Play Tonight's Roulette On Apple's Earnings Release?

Apple (APPL) will report its second-quarter earnings (ending March 2013) after markets close tonight and Wall Street will scrutinise them for every tiniest detail as to gross margin, market share, units sold and guidance. Why all the fuss about a technology company?

Well, Apple was the world's largest company measured by market capitalisation but a 45 percent decline from its all-time-high sucked USD 284 billion in market value away from its shareholder - a sum which is equivalent to Google's entire market capitalisation. This alone is sufficiently spectacular to grab everyone's attention. Add to this dramatic change in share price, the "intergalactic war" between Apple, Google, Amazon and Samsung in the two most important consumer categories at the beginning of this century, namely tablets and smartphones. This is essentially the battle for the world consumer and the figures are staggering. Apple is almost like a battle of religions when you listen to users of electronics devices and the same fierce argumentation, not to say love/hate relationship, has swept into the ranks of investors. That is why everyone cares about tonight's earnings release.

Apple's earnings releases are like roulette
Looking at the last 43 quarterly earnings releases we get a picture of a sheer mining field for traders. The chart below shows the one-day price reaction following the earnings release and as the wise reader has already figured out, this is a quite volatile price response. To be precise, the standard deviation is 6.5 percent, or in other words, 31.8 percent of the reactions are likely to be lower than -5.2 percent and higher than 7.8 percent. This is quite dramatic and signals the substantial uncertainty that normally surrounds Apple's sales and earnings figures. Playing the earnings release directional and naked (that is going long or short the cash equity) is almost like roulette on the casino. Everything can happen.


A better strategy given the big drop in the share price would likely be long options on Apple with one month to expiry. The May 18 call option with strike 400 costs about 16.85 (around 4.2 percent premium for one month's worth of potential upside if earnings beat). We will shortly present the upside case for Apple.

Where is Apple headed and are investors too pessimistic?
Despite the plunge in share price reflecting rapidly deteriorating expectations for revenue and earnings, 12-month rolling revenue has climbed consecutively for 57 quarters and the current revenue growth rate is 28.8 percent annualised. The two fastest growing geographical segments (Japan and China) almost doubled in 2012. China represents today around 14.4 percent of total revenue. Especially China could be the joker that positively surprises.

The chart also shows the margin pressure that has been ongoing for a couple of quarters. This has happened before so is that something to be worried about. Yes, and especially because previously it has been only been tied to product cycles. This also plays a role this time but in the mean time Apple's new main competitor, Samsung, has made tremendous progress on its phones and pressuring Apple on price. Could margins go lower in the next couple of quarters? Of course they could and the current market price is signalling this and maybe even a crash in margins; remember stock valuations are driven by return spreads which is directly linked to margins. However, a crash is unlikely on the scale that we have witnessed in Nokia and Blackberry because Apple has a much more sophisticated moat through its ecosystem.

I admit gladly that I was wrong in the beginning of the year and ahead of the last earnings release. My take back then was that the market would reward Apple for its penetration in China and reprice the stock given the big drop. However, the multiple contraction continued relentlessly and the negative news went on. In this earning release I think Apple needs to deliver a lot less to satisfy Wall Street and a positive catalyst for the share price could be further buyback or increasing the dividends.

Apple is currently trading at 5.8x on EV/EBITDA compared to 7.8x for the information technology sector as whole, S&P 500 is valued 9.4x EV/EBITDA. I find the valuation of Apple ridiculous as the price is discounting a huge crash in margins and full stop on revenue growth in the short-term which seems unlikely given IDC's growth expectation for global sales of smartphones in the period 2013-2017 (an increase from 900 million to 1.5 billion in the period). Then add the global growth in tablets. I do not think Apple is over and I certainly do not think they should be priced for zero growth. A bounce back in Apple in 2013 could happen.