Apple's Forecast Sets Off a Stock Slide

News that Apple expects thinner profit margins sent shares of the consumer electronics maker plummeting on July 22.

The prospect of diminished profitability through the rest of fiscal 2008 and into the following year overshadowed what was otherwise a blowout quarter. Having forecast earnings of $1 a share on sales of about $7.2 billion, Apple (AAPL) delivered earnings of $1.19 a share and revenue of $7.46 billion.

But investors fixated on the margin forecast. CFO Peter Oppenheimer said gross margins, a key gauge of profitability, will drop below 32% in the current quarter, which ends in September, from 34.8% in the second quarter, which ended on June 30. Gross margins will probably average 30% in fiscal 2009, Oppenheimer told analysts and investors during a conference call discussing the results.

The prospect of thinner margins is particularly jarring at a time when Apple is selling more Macs than ever. The company sold 2.5 million units of its flagship computer this quarter, a record. Oppenheimer was circumspect in his explanation for the margin forecast. He chalked it up to a "a future product transition that I can't talk about today."

New Chips, Bigger Screen?

Apple is typically tight-lipped about coming products until they're ready to be discussed in detail. But analysts inferred that Oppenheimer means cheaper products are on the way. The most likely candidate: Mac notebooks. Rumors of a major revamp of the notebook line, which accounted for 30% of sales in the quarter, have been rife for months. And sales of notebooks are typically strong during the company's fourth quarter, which covers the back-to-school shopping season.

TBR analyst Ezra Gottheil, in a research note issued after the conference call, speculated that the most likely candidate for a product change is an Apple notebook sporting the latest Intel (INTC) chips. "We believe Apple will refresh its notebooks with the latest Intel Centrino 2 processors, which will improve performance and increase battery life," Gottheil wrote in the note. Apple may also introduce a larger-screen MacBook, he said.

Why cut prices on the Mac? According to Charles Wolf, an analyst at Needham in New York, the most likely reason is that Apple wants to press its already impressive market-share gains in the PC market. Research firm Gartner (IT) pegs Apple's share of the U.S. PC market in the second quarter at 8.5%, behind Hewlett-Packard (HPQ) and Dell (DELL) but ahead of Acer and Toshiba (6502.T). "Apple rarely cuts prices," Wolf says. "What it usually does is enhance products within a price band. This suggests to me that they're going to drop prices on the MacBook or the iMac and that it will carry a lower gross margin."

A Juicier Apple TV

Add the potential price cut on MacBooks, with an already announced back-to-school promotion that involves giving a free iPod to customers who buy a Mac, and you have a recipe for falling margins.

Apple may also be plotting a revamp of its Apple TV, a device that lets users play video downloaded from the Web, says Gartner analyst Mike McGuire. A major upgrade to Apple TV—say, the inclusion of a much larger hard drive or the ability to record TV shows the way a TiVo (TIVO) does—might eat into margins. So might a substantial expansion of Apple's iTunes Store and online rental capacity, which would force Apple to buy more servers and more Internet-serving capacity. Recent moves involving online movie-rental service Netflix (NFLX) and its partnership on a set-top box with electronics concern Roku, McGuire says, might be spurring Apple into action on this front.

Shaw Wu, an analyst at American Technology Research in San Francisco, suggested that prices of materials Apple uses in its products—aluminum and plastics—may be on the rise. Oppenheimer and COO Tim Cook said pricing on components like flash memory and LCD screens are "favorable," while prices on DRAM computer memory are likely to increase in line with higher seasonal demand in the second half of the year. "Everyone knows Apple is typically very conservative in its guidance, but given the way the markets are now, people are taking it at face value and assuming the worst," Wu says. "Right now there are just so many unknowns."

The Steve Question

Another unknown for some observers centers on the health of CEO Steve Jobs, who in 2004 was successfully treated for pancreatic cancer. During the conference call an analyst asked whether Jobs had taken ill again. Oppenheimer was dismissive. "Steve loves Apple and serves at the pleasure of Apple's directors," he said. But "Steve's health is a private matter."

Piper Jaffray (PJC) analyst Gene Munster found the response "un-comforting," but reckons the company would say more if there was reason for doubt. "If there was anything he knew about [Jobs'] engagement being in question, I think they would have said something," Munster says.

But analysts were mainly focused on margins—and felt a chill from Apple's remarks. Word of slimmer expected profits hammered the stock in extended trading. On July 22, it dropped $16.40, or almost 10%, to $149.89. The rout got under way the day before, in extended trading, after the results were released.

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