Final Thoughts on Apple's 4Q11

iPhone. We Still Don’t Know How People Buy Phones. 

While everyone has been quick to blame unrealistic expectations for Apple’s 4Q11 “miss”, I think the rare earnings disappointment was partially due to a lack of understanding on how iPhone demand fluctuates and how people buy phones. Apple just became a much harder company to model.

It is incorrect to say that analysts never considered people waiting to buy iPhones ahead of a rumored iPhone refresh. Almost every analyst note published in the past three months mentioned an iPhone refresh and the tendency for pent-up demand to build as consumers wait on iPhone purchases.  Apple management forewarned the same scenario on Apple’s 3Q11 earnings call. People were expecting it.  Even my analysis was based on the idea that a slowdown in iPhone 4 sales in countries that typically get the new iPhone on launch would be offset by continued strong iPhone 4 sales in countries where the new iPhone would take months to reach. That didn’t happen.

Instead, the world pretty much stopped buying iPhones in September.  I don’t think it’s much of an exaggeration to say that iPhone sales almost came to a screeching halt towards the end of September. Apple specifically mentioned that sales slowed further in the second half of the quarter.  Running rough calculations, I estimate iPhone sales may have been tracking down 20-40% yoy in the U.S. towards the end of September. Pretty remarkable. I wonder if Apple retail stores saw this noticeable decline in demand? Analysts underestimated how many people were aware of iPhone rumors and were waiting to buy. Apple was surprised too, with both Tim Cook and Peter Oppenheimer mentioning “rumors” as one cause for weak iPhone sales.  Anecdotally, I talked with quite a few BlackBerry and Android users over the summer, all of whom were well aware of a new iPhone coming out sometime in the fall. I assumed there were other people still buying iPhones.

The iPhone miss (and let me be clear, the iPhone number was pretty negative at only 21% yoy growth) came as a huge surprise with analysts and the investment community thinking the iPhone demand cycle had become independent of product transitions. We thought that sequential quarterly iPhone growth is the new normal, regardless of how a new iPhone impacts deferred sales. Apple’s significant 3Q11 iPhone beat cemented the idea of sequential quarterly growth. Ironically, many analysts thought the new iPhone was going to be unveiled at WWDC and had modeled for declining iPhone sales in 3Q11 due to deferred sales (people waiting). Instead, Apple beat everyone’s iPhone estimate by a mile as iPhone rumors really didn’t grow until August. Independent Apple analysts (including myself) concluded it would be unlikely that Apple would report a sequential quarterly decline in iPhone shipments in 4Q, which meant Apple would sell more than 20.3 million iPhones (their 3Q11 total). We weren’t necessary making a call on growth assumptions, or at least I wasn’t. Some analysts did get it right. Goldman Sachs modeled 16.9 million iPhones – essentially spot on. Still wondering why Goldman was picked first for Apple’s earnings Q&A?

I don’t think our iPhone expectations were overly optimistic though as our previous demand forecasts have now shifted to 1Q12. Our annual iPhone sales estimates remain largely unchanged. Instead, our timing was wrong. I think iPhone’s increasing demand complexity was the main culprit for the iPhone miss. Even Apple management thought they would sell more iPhones in 4Q11.* We still don’t understand how consumers buy phones. For many, buying a phone is categorized as “the big purchase” even though the actual cost of the phone is spread over 2 years. A $110 monthly cell phone bill 17 months from now is not as important as the difference between a free subsidized phone and a $199 subsidized phone today. People wait to buy phones until their contract is up and - this is key - they are willing to wait after their contract is up to take advantage of the carrier’s subsidy and buy a phone that they really want, even if it means holding off on a new cellphone for an extra 4 or 5 months. This trend will only grow as smart phones flourish.

Reports of record iPhone 4 sales over opening weekend (including positive commentary from AT&T, Verizon, and Sprint) are evidence that iPhone demand is back. Going forward, analysts should model a slowdown in iPhone sales during product transitions. If a new iPhone is rumored for October 2012, one should assume people will stop buying iPhones in September. Seems obvious now, but many got it wrong. In addition, a new form factor will also lead to difficultly in meeting initial supply, which could hurt early sales.

iPad. The Wild West. 

Apple sold 11.1 million iPads in 4Q11. I expected 11.7 million and I had originally expected 11.1 million, so iPad is performing near my expectations. Unfortunately, many independent analysts have been running with extremely aggressive iPad expectations. I do think these expectations need to come down.  Apple noted iPad supply and demand is now in balance. Apple sold every iPad that consumers desired; 11.1 million/quarter.  I still get nervous with iPad because it is such a young product.  What if demand really isn’t as good as we think? It doesn’t mean the product is a failure, instead maybe people just haven’t yet become comfortable with tablet computing. Sales fluctuations will occur and people need to plan for it. I found it interesting that Tim Cook made the claim that iPad could turn out to be larger than the PC market. In the past, Apple’s remarks were more vague and general. Apple wants to set the tone for iPad. This is the bet. This is the future.

Mac. Steady as She Goes. 

Apple’s forgotten child (at least in many investor’s eyes) continues to do well, taking market share from Windows with both hands. Strong 37% yoy growth in portables (thank you Macbook Air) speaks well of Apple’s growing brand in the traditional PC market. Yet compared to iPad and iPhone, Mac’s influence is just too small to impact earnings to any large degree.

iPod. Out to Pasture.

Declining iPod sales are now normal and to be expected. In fact, iPod declines are accelerating. Sure, the “newer” iPods might change this trend a bit in the near term, but when excluding iPod Touch, the iPod is only a fraction of its former self.

Guidance. Strong. 

Apple’s 1Q12 guidance was very strong, near current consensus (which is very rare). Management indicated they will sell a record number of iPhones and iPads during the holiday quarter (not that shocking). Since Apple “missed” earnings, analysts will be more conservative with their forward expectations, unsure of how much cushion Apple built into its guidance. Many analysts were already running with conservative assumptions so the 4Q11 “miss” should not weigh much on forward EPS estimates.  

Thoughts on Apple. Quarterly Results Rarely Matter For Superior Management Teams

Earnings misses are not the end of the world.  They can be healthy, serving as a foundation for further gains. Misses act as a reset for increasingly lofty expectations. Problems arise though when people look for answers to an earnings miss and are quick to make incorrect assumptions.  A prime example is Apple’s retail store trends. Same store sales were down approximately 10% (which means that your local Apple store reported 10% less revenue, on average, this past quarter vs. last year – a pretty sizable decline). Well, hello, iPhone sales were miserable. With an ASP of over $600 and a concentration of Apple retail stores in the U.S., a slowdown in iPhone sales (maybe as much as 30-40% in September in the U.S.) will have an impact on total retail store revenue. It doesn’t take a genius to figure that out. 

Apple will get penalized in the near-term because of its earnings “miss”. People will remain more cautious on iPhone and iPad growth.  Expectations are being reduced (especially among the independents).  Apple bears are getting louder. People are wondering. People are asking. Earlier this week, the biggest question was how high the stock would gap up after earnings. Now people are thinking of the “what ifs”, what if people stop buying iPhones, what if iPad sales slow down. While such questions might seem silly to think given the technicalities of Apple’s “miss”, its nevertheless happening.

Good companies sometimes have “bad” earnings reports (who would have thought 50% EPS growth would be considered bad). In such circumstances, time is your friend. For long-term investors, quarterly results shouldn’t even matter much, instead attention should be given to the current management team and its ability to innovate.  

*UPDATE: Thanks to @adamthompson32 for pointing out that Apple actually said 4Q11 iPhone sales were better than expected. Tim Cook: “And as we have predicted…(iPhone) sell-through decline did occur in the quarter, but not nearly to the extent that we thought and therefore, we significantly beat our guidance.”