Yesterday, after the market closed, Apple (AAPL) released their calendar Q3 earnings. They beat estimates on the top and bottom lines, with iPhone sales matching expectations and the high-margin services recording higher-than-expected revenue. You would think that is all good news, but the stock responded by dropping around 4.5% in the aftermarket. It has since bounced slightly but as I write, it will open this morning roughly a couple of bucks below yesterday’s close. How can that be? How can the market interpret good news as bad?
Other than “Do you have a stock tip for me?” and “Where is the stock market going?” the most common thing I get asked when people find out that I write about the markets is, “Why do stocks that beat earnings estimates drop so often?”
It is one of those things that, on the surface, makes absolutely no sense. The most fundamental factor on a company’s valuation is how much money it makes, and we know that expectations are baked into market pricing. So how is it that a company can beat those expectations and then see their stock react by trading lower?
Some of the time it is because traders are looking at something other than earnings, usually revenue. If a company beats on the bottom line but sales are dipping, then the belief is often that the beat came from cost cutting, price hikes or a one-off boost to profits, and is therefore probably not sustainable. Apple, however, also posted a small beat on revenue, so that isn’t the problem here.
The most common reason for a counterintuitive post-earnings move, though, is a company’s forward guidance. It may sound obscure, but a stock’s price is impacted by expectations for expectations. Companies are not obliged to tell us in their earnings statement what they expect for the upcoming quarter or full year, but most do, and when their forecast falls short of what Wall Street analysts have forecast, the stock will drop regardless of what happened in the most recent quarter.
This is what seems to be pushing AAPL lower this morning. Analysts were anticipating a forecast from Apple for some growth next quarter, but that didn’t materialize.
Obviously, fourth quarter sales are a big deal for a company like Apple that, despite being labeled as a tech company, essentially designs, makes, and sells consumer goods. As every parent of a child older than twelve can tell you, these days the most wanted “toy” this time of year is usually the latest iPhone, Apple Watch, iPad, or MacBook, not a doll or action figure or whatever, so holiday sales make up a big percentage of Apple’s annual total revenue. This quarter, AAPL is expecting Q4 revenue that will basically match last year’s, a disappointment for the Street.
Then there is what I regard as one of the most often overlooked drivers of a stock’s reaction to earnings: the positioning and sentiment of the market going in. Apple has been bouncing along with most tech stocks this week as rate hikes seem to be ending, so many traders will have been long going into yesterday’s numbers. They would have been looking to take a profit on a positive reaction, but then would have been squeezed out by the start of a post-earnings drop, adding to sellers in what is always a thin market immediately after a release.
With Apple, though, while the reason for the drop is clear the logic of it is questionable, and the bounce back off the lows this morning is probably more representative of what is to come than the drop itself. In an environment of rate hikes and where until just a week or so ago there seemed to be almost unanimous agreement among economists and analysts that we were heading for a recession, the forecast for flat fourth quarter sales is actually not that bad. Then there is the makeup of the company’s revenue. The growth in the services sector is more important than anything. It is high margin, repeatable, and sticky revenue, and the more of Apple’s total sales that come from services, the better the prospects for the company.
All of the above things, revenue rather than EPS, the makeup of the revenue, forward guidance, and market positioning are parts of the answer that I give when I am asked why stocks so often drop on good earnings. They all factor in, but probably the most important thing to say about such moves is that they often represent an opportunity for long-term investors to benefit from short-term market dynamics. That is the case here. Apple may have disappointed in some ways, but growth in services revenue and maintaining sales levels in a difficult Q4 are both good reasons to believe that the company can continue to thrive, and that AAPL will be significantly above current levels next year.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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