MDJ 2020.01.28

The text behind the numbers

The Text Behind the Numbers

This afternoon in the US (4:30 PM EST on Wall Street, 1:30 PM PST in Cupertino, 2020.01.28 21:30 GMT) Apple Inc. will release the results of the company's first quarter of fiscal year 2020. Coverage will happen live on a slew of websites, on CNBC, and on Twitter (we'll be committing attempted punditry @macjournals if you care to watch).

We thought we'd take some time in this introductory issue under new tools to go through some of the basics of Apple results, what they mean, why they matter, and why, ever so occasionally, an analyst reaction or question can be so stupid.  

What's predicted

During last quarter's conference call, Apple issued the following guidance for Q1 FY2020:

  • Revenue between $85.5 billion and $89.5 billion (including foreign currency exchange benefits of over $1 billion)

  • Gross margin between 37.5% and 38.5%

  • Operating Expenses (OpEx) between $9.6 billion and $9.8 billion

  • Other Income and Expenses (OI&E) about $200 million

  • Tax rate of about 16.5%

Analysts, for their part, provide earnings estimates as earnings per share (EPS). As these go to three significant figures, it's inconsistent to compare them to Apple's profit estimate (37.5-38.5% of $84.5 to $88.5 billion, excluding currency exchange profits) because we will not know the number of shares outstanding until Apple reports that later today. Given that caveat, according to SeekingAlpha, the average of analyst estimates is:

  • Earnings per share of $4.54

  • Revenue of $88.38B, very close to the top of Apple's range

How today will go

Public US companies of Apple's size and structure must tell investors how they're performing "quarterly." For Apple, this means every 13 weeks for most years. 13 weeks per quarter times 4 quarters per year is 52 weeks, times 7 days per week is 364 days per year, which you may note is “not enough.” Depending on when the leap years fall, after five or six years, the company books a 14-week quarter to keep the 13-week boundaries near the beginnings of the four calendar quarters. That last happened in FY 2017, so comparisons to prior-year performance will be just fine today.

At the time noted earlier (4:30 PM EST), Apple issues a press release on Business Wire and PRNewswire, provides the same to investors, and files the same data with the US Securities and Exchange Commission. Selected journalists (not including MDJ) get the material directly in email; others have to wait until one it trickles through to Seeking Alpha or similar channels.

CNBC starts its live coverage as soon as they get "the numbers." However, through a special arrangement, they will have already spoken to CEO Tim Cook about the company's performance, with the understanding that nothing can be revealed to anyone until it goes on air. (Were anyone at CNBC, not only the reporter but also the motion artists who put Cook's words in on-screen graphics) to try any after-market trading before CNBC aired the info, the SEC probably would congratulate them with a nice fat insider trading lawsuit.

30 minutes later, Apple holds its quarterly conference call for financial analysts. The press is welcome to listen—in fact, everyone is welcome to stream the call "live" (delayed only by streaming protocols and typical Internet lag). In years past, journalists could call a direct phone line to the conference call provider and not be subject to net foibles. Now that privilege is only for the selected few; others must stream the call and hope for the best.

When the call starts, Apple's director of shareholder relations discusses some formalities, and then CEO Tim Cook reads a prepared statement. This is like Tim's "updates" at product launch events or WWDC, but a lot longer and without slides. The audience here is financial analysts who probably do not know as much about Apple as you do. You know how much the Mac Pro (2019) costs and why you (probably) will not buy one. Analysts only know it redefines "costly," it's not aimed at you, and they want to know if there are enough realtime video editors and live musicians using 1000 tracks at a time to make the Mac Pro as profitable as an iPhone. If so, great. If not, they'll think it's a waste of Apple's time and tell their clients as much.

Here is the Six Colors transcript of Apple's previous quarterly call. Look at it for yourself and judge that we weren't kidding about the length. Tim's preamble is nearly 2,300 words long! He then tosses to Chief Financial Officer Luca Maestri, who reads a different prepared statement going over Apple's financial numbers in analyst-level detail. Mercifully, this statement is usually shorter: last time, it was only 1,911 words. (Last quarter, Tim Cook read his statement for 15 and a half minutes, followed by Luca Maestri reading his for another 14 minutes. Since Apple allots only 60 minutes for the call, it's a good way to limit questions.)

The call is then opened to analysts, who got to dial the most special phone number of all and enter a queue to ask questions of the Apple executives, including corporate comptroller Gary Whisler who often has nothing to add. Apple asks analysts to ask one question and one follow-up, with varying degrees of success. Most of the analysts have heard these calls before and know now not to waste time asking any questions about future products, as the execs will cut them off with "we don't comment on future product possibilities."

Depending on the length of the CEO's and CFO's statements, they'll field anywhere from 35 to 45 minutes of questions from the (invited) analysts, and that's it. Six Colors usually has a transcript up within 24 hours, often much faster. Apple releases its own audio recording of the call a couple of hours later in its Apple Quarterly Earnings Call podcast feed, where it stays for two weeks and then vanishes. And we do it all again in 13 weeks!

So why is there so much stupid?

It's less the fault of individual analysts and more an issue of what financial firms want from those analysts.

According to the Wall Street Journal (warning: opinion sections of the WSJ do not necessarily receive the rigorous fact-checking of news pieces), there were "only" 3,671 public companies in the US in 2017 (down from 7,322 in 1996). Not even the largest financial services company can hire 3,671 analysts to track those companies, and it would be a massive waste of time anyway, as most companies don't make news on most days.

Therefore, firms doing analysis combine companies of similar businesses into industries and track those instead. Although they have different methods and goals, it's evident that GM, Ford, Honda Motor Company, Toyota, BMW, Volkswagen, etc. are primarily concerned with building motor vehicles and selling them at a profit. Dell and Acer are mainly interested in selling you computers of one size or another. eTrade, Charles Schwab, and Wells Fargo Advisors all want to sell you financial instruments and collect fees for the management thereof.

Alas, not every company fits neatly into these categories. Walmart and Amazon, for example, want to sell you everything. They get lumped into a big category called "retail" in a class above more specialized retailers like Kroger (groceries) or Sears (garbage).

This is what has always hurt Apple. Until 2001, Apple was merely a computer company to analysts. Apple sold computer hardware, just like Dell or HP or Compaq or Kaypro (this is not a new problem). By the 1990s, computers were considered a "commodity," like sugar or wheat or a "Real Housewives" show. That means most people would consider one brand as good as any other, and the purpose was to make the product as cheaply as possible to extract the most profit.

If you pay more than a base price, you'd better be getting something special or you're an idiot—and with commodities, everything is alike. Sure, individual shoppers might like "pure cane sugar from Hawaii," but for Coca-Cola's purposes, sucrose is sucrose, regardless of its source. Paying $0.002 more per ton of sucrose is just throwing money down the drain. ($4,420 per year, but still.)

Analysts covering 15-20 computer makers per year did not have the time for arguments that a Mac was special. A midsize car is a midsize car; an entry-level PC is an entry-level PC. When Walmart has to put PCs at every register in the country, they're going to buy the cheapest ones that fit the specs. Any buyer doing otherwise is wasting money.

You know this is a false comparison—support costs for Mac have long been cheaper, most models included features that required add-ons from PC makers, and so forth—but the market spoke. 90% of people purchased PCs, and that was that. Apple was not making the right kind of PCs and was doomed.

When the iPod came along in 2001, it got shoved into a broader "audio" category at most financial firms, and was quickly dismissed: $300 for something you could already buy for $75? This is portable music through cheap headphones, and no audiophile will pay that price for that quality. But again, it was special: provably easy to use and large enough to hold 100 CDs worth of music. Even so, it didn't take off until Apple made it available to Windows users as well.

But now we have a problem: Apple is a company making two things. Computer analysts pegged Apple as a computer company dabbling in peripherals, while audio analysts were starting to think of Apple as a music company that also still made computers for some reason.

The iPhone did not improve this situation. For most of the last decade, iPhone has generated the vast majority of Apple's revenue. To most analysts today, Apple is a smartphone company, full stop. It may dabble in tablets and computers and now (for some godawful reason) television, but the iPhone pays the bills, and iPhone sales growth is slowing. At some point, everyone who wants a working iPhone will have one, and Apple will have to entice upgrades with powerful new features that are worth paying $30 to $50 per month for a year or two. Analysts fear Apple cannot do this, just as their predecessors feared Apple could not keep the shiny graphic interface superior enough to Windows to make any difference.

The more holistic analysts wanted Apple to sell more products to people who already had the hardware to use them, and that leads to Apple's current major push in "Services." That's iCloud, Apple TV+, Apple Music, Apple News, Apple Arcade, and AppleCare, among others—anything for which you pay a subscription price for, well, a service.

Analysts often see services as free money—as long as the service is useful and competent, people will pay $3 a month for more iCloud storage space, or $5 per month for great Apple Arcade games. They're concerned about television because it is unbelievably freaking expensive to produce a single show that cannot possibly appeal to everyone. (There are 327.2 million people living in the United States. Game of Thrones, one of the most lauded TV series of this century, reached an average of 44.2 million viewers per episode in its final season, or about 13.5% of the population. Even the biggest hits are pebbles splashing in the pond of Peak TV and peak channel selection.) 

So what?

There may be one person who can keep track of everything Apple is doing at a deep enough level of detail to understand the plot, and we'd all better hope that person is Tim Cook. If a financial analyst (or newsletter author) can do it, he or she should be making a lot more money elsewhere.

In other words, no individual analyst is likely to understand the whole of Apple Inc. The ones focused primarily on performance over the next 12 months are going to focus like lasers on iPhone sales, and demand that the 2019 Christmas season sold more iPhone 11 models than the 2018 Christmas season did iPhone X models. If that didn't happen, or even if the rate of growth is not big enough, they're going to say Apple messed up. Apple's stock price is near all-time highs, and nervous investors looking to sell at the first sign of trouble will find it.

Analysts who instead focus on services are likely to find a better story, as everyone expects Apple's services revenue to continue to grow for a while. Apple TV+ may be free for the first year to anyone who purchases a new Apple product now, but if 50 million people convert to paying subscribers at $60 per year, that's $3 billion added to the top line. Motley Fool recently asserted that Apple could get more than 100 million Apple TV+ subscribers, although we would not bet anything substantial on that happening.

You may have noticed we haven't even mentioned Apple Watch, because it's all but a rounding error in these discussions. Apple Watch sells well and is profitable, but it's still an iPhone peripheral. Even when it can stand alone without a phone, it's not likely to be someone's first purchase into the Apple ecosystem.

We didn't mention iPad either for similar reasons. Some analysts undoubtedly see iPad sales as a heuristic for education sales—competing with Chromebooks more than anything else in that field. Like the watch, iPad is profitable; unlike the watch, sales typically aren't growing. Perhaps others share John Gruber's disappointment that the iPad is not yet what it should be, but it's worth noting that a lot of iPad changes that people seem to want would be easy to make if Apple were willing to give up iPhone app compatibility. With bestsellers like PayPal and Castro not yet offering native iPad apps, that's a tough trade-off to make.

Computer analysts are probably still waiting for Apple to make Windows-compatible PCs, but the commodity argument has them fooled again. If Apple lets macOS run on third-party hardware again or just gives up and ports the OS to generic PC hardware, they're ceding control of developing their own products to the makers of other companies. Can you imagine 2005-era Microsoft being responsive to Apple needing massive changes in Xcode and Windows to enable future peripherals like better iPods? Microsoft may not be that kind of threat today, but failing to control its own development would put Apple in more than one untenable situation. With its A-class RISC processors in non-Mac devices, Apple has been moving towards more control, not less.

And so we reach the standoff. Financial firms can't afford to hire Apple-only analysts, and those covering Apple as part of a broader "industry" want Apple to behave like that industry rather than behaving like...well, Apple. And they think they're right! They're relying on lots of experience and data from looking at other (cellphone or TV production or computer or service) companies, and telling their clients that these strategies have never worked before. That's what financial firms want analysts to do!

It's just that to those who pay more attention, it can sound like clueless gibberish. Don't necessarily blame the analysts, blame their marching orders.

But do blame Wall Street as a whole for the most annoying part of this system—Apple's numbers must meet or exceed the guesses that analysts made with less information than Apple has. If they don't, the entire financial industry and media will assume that Apple screwed up, not that the analyst estimates were terrible.

Nice work if you can get it.