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Apple's "disappointing" quarter cause for questions, not panic


In amongst the MoLo Madness, there's been some back and forth in the blogosphere today over the possibility that Apple's third quarter financial results were "disappointing" or not, mostly based on the fact that professional analysts predicted Apple would earn far more than it did and now they're butthurt.

The case for this being stupid is well summed up by Peter Cohen for The Loop:

After last night's earnings report, in which Apple exceeded its previous guidance for the quarter, financial reporters quickly noted that Apple missed analyst expectations. But analysts are consistently wrong about Apple's earnings, so why do we put any stock in these people's guesses at all?

Now, whilst it's true that Apple beat its guidance, I don't think that necessarily means everything was rosy. In fact, I think it can be argued Apple did have a disappointing quarter by the best measure we can apply: its own.

"Earnings guidance"

So, what is earnings guidance anyway? We're going to need to understand this to go any further.

Earnings guidance, also known as "forward looking statements", is a comment that the management of a firm makes about how they expect the short-term future to play out. For Apple, it's part of the financial statement for each quarter, containing an estimate of the revenue expected to be made in the next quarter. Internally, it's the culmination of an estimation process that takes in all the various product lines Apple sells.

Guidance is important because, fundamentally, Apple knows an awful lot more about how it's doing internally than any external analyst can hope to. In theory it's the most accurate prediction there can be. However, it also has an Achilles heel.

Imagine if your boss came to you and said "I want you to tell me how well you're going to do in your job for the next three months. If you beat the number you give me, I'm going to congratulate you; if you miss it, I'm going to be mad." You know that your boss is hardly ever in the office and can't tell what you do all day, so doesn't really have any idea about what decent performance looks like. What would you do? You'd lowball your estimate to give yourself more breathing room, of course.

This is what most firms do with their guidance. That's not to say Apple deliberately marks estimates down, which would be a bit naughty. But when faced with a range of uncertainty -- which all predictions of the future must deal with -- it's going to err on the side of caution rather than irresponsibility.

To quote Bullish Cross:

The reason Apple regularly beats its revenue guidance so consistently between 12-18% every quarter is the fact that of any entity, research group, analyst or fund manager, Apple's management is by far the best positioned to know exactly how the company will perform in any given quarter. In fact, Apple probably possesses on the order of 20-30 times more information than everyone else put together.

Being so well positioned, what Apple does before offering it's [sic] sales guidance is it formulates a conservative internal outlook. After doing so, Apple then offers a guidance number that is just about 10% below that internal sales expectation.

Good conservative accounting practices dictates that if and when a company decides to offer guidance on its sales expectations, the company must provide an outlook that is reasonably conservative, consistent and comparable across quarters. The expectation set by the company must allow the average analyst to reasonably infer what is likely to unfold. Both reported financial statements and unaudited financial forecasts must be reported consistently across quarters, comparable across quarters and conservative across quarters.

Thus, Apple ultimately ends up offering a guidance number that is 12-18% below what it ends up reporting. The reason for this is simple. As with any other company, Apple's internal expectations tend to be slightly conservative. So when the company offers a sales estimate that is roughly 10% below its internal expectations, those internal expectations are already slightly conservative leading to the ultimate 12-18% beat.

Apple's historical "guidance beat"

That quote introduced the idea of the "guidance beat": the proportion by which Apple's actual revenue is larger than the revenue it predicted.

Here's Apple's guidance beat, as a percentage of the estimated revenue, for the last few years:

Apple's disappointing quarter

(Data sourced from apple.com and seekingalpha.com.)

Almost three years of beating its own guesses by an average of 19% and never less than 12% -- but all Apple managed last quarter was 3%.

Now, I don't present this data to suggest that anything is badly wrong at Apple. Far from it. I do think there are interesting questions to be asked about these results, as Dan Frommer wrote, but I'm no financial wizard so I'm not the person to dig into those. The bald numbers are that Apple made $35 billion in revenue and kept $8.8 bn of that as profit. These are staggeringly huge figures.

However, I do think the graph above makes a strong case for two linked conclusions:

  • Something unusual did happen last quarter.
  • Whatever it was, Apple didn't see it coming.

Putting on my Blogger Speculation Hat (a battered trilby with a hand-drawn obviously-fake PRESS badge tucked in the ribbon), I'm going to speculate that perhaps Apple was unprepared for the iPhone sales number.

On the conference call, Apple's CFO Peter Oppenheimer said "Our weekly iPhone sales continue to be impacted by rumors and speculation regarding new products," as if it was all the fault of us nasty bloggers. This is, frankly, hooey. After five years of annual iPhone refreshes (with one three-month blip, admittedly), there are whisky-sodden Peruvian goat herders who've never even seen an iPhone in their lives who could still tell you we're due a new iPhone in a couple of months.

If that's all it is -- and I see no reason to think different(ly) -- then Apple will recover this ground in a significant sales spike when the new iPhone does eventually ship, of course. It's not lost revenue; it's merely delayed.

As Frommer says, there are other things Apple might be worried about; the iPad has a lower profit margin than the iPhone, and is an increasing proportion of its sales; and if the rumours of a cheaper 7.8" device are true that's only going to get worse. Apple is a luxury device maker so obviously it's at risk to the ongoing Euro crisis, and so on and so forth.

It's not my intention to be alarmist. I don't think Apple had a bad three months. But I do think that dismissing the last quarter with a wave of the "it hit its guidance so nothing else matters" wand is simplifying the story a step too far. Something interesting happened. The question is... what?