Investors Should Love Apple's Q1 Guidance

By Markets Fool.com

Apple (NASDAQ: AAPL) shares fell more than 2% on Wednesday following the release of the company's fourth-quarter earnings report on Tuesday. Revenue and earnings per share for Q4 both met expectations, so investors must be disappointed with the company's guidance for the all-important holiday quarter.

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In fact, Apple investors should be extremely pleased with the company's guidance. The iPhone maker expects to return to revenue growth in Q1 after three quarters of decline -- and its forecast could turn out to be quite conservative.

Apple is on track to have another great holiday quarter. Image source: The Motley Fool.

Revenue growth resumes

For the current quarter, Apple has projected that revenue will reach $76 billion to $78 billion, up from $75.9 billion a year ago. On the one hand, it's a good sign to see Apple returning to growth, especially considering that its sales in Q1 of fiscal 2016 were somewhat inflated by an unsustainable increase in channel inventory.

On the other hand, Apple is benefiting from an extra week in the current quarter. That means its guidance actually implies a year-over-year decline in the weekly sales rate.

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Furthermore, Apple forecast that its gross margin will be 38% to 38.5% this quarter. That would be down significantly from 40.1% a year ago and 39.9% the year before that. This apparent margin pressure also may have spooked investors.

Supply constraints emerge again

To put Apple's Q1 guidance in context, it's important to recognize that the company faces supply constraints for its new iPhones, particularly the iPhone 7 Plus. Demand for larger iPhones has been rising steadily in recent years, and the Samsung Galaxy Note 7 disaster has likely driven even more big-screen phone fans to switch to Apple.

Demand for the iPhone 7 Plus is far outpacing supply. Image source: Apple.

On Apple's earnings call earlier this week, CEO Tim Cook bluntly stated that he wasn't sure Apple would be able to reach supply-demand balance for the iPhone 7 Plus this quarter. (By contrast, he does expect supply to catch up to demand for the iPhone 7.)

Indeed, lead times for the iPhone 7 have improved significantly in recent weeks. Apple's U.S. online store lists most iPhone 7 models (excluding the popular new Jet Black color) as available for next-day delivery. In-store availability at U.S. Apple Stores is also rising. By contrast, most iPhone 7 Plus models have a backlog of several weeks online, while retail stocks are minimal.

Back to the future?

Cook's tone regarding the iPhone 7 Plus harkens back to his comments two years ago about the supply-demand imbalance for the iPhone 6 and iPhone 6 Plus. At that time, he told analysts that supply was "not on the same planet" as demand.

By contrast, last year and three years ago, Cook sounded much more confident on the Q4 earnings calls that Apple would be able to build enough iPhones to meet demand during the holiday quarter. Sure enough, in both of those years, Apple exited the first quarter with iPhone inventory within its target range.

The difference in outlook corresponds to a stark difference when comparing Apple's results to its guidance. During fiscal 2014 and fiscal 2016, Apple's Q1 revenue fell within its guidance range, while gross margin modestly exceeded the high end of the range.

Meanwhile, for Q1 of fiscal 2015 (corresponding to the iPhone 6 and iPhone 6 Plus launch), Apple crushed its guidance. Revenue came in 12% above the high end of Apple's forecast, while gross margin was 1.4 percentage points better than the high end of the guidance range.

Two years ago, Apple had its most successful iPhone lineup ever. Image source: Apple.

What does history tell us?

Past performance is no guarantee of future results. That said, for great companies like Apple, it's usually a pretty good predictor.

Apple's supply chain prowess is virtually unmatched in the consumer electronics industry. The company also has a ton of leverage with suppliers, due to its massive scale. As a result, when its biggest challenge is building enough iPhones -- as opposed to finding enough iPhone buyers -- Apple typically finds a way to improve supply while boosting manufacturing efficiency to drive down costs.

Investors still shouldn't expect an earnings beat on the scale of two years ago. At that time, analysts had a hard time gauging just how much the introduction of larger phones would increase Apple's market opportunity. Furthermore, the supply-demand imbalance appears to be limited to the iPhone 7 Plus this year, rather than both models in fiscal 2015.

Nevertheless, based on Apple's track record, it will probably be able to increase iPhone 7 Plus production faster than its forecast implies. That could lead to Apple reporting Q1 revenue and gross margin comfortably above its guidance range.

Strong demand and tight supply for the iPhone 7 Plus could also help Apple maintain its sales and earnings momentum beyond the holiday quarter. That will provide a nice bridge to the introduction of Apple's 10th anniversary iPhone next year -- an event that could drive the next big cycle of growth for Apple.

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Adam Levine-Weinberg is long January 2017 $85 calls on Apple and short January 2017 $110 calls on Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool is long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.