Apple's March Quarter Guidance Is More Likely To Disappoint Than Bring Relief

Apple is scheduled to report its detailed December quarter results and provide guidance for the March quarter after the close on Tuesday, January 29. Since Tim Cook provided many of the key financial numbers for the December quarter when the company preannounced disappointing results on January 2, almost all of the focus will be on the March quarter outlook.

The company’s January 2 press release stated that it would generate revenue of $84 billion for the December quarter vs. its guidance of $89 to $93 billion, with the other key financial components (gross margin and operating expenses) being in-line with what was provided on November 1. Apple’s shares fell from $157.92 on January 2 to $142.19 the next day but have essentially recovered all of their losses closing at $157.76 on Friday, just $0.15 below the pre-announcement price.

March quarter expectations

The average sell-side analyst revenue estimate for the March quarter is now at $59.3 billion and EPS is $2.65. I believe most analysts are expecting gross margin guidance to be a range of 38.0% to 38.5%, which is what it has been for the past five quarters.

However, there can be a difference between the published Street estimates and what investors are expecting. The reasons for this include Street estimates lagging expectations as sell-side analysts don’t want to change their estimates when there is an upcoming earnings announcement (but Apple’s was early enough and significant enough they should have) and historically sell-side analysts don’t cut deep enough or raise projections enough when there is a significant announcement, while investors are more willing to get in front of conditions getting worse or better.

I would peg the over/under for Apple’s March quarter revenue and gross margin guidance to be $58 billion and 38.0%, respectively. Unfortunately for Apple shareholders, I believe guidance could come below both of these forecasts .

This may turn out to be a situation where what a company announces is disappointing on the surface but the stock reacts positively. However, I believe that the type of shortfall Apple experienced in the December quarter is not a one-time event and usually there is another shoe to drop.

Apple provides three key guidance numbers and a fourth, EPS, can be calculated from them. Below is an analysis of previous quarter-to-quarter results and how they could come into play with this year’s guidance.

Revenues typically decline over 30% from the December to March quarters

Over the past three years, Apple’s revenue has declined over 30% from the December to March quarters. It was four years ago that the decline was less than that (22.2%), but that was when the iPhone 6 and 6 Plus were not able to satisfy demand in the December 2014 quarter.

Previous December quarter to March quarter revenue declines:

• December 2014 to March 2015: Down 22.2% (iPhone 6 & 6 Plus available)
• December 2015 to March 2016: Down 33.4%
• December 2016 to March 2017: Down 32.5%
• December 2017 to March 2018: Down 30.8%
• Average of the past three years: Down 32.2%

The average sell-side published estimate for Apple’s March quarter revenue is $59.3 billion, which would be a decline of 29.4% from $84 billion. While this would still be a substantial drop, given the demand issues the company is facing it feels like this won’t be enough. To match the 32.2% average decline of the past three years revenue would come in at $56.95 billion, which would be lower than what I believe most investors are expecting.

One interesting item to note is Katy Huberty at Morgan Stanley is using $62 billion for her March quarter revenue estimate, while consensus is $59.3 billion. At $62 billion that would only be a 26.2% quarter-to-quarter decline, which is significantly higher than the investors she talks to are expecting (she pegs that at $58 billion).

Toni Sacconaghi at Bernstein points out that changes in the iPhone’s inventory levels could have a significant impact on what guidance Apple gives. If there was a significant inventory build (either planned or unexpected due to lower iPhone sales), such as the 4 million units in the December 2017 quarter, it could lead to a larger than expected portion of iPhone sales for the March quarter being satisfied by inventory.

Since iPhones are counted as being sold when they go into inventory, this would put downward pressure on March quarter’s revenue and earnings guidance. Unfortunately, Apple stopped providing the changes to the iPhone’s inventory in its last conference call.

Gross margin has been remarkably steady

Apple preannounced that December quarter’s gross margin will be approximately 38.0% vs. guidance of 38.0% to 38.5%. It is positive that with a $5 to $9 billion revenue shortfall that the company was still able to hit the margin guidance.

Previous December quarter to March quarter gross margin changes:

• December 2014 to March 2015: Up 0.9% (iPhone 6 & 6 Plus available)
• December 2015 to March 2016: Down 0.7%
• December 2016 to March 2017: Up 0.4%
• December 2017 to March 2018: Down 0.1%

There are multiple factors that impact gross margins, so it is challenging to predict what its guidance will be. However, since its result has been between 37.9% to 38.5% for the past seven quarters (including the December 2018 quarter) and guidance has been 38.0% to 38.5% for the past five quarters, it appears that most analysts are expecting the guidance to be the same 38.0% to 38.5%. If it comes in below 38% it could lead to a negative reaction since it indicates margin pressure.

Operating expenses falling more than expected signal cost cutting

Apple’s preannouncement included that operating expenses would come in around $8.7 billion, which was at the low-end of the $8.7 to $8.8 billion guidance. While it won’t be scrutinized as much as revenue and gross margin, how much operating expenses are expected to fall will give a clue if the company is putting cost-cutting programs in place.

Previous December quarter to March quarter operating expense changes:

• December 2014 to March 2015: Down $117 million
• December 2015 to March 2016: Down $318 million
• December 2016 to March 2017: Down $323 million
• December 2017 to March 2018: Down $110 million
• Average of the past three years: Down $250 million

If the guidance for March quarter’s operating expenses is $8.3 billion or lower it probably indicates incremental cost cutting beyond normal seasonality.

EPS is being helped by stock buybacks

While Apple doesn’t provide explicit EPS guidance it can be calculated when you estimate the share count. From the original guidance the company was expecting EPS to be in a range of $4.42 to $4.75 for the December quarter, but based on the January 2 announcement it should be $4.16 vs. $4.06 a year ago. While revenue is declining 5% year over year, EPS is going up over 2% due to share buybacks and a lower tax rate, 16.5% vs. 25.8% a year ago.

The average Street analyst has March quarter’s EPS coming in at $2.65, which is down from an expected $2.95 before the preannouncement. The $2.65 would be a decline from the March 2018 quarter’s $2.73 even with a drop of 7% to 8% in the number of shares outstanding.

However, I would not be surprised to see the guidance provided next week to have an EPS outlook below $2.65 as many of the sell-side models I’ve looked at have gross margins at 38.0% or higher. While gross margins do not always decline from the December to March quarters, if revenue comes in at $59 billion with gross margin at 38.5% (which I believe is too high) and operating expenses at $8.3 billion (down $400 million quarter to quarter) EPS would be $2.62 or three cents below consensus.

While $0.03 is small and just over a 1% miss, I believe investors will react negatively. And I believe EPS could even be lower due to my projections being more on the helpful vs. conservative side.

Maybe there is enough angst for a rebound. Or maybe not.

While Apple’s shares have bounced back from their $142 low and have erased most of their oversold position on a short-term basis, there is justifiably still a lot of concern about what iPhone demand will be in 2019 and beyond. If the guidance is better than expected the stock should pop.

However, if the March quarter’s outlook is weak, they will be reminded that Tim Cook decided to stop giving iPhone unit sales with this report, which must mean something is wrong (or at least means bad news).