Here’s How Apple Can Beat Earnings Expectations

Apple (AAPL) is only a couple of weeks away from reporting the results of its fiscal 3Q19, an event that is scheduled to take place on July 30 after the closing bell. Consensus expectation is for revenues to reach $53.42 billion, just above flat YOY, ending a series of two quarters of top-line contraction. EPS of $2.10, on the other hand, would fall well below last year’s $2.34 – primarily a reflection of lower gross margin and richer opex.

The Street’s projections are mostly aligned with Apple’s mid-point guidance delivered last quarter, if not even a bit de-risked. If history can serve as reference, considering the past eight quarters of all-round positive earnings surprises (see Seeking Alpha’s earnings analysis page), the Cupertino company may very well be able to clear the low bar that it set for itself once again.

About the most recent quarter

In order to do so, Apple will need to fight headwinds on a couple of important fronts. The most meaningful of them pertain to (1) the iPhone and (2) the challenging Chinese market, with the intersection between the two looking most vulnerable.

On the former, smartphone sales have been lackluster lately, as the product category has yet to see a new model release to match the success of the iPhone X. The most recent report from market intelligence provider IDC continues to speak of softness in the short term, although it also supports a return to growth in the horizon on the back of 5G acceleration as 2020 approaches.

To be fair, I do not consider the iPhone as a standalone business a meaningful pillar of the long-term investment thesis. I have argued that, in general, smartphones tend to head towards the mature and declining stages of the product lifecycle, with events like the upcoming 5G upgrade period providing only temporary relief to growth deceleration – IDC’s graph below depicts the dynamic well. Instead, I believe iPhones will be enablers of growth in other parts of the business (e.g. services), as Apple’s installed base continues to expand.

Perhaps helping Apple to deliver above-consensus results this quarter will be the less talked-about segments, including iPads and, to a lesser extent, Macs. Both categories had their product refresh announced at the very end of the second quarter, and the increased demand for the new models could drive a spike in revenues in both cases.

Further down the P&L, I believe Apple could deliver gross margin just above the mid-point of its guidance range. Although component costs will likely continue to be a headwind, I think the market may be underestimating the profitability impact of the revenue mix shifting fast to the higher-margin service business. Should I be right about this, and assuming the company is able to once again do a decent job at controlling opex amid lack of more robust top-line growth, I believe EPS could land three cents above current consensus.

Looking farther down the road

Earnings results aside, I believe AAPL continues to be a solid investment. In fact, I have recently called it “my FAAMG stock for the rest of 2019”. Justifying my optimism is the company’s long-term prospects, which I believe to be promising yet discounted for short-term worries over trade policy and global economic deceleration.

More specifically, I see in the more stable and predictable services revenue growth and the success of new device form factors, including the Watch and other wearable products, the foundation of the bull thesis.

As I have estimated recently, I believe fiscal 2020 services segment profits could represent half those of smartphones, while Apple Watch revenue growth should amount to more than one-third of Apple’s total company consensusrevenue growth next year. While the business transformation continues to unfold, the Street seems too busy counting iPhone units shipped in the most recent quarter and missing the bigger picture.

Trading at what appears to be an attractive long-term PEG multiple of 1.4x (current-year P/E divided by five-year earnings growth projection times 100, see chart above) and still well off the all-time share price peak of $227 reached in August 2018, I reinforce my convictions on this stock ahead of earnings.

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