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July 20, 2006

Apple is Back and There is More to Come

Thanks to my friend and fellow StreetInsight.com contributor, Jeff Bagley, for again allowing me to reproduce his excellent summary of Apple's June quarter earnings report and conference call. All is well for Apple as I have been repeatedly saying despite all the gloom and the declining stock price. The shares have lots of upside left even after today's 11% gain. Here is Jeff's summary:

Once again, Apple Computer (AAPL) blew away analysts' estimates, with most key metrics above expectations. Although guidance was muted, as usual, the stock was up substantially after hours as investors breathed a sigh of relief that Apple's resurgent growth will likely continue apace.

Higher Gross Margin Fuels a Huge Earnings Beat

The company reported earnings of $0.54 a share, up 46% over the same period last year, and a whopping $0.10 ahead of analyst expectations. Revenue was essentially in line with expectations, at $4.4 billion, but the company posted a gross margin of 30.3%, up sequentially and well ahead of management guidance and consensus of 28.5%. Management noted that the component commodity environment was very favorable for Apple in the third fiscal quarter, and should remain so in the September quarter.

Sigh of Relief on Unit Shipments

Importantly, Mac shipments of 1.327 million units outpaced expectations of about 1.2 million to 1.25 million units. iPod units shipped, meanwhile, totaled 8.11 million, ahead of lowered expectations. These numbers came as a great relief to investors, as there was an incredible amount of hand-wringing regarding unit shipments throughout the quarter.

Uptake for New Intel Macs Very Encouraging

The "halo effect" is alive and well. Management is "thrilled with the growth of our Mac business," indicating that 75% of the Macs sold throughout the quarter had Intel (INTC) inside. Based on a survey at the company's stores, almost half of customers buying a Mac were new Mac users. That's huge, and supportive of my thesis that Apple has a tremendous market share opportunity ahead of it.

The company is very well positioned for increased sales for the back-to-school season now that the Intel chipset transition is nearly complete. (The transition will likely be 100% complete by year-end.) Management noted that sales to the education market were extremely robust in the quarter.

Look for New iPod Products Soon

Apple is very secretive about its product pipeline, so little was said in terms of timing or specifics of new iPod products. Steve Jobs, in the press release, did note, however, that they "...are extremely excited about future iPod products in our pipeline." I don't believe he would say that if new product introductions weren't imminent.

Recall that some analysts were speculating that they wouldn't have an iPod product upgrade in time for the back-to-school selling season. While that still might turn out to be true, I and others are looking for new product announcements in early August, when the company holds its developers conference. Apple stock has typically performed well as new products are announced....

Retail Store Rollout Very Successful

The company added 14 new retail stores in the quarter and now has a total of 155 stores in operation. Customer interest has been phenomenal, with customer traffic of 17 million people (not all buyers, of course) through the company's stores during the quarter. Management noted that the new Manhattan store already has had a half a million visitors.

About half of Apple's sales came from direct channels (Apple stores plus on-line stores) during the quarter, up from 44% in the March quarter. This is encouraging, but the company still appears committed to expanding its distribution to non-Apple locations, which I believe is a sound practice. There's a lot to be said for product ubiquity.

Options Overhang Greatly Reduced

The company noted that based on its investigation, there will likely be no material adjustments to financial results included in the third-quarter earnings release. They said nothing about prior periods, but given that they are looking at the time period from 1997 to 2001, I believe the options issue is a nonevent for Apple.

Balance Sheet Remains Pristine

Apple's balance sheet remains pristine. A little too pristine, if you ask me. The company had about $9.2 billion in cash and short-term investment on its books at the end of the quarter and no debt. That's about $10.47 a share in cash. Sure it's great to have such a cash cushion, and interest rates have risen, but that cash would be better off in shareholders' hands in the form of a dividend or share repurchase. (I like dividends!)

I doubt the Board will change in its aversion to share repurchases, but all that cash creates a great deal of uncertainty that they might do a big, stupid acquisition. Remember the rumors that Apple might buy Disney?

Stock Poised to Outperform

Although I've been accused of being married to this stock, I still firmly believe that Apple represents an incredible opportunity for long-term capital appreciation. The Mac business is in the early stages of its resurgence, and new product introductions will likely fuel a healthy new product cycle for iPods.

Apple is at the forefront of the digital revolution, with its products fast becoming the de facto standard for the legal distribution of music. Significant opportunity exists for video as well, especially as the masses upgrade to higher Internet speeds.

What do you pay for such an opportunity? That is, of course, open to debate. But estimates will likely once again continue to trend up, and the company has a boatload of cash. With new products in the pipeline and investors now reassured about the company's growth, I believe long investors have an excellent setup with Apple stock. It remains my largest holding, for both my clients and my personal account (at Northlake, Apple is a large but not the largest holding and it is one of the largest positions in my personal accoutns as well).

Posted by Steve Birenberg at July 20, 2006 11:44 AM in AAPL