Missing iPhones Found at Sundance

I've been reading up on the phenomenon of the missing iPhones and the only thing I can conclude is they might all have been at Sundance. Honestly, it seemed every line we were standing in had multiple iPhones in use. I know that speaks more to where Apple has mindshare than anything else, but I can confidently state that iPhone market share among movie fans and Hollywood types is at least meeting expectations.

On a serious note, I think there are two issues. First is whether demand for the iPhone at current prices and as currently configured is less than expected. Second is whether meeting unit volume expectations through sale of unlocked phones is positive or negative for Apple.

The answer to the first question may be yes, particularly in Europe. However, enough phones have been sold and current customers are satisfied enough that demand issues can be solved with a 3G phone, a lower-priced unit, lower prices, or increased functionality. Say what you want but the activation of over 2 million phones in seven months suggests that the iPhone is here to say.

As for unlocked phones, Bernstein did some interesting work, suggesting that there is earnings downside if a higher-than-expected portion of the unit volume is unlocked due to the loss of carrier payments. Carrier payments might be as high as $20 a month at close to a 100% margin. Bernstein believes that if 3 million of the 10 million phones that might be sold in 2008 are unlocked, Apple would earn 37 cents less in EPS this year and next year. That works out to 8% and 6% of current 08 and 09 EPS estimates, respectively....

....I think that Bernstein was already assuming that as many as 2 million phones were going to be sold unlocked. In other words, the fact that it appears that an incremental 1 million phones are going to be sold unlocked is what generates the 37-cent shortfall. I may be misreading the report, however, so if you think I got it wrong, please let me know.

I don't know exactly what assumptions all the analysts are making about unlocked phone sales in their models, but in October, Apple itself estimated publicly that unlocked phones were 22% of sales. If analysts took the company at its word and built that or higher into its models for 2008, then the 37-cent penalty might not be fully realized. Then again, some analysts may have underestimated unlocked phones in their models

The final piece of the puzzle is how this impacts Apple shares looking forward. If estimates need to fall by 6% to 8%, the current drop in the stock seems to have captured it. The issue is then with the multiple as a less successful iPhone cuts into the company's long-term growth rate.

I think Mac momentum alone justifies the current stock price, which is about 20 times 2009 estimates before adjusting for $20 in cash that will be near $30 at the end of 2008. However, the stock is broken, and the rebound will be slow until iPhone, iPod and Mac demand trends for early 2008 are clearer or more new product introductions are made. The shares are over-owned, leaving demand lacking relative to supply as long as a confidence crisis exists concerning Apple's fundamentals.

More Thoughts on Apple

In my Apple (AAPL) earnings summary on Tuesday, I said there were enough issues to prevent the stock from staging a quick rebound. Those issues don't justify the type of decline we saw yesterday (down big intraday), but the stock is overowned, and as Jim Cramer pointed out, the big money is rotating away from tech, industrials and energy to financials, retail and other early-cycle stocks.

Morning-after analyst commentary was predictable. Many analysts defended the stock, with several increasing estimates given the big beat in the fiscal first quarter. Most noted that guidance seems unusually conservative and that the company should still at least meet the consensus for the March quarter.

Also predictably, there were a few downgrades. The downgrades were based on loss of momentum for the stock and iPods and general worries about consumer spending (that, of course, brings up the question of whether Apple is a retailer or a tech stock).

Few would argue that Mac momentum remains robust and will have an outsized positive impact on financial results as Mac sales becomes a larger percentage of revenue due to the higher margins.

iPods, on the other hand, are creating real concern given the "non-linearity" of U.S. demand in December. In fact, U.S. iPod units were flat in the fiscal first quarter. International sales must have been better than expected given the overall numbers and management's comment that despite the slow December in the U.S., overall linearity for iPods was as expected in the December quarter....

....iPod trends are a real challenge for the shares. I am not denying that. However, there are some offsets to consider. First, despite a disappointing 5% increase in unit volumes, revenues rose 17%. This is the best growth in four quarters -- a marked acceleration from
-1% to 5% growth in the last three quarters. The reason is a sharp increase in average selling prices: $181 this quarter vs. $163 a year ago and $159-$160 for the last three quarters. The mix shift in favor of Nanos and the Touch at the expense of Shuffles was something management planned and executed.

Second, one of the big fears about iPods over the last two years was that the category would lose out to phones. This is why the iPhone was so important. Why shouldn't we consider the iPhone an iPod variant?

Some significant percentage of iPhone sales likely would have been larger-capacity iPod sales. Last quarter saw 2.3 million iPhones sold. If 1 million were iPod cannibalization, iPod units would have grown 10% and revenue would have grown 23%.

Apple shares were very volatile yesterday, partially due to slower iPod growth forecasts. But shouldn't management get some credit for expanding the iPod footprint to phones and Wi-Fi handhelds (the Touch)? Defending your turf and self-cannibalizing while still significantly growing your revenues and profits is what good management is all about.

I believe Apple's earnings growth, product volumes and ASPs will still at least meet analyst estimates in 2008. If so, EPS will grow 30% this year. 2009 consensus calls for EPS growth of 25%. The balance sheet has $20 a share in cash with another $7+ coming in 2008. The cash is severely underearning relative to the operating business. Adjusted, the shares are trading at less than 20 times earnings.

The stock is broken. It will have an uphill climb to rebound. But as new products are rolled out and indications on March quarter operating trends reveal the guidance is overly conservative, confidence will return. That makes Apple a good buy right here.

Apple: Not Good Enough For This Stock

I am not going to recap all the numbers from Apple as you can read that elsewhere. The December quarter was very good but not without issues. Mac and iPod sales came in a little below aggressive estimates. This was easily made up by better than expected ASPs. A bigger issue will be that US iPod units were flat and were a little weaker in the holiday season than the first part of the quarter. Be ready for the iPod is dead headlines. Management said it was happy to trade units for ASP and this was part of the strategy behind the Touch. I see nothing else to quibble about in the December quarter.

Guidance for the March quarter is the real issue that took the shares down 10% after hours. 94 cents on revenues of $6.8 billion is below the $1.09 and $6.98 billion consensus. In its last quarterly report Apple actually guided above consensus so while they are very conservative, there is some precedent to interpret this guidance unusually negative.

The guidance assumes much worse sequential performance than has occurred the last two years....

....Revenues are projected to drop 29% vs. drops of 26% and 24% the last two years. EPS are expected to decline 47% vs. 24% and 28% the prior two years. On the call an analyst pointed out that last year management guided to a 52% sequential drop in EPS and came in at 24%, thus he asked what has changed to prevent this from happening again. I think he has an excellent point with one caveat. Last year's March quarter was the first one where gross margins exploded due to collapsing component costs. That said, gross margins in the December quarter were just 40 basis points below the March 2007 quarter and on the call management said that component costs looked pretty similar for March 2008 as December 2008. They pointed to fewer Leopard sales and less cost of goods sold leverage due to lower sales as the reason for assuming a 250 basis point sequential drop in gross margin. The gross margin guidance seems conservative on this basis and more so when remembering that Macs are gaining in the sales mix and have higher margins than iPods.

The next thing I did was try to plug in unit volumes and ASPs for Macs, iPods, and iPhones to get to the $6.8 billion revenue guidance. I couldn’t do it. I consistently come up slightly north of $7 billion. I am using similar sequential moves in units and ASPs as prior quarters. Given momentum in Macs, I think this is conservative.

The stock now trades at 20 times 2008 estimates which I still think are going higher given that Apple beat 1Q consensus by 25 cents and 2Q guidance is only 15 cents light (and ridiculously conservative). EPS rose 55% in the December quarter. The current consensus for 2008 implies 25% growth. I think the shares are offering an attractive entry point. However, there is just enough here for the bears to make hay so I do not expect a quick rebound from the $138 after hours level.

Best Case For Apple

I’ll be covering Apple’s earnings call after the close. Here is my preview. I decided to look at aggressive assumptions to see where a best case scenario might be for the December quarter. Since the stock needs both a substantial beat and decent guidance I wanted to see what the beat might look like.

Here are the assumptions I used: (1) 2.5 million Macs sold with ASPS up about $75 sequentially, (2) 25 million iPods with ASPs up to $175 vs. $163 last year, 2.5 million iPhones shipped generating $315 million in revenue, a 30% increase in all else driven by Leopard sales, and a 100 basis point sequential uptick in gross margins.

These assumptions lead to revenue of $9.85 billion and EPS of $1.88 versus the current high estimates of $9.96 billion and $1.77....

....With the exception of the iPhone revenue I actually think my assumptions are quite achievable. They are consistent with demand trends in the quarter and the ASPs are similar directionally from prior December quarters. The one big swing factor is gross margin. Each 100 basis point swing is worth 7-8 cents. My thinking is that Macs and Leopard gained in the mix from the September quarter and component costs were pretty similar. This would add up to margin expansion but in the last two December quarters gross margins fell sequentially.

Given the state of the market, there may be a little more riding on Apple that usual. I hope my preview and this note help.

Apple 1Q08 Preview

Another Apple earnings report comes after the close today, so time for lots more overanalysis and outsized volatility in the usually volatile shares. Estimates have been rising as the quarter went along since it became apparent that Mac sales were booming. News from MacWorld that Leopard and iPhone sales were ahead of expectations in the December quarter raised the bar further. The only product line with any concern is iPods where there is some worry about unit volumes relative to high expectations....

....For the first quarter, the current consensus is $1.51 on revenues of $9.46 billion. This would represent EPS growth of 41% and sales growth of 33%. The high estimates I $1.77 which may give some indication of where the whisper number resides. Mac sales are expected to be around 2.4 million units. iPhones were already announced at 4 million units. iPods are expected at 24-25 million.

Variance could come from better than expected Mac ASPs, a mix shift in iPods favoring nanos and the touch at the expense of the low priced shuffle, and more high margin revenue from Leopard that expected. In addition, component pricing, particularly memory seems to have been very favorable again in the quarter after some signs early in the quarter that memory prices were firming. Finally, the financial model for the iPhone remains unknown and could provide a surprise.

For the March quarter, current estimates call for EPS of $1.09 on revenues of $6.98 billion. This would represent EPS growth of 26% and revenue growth of 33%. The sequential decline from the December quarter is in line with the last few years. The assumption that margins may fall from the year ago quarter seems conservative to me given the dramatic margin expansion over the second half of 2007.

Even though Apple shares have gotten nailed since the start of the year, I don’t think it is fair to assume the bar has been reset lower. Apple must have good results and guidance with no blips for the stock to work from any level. For Tuesday’s report I think the most likely reactions will come from iPod sales, international iPhone sales, operating margins, and Macs. I am long and would be long into the report if I were a trader. Obviously I expect upside pretty much across the board and acceptable guidance built off the strong momentum in Macs.

Another Blowout Quarter For Apple

Apple reported another great with upside to Mac unit volumes and operating margins producing much better than expected EPS of $1.01. Numbers had been rising recently such that analysts were looking for mid to upper 80 cents. Even more impressive than the September quarter results was the fact that Apple provided December quarter guidance which slightly exceeded Wall Street forecasts. Heading into the report, the consensus estimate for the December quarter was $1.39. Apple guided to $1.42. If memory serves, this is only the second time in the last three years where Apple provided guidance at or above Wall Street forecasts. Given the company guides conservatively, the forecast implies another very strong quarter.

The shares now trade on 2008 and 2009 prospects. For 2008, the current consensus is $5.00 with many estimates in the $5.15-$5.20 range. For 2009, the forecast is for over $6.00. Even taking into account over $15 per share in cash on Apple's balance sheet, the stock carries a high valuation with a P-E ratio of 36 times 2008 estimated earnings. Apple's recent huge upside surprises probably mean that 2008 estimates are way too low. This is almost certainly the case if iPhone sales meet company targets of 10 million units in 2008. The iPhone is very profitable thanks to revenue sharing on monthly bills of cell phone subscribers. Thus, despite the momentum in Mac sales, the refreshed iPod lineup, and likely continued significant share gains in Macs, the iPhone has become more important as a driver of Apple shares now that they have moved up to new highs in the $180s.....

....I suspect Apple shares can move significantly higher as long as earnings momentum continues and the stock market cooperates. I reduced positions in the $160s with an eye on $180-200 as another point to trim. The strength in the September quarter earnings and clear momentum in product sales should allow the shares a little more upside. As a result, my strategy now is to trim again as the shares firmly cross $200. Nothing wrong with taking a profit, especially in a high multiple stock where risk is significant if an earnings or growth hiccup occurs.

Trimming The Tree of Apple Profits

With the market ramping and Apple and other tech stocks leading the way, I sold a portion of Apple in many client accounts on Friday as it crossed $160. I completed sales only in accounts where the position size was pushing towards 4%.

I have a detailed spreadsheet on Apple and no matter how much I tweak it, I have a hard time getting to a target price too much above $160 based on assumptions about sales, earnings, and cash flow that I am willing to use right now. Another way of saying this is that Apple has reached my stretch target based upon my current estimates. When that occurs, my portfolio management discipline is to trim the position and capture some profits. Clients who have been with Northlake since early to mid-2005 will find this strategy to be familiar. In fact, for clients where I was buying Apple in the $30 in early 2005 this marks the third or fourth time I have trimmed it. Sure, with the benefit of hindsight I regret trimming it at $48, $71, and $110. However, there are no sure things on Wall Street and it never hurts to pocket some of your gain.

One legitimate question is whey I wouldn’t sell the entire position at $160 if it has reached my stretch target....

....The reason is that my target is based on conservative assumptions. To help control risk and find really attractive stocks, I use conservative earnings estimates in my spreadsheets. If a stock looks attractive on conservative numbers then there may be even more upside and less risk that I assume. That is always a good combination.

Apple has consistently beaten estimates over the past three years. I think that is likely to be the case through 2008 as the market share gains for Macs and iPhones continue. If I do plug in higher estimates, I can get to $180-200 for Apple. The upper end of that range now becomes my new stretch target and the next place clients should look for their positions in Apple to get a trim.

About That iPhone Price Cut

The following quotes come from a new report on the iPhone from Bernstein Research: "Apple could conceivably sell iPhone hardware at a substantial loss while generating greater profit per iPhone than it does from the highest end iPod…..this potentially gives Apple a storng incentive to price the iPhone aggressively to drive sales, even at the expense of cannibalization of the iPod business where ASPs and GMs (gross margins) are notably lower."

I don’t mean to flippant or a bull with my head in the sand but this analysis is hardly consistent with all the doom and gloom from last week when the iPhone price cut supposedly indicated the product was a flop, or as Tero Kuittinen of RealMoney.com called it, "a platinum turkey." On the day the price cut was announced I wrote, "since we don't know how the revenue share works with AT&T on iPhone sales and subscriptions, the financial impact of a price cut, particularly if it stimulates demand, is hard to gauge, even more so with the deferred revenue accounting."

Capturing the bearish spin that dominated coverage of the price cut, the next day Bernstein issued a bearish report on the price cut titled, "Big iPhone Price Cut and iPod Touch Product Positioning Both Raise Meaningful Questions." To Bernstein's credit, as usual they completed thorough analysis to answer the "meaningful questions" and published the results even though they appear to conflict with their initial assessment. This is a good example of why Bernstein's research is highly valued on Wall Street.

I know Apple is way overanalyzed and I am more guilty than most in that regard. I also know that we all tend to talk our book. Again, I plead guilty. But the universal assumption that the price cut represented a problem and the skepticism of Jobs statement that Apple really wanted to accelerate sales and establish the iPhone ecosystem in the US as quickly as possible appears to have been misplaced. Or at least wrongly or insufficiently analyzed.

New iPods Overshadowed By iPhone Price Cut

As the Apple iPod event was going on yesterday, I posted this comment on RealMoney.com:

"New colors for the Shuffle, a redesigned Nano focused on an improved video experience, higher capacity classic iPods topping out at 160GB, and iPod Touch - it seems like an iPhone without the phone. Seems like a very good lineup for the holiday season to me. Something for everyone. After last year's 21 million unit holiday iPod blowout a fully refreshed and upgraded lineup was necessary to maintain growth in iPods. Regardless of where the stock goes in the very near-term, I think this new iPod lineup is as good as anyone could have hoped. With Mac sales booming, fresh iPods, reasonable iPhone sales, and the new operating system coming, I think the Apple earnings story is shaping up very well. I remain a bull on AAPL."

The stock sold off sharply once the event concluded keying off the $200 price cut on the 8GB iPhone. Investors interpreted this as a sign that demand was dropping off quickly. I probably can’t argue with those who want to interpret it as a negative datapoint as far as demand goes. However, the only two major complaints about the iPhone since its introduction have been the price and the AT&T network. Morgan Stanley wrote yesterday that they have seen studies that a price cut of this magnitude could stimulate demand by as much as 30%....

....With holiday season coming, the iPhone at $599 would have been out of line with the new high capacity iPod Classic and iPod Touch (an iPhone without the phone). I think the Touch is going to be a home run product and easily outsell the iPhone. It seems logical that Apple promised AT&T the price cut if they could offer the Touch this holiday season. Additionally, somewhat lost in the commotion was that Apple will be selling ringtones for the iPhone and songs via wifi over the iPhone. AT&T won’t be sharing at all in that revenue so cutting prices to stimulate demand which in turn drives sales of revenue that belongs 100% to Apple was probably a key part of the decision-making process. Also, since we don’t know how the revenue share works with AT&T on iPhone sales and subscriptions, the financial impact of a price cut, particularly if it stimulates demand, is hard to gauge, even more so with the deferred revenue accounting. Finally, Jobs reiterated yesterday that the iPhone will launch in Europe in the fourth quarter. Maybe that price cut is part of the deal to get it done. Or maybe the price cut is a prelude to a $499 or $599 iPhone 3G? The point is that the initial reaction to the price cut might have been one-sided.

I stand by my bullish outlook built primarily on Macs, secondarily on iPods, and boosted by iPhone and upcoming Leopard sales. No one is disputing the strength of Macs this back-to-school season. The new iPod lineup hits all price points and offers functionality for everyone. The iPhone is now better positioned as a holiday item (mobile phones have been popular Christmas presents for years). With the product lineup and pricing clear, the risk to demand for Apple products over the critical next fourth months has moderated. I was mostly recently a buyer of Apple at $123 and then $114 for clients whose position sizes were too small or newer clients who did not own yet own Apple. Yesterday's news makes me comfortable paying a higher price next time I need to add to adjust client positions.

Apple iPod Event on September 5th

Earlier this week, Apple sent out invitations to a "special event" on September 5th. The invitation clearly signals iPod related announcements. The better websites in the Apple rumor mill are suggesting that the company will convert all iPods to flash, a new flatter and wider nano (presumably to offer better video capabilities), and touchscreen video iPod modeled after the iPhone. In addition, the Mac operating system in use on the iPhone will be used on the new iPods (which may mean the end of the infamous and highly successful click wheel in some models). The last few words of the invitation copy the final words of The Beatles last press release so Beatles music on iTunes seems like a possibility as well.

As you know, I have been a vocal Apple bull and I am a big believer in the Mac market share story and think that the software side of Apple is underappreciated asset. I've been long Apple for Northlake clients since January of 2005, while both trimming and adding to positions on the way up. My most recent trades were to add shares in the past two weeks in the range of $114 to $123. On Street Insight and Real Money, I have actively and readily defended the shares and regularly reminded readers of the bull case.

The iPod rumors are consistent with my own expectations. In fact, I think the rumors are a minimum requirement for Apple bulls in the near-term. December quarter iPod comparisons are extremely difficult as last year the company sold 21 million iPods, up 50% from the blowout 2005 holiday season. iPhones will help, especially due to the high average selling price (last year the phenomenal success of the Shuffle caused a serious drag on ASPs), but strong demand for traditional iPods is necessary to keep the over 30% of revenue driven off the music platform growing at a solid clip. iPod revenue was down 1% in the March quarter and up just 5% in the June quarter...

...I think that Macs will be really strong in the September and December quarters, enough to meet and beat street estimates. However, for significant upward momentum in Apple shares to be sustained at significant new highs, iPods must be contributing as well. For that reason, a strong new product lineup on September 5th is critical to the near-term investment case for Apple shares.

At a minimum, maybe the passing of September will usher I calmer era for Apple shares. 22 of the $29 trading days since July 19th have seen the shares have a daily range of at least $4, with many days reaching $4-6 or more.

Brief Apple Update

I have been waiting to round out long positions in Apple and build new positions for clients. SInce the stock brokedown and the market collapsed, I had been targeting $125 for Apple but decided to wait and with the stock decisively breaking that level I decided to make the move. I am optimistic about near-term trends in Mac sales. I am counting on an iPod refresh for the holiday season. I believe those who are saying iPhone sales are on track.

The stock is trading at 27 times 2008 estimates. It is a little cheaper adjusted for $15 per share in net cash on the balance sheet that has been rising by over $1 per quarter. Given my comfort with a 20% EPS growth rate for several years off the FY07 base, I think the valuation is reasonable. I know that the technicals stink and that the stock tends to move in major multi-month cycles but sometimes value wins out over emotion.

Apple 3Q07 Earnings Preview

My friend and Real Money colleague, Bob Faulkner, is handling the Apple conference call for the website this quarter. Bob specializes in technology so his input is especially interesting. I'll be listening to the call as well.

In the "Continue Reading" section I have reporduced Bob's preview. I generally agree with him across the board. Beyond what Bob has mentioned, key things to watch are Mac and iPod unit sales and ASPs and comments surrounding margins and memory pricing. Estimates for Mac sales are around 1.6 million units while iPod estimates have been drifting lower to 9.0 to 9.5 million. On margins, expect cautious commentary toward 4Q due to the recent increases in memory pricing. I think this area represents the greatest risk to Apple shares in the near-term.

Here is Bob's preview....

APPL will be reporting FQ3 results after the close tomorrow night with a conference call at 5:00 PM EDT. The expectations are high and there will be more eyes focused upon these results then the new Harry Potter book. Current consensus is for revenue of $5.28B (+21% YY; flat QQ) and EPS of $0.72.

In the prior quarter, the company reported revenue of $5.26B (+21% YY; -26% QQ) and EPS of $0.87. GM was 35.1% up 530 bps YY and 410 bps QQ primarily the result of low component pricing, product mix, lower services cost and leverage. OM was 18.7% an increase of 660 bps from last year and essentially flat sequentially. Cash from operations was a very solid $700M versus cash used in the year ago period. Total cash and equivalents increased about $700M to $12.6B. A/R declined about $700M dropping DSOs to an amazingly low 16 days (-5 days). Inventory fell $100M putting DOI at 5 days, down one day from FQ2.

The driver for the top-line last quarter was essentially the notebook business with revenue up 82% and units up 79% versus the year ago period. While iPod units were strong (+24% YY), revenue actually declined 2% YY on lower pricing.

Guidance for FQ3 was for revenue of about $5.1 billion with GM of about 32% (increasing component prices). Opex should be about $915 (including iPhone launch expenses) with other income of about $150 million and a 32% tax rate. This translated into EP of approximately $0.66.

Some people (myself included as you can see from the put position below) expected a sell-off in AAPL’s stock following the introduction of the iPhone. Obviously that didn’t happen and it has continued to ratchet higher fueled in part by four “target price” increases in the month of July alone. Add to that various stories about market share gains for Macs in the quarter, difficulty meeting demand for the new LED-lit notebooks and record sales at retail stores.

All that plus the iPhone too, this quarter is going to be a BOOMER, isn’t it? Well, yes, no and maybe. APPL will easily surpass it’s own guidance since its guidance is usually low-balled. But how high is up?

The iPhone sales will be tricky for a number of reasons. First and foremost is the subscription accounting. The company will recognize revenue from these products over 24 months, not all in the quarter of sale. While that is well understood by the street, I can’t say that it is by the investing public. A possible partial offset of this issue is how many were sold? There have been a wide variety of estimates of what went out the door in those last two days of June but from APPL’s perspective, that’s not the point. Products that were sold by AT&T well into the following week were likely shipped to the carrier before the close of the quarter so the actual number of units “sold” could be higher than many expect.

Certainly the last big issue will be the impact on iPod sales. Yes, there probably was cannibalization by the iPhone but it’s not a perfect world. Anyone expecting otherwise is probably living in a fantasy world. What’s more important is that the profitability on the iPhone will eclipse the iPod but without damaging the iTunes revenue stream. That works for me.

In reality, I’m not certain it matters what AAPL reports as long as it’s above their own estimates. There is so much enthusiasm for the stock right now given the potential for the iPhone and its various relatives that any attempt to take the stock down will be met solidly by dip-buyers who thought they’d missed out on this name.

Lots of Shine to Apple

Apple (AAPL) 2Q07 results were spectacular and the feared "even more conservative than usual guidance" failed to materialize. I think the shares should be higher and my only concern is technical in that the muted upside suggests the massive battleground that has become AAPL will continue. I was especially pleased with Mac sales which showed a little upside in the quarter. I don’t think the upside was any more meaningful than the slight downside last quarter but the trend is unmistakable: Macs are gaining share. iPod sales were also solid although they were effectively preannounced. Growth in non-US markets continues strong (ex-Japan) which is key as iPod market share is much lower abroad. Assuming a decent stock market I think AAPL shares are entering a new higher trading range of $95-115 ahead of the iPhone launch. I have little fear about initial iPhone demand. What will matter is product reviews. I am perfectly happy to have so many bashers of the product out there as they are keeping expectations in check.

There is really a lot to say about AAPL this quarter than in the past. The quarter was fantastic and there is virtually no reason to complain. EPS came in at 87 cents easily beating consensus of 64 cents and the whisper number of 70 cents. Part of the upside came from better tan expected revenues due to an extra 100,000 Mac sales and stable average selling prices on iPods.....

The real upside though came from margins as sharply declining component costs, especially for memory, led gross margins to come in at 35%, fully 5% ahead of management guidance and 3% ahead of street estimates. Management noted that they are starting to see some firming in component prices and guided June quarter gross margins to 32%.

Overall, it was a great quarter and the shares should settle in a new higher trading range as the iPhone launch is anticipated. There are many skeptics on Wall Street about the iPhone who complain about battery life, slow internet connection speeds, high pricing, lack of a keyboard, and the dirt that will accumulate on the touchscreen. No one has ever used or held an iPhone so we shall see. I do think that expectations are more subdued due to all the skepticism so a smooth launch could be a big positive for the stock. Also, the September quarter brings the back to school season where Mac sales should boom and then December might see new iPods incorporating the larger, touchscreen display on the iPhone. In other words, AAPL has lots of momentum and the shares could go much higher.

San Jose Mercury News Clears Jobs of Criminal Activity in Options Probe

In a lengthy article, the San Jose Mercury News is reporting that it is unlikely that Steve Jobs will be charged with a criminal offense in the Apple (AAPL) options backdating scandal. The article leaves open the possibility of SEC action but SEC action would not require Jobs to leave the company.

The article contains a timeline of Board actions that seem to exonerate Jobs. We won’t know the outcome of the investigations by the US Attorney’s office or the SEC until they are announced but for the short-term the market is likely to be very happy about the article.

Timing on this article is good as AAPL reports after the close on Wednesday.

Apple Acting Well

Apple (AAPL) held up well during the market pullback and now is leading to the upside, trading at its highest price since the breakdown following the December quarter earnings report in mid-January. I've written endlessly on Apple, as you can see if you click the AAPL link immediately below, so for another perspective here is a link to a well-written and well-reasoned bullish article that appeared on theStreet.com:

Jon Markman's Article on Apple

Interesting New Report on Apple

Bear Stearns is out this morning with a detailed new report on Apple. Bear is not changing its buy rating or earnings estimates. Instead, the report lays out Apple's growth profile focusing on four areas: Macs, iPods, Apple TV, and iPhone. The overall theme is that Apple is not a one product company but rather has multiple platforms for growth. This is new for Apple compared to its history. Bear Stearns goes on to outline the likely product development paths for each of the four platforms.

If you want to read the report, click "Continue Reading...." for a link to a PDF file.

Download Bear Stearns Report on Apple

A Look at Apple's Valuation

After reading through a lot of analyst comments about Apple's earnings, I think I captured the general consensus well with my follow-up piece. Most analysts agree with my bullish view and the fact that numerous catalysts exist over the balance of 2007, particularly as the June and September quarters become the focus of investor attention. As far as the March quarter, most analysts think that the guidance was conservative, especially as it relates to margins.

Following the big EPS beat in 1Q07, the consensus estimate has moved up to $3.18 vs. about $2.80 previously. Apple ended the quarter with $13.44 per share of cash. Extrapolating interest income from recent quarterly reports indicates that the cash balance might contribute about 43 cents to earnings in fiscal 2007. Adjusting the current price for the cash balance and its contribution to EPS reveals that APPL is trading about 27 times projected 2007 earnings. The multiple comes down another point if AAPL gets credit for its probable calendar year end cash balance. 2008 consensus is now at $3.75. Adjusting this figure for cash balances and interest income puts APPL about 21 times 2008 estimates.

As a comparison, Google trades.....

at 35 times current year estimates, Microsoft trades at 20 times, and Cisco Systems trades at 20 times. Hewlett Packard, the other company gaining share in PCs, trades at 17 times. Looking at other growth stocks, Starbucks trades at 40 times, Disney trades at 20 times, and Whole Foods trades at 30 times.

I'd argue that AAPL that has as good as or better 2007/08 fundamentals than any company on this list except GOOG. Therefore, I think 27 times 2007 earnings is at worst a fair valuation, and in reality a cheap valuation for AAPL. And if APPL executes over the balance of 2007, the stock looks extremely attractive on 2008 estimates.

With AAPL shares giving up the bulk of their post iPhone related gains while 2007 estimates, with a minimal iPhone contribution, moved up sharply, I think an attractive entry point is at hand. Furthermore, based on my extensive reading of Real Money, Street Insight, other investment sites, technology/gadget sites, and blogs, it is my opinion that sentiment toward APPL shares is cautious. In fact, there is an overwhelming sense that APPL is going to fail either with the iPhone, iPods, Macs, or all three. I think the combination of cautious sentiment, the recent pullback, increased estimates, and a series of positive catalysts over the next six months reinforces that now is a good time to be long AAPL.

And for those of you who just can’t get enough, rumors are that AAPL has bought a Super Bowl ad. Speculation is that the ad will feature a deal that will give iTunes a three month exclusive on the first ever legal digital downloads of The Beatles catalogue. Other speculation focuses on whether a Beatles specific iPod is coming, including the possibility that a Beatles deal will be announced along with a long awaited touchscreen video iPod. I'd bet that the ad is iPhone related. Regardless, just when I was hoping the chatter around APPL might die down, it looks like we got another week to go before things calm down a bit.

Many Bullish Catalysts For Apple Over Next Six Months

Apple (AAPL) shares continue to pull back sharply following release of the company's latest quarterly earnings report. I remain surprised by the size of the pullback as well as the large amount of negative press Apple is getting surrounding the introduction of iPhone. I think a major disconnect has developed as many bullish catalysts exist over the next six months. Here are some follow-up comments to my earnings coverage now that I have had a chance to review analyst commentary:

First, I think comments that Mac sales were disappointing are fair. The number isn't bad and the market share gains are large, but a major thesis for Apple bulls, myself included, is that Mac sales would cover for any maturing in iPods or even disappointment in the iPhone. Mac sales will still cover these risks but maybe not as much as previously thought at least for 2007. In the short term, you can score that one for the bears.

However, I think that is about all you can score for the bears, leaving aside any debate over the iPhone.....

Estimates are rising by 25 cents to 30 cents. It looks like iPods might be able to sustain a higher profit margin than previously expected. It also looks like iPods are gaining traction in Europe, a market that bears had previously pointed to as indicating that iPods were going to mature more rapidly that expected. Macs also appear to be gaining share in Europe. Mac average selling prices look to be settling at a higher level than expected which provides a strong boost to profitability. Operating expenses may be under better control than previously thought. March quarter guidance looks like it is based on conservative assumptions. The June quarter could be huge with initial iPhone shipments, stronger Mac shipments to the professional market when Adobe ships the latest Creative Suite, and the launch of the extremely high margin Leopard operating system upgrade for Macs. The September quarter is shaping up well for Macs with signals from management on strong educational and institutional demand and rising "student intent to buy" measures.

I think those bullish factors outweigh the risks and will serve to contain the weakness the shares are again exhibiting this morning. I'm not a trader, so I have no opinion if the shares are a buy right now, but I am highly confident that come late spring, summer, and fall, Apple shares will be significantly higher than where they are trading today.

Apple December Quarter: Great But Provides Some Ammunition For Bears; Bears Will Run Out of Ammo, However

What follows is my analysis on Apple immediately following completion of the company's conference call to discuss December quarter earnings. I'll have more to say once I review analyst commentary but I am surprised that the shares are trading off sharply this morning. I think the drop will prove temporary – the results were good and there are plenty of positive catalysts ahead. This is a good example of short-term emotions and technical day trading driving a stock independent of long-term fundamentals.

Apple (AAPL) reported a great quarter, blowing away estimates. Revenues of $71 billion beat consensus of $6.4 billion and EPS came in at $1.14 versus estimates of 78 cents. Great gross margins and expense control allowed the excess revenues to flow through to net income. A slightly lower than expected tax rate added 2 cents.

As far the stock goes, I'd say the quarter leaves the debate over AAPL in pretty much the same place as before they reported. The company beat by 34 cents. Put a 30 multiple on that and you add $10 to the stock price. That is basically the increase in the AAPL shares heading into earnings and coming off MacWorld.

I think it is fair to say that analyst estimates won’t go up by much, probably by less than the beat. This factor will limit gains in the shares that would otherwise be expected by such a large beat. Management noted that unusually favorable commodity pricing boosted gross margin and that is unlikely to prove sustainable. Also, the massive beat on iPod units and good but not great Mac units will flow through analyst models in a way that limits EPS upside over the next three quarters.

I think the biggest issue that caused the stock to pullback off its initial post earnings spike was disappointment with Mac unit sales. The number was good at 1.6 million units but below many estimates, including my own, calling for 1.7 to 1.8 million. The effect on the income statement of any shortfall was mitigated by much better than expected ASPs which was a contributor to the gross margin beat.....

Apple had a good explanation for the Mac units, which beat internal goals. Management pointed out that extrapolations from the September quarter were biased by unusually strong educational and institutional demand, including two very large orders of 50,000 units. This was news to me. The next and obvious question was does this indicate that the "halo effect" is not as strong as expected. Here is the company's answer from the transcript:

There are several things that I feel really indicate there is a halo affect. One, we've grown at three times market. Two, that in the U.S., we've grown at 31% versus a market of 3%. Three, if you look at the latest student monitor information, the intent to buy a Mac is up substantially. As an example, the intent to buy a Mac portable went from 17% to 28% in a year. Also, my view is that we have significant momentum on the Mac. This is the eighth quarter of the last nine that the Mac outgrew the market. And I don't think a lot of people can say that. And so we are thrilled with this number. It is higher than what we projected. I can't speak to the models that you guys have worked, but we are thrilled internally on the number.

We can debate this all day. I'll take management's side based on my own observations of the halo effect and the data.

The music business was astounding in the quarter with 21 million iPods. The ASP came in as expected, under pressure due to the shuffle. But an inline ASP on blow away upside units means that strength was across all products, not just the shuffle. Music was also boosted by very high sales of gift cards, up two times versus a year ago. Analysts will clearly say this is the peak for the iPod. Could be, but they said that last year. The "iPod growth is going to slow dramatically" camp is a secondary but real reason why the shares pulled back in after hours trading.

Guidance will also be hotly debated and is probably the second biggest reason for the after hours action. The company guided below street estimates for the March quarter. That is not unusual but there was a feeling that analysts had it right this time. APPL explained the guidance on numerous occasions and my conclusion is that it is customarily cautious. Key issues for guidance include product mix, operating expense leverage, commodity input pricing, software sales, and expected heavy gift card redemptions. Each of these items is expected to put pressure on gross and/or operating margins relative to the December quarter. Seasonality on iPod and Mac sales is expected to be normal implying about 9 million iPods and 1.4 million Macs. iPod growth would be mid to upper single digits but last year had some unmet demand spillover from the holiday. Mac units will grow by 20-30% indicating the halo effect is healthy.

In summary, APPL is an overanalyzed stock (yours truly included). It is high profile, leading to a lot of posturing by bulls and bears alike. Analysts were tougher than usual on the call, which I think is because of bears accusing bulls of iPhone hype. Add the tough questioning to questions that will be raised about Mac units and guidance and a muted reaction the blowout earnings is not surprising.

I think the cautious posturing is healthy for the shares as is the overly critical analysis of the iPhone that is becoming conventional wisdom. As I began, the blowout earnings totally justify the latest $10 move in the stock. That leaves us right where we were before MacWorld. I think the caution will give way to bullishness, especially as approach what could be a big June quarter with initial iPhone shipments and a huge bump in high margin software sales when the new operating system is released. That will be followed by another big back to school season in the September quarter. Seems like a real good setup for the bulls to me.

Apple December Quarter Earnings Preview

Despite the sharp advance in Apple (AAPL) shares over the past week, I think the setup is favorable heading into the company's earnings report after the close on Wednesday. I expect better than expected Mac sales, solid results in iPods, and March quarter guidance no worse than the cautious commentary everyone is expecting. If I am correct, I think the shares can avoid a sell the news reaction and sprint to new highs across the $100 barrier.

Strong Mac sales have been key to my bullish stance on Apple for the past year. One Mac equals seven iPods at a higher margin so continued share gains for Macs really drives APPL's income statement. I expect December quarter sales to exceed estimates which call for 1.6 to 1.8 million units and flats ASPs. Stronger than expected Mac performance will support recent gains in the shares and leave the iPhone introduction as truly additive. Within the Mac line look for notebooks to be especially strong, potentially producing Apple's first ever quarter with over 1 million units. Desktop units are likely to be flat with the uptick awaiting the June quarter introduction of Adobe's new Creative Suite to drive an upgrade cycle for professionals....

iPods face a tough comparison vs. the astounding 14 million unit quarter a year ago which was boosted by an extra week and an unusual 10% sequential jump in ASPs. After some mid-year worry about iPod demand, it appears sales were very healthy this holiday season and many recent estimates call for 17 million units. Anything at 15.5 million or greater is probably good enough. The bigger question for iPods surrounds ASPs. Most estimates range from $155 to $170 per unit, down sharply from $208 a year ago and $179 last quarter. The culprit is a heavy mix shift in favor of the $79 shuffle, which appears to have been a huge seller during the holidays. With units up 20-30% and ASPs down 20-25%, it is possible that iPod revenue could actually be down year-over-year. This would come as a shock to some investors and could emerge as a key negative talking point following the earnings. On the flip side, although management does not breakout margins by product line, it is my belief that the shuffle is the highest margin product in the iPod family.

Modest growth in other music, peripherals and other hardware, and software will support EPS growth but aren’t expected to provide a positive or negative surprise. These line items are expected to contribute about 20% of quarterly revenue. Software is expected to provide a big boost to the June quarter when the latest version of the Mac operating system, Leopard, becomes available.

Consensus estimates for the December quarter call for revenues of $6.42 billion and EPS of 78 cents. Both estimates are well above APPL's normally conservative guidance. Hitting guidance would be very bad news for APPL shares. In fact, a little bit of upside to consensus is probably expected. Most analysts feel AAPL is being especially conservative in its gross margin guidance and are assuming a mix shift toward Macs will boost operating income.

APPL usually provides guidance for the next quarter. Presently, analyst estimates
are $5.22 billion for revenue and 60 cents for EPS, representing gains of 10% and 25%, respectively. Lack of new product introductions in the quarter are holding back the gains and the possibility of a pause in video iPods ahead of the iPhone introduction in June is plausible. I believe that cautious commentary on the March or June quarters is the biggest risk to APPL shares coming off the report.

Investors may also hope to hear something on the options scandal or new products. I think they will be disappointed. However, I do think that the possibility of exciting new iPod products for next holiday season exists. Imagine an iPhone without the phone as the true video iPod. Make it a 30GB or 60GB machine and you have a full video iPod with a touchscreen interface and wifi for internet connectivity including web mail and text messaging. Throw in photos, contacts, and a calendar and you have a product that would witness huge demand. If the Cingular deal prevents all that functionality, just a new touchscreen true video iPod would still be immensely popular.

Finally, there will likely be comments on the iPhone, specifically addressing the many questions raised about functionality, battery life, and additional versions of the product. I am not sure if APPL will comment but some indication about the product path, especially the integration of 3G wireless technology, would be well received by the investment community.

Apple's iPhone: Initial Impressons

There is no doubt that the new iPhone from Apple, Inc. (AAPL) – they officially changed their name yesterday by dropping "computer" – has a serious WOW! factor. The product is substantially beyond any expectations and easily supports the 8% gain in APPL shares yesterday.

Make sure to head over to Apple's website and check out the various demos on the music, video, telephone, internet, email, and text messaging capabilities of the iPhone. It really is amazing. Something as simple as rotating the iPhone from portrait to landscape and watching a photo automatically reorient itself will make you go WOW!

Or better yet, watch this 4 minute live demo of the phone courtesy of CBSNews.com and YouTube.

Beyond the iPhone as a product, I tried to take a stab at what it could mean financially….

I started with Bernstein's 2008 revenue breakdown. Bernstein's new research on AAPL was cautious but incredibly through and well reasoned so I figure their numbers might be a good place from which to benchmark.

Bernstein is using an estimate of $26.8 billion, a little below the current consensus revenue estimate for 2008 which stands at $27.8 billion. Of that $26.8 billion, Bernstein currently assumes that the iPhone will bring in $1.2 billion with Macs and iPods each generating $9-10 billion.

In his keynote, Steve Jobs said that APPL is targeting a 1% share of the phone market in 2008, equating to 10 million units. Pricing for the two versions of the iPhone was announced at $499 and $599. Presently, a nano plus a Blackberry will cost you about $500. Assuming that APPL sells 10 million units at $550 per unit, the revenue will be $5.5 billion. So even if Bernstein's concerns about iPhone cannibalization of iPods prove correct, there appears to be plenty of upside for APPL in 2008 if the iPhone meets initial expectations.

Assuming the iPhone produces an incremental $3 billion in revenue at an iPod-like 20% margin, AAPL is potentially looking at an incremental $600 million in operating income. Subtract taxes and you are looking at more than 45 cents in incremental EPS. Current consensus EPS for 2008 is $3.29.

I'd call that significant. Even more important, the iPhone along with AppleTV (formerly iTV) look like they are opening up massive new markets for APPL. This should improve investor confidence in the company’s long-term growth rate which in turn helps to support the premium valuation on APPL shares.

I am staying long AAPL with my focus now on next week's earnings report. I expect good numbers from both Macs and iPods. My only real concern at this point is how much the growth rate will slow on iPods in 2007 and beyond. With the iPhone likely to be very popular and highly priced, I am not too worried but it is worth keeping an eye on.

MacWorld Preview: How Expecations Impact Apple

MacWorld convenes next week and expectations of investors for good news out of Apple Computer (AAPL) are high. The shares have bounced significantly off their late December lows following what appears to a great reduction in risk related to the options backdating issue – in other words, investors are betting that Steve Jobs is safe even in the face of shareholder lawsuits and the distinct possibility of a formal SEC investigation.

Despite the pop, I think the trading ahead is subdued and sentiment is not particularly bullish. In fact, I think many investors are assuming that MacWorld is going to be disappointing and lead to a sell-off in the shares. I don’t know how to game it for trading purposes but I do the know the much bigger news for AAPL shares will be December quarter earnings and March quarter guidance which are due later this month.

As far MacWorld, rumors are running fast and furious....

The latest is that Apple will introduce a tablet Mac. The sourcing on this seems good but I see a tablet as a niche product with limited stock market and financial implications. I do think a tablet is a good idea for Apple as the design factor plays to the company's strength and ultimately a tablet could morph into a home controller for networks and various other devices. That fits in with the digital content strategy that is the core of Apple's strategy (sorry, bad pun.).

The real big news investors are looking for out of MacWorld surrounds the iPhone. I think to satisfy investors, at a minimum, Apple must formally introduce the product and explain how and when it will come to market in the first half of 2007. Will Apple go it alone as an MVNO? If not, what deals are in place with current mobile operators? Additionally, I think investors will be looking for the product development path. For example, is a Blackberry type device in the future? In terms of actual introductions, I believe expectations exist for a candy bar phone that essentially combines an iPod nano with a cellphone. Apparently, Apple has resolved power issues by having a battery for each device built right in. Also, unlike most music phones on the market, storage capacity is supposed to be significant – 4GB and 8GB. Disappointment related to the iPhone is a significant risk for Apple shares next week. My pal Cody Willard from Real Money is long and Apple and thinks iPhone related disappointment is a real possibility.

On iPods, expectations are more varied. Some observers are looking for a "true video iPod" which moves video to the core of the device at the expense of music. This would not just be an upgrade of the current video iPod but instead a completely new design incorporating a large screen and unique video technology such as touch screen controls. I don’t think lack of a true video iPod at MacWorld will cause much consternation among investors but it does raise the stakes for later this year. iPod sales during the holidays were great but even optimistic estimates have the growth rate slowing to 25-30% year-over-year. Without a true video iPod analysts would be unlikely to assume more than a 10% for next holiday season. Even with soaring Mac sales, which I expect will continue, a complete loss of iPod momentum is a problem unless the phone rollout goes without a hitch.

Investors are also expecting the formal introduction with product availability of Apple's iTV device that was introduced last fall. I see this product as evolutionary and central to Apple's digital content strategy but I don’t think it is likely a home run from a financial perspective. The easy movement of downloaded content from a Mac or PC to the family room TV is critical to any digital content strategy. I just don’t think even Apple can make it simple enough yet for most households to make it a breakthrough product for 2007. And don’t forget there are issues with the quality of downloaded video relative to what consumers are used to seeing on their TV sets, even before HD is considered.

Finally, beyond the tablet Mac, I have read little about the possibility of new products in the Mac line. Some people believe that a smaller 12 inch version of the MacBook is a possibility but maybe that is the tablet. I do think a really portable laptop would be a winner especially as digital content plus email and internet connectivity is a very large market. Heck, that is all most consumers need in a personal computer.

Hopefully, this post provides a baseline against which to judge the hype and hyperventilation that will occur next week. I remain long Apple across the board based on my belief that 2007 is shaping to be another great year driven by Mac sales to consumers. And don't forget much of the creative market won’t upgrade to Intel-based Macs until Adobe issues its next generation Creative Suite this spring. I think December quarter earnings are a better catalyst for Apple shares than MacWorld but for this massively analyzed stock and company (count me as guilty!) anything can happen.

Apple Files 10-Q With Options Update

In hindsight, it appears that some of December's weakenss in Apple shares (down about 10% prior to today's open) was due to speculation about developments in the options back dating scandal. It is likely that prior to the publication of articles in Law.com and the Financial Times some investors may have gotten wind of the gist of the content. This is purely speculation on my part but it fits the profile of the stock trading in which the decline from $93 to $81 went far beyond concerns about the current quarter or the iPhone.

Apple is rebounding strongly today following the release of the company's restated 10Q and Annual Report. The 10-Q has a lengthy discussion of the options issues including a thorough recap of the internal investigation. My conclusion is that Apple is not out of the woods on this issue but investor concerns should decline dramatically.

Apple admitted that it screwed up and even the lawerly language used in the 10-Q does not cover up that fact. Two things are clear. First, Apple conducted a very thorough investigation. Second, Apple is going to defend Steve Job's actions. I still expect the SEC to pursue a formal investigation but I doubt that they will find anything more damning than what Apple has now admitted.

I expect investor attention towards Apple shares to largely refocus on fundamentals. That means a very strong December quarter earnings report and new product introductions at January's MacWorld. But the options issue will hang in the background until the SEC wraps up its investigation. And reporters will still dig around for incriminating info about Jobs related to the options issues.

Apple is way overanalyzed and investors have very strong emotions about the company. This means trading is likely to remain even more volatile that usual. But I expect the upward trend to resume and a move to over $100 is very plausible if my expectations about the December quarter, MacWorld, and the 2007 outlook are met.

Not surprisingly, I am staying strong across the entire Northlake client base and in my personal accounts.

Apple Shares Remain Unusually Weak

The point of my post about the Forrester report on Apple's iTunes sales was not really to discuss AAPL. Instead, I was trying to point out how the type of analysis can impact the conclusions drawn. In other words, good inputs lead to useful outputs and vice versa.

When I posted this piece on StreetInsight.com, two contributors, Scott Rothbort and Jeff Bagley, responded to my post and reiterated their own bullish views on Apple. I am in total agreement and remain long as ever, including adding the stock to new accounts last week (Northlake owns pretty much the same portfolio for all individually managed accounts but client agreements usually allow ample flexibility as to the timing of the transition to Northlake's investment strategy.)

Similar to Scott and Jeff, the basis of my bullishness on Apple is Macs, not iPods or iPhones or iTV. I believe Apple's market share gains in Macs are just beginning and will go beyond most current estimates and be persistent and sustainable. Apple has bet the company on management of digital content. The operating system, the applications, and the hardware (Macs and iPods and the soon to be iPhone and iTV) are all built around the idea that PC use, particularly among consumers is being dominated by the need to manage the digital lifestyle. Apple is miles ahead of Microsoft on this front, providing a competitive advantage vs. all the windows-based PC manufacturers including Dell Computer (DELL) and Hewlett Packard (HPQ). Given the small share Apple has on a global basis, the rapid developments in digital content, and the increasing use of digital content in the business world, Apple has made the right bet and will reap the benefits for several years....

I believe that December quarter Mac sales will be very strong. Coming on the heels of the great Mac sales in the September quarter and a strong holiday season for iPods, I believe the shares are undervalued based solely on Macs, iPods, accessories, and software.

I think recent weakness in Apple shares has as much do to fears the iPhone will fail as fears it will be late to market. Getting the iPhone to market in mass quantity is tricky and just a few percent market share of the global phone market has huge positive implications for Apple's financial performance. However, I think investors were a little too matter of fact about the sure fire success of the iPhone. The decline in the stock during December has reset the bar on the iPhone and set up a positive reaction to the good news that is coming on Mac sales.

iTunes Sales Are Not Collapsing

Leaving aside the debate concerning why Apple Computer (AAPL) shares have been acting so poorly and whether it is deserved, I think it is fair to say that the Forrester report that said iTunes sales were plummeting was the start of the severe downward pressure. As you might recall, the Forrester report generated a huge amount of publicity and critics noted it was flawed and completely inaccurate.

Last week, the Wall Street Journal had an article discussing the report. It turns out that what Forrester measured was iTunes download activity comparing January 2006 to June 2006. This is a far different methodology than would be used on Wall Street, which deciphers growth trends by looking at year-over trends.

In this case, Wall Street's approach is correct as the Forrester methodology fails to address significant seasonality in digital music sales. January is a high point, especially for iTunes, because of the popularity of iPods and other MP3 players as holiday gifts. iTunes seasonality was probably greater than usual last January as the blowout iPod sales of 14 million units in 4Q05 arguably represented the peak of iPod mania. Add in the iTunes gift cards received in December 2005 and is it any real surprise that June 2006 iTunes sales were below January 2006?....

The headlines on the Forrester report would have been much more effective if they noted that in 2006, June iTunes sales were off 65% from January while in 2005, the comparable decline was just 39%. This data still fails to note that year-over-year growth in iTunes remained strong and that December 2006 might surely represented the peak of iPod growth acceleration, but at least it would lead investors to ask the right questions about a possible slowing in the growth rate of iTunes sales.

And that is the real issue. Sales at iTunes are not keeping up with the growth of the installed base of iPods. That means that either new iPod buyers are purchasing fewer music tracks and videos from iTunes or early adopters are slowing their rate of purchases.

This strikes me as more of an issue for the content companies as digital downloads are supposed to take over and provide a revenue stream to replace lost physical sales. But for Apple, it could be an issue if it indicates that consumers are seeing less utility in their iPods. That might slow the sales of iPods and also could be a sign that Apple's strategy to build an operating system around delivery and manipulation of digital content might have less traction than expected.

I don’t believe that and see Apple's operating system and integrated digital content applications as the company's key competitive advantage that will drive better than expected market share gains for Macs, and, in turn, the stock price.

Some folks might take the other side of that bet. But one bet we would all agree on is that Forrester would have done a much greater service to followers of Apple, the music companies, and digital content in general, had they better framed their conclusions rather than look for lots of free press by drawing in accurate conclusions from a flawed analysis.

Recent Apple News

Lots of Apple Computer (AAPL) news today. UBS is out with a note claiming that Apple will enter the wireless via a mobile virtual network operator (MVNO). UBS Telecom analyst John Hodulik was discussing this in the hallways of their conference last week but went public with his thoughts today. Given a loyal Mac user base and the built-in distribution system of Apple Store's, I think that this MVNO stands a better chance of success than others that have generally underperformed expectations in the U.S. market. I think the parallel here is Virgin Mobile in the U.K., not ESPNMobile in the U.S. While this news, if accurate, will give a small boost to Apple due to recent concerns that the launch of the iPhone would be delayed, a greater impact might be on the major wireless operators in the U.S. Hodulik notes that Apple would be entering the high-end market with an unsubsidized handset, and he believes that Sprint Nextel (S) with its high data usage is most vulnerable....

Separately, Morgan Stanley sharply raised its 2007 and 2008 earnings estimates for Apple due to an "expanding product portfolio, growing distribution engine and market share opportunities." Morgan Stanley also raised its target on Apple from $90 to $110.

I remain very bullish on Apple as it is one of the only large-cap stocks that offer 20% earnings growth over the next few years. I used yesterday's weakness related to an odd report claiming that iTunes sales were collapsing to add Apple to several new accounts. I continue to own the shares across the entire Northlake client base and in my personal accounts. I think the shares could reach new highs over $100 in the run-up to MacWorld in January. My current trading strategy might lead me to again trim positions in Apple at that time if my forecast proves accurate.

Follow-Up Comments On Apple

I have a few follow-up comments to my earnings call coverage of Apple Computer (AAPL). First, analyst commentary fell along the lines I expected. Estimates are going up, bullish analysts are reiterating their recommendations, and cautious analysts remain worried about valuation. So far I don’t see any upgrades or downgrades. Second, analysts are saying that the lower tax rate added 6 cents. My analysis indicated 4 cents. I assumed a slightly lower 30% tax rate was expected while analysts were at 32 cents.

My earnings commentary was lengthy so I left a few things out....

I did initially find some questions beyond the tax rate when I plugged the numbers into my spreadsheet. Both inventories and accounts receivable seemed a little too high relative to the last couple of years. The ratios weren’t bad, just elevated. This came up on the call and management stated very firmly that channel inventories are a little low for Macs and right on target for iPods. The increased inventory was attributed to 41 new Apple Stores plus a desire to meet excellent demand and not let shipping times get stretched out. Comments on receivables were limited but the CFO said they were in line with his expectations.

Also on the balance sheet, I noticed a large increase in other current assets. This did not come up on the call. This line has been rising rapidly but the increase was unusually sequentially at least compared to a year ago. I’ll try to follow-up on this with the company. Payables were also up sharply, likely reflecting the receivables increase. Management noted that they felt working capital management was a strength in the quarter and were proud of the cash flow generation.

The Other Music line which reflects iTunes sales, Apple branded accessories, and accessory licenses was flat sequentially. Since more than doubling in the December 2006 quarter, this revenue line has stalled on absolute basis (although it was still up 70% yoy). In response to a question, management indicated that iTunes sales are seasonally weak in the September quarter due to lower PC use in the summer and a weak album release schedule. Additionally, accessory inventories were reduced ahead of the introduction of the new nanos and shuffle. Sequential growth should reappear in the current quarter.

iPod market share in the UK, Canada, Japan, and Australia is 40-50% according to management. In France, German, Italy, and Spain, the company said its market share has grown by 6-7 points. These markets are important as there is some evidence of maturity in the US market where iPod penetration is highest and AAPL has a market share of 75%.

The Mac distribution test with Best Buy appears successful as it will be expanded form 7 stores to 50 stores. There is also a test under way with Circuit City but it is just getting started in a few stores. My sense is that management is willing to look a more favorably on distribution outside of internal efforts.

Management provided no numbers but the new shuffle will ship before the end of the month and I sense expectations are very high for this time. It is a sexy little package and buzz is good. At under $100, it will be a very strong holiday item. Also, it makes a great second iPod for all the heavy users out there who want something new but don’t want to drop several hundred bucks. Could unit shipments of shuffles reach 5 million or more all by themselves this quarter?

Finally, as usual, management provided no insight to the new product questions which were heightened by Jobs press release comments. They did say that they are “very confident” in the product pipeline.

Hopefully, I can join in others in reducing my obsession with all things Apple until the Christmas selling season begins in earnest. Until that time, the outlook remains very bullish.

Apple Reports Another Great Quarter

Apple Computer (AAPL) reported another excellent quarter. There is absolutely no reason that anyone who was bullish prior to the quarter should change their opinion. And there is reason to believe bears might have to rethink their position. Estimates will rise by about the same 5% increase in the stock price after hours so the stock is no more expensive that it was prior to the report.

The quarter was very strong at 62 cents on revenues of $4.84 billion. Consensus was 51 cents on $4.64 billion in revenues. An unusually low tax rate helped significantly by a one-time credit helped EPS by about 4 cents but even at 58 cents it was a superb quarter from an earnings standpoint.

Revenue upside came from better than expected unit sales of Macs and iPods. For Macs, notebooks were the star at almost 1 million units. I found the ASP to be quite good as well. I had modeled it down by a $100-200 after watching the new Macbooks priced at $1099 fly out the door. I guess they sold plenty of black ones and MacBook Pros which sell at premium prices.. Desktops were actually not bad at up 4% considering the massive shift industrywide in favor of laptops. Desktops should pick up next Spring when Adobe releases new software that runs native on the Intel Macs.

iPods also were better than expected as unit sales of 8.7 million exceeded management guidance and were ahead of recent downwardly revised estimates. The $10 ASP decline was more or less expected. On the call, management characterized demand for the new nanos as “excellent” and said that there was a noticeable pickup in demand after the new nanos were announced.....

Gross margins of 29.2% beat guidance by about 100 basis points and were generally in line with analyst estimates. Some analysts were at 30%. Any variance was likely explained by component pricing and product mix.

Operating margins were superb as operating expense growth was flat sequentially against a 10% sequential increase in sales. This fact along with the revenue upside explains the EPS surprise.

Guidance of $6 to $6.2 billion in revenue and 70-73 cents was slightly below consensus as usual. When the media reports that AAPL lowered guidance what they are really saying is that guidance is below consensus as there was no prior 1Q07 guidance. This news as is as expected and not any worse as some analysts recently had worried. Commentary related to unit shipments, gross margins, and operating expenses for next quarter was constructive.

Let’s say AAPL is at mid-point of their revenue guidance. That would mean that revenues grow $1.3 billion sequentially. Last year, the company shipped 14 million iPods. That figure was boosted by 1 to 1.5 million by a 14th week against just 13 this year. Let’s say that this year we get 15.7 million units, or a sequential gain of 7 million units. Management cautioned that ASPs will come down in 4Q. Let’s call it $170 or down 10% year over year. 7 million incremental iPods at $170 is $1.1 billion in revenue.

If that is the case then revenue growth from Macs and all else needs to be only $200 million to meet guidance. That should be a layup. On the call, management noted that seasonality and the non-recurrence of an inventory drawdown should lead to an uptick in Other Music sales which is the iTunes Music Store and accessories. Year over year growth was 70% on this line in the just completed quarter. Last Christmas was when this segment really ramped so let’s call it a 20% year over year gain this year and you got another $100 million in incremental revenue.

That leaves Macs needing to be up just $100 million to meet the midpoint of revenue guidance. Last year, sequential growth in Mac revenue was 7% or $100 million. Mac revenues in the September quarter were $2.2 billion. Leaving aside the fact that we just completed the highest unit quarter for AAPL in 6 years and that the company is clearly gaining significant market share and that seasonality provides a tailwind, Mac revenues need a sequential gain of just 5% to meet guidance if my prior assumptions are correct. That seems awfully conservative given that MacBooks will be a hot Christmas item.

So the bottom line is that guidance appears conservative unless there is a sudden shortfall in Mac or iPod demand. It seems unfathomable that Macs will fall short so that leaves iPods. I guess it is possible that there is a miss as Zune will be out there and music phones are gaining popularity. But even if there is a 1 million unit shortfall, that is made up by just 125,000 extra Mac units. I think that is likely, probably conservative.

I know that AAPL has to beat the number again next quarter to drive the stock but hopefully this analysis shows that is likely. And if next quarter comes through, the story seems clean for calendar 2007 as the press release quoted Steve Jobs as saying it will be “one of the most exciting new product years in Apple’s history.” Hmmmm.

I am staying long and still expect the shares to make a new all-time high by Christmas.

Apple September Quarter Earnings Preview

While Apple Computer (AAPL) shares are always volatile around earnings, I think the set up heading into this quarter is unusual. On the one hand, it is AAPL. The expectations are high and the company might receive more scrutiny than any other. The stock has rallied 50% from the summer lows following the excellent June quarter report that showed that Mac sales were finally taking off. So, based on history, AAPL probably needs to beat and raise to juice the stock.

On the other hand, the stock has largely sat out the recent rally as it is just barely higher than its early September level. Furthermore, there has been lots of cautious commentary about iPod shipments and the likely fourth quarter guidance. So, maybe just an inline report with as expected guidance will be good enough for the bulls.

For the September quarter, which is 4Q06 for AAPL, consensus calls for EPS of 51 cents and revenue of $4.66, up 34% and 27%, respectively. Growth will be driven largely by increased shipments of Macs, especially notebooks....

Analyst estimates look to be close to 1.5 million units, producing revenue of just short of $2 billion. There is lots of anecdotal evidence of strong Mac sales for back to school as the new MacBooks were a must have item. A small uptick in desktop sales is possible as the company introduced an Intel-based system. Desktops are more likely to get a boost when Adobe upgrades its software early next year. Overall, Mac sales are the story this quarter. Look for lots of excited comments if the company passes 1 million units in notebooks this quarter.

iPod sales are tougher to gauge. As with last quarter, as the quarter moved on expectations fell. I have seen estimates for units of 8.2 million up to about 8.7 million. Last year, the September quarter saw units of 6.5 million, so growth is still around 30%. ASPs will probably be down about $10 from last year’s $188.

The bigger question for iPod sales, and for AAPL shares, surrounds the December quarter. Seasonally it is a big quarter. iPods are a popular holiday gift item but last year the company completely blew away estimates with 14 million units. Sequential unit growth last year was 115% with ASPs rising $13. My long standing fear for AAPL shares has been that this comparison would lead to a miss for iPods and a return of the bear thesis that AAPL is blowing it again. My sense is that current estimates call for iPod shipments of 17 million units for sequential growth of 100% and year over year growth of 20%. Plus last year’s fourth quarter had an extra week that added 1 million units. Normally unreliable indications from the supply chain suggest AAPL might be preparing to ship as many 21 million units this year.

What worries me is if the figure comes in at 15-16 million. This would be accompanied by lots of stories about the end of the iPod phenomenon and how music phones are replacing iPods. In the end, I suspect that December iPod shipments won’t fall short as music players will get a boost as a category from the new product introductions from Apple, Microsoft, and Sandisk. So one more big Christmas for the category will likely occur.

Analysts will get a sense of iPod shipments for December from AAPL’s guidance. Presently, consensus estimates are for EPS of 57 cents on revenues of $6.45 billion. I hope that AAPL’s guidance is close to these figures. I think it will be because I expect MacBooks to be an extremely popular Christmas item. Remember that Macs have an ASP 7 times an iPod at a higher margin. A 1 million unit shortfall in iPods is made up by an additional 133,000 Mac units in terms of revenue and fewer in terms of operating profits.

I am long AAPL and as usual nervous ahead of the quarter. I remain steadfastly bullish over the next couple of years as I think the market share gain in PCs is for real and has lots of upside. Additionally, I am optimistic that additional revenue streams will develop from phones or smart phones or the iTV device or software. Apple remains a long-term growth stock regardless of quarterly fluctuations. There aren’t many real growth stocks with market caps as big as AAPL so I am willing to tolerate the volatility surrounding quarterly results.

More Apple Cell Phone Rumors

ThinkSecret.com is reporting that Apple Computer (AAPL) will be launching a cell phone through Cingular early in 2007. The report says that Cingular will have a six month exclusive. This report is just a rumor and based on my own perusal of the ThinkSecret website I wouldn’t put a lot of stock in it.

However, if it is true it raises a couple of interesting points. First, most analysts had assumed that AAPL would launch be a mobile virtual network operator (MVNO), leasing spectrum from someone like Sprint and then reselling it. Current MVNO’s in the US have not been very successful. If AAPL avoids MVNO, is that a positive for wireless operators? Second, the phone is supposedly to be tightly tied to iTunes. If so, that means users will expect iTunes pricing, meaning 99 cent over the ari downloads. After all, the phone will surely have a USB connection so you can hook up to your computer just like an iPod. Presently, mobile operators charge $1.99 or more for downloaded songs and ringtones. It seems like an Apple iPhone could collapse this pricing structure. Ringtones are already a big business so this could have negative ramifications for mobile operators. Then again, if Apple can upgrade the music phone experience (so far music phones have not received good reviews in the US), the market could grow much more rapidly offsetting any pricing compression and igniting another round of phone replacements....

For Apple, the upside in a phone venture is based on the number of units it sells and how the phone protects the company’s domination of the digital music business. ThinkSecret says the company expects to sell 25 million units in the first year. That seems high given that Motorola (MOT) has sold a little more than 50 million RAZRs so far. For sake or argument, 25 million units at $150 per unit is $3.75 billion in revenue. This year is Apple is projected to have $19 billion in revenue so a phone could be a big deal. And 25 million phones is not that much in a market that sells over 900 million phones globally. Put a 15% operating margin on that revenue and you have $562 million in operating income. The tax rate has been running around 32% with a slowly rising share count of 875 million, producing incremental EPS of over 40 cents per share vs. current 2006 estimated EPS of $2.15. The 2007 consensus estimate is $2.64 but probably contains some cell phone EPS, though probably not too much.

As I have said many times, AAPL is one of the few large cap growth stocks that has real double digit growth. It is worth a premium multiple as long as momentum is sustained. With a cell phone, a set top box device, ongoing iPod upgrades, and significant market share gains in laptops, momentum seems likely to be sustained through at least 2007. I think the shares are headed for a new all-time high ($86.40) during the upcoming holiday season.

Zune Not A Near-Term Threat To iPods

Apple Computer (AAPL) shares have continued to rise following the introduction of Microsoft's Zune music player. Apple has benefitted from growing recognition of the company's outstanind momentum in Mac sales, excitement over the previewed iTV device, and the introduction of updated iPods for the holiday selling season. Additionally, the Zune has been met with a yawn from previously worried observers. I think the momentum will hold and AAPL shares can make a new all-time high in the nex several months.

Given the recent focus, here are are some thoughts on the Zune player written from the perspective of the impact on Apple shares over the next three to six months. Obviously, Zunes and iPods will both develop their capabilities and ecosystems, so I am keeping my mind open on a long-term basis.

I see three differentiating factors for Zune vs. iPod. First, the wireless capability. Second, the subscription model. Third, the larger screen. For this holiday season, I see minimal value in wireless, potential value in the subscription model and real value in the larger screen....

As far as I can tell, the key wireless feature is that Zune lets you do is receive songs from someone else's Zune (with limited playback). Microsoft (MSFT) appears to be placing a lot of emphasis on this "connected entertainment," relating it to the success of MySpace. It doesn't seem to be a big deal to me. Until there are tens of millions out there, your friends have to have Zune unless you want to approach somebody on the street you happen to notice has a Zune.

I suppose Microsoft thinks the MySpace concept will drive groups of friends to buy Zunes so they can share. Anecdotally, I asked my son, who is freshman at NYU, how many people on his floor had an iPod. He said virtually 100%. That would seem to be the target market for the "connected entertainment" concept. Are these kids going to dump their hundreds to thousands of dollars in investment in an iPod and iTunes downloads just so they can share?

Also, does anybody know if Microsoft has any kind of patent on this sharing technology? If not, I've got to think that Apple would respond quickly if it took off.

I guess wireless also means syncing Zune with your library without wires. Again, I say big deal. It's really not very hard to attach your iPod to the USB port. Finally, I'd expect wireless to hurt battery life. Cody Willard seems to see other potential uses for the wireless capability but Microsoft doesn't seem to be mentioning anything else.

Some folks will like subscription if it is accompanied with a solid player, so some value exists there. The larger screen is good for video, assuming the picture quality is not compromised. That seems like something Apple could have done unless maybe the part of the click wheel we can't see gets in the way. I wonder if flipping the Zune portrait and landscape for music and movies might cause some issues with the controls? Also, when I read Apple blogs, folks are really hung up on picture quality. Is there a risk of degradation when you flip it? I wouldn't expect so but something to think about. We also need to see whether Microsoft will offer a better library of video downloads. I thought the interview on CNBC with the head of Zune left open the possibility that it would launch with minimal video downloads available.

As to disadvantages, I personally think it looks clunky and early blogger comments indicate it is bigger and heavier than an iPod. Zune doesn't have a click wheel. Apple has that ergonomically friendly feature patented. We don't yet know about pricing but I think Apple upped the ante there with the new iPods. Also, the ecosystem of accessory suppliers for iPods is huge and provides a competitive advantage. Will Zune be able to ramp accessories quickly?

Finally, and probably most important, will the Zune store, apparently named Argo, match iTunes? iTunes is the part of the Apple ecosystem that is underappreciated by investors. And the latest version improves on an already great program.

The bottom line is that if Microsoft wants to sell units, they can probably get it done. They could steal a little market share from Apple but most likely its market share gains will come from the 25% Apple doesn't have. And Zune better get a cool factor quickly or at least for this Christmas, it won't be under the tree. Someone on RealMoney or Street Insight said that you don't want to open a Zune and have to fake your excitement because you really wish it were an iPod.

I am staying long Apple and watching booming Mac sales while CNBC and too many others are focused on music players.

Impressions of Apple's Product Announcements

Overall, the Apple Computer (AAPL) announcements were in line with my expectations. I almost got right the new wireless device that will get the video you download to iTunes over to your TV: It's not a MacMini; it's just half the size. This product, due in the first quarter of 2007, is probably the most important announcement on a long-term basis. But I wouldn't overlook those new iPods and the upgrade to iTunes. (I've already installed it in a Windows PC, and it has some nice enhancements in navigation and offers free album art for all the CDs you've ripped into iTunes previously.)

The iPods are basically double the capacity in slimmer, smaller and similar forms, with improved screens, all at the same or lower price points. There was not an introduction of a true video iPod, which I guess means even better resolution on a larger screen, with a movie-like aspect ratio.

The reason the iPod refresh is important is because one of the few blemishes in the near-term story for Apple is the incredibly difficult December quarter comparison against last year's 14 million unit quarter. I've long feared the screams of joy from bears when iPod sales this holiday season didn't grow or even fell short vs. 2005.

The refresh seems to offer a good reason to upgrade for current users, which, along with latent demand from those still looking for their first MP3 player, ought to give a nice push to unit sales. Even better, the refresh should set the stage for solid year-over-year growth as 2007 unfolds.....

The bottom line from today's announcements is that the big picture remains the same: AAPL has opportunities to add billions and billions of good margin revenue as it grows iPod and Mac sales, possibly introduces a cell phone and enters the living/family room. As I've said often, there aren't many mega-cap stocks that offer real prospects for 15%-20% annual growth. Apple does, and on that basis, the shares deserve a premium valuation and should head to new highs over the next three to six months.

New Products Due Today From Apple

Sometime later today, Apple will unveil its long awaited new products and services. Consensus seems firmly to predict that new higher capacity iPod nanos with new outside covers will be introduced. Consensus has also coalesced around the launch of an iTunes movie store. The remaining question is what else might be coming. The invitation apparently uses the “and one more thing” language which in the past has been a tip that something big is coming. Speculation has surrounded a true video iPod, a cellphone or PDA, and a piece of hardware that enables videos, TV shows, and movies purchased from iTunes to be played on your TV.

The best informed speculation I read was on AppleInsider.com in an article which contained this nugget:

” Just as he asserted that consumers are more eager to own their music tracks for 99 cents a piece rather than rent them on a monthly basis, he realizes that few are willing to plunk down ten bucks for a two-hour movie that they'll have to watch with their neck cranked towards a miniature screen resting in the palm of their hand. As someone at the forefront of the motion picture industry, he knows films are designed for the big screen and later adapted for the home living-room theater.

For these reasons, Jobs many months ago commissioned an elite group of Apple engineers to get the ball rolling on an intuitive hardware solution that would more closely tie the company's digital media strategy to the living-room. And so AppleInsider has been told, Apple has been quietly developing a video streaming device that will interface with an updated version of its iTunes jukebox software.”

If such a product were introduced that COULD BE big but only if the solution is SIMPLE. I’ve been speculating for over a year that Jobs real goal was the living/family room.....

Apple already has a huge growth opportunity by gaining market share in PCs or by introducing a cellphone or PDA. Both of thse markets are enormous and dwarf the annual market for iPod music players. Just 1% market share in those markets is billions of dollars in annual revenue. If the living/family room is opened up with each households thousands of dollars of investment in TVs and stereo, Apple could not only sell products for that market but could also reinforce its market share gains in PCs and maybe even next generation PDAs.

I suspect that “one more thing” will address this PC/TV convergence. And the opportunity is huge is Apple can offer a SIMPLE solution. I mean really SIMPLE. Right now, the iTunes broadband connection is coming into the home from a phone or cable jack that is very often not situated anywhere near the primary TV. The problem in search of a SIMPLE solution is how to get the video downloaded from iTunes over to the TV. It seems that wireless is the only way and Apple already has Airport Express as a solution to build upon. Will the MacMini be reworked into a receiving device that attaches to the TV and receives a wireless feed from an iTunes enables computer somewhere else in the house?

I am not a tech person so I don’t know the answer but I do know the opportunity for Apple is huge and I know that to really capture a mass market opportunity the solution has to be simple, like iPod + iTunes.

I’d encourage you to read the comments section of the AppleInsider.com post linked above and read the comments in this post as well.

As for Apple stock, it has had a good run so today’s announcements already build in something special. Anything short of special seems likely to lead to a sell-off. But if a sell-off comes keep your eye on the big picture….billions and billions in high margin revenue from the computer, cell phone, and digital home markets. This where the second leg of the Apple story has always been and this is the lens through which today’s product introductions should be viewed.

Dell Blows Up - Little Impact on Apple

Apple Computer is trading off over 1% pre-market due to Dell Computer’s ugly preannouncement. While the health of the PC market is clearly in question, I would note this from Dell’s press release:

"These estimates primarily reflect aggressive pricing in a slowing commercial market worldwide"

For the time being AAPL’s fundamentals are driven by market share gains in consumer PCs. In fact, I know over a half dozen individuals and families who have switched from windows machines to Macs in the past two months. Purely anecdotal I know but combined with AAPL’s incredibly strong laptop sales in the last quarter, I don’t think there is necessarily a read through from Dell to Apple. In fact, maybe Apple is part of Dell’s problems.

Some More Thoughts on Apple

My friend Jeff Bagley did his usual great job covering the Apple Computer (AAPL) earnings release and conference call. I fully endorse his bullish view but since I've written extensively on AAPL, I wanted to offer a few observations of my own.

As I have been saying for some time, I think the key to the quarter and the outlook is Mac sales. And the news from the June quarter is very good. MacBook unit volume was 798,000, a 61% increase vs. a year ago. There was plenty of anecdotal evidence that laptop sales were strong but this is really a good figure. I think it is 100,000 or more units ahead of some analyst estimates. The momentum appears very good and the next two quarters will show similarly huge increases. To put the 798,000 in perspective, in the seasonal strong September and December quarters of 2005, AAPL averaged about 600,000 laptop sales.

Despite the huge increase in laptops, overall Mac units were up only 12% because desktops down 23% from 2005. It still isn’t clear when the new Intel desktops for the professional market will ship but I think the huge jump in laptop sales last quarter bodes very well for the quarters after the desktops finally ship. So if you believe that MacBook momentum will be sustained for at least several more quarters, overall Mac growth will get a huge boost when the new professional desktops ship. This should give some comfort to the 2007 growth profile.

As for iPods, there was clearly relief when the unit figure came in at 8.1 million.....

I suspect that iPods got a boost from MacBook sales, as at least for college students, there was a buy a MacBook, get a free nano promotion. ASPs were flat vs. a year ago, so this promotion doesn’t look like it was too damaging and it was probably a good way to clear inventory ahead of the update to the nano line that is due anytime.

Looking ahead, in the September 2005 quarter, iPod shipments were 6.5 million, so the product line should show continued growth if shipment and demand levels just hold steady. Even without a refresh, that seems plausible given back-to-school demand. Things get much tougher in the December quarter, however, since AAPL shipped 14 million units a year ago. I suspect the next scare for AAPL shares will come when analysts begin to point out the possibility of no growth or negative growth for iPods in the December quarter.

Two other issues that created a problem in the second quarter looked a lot better last quarter. First, much concern was expressed 90 days ago when units and revenues at the company's retail stores saw growth of just 7% and 11%, respectively. In the September quarter, growth returned as units rose 50% and revenues climbed 29%. Similarly, last quarter's quarters slow growth rate in Japan reversed, as revenue growth accelerated to a year over year gain of 14% vs. just 8% in the March quarter.

Accessory growth remains on fire, up 90% year over year. This remains an underappreciated part of the Apple story and likely provides a nice boost to margins that is less dependent on volatile component pricing.

Lastly, software, another high margin business is set to contribute to the next couple of quarters. In the June quarter, software sales were down 9%. In 2005, I believe that the last big upgrade to the Mac operating system came in the June quarter so it was a tough comparison. That upgrade is due in the current quarter, so look for a big acceleration in software for the next few quarters. Sequential growth in software upon the introduction of the last OS was over 40%.

Put it all together and yesterday's big gains in AAPL are totally justified. I think the coast is clear for more gains as MacBooks continue to gain market share, new professional desktops are introduced, the operating system upgrade is launched, and the iPod line is upgraded for the first time in a year. All that should power the shares for the next several months. And as Jeff points out, AAPL has plenty of room to gain market share and expand its share of the consumer electronics wallet, so the multiyear growth story remains completely intact.

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).

Some Thoughts Ahead of Apple's Earnings

I wrote the following before my Barron's showed up on Saturday with a bullish cover story on Apple Computer (AAPL). Barron's has previously written negatively on AAPL so it shouldn't come as a surprise that AAPL shares have firmed up this week. The story is consistent with what I have been writing about AAPL.

I'll have more comments about AAPL after the company reports earnings Wednesday after the close. The comments below provide some perspective on what to expect and how the shares might react.

In a note from last Friday, UBS discussed whether the steady and large decline in AAPL shares discounts slower iPod growth, the options backdating controversy, and delays in shipments of new versions of the iPods. UBS and most other analysts acknowledge that Macs are selling very well, ahead of estimates entering the soon to be reported 3Q. The bullish theory would be that if the shares are discounting the known weaknesses then a relief rally could occur after AAPL reports next Wednesday afternoon.....

UBS noted one thing that might work against the relief rally: current estimates for 4Q ending September seem likely to be well above guidance the company will provide on its conference call. Right now, consensus calls for a 12% sequential gain in revenues and with just a few cent uptick in EPS. UBS thinks that AAPL is likely to guide for flat to up revenues especially if long rumored delays in the introduction of new iPods are confirmed. In 2005, APPL guided for flat sequential growth in the September quarter and then came throughh with growth of over 4.5%.

The flip side of the lower 3Q revenue due to new iPod delays is that new iPods will ship mostly in the December quarter which is 1Q07 for AAPL.

So the question becomes, has the market gotten ahead of analyst estimates and already discounted guidance that will probably be below consensus? Bulls also have to hope that commentary from management and analysts supports a strong December quarter with likely spillover into the March quarter.

I remain long AAPL anticipating better than expected Mac sales in the September and December to be the driver of the shares. I also think the upgrade to the Mac operating system due in August will help drive results, especially profits, as software carries very high margins. Finally, iPods could again become a positive catalyst if new models are shipped in plenty of time for the holiday season.

I’ve been wrong to hold AAPL so far this year but I do not plan to throw in the towel when I believe that sentiment is overly negative relative to the fundamentals I expect over the next several quarters.

Apple Implicated in Stock Options Scandal

Analysts are predictably defending Apple Computer (AAPL) on last week's news that the company is caught up in an options backdating scandal. Merrill Lynch did a good analysis showing that options granted very close to the annual low in the share price were only 5% of total options. None of these suspect options were granted to Steve Jobs. Excluding Jobs, a larger 15% were granted within 5% of the annual lows.

According to Apple's press release, Jobs did receive one huge grant of 20 million options in 2000 which was apparently cancelled and provided him no financial benefit. However, the New York Times noted that in 2003 when Jobs options were cancelled they were worthless. Further, the options were replaced by a stock grant worth $75 million dollars that had a three year vesting period.

10 million shares of the Jobs grant were announced on January 19th, 2000 in a press release issued by Apple. The press release said that the exercise price was about $87 as of the date of the grant which was January 12th. On January 19th, Apple already was trading at $106, giving Jobs a $190 million paper profit. The gist of the options scandal is that company's were granting options after the fact and backdating them to the lowest prices of the past year providng no risk profits to managers while diluting shareholders. It is not clear if Apple did any backdating in this case. An internal investigation will be conducted to determine if any impropreity occurred.

Analysts are focused on whether the investigation undercuts shareholder support for Steve Jobs and Tim Cook. Assuming management is left in place, analysts seem unconcerned. Apple longs are lucky that the company is something like the 50th to be implicated rather than the 1st.

Mac Sales Looking Good For Apple

News broke last week that Microsoft (MSFT) won't have a fresh operating system or a fresh update to Office for the Christmas selling season. On the other hand, all indications are that the new consumer laptops from Apple (AAPL) are selling above initial analyst estimates (which were probably conservative).

APPL shares are trading near their 2006 low. The stock's weakness has been mainly related to fears about iPod sales. While I would prefer to see stronger iPod sales, I stand by my bullish thesis built on accelerating Mac sales. One million iPods are worth $200 million in revenue to Apple. With an ASP of $1300, or over six times an iPod, it takes only an incremental 150,000 Mac sales above expectations to make up any revenue shortfall from iPods. And Macs have higher margins.

I've been wrong on Apple this year but I think the setup is good heading into the company's seasonal strong period driven by back-to-school and holiday sales. Most analysts have reduced iPod shipment and earnings estiamtes. The expectations bar has been lowered so that a decent earnings report and in line guidance should support the shares. Positive news about better than expected Mac sales and/or a refresh of the iPod line could boost the shares.

I am sticking with AAPL but expect lots of volatility surrounding the company's June quarter earnngs report.

Analysis of Apple's Earnings

I believe the reason why the AAPL earnings report was initially greeted with enthusiasm was better than expected Mac sales. Since it's AAPL and overly analyzed and picked apart by shorts, longs, analysts, investors, and day traders, there is lots of noise today about the future growth rate of iPods and the retail stores. However, I think it is clear that the next big move in AAPL, if it occurs, will be because of accelerating in Mac sales.

Last quarter, total Mac sales grew 4% year-over year with ASPs up about 1% to $1,413. Notebooks led the way with units up 8%. Notebooks probably benefited from an overall industry in their favor, introduction of the MacBook Pro, and the still attractive $999 iBook. Desktops grew just 1% year-over year.

I think that 4% growth in Mac sales came as a relief to investors. Given all the chatter about the transition and the fact that iPod shipment estimates had dropped sharply in the last month, it was in Macs where the risk existed. With new products set to ship within the next few months, investors can now look forward to accelerating Mac sales over the balance of 2006 due to new products in seasonally stronger quarters (first back to school then holidays)....

In the March quarter, total Mac revenue was a little under $1.6 billion. I think that will rise to over $1.7 billion next quarter and maybe $1.9 billion or more in the December quarter. Off the March quarter total revenue base of $4.35 billion, just the acceleration in Mac sales adds about 4% to sequential revenue growth. I think that is significant and shows why the decent March quarter Mac sales were so well received. One thing often overlooked in discussions of AAPL's revenue growth is that ASPs for Macs are almost 7 times higher than ASPs for iPods. That means 1 million iPods equals 142,000 Macs. So even as iPod sales growth steadily decelerates, if Mac sales grow off the 1.1 million quarterly pre-Intel unit base, AAPL still grows nicely overall. A few months ago I wrote this and it resonates again as the key takeaway from the March quarter:

Last year (2005), according to Gartner, worldwide PC sales grew to 218.5 million units, up 15.3%. On the basis of that data, AAPL had a market share of 2.2%. Assuming flat PC sales, each 50 basis points in market share is worth 1.1 million units, nearly a quarter of AAPL's total 2005 unit volume. Assuming the company can maintain an ARPU of $1,350 that works out to $1.5 billion in revenue, for a growth of 12% off the iPod plus Mac 2005 revenue base. If you believe the halo effect is worth anything, gaining 50 basis points of market share on a global scale each year is not such a stretch. And don't forget, margins on Macs are higher than margins on iPods, so on the operating income line, any market share gains in PCs will be magnified.

Two other things in the quarter looked good to me. Other Music sales which includes iTunes Music Store and iPod accessories and licensing was really strong again, seeing virtually zero decline against the holiday driven December quarter. Accessories are really high margin and remain an area underappreciated by investors.

Software sales were also strong, up 35%. This is a high margin business so incremental growth relative to expectations is worth a lot to the stock. This business jumped to a new level in the June 2005 quarter (new operating system issued) so comparisons toughen from here on out. However, software sales are attached to Mac sales to some degree, so if accelerating Mac sales materialize, another underappreciated business will be contributing.

As for iPod sales, 8.5 million was on the light side. Management seemed to support analysts who calculated that seasonality was normal if some channel fill and an extra week in the December quarter are taken into the account. AAPL's guidance suggests that iPod sales will be flat sequentially, which will drop year-over-year growth to 38%, down from 61% this quarter. New products and back-to-school should cause a sequential pickup in growth in the September quarter. Then things get really interesting as the 14 million unit December 2005 blowout comes into play. This will cause concern over decelerating iPods sales to come to the fore. Once again, it shows why Mac sales have moved to the forefront of the AAPL story.

Apple Computer Earnings Preview

Apple reports it second quarter earnings for the period ending March 31, 2006 in less than two hours. The stock is likely to have a signficant reaction to the earnings and to the guidance the ocmpany provides for its June quarter. I am very confident that Apple shares will agian trade up sharply before the end of 2006. As seasonal demand for computers and iPods kicks in staring with the back-to-school season, I think investors will return to Apple shares. As for what happens tonight and in the next few months, barring an unusual surprise in either direction, I don't think it really matters. You will hear lots of chatter tonight and tomorrow about iPod demand, Mac sales, new product introductions, margins, and channel inventories. I think it will mostly be just noise, at least as it relates my longer term bullish view.

Despite my best efforts to get you and myself to ignore tonight's action, I want to provide a more detailed preview. Once again, I am going to lean on my friend and fellow StreetInsight.com contributor, Jeff Bagley. Jeff and I trade-off coverage of Apple's earnings for StreetInsight. This quarter it is his turn, so rather than reinvent the wheel, I'll just post Jeff's outstanding preview comments in the "Continue Reading" section.

Courtesy of Jeff Bagley and StreetInsight.com:

Expectations have been coming down for Apple Computer's (AAPL) March and June quarters, based on slower growth projections for the ubiquitous iPod and a slow launch of the new Intel (INTC)-based notebook computers. As a shareholder of the company, which is in the process of revolutionizing the delivery of entertainment content, lowered expectations are music to my ears.

Apple Stock: Highflier Status Suspended

The trouble with Apple stock all started early this year with the Macworld Expo. It was then that the company alerted the world that iPod demand was not only strong for the just-ended Christmas quarter but that iPod shipments blew away even the most optimistic forecast. Analysts raised their estimates across the board, and the stock rallied strongly, reaching the mid-$80s.

But then the actual earnings release came. The results were essentially what Wall Street was looking for, but forward guidance was significantly below recently increased estimates. Specifically, management guided to $0.38 on revenue of $4.3 billion. Given the spike in estimates following Macworld, analysts were looking for the company to earn far more: $0.48 on revenue of $4.7 billion.

Low-balling guidance had been management's forte for some time, given that Apple has trounced its own projections for several quarters in a row. Accordingly, many investors, including myself, thought that this was standard operating procedure. But as the quarter unfolded, it became apparent that there were good reasons why the company would have a relatively soft quarter.

The company, transitioning to Intel-based chipsets for its PCs, was facing a slowdown in its legacy system sales. Also, a seasonal slowdown in iPods was not longer merely a dream of Apple bears; it was almost a certainty following a 14.5 million-unit Christmas quarter. And worse yet, new products came out slower than expected. The stock fell sickeningly for almost the entire quarter, shedding about 30% from its high to its low. The stock's chart became broken, and sunk until it bounced off its 50-day moving average.

iPod Shipments Down Sequentially

Analysts are now looking for Apple to earn $0.43 a share on revenue of $4.5 billion, representing year-over-year growth of 26% and 39%, respectively. As mentioned, most estimates for the company have come down during the quarter. Most analysts are looking for iPod unit shipments in the range of 8.8 million to 9.6 million units. The average forecast is probably about 9.6 million units, but most fresh estimates are below that.

The company probably benefited from some channel fill, as it shipped a large amount of product to the normal retail channel following the Christmas selling season, in which it kept a great deal of product for its own Apple Stores in the face of extremely high demand.

Most channel checks indicate significant iPod inventory, and supply chain checks corroborate most analysts' views that iPods faced a fairly substantial decline in final demand. This has led many to believe that the June quarter guidance will likely be subdued as the retail channel works off its significant inventory.

PC Shipments: A Transition Quarter

Product transitions wreak havoc on any company's operations, and Apple is no exception. As a result Apple's transition to Intel-based chipsets for its PCs, consumers have held off their purchases of legacy (i.e., soon to be obsolete) Mac laptops and desktops in order to get the new, new thing.

Of course, product transitions never go that smoothly, and Apple was rather slow in rolling out its new MacBook Pro. With only two SKUs with the new chipsets -- and one of them didn't ship until the middle of the quarter -- expectations for CPU units have been reined in considerably. Most analysts are now looking for PC unit shipments of about 1.0 million to 1.1 million.

Beware of Weak June Quarter Guidance

There is some good news and some bad news regarding forward guidance. The bad news is that in the June quarter, earnings growth will likely be held back by the same culprits that conspired to slow its March quarter growth. Especially burdensome is the stuffing of the iPod retail channel.

The good news is that there aren't many investors out there who aren't already aware that third-quarter guidance will be punk. This, again, sets us up for low expectations, and that, again, is music to my ears.

Investors Will Likely Begin to Focus on the Second Half
Insofar as the market is a discounting mechanism and as investors tend to anticipate changes in fundamentals months before they actually occur, Apple stock should start to regain its luster. There are many catalysts for the stock, but most of them are based on continued new product innovation.

First, there is the video iPod with a larger screen. Put some downloadable movies on the iTunes Web site, and the digital revolution takes another step forward.

Then there's the continued transition to the Intel chipsets. I believe there will be a variety of new Macs to choose from for the all-important back-to-school selling season. With the delay in the consumer version of Microsoft (MSFT) Vista, and to a lesser extent the release of "Boot Camp" software, Apple is in an excellent position to gain share.

And finally, there is the holy grail of Apple longs: the long-awaited iTunes Cell Phone. Forget being constrained to only 100 songs, which was the case with the Motorola (MOT) ROKR cell phone, which fell flat. Combining the iPod and a cell phone could well be the silver bullet. That is, the next new, new thing that could be even bigger and better than the iPod.

Therefore, while Apple bears grouse about peaking penetration rates, Apple bulls take comfort in the fact that the company is doing the right things. And that's creative destruction. A necessary ingredient to successful long-term growth of any product portfolio is the ability to render old products obsolete with genuinely new and improved products. One can't be afraid to cannibalize sales. If you don't do it, your competitors will.

So while we have a couple of tricky quarters to get past, the future looks bright for AAPL, especially since the current valuation -- with $10 a share in net cash -- discounts many investor concerns that appear mostly short term in nature.

A Debate Over Apple Computer

Over and StreetInsight.com, where I write daily commentary, there has been a series of posts debating the value of Apple Computer (AAPL) shares. A StreetInsight colleague got the ball rolling with a cautious post. Another colleague and I took up his challenge and responded. What follows is the exchange as it is currently archived on the website:

We had an exchange on our site (March 29 and March 30) regarding methods for valuating Apple Computer's stock. Tom Au got the ball rolling when he posed the following open question to AAPL bulls: "Does anyone think that Apple's return on equity could go as high as 30% in the next year or so, based on a book value today of about $11 a share?" To which Apple bull Jeff Bagley replied that "any valuation method that depends primarily on ROE is mostly meaningless when it comes to Apple Computer." Jeff admits that it has been a painful few months for AAPL bulls, but he puts his valuation in the company's positive free cash flow yield of more than 4.0%. The following day, Steve Birenberg also weighed in by agreeing with Jeff. Steve pointed out that an ROE-based valuation doesn't mean all that much because AAPL is a momentum stock.