Q on economic headwinds; A: We will leave economic commentary to others, (POTC felt INTC's CC was 100X more transparent, as they didn't make 1 excuse and did say macro economic trends today are NOT affecting their business); we have outstanding innovative products, growth was twice of last year’s quarter.
29m Somewhat convincing argument offered in AAPL future going forward.
29m David from Goldman Q regarding the 2.0 iPhone software date; A: iPhone 2.0 intended to be delivered in late June; 30m management hesitant in NOT wanting to admit impact of falling gross margins, our readers should listen to the CC at the 30m mark.
32m Kathy from Morgan Stanley Q on gross margins, Kathy was more emotional/colorful A: "Katie"(management addressed her) when we gave previous gross margin guidance, we did do better, 33m IT IS A COMPETITIVE WORLD. Follow up Q on store openings: A: Nothing has changed from our previous plans.
34m Richard from Citigroup struggling with gross margin Q, very rational and prodding analyst, A: Our Mac Leopard revenues explained, by far our best selling release, ( less leverage on fixed costs (while clearing throat)
38m Follow up Q on memory pricing; A: We envision it trading at a narrow trading range, but I don't believe it'll go lower.(POTC saw this as a weak answer, when a company has pricing power, they do not have to rely on being lumped with commoditized issues.)
38m Andrew with Bear Stearns Q on cash flows and what delay in iPhone meant for this quarter, and tax rates, and consumer trends A: Laughed as he said we had a good Dec quarter, went over disseminated numbers, retail stores exceptionally well; tax rate was forecasted at 32% for year, but now see 31% for June and September quarter; we sold 1.7M iPhones during quarter and we recognize revenue over 24 months. POTC sees revenue recognition being an detrimental psychological issue here going forward, caution.
43m Piper Jaffray analyst Q on iPhone A: March 6th we'll realize revenue on iPhone; as I've said in prepared remarks we will then provide software for free; reiterated free, therefore deferring revenue. POTC hates deferring revenues; we've come across too many companies who offered that excuse, and we don't buy it! Even from APPL, caution.
45 Shannon from Croft Research Q on pricing, needed more color on carrier driven pricing A: Carrier information is confidential.
46m Shannon became animated and management declined to answer her question, as they cannot divulge all information for competitive reasons, follow up on channel inventory and linearity; A: Strength in all geographies, linearity explained in more detail in 47m mark.
Follow up from Shannon at 48m on gross margins A: Management began laughing, they said customers love it, referring to the iPhone
48 Steve from Bank of Montreal Q on revenues of 2.0 software; A: No catch up period involved; follow up about gross margins, large drivers A: Really hard to do year over year comparisons, I'd prefer to stick with sequential metrics.
50m follow up was variance in terms of geographies materially different A: 51m STUMBLING ABOUT PUTTING OUT 10Q SOON, THERE'S LITTLE BIT VARIABILITY
52m Merrill Q seasonality in June quarter A: June sees sequential in Mac shipments, especially K-12, September weighted more toward higher education.
53m follow up on iPhone unlocking A: STUMBLING ON UNLOCKING, IT IS SIGNIFICANT, HARD TO QUANTIFY, iPhones being used in many countries.
54 Tony from Sanfor Bernstein Q: iPhone supply was outstripping demand, VERY GOOD QUESTION, TOUGH ANALYST; A: Currently inventories low in store and in channel, in aggregate Europe is low, U.S. is low.
55m follow up on better balance inventory A: You can have short term imbalance, and today inventories are low in U.S. and Europe.
57m this is our first Q1 to Q2 we've been in the phone business; (see Commandment # 6 about excuses; POTC feels this will only get worse going forward.
Tony tried to pry more information A: Management dodged the question in POTC's opinion;
average selling price (ASP) was slightly down.
58m Charles from Needham & Co Q on providing color on Mac purchases A: No info on Windows users purchasing Macs, professors and travelers good customers.
CC ended at 60m

We would not recommend buying or holding a single share of AAPL. The fact AAPL has entered in to the ultimate dog eat dog phone arena was a mistake, but for a company of AAPL’s size and dominance in one market it was a natural progression to try and succeed in another market. The exchange in the 33m when management admitted it is a "competitive world" was the theme of the CC as far as POTC's take away. Also, the stumbling and hesitation in multiple areas was unacceptable and not transparent. Intel's Paul Otellini and Stacy Smith, and Google's Eric Schmidt are giants compared to AAPL's executives. The fact Steve Jobs failed to show up for CC has a detrimental affect on psychology.

Lastly, when the 10Q is disseminated on Friday, or Monday of next week, we predict a 10% sell off. Please heed the warning. The Apple we saw today was no Golden Delicious. On the contrary, it was a sour plum dumpling filled with excuses. Our readers would be wise to avoid the stock until we see a change in executive psychology on the CC.

The Psychology of the Call thanks you for your continued support; and don't forget to print, copy, paste, email, and fax our blog spot to your friends!

Related Story: In Europe, Attempts to Fit iPhone to Needs of Service Providers


Anonymous said...

"POTC hates deferring revenues; we've come across too many companies who offered that excuse, and we don't buy it! Even from APPL, caution."

Why so? Seems you don't have much of an understanding for GAAP Accounting Guidance. In this instance, Apple has to recognize it on a deferred model. It's not like they get to pick and choose what to do. Further, the deferred calculation is tested by auditors - not like they can decide when to take the lumps.

Explain what your issue is with a company having to follow accounting guidance?

Anonymous said...

We didn't question GAAP accounting. We have a problem with Apple's entrance into the predatory and commoditized business of phones, where their margins will continue to fall with the reality of choice/competition. The main problem with deferred revenue for AAPL will be exposed in their 10Q relating specifically to their iPhone margins. The fact that so many iPhones are being "unlocked" (pirated) can force AAPL to fall back in love with their claim to fame, the iPod. AAPL said they will recognize revenues from iPhones over 24 months, and that time frame, even though acceptable GAAP accounting is psychologically a tail wind as more phones are bought, pirated/unlocked, and therefore AAPL will suffer from low margins.

We see AAPL's entry into the cell phone market as the beginning of end for high margins and explosive stock price. That is ONLY our opinion, and that's why we love the free market system; Commandment #8 says there are in fact two sides to the market. We feel AAPL has entered uncharted territory, even by their own admittance. Lastly, we're not excusing Steve Jobs from being absent from class; no apples will raise his marks.