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September 12, 2005

Apple Introduces the iPod Nano

Today I contributed the following commentary on Apple Computer to StreetInsight.com, the professional service of theStreet.com. Since Northlake clients are long Apple in their portfolios, I thought the note might be of interest. I have also included the text of two other comments on Apple that were contributed by other money managers who contribute to the various websites owned by theStreet.com:

Based on reports from various Apple Stores around the country it appears the iPod nano is major hit. Numerous stores had lines at the cash register and traffic was extraordinary. At the Apple Store where I bought my nano, the sales people reported that much of the initial traffic was from people who already own iPods. I think that the nano will drive a major "upgrade" cycle for current iPod owners in addition to bringing even more buyers (according to AAPL only 6% of the people in the United States own an iPod). The nano, with 500 or 1000 song capacity is a nice compliment to a currently owned 20 or 40GB model. It is also a nice upgrade over a shuffle. I think the nano will be the hot product this Christmas and current estimates for total iPod unit shipments over the next two quarters are low....

....Last quarter, AAPL reported a gross margin just short of 30% and SG&A as a % of sales of 13.4%. For sake of argument, let's say AAPL ships an incremental 1 million iPods due to the popularity of the nano. Using the average retail price of the 2GB and 4GB versions of $225, AAPL would realize an incremental $225 million of revenue. Applying a 30% gross margin, a 15% SG&A ratio, and a 33% tax rate, an incremental 1 million iPods would produce $22 million in net income and 3 cents per share in earnings.

I believe this math could be conservative. First, I believe iPods have a higher than corporate average gross margin. Titus Menzies (another contributor to Street Insight) calculated that AAPL might earn a 43% gross margin on the 2 GB nano. Second, I believe an incremental 1 million shipments may prove low. Through the end of last quarter, AAPL had shipped more than 21 million iPods (another 6 million or so likely in the quarter ending 9/24/05). I think at least 10% of those iPod owners will add a nano to their collection. Even if some of those folks would have bought another iPod, there will clearly be first-time buyers attracted to the nano sooner than expected due to the incredibly positive product reviews and word-of-mouth.

So let's say Titus is correct and the gross margin is 43% on an incremental 2 million nanos. Keeping SGA% and the tax rate constant, that creates an additional 10 cents in EPS.

I believe AAPL books revenue based on shipments, not final sales. It is hard to guess how many nanos will be shipped by the end of the fourth fiscal quarter on 9/24. However, I think it s fair to guess that estimates for the fiscal year that begins on 9/25 will rise by about a dime. Consensus is presently $1.63 with the high estimate at $1.75. So assuming current estimates are accurate, at $51, AAPL trades at 29 times forward earnings. There is almost $9 per share in cash on the balance sheet generating 15-20 cents in EPS, so alternatively AAPL is trading at an adjusted price of $42, or 26 times cash adjusted EPS.

I don’t want to call that cheap but given the momentum in earnings and the upside from the halo effect (Macs cost 4 to 10 times nanos), I don’t find that an unreasonable valuation. I sold half of client positions in AAPL last week when it reached my initial target. I don’t regret that but if I was privy to the nano, I wouldn’t have sold. It is that good of a product and another game changer for the digital music industry. It also reinforces the halo effect and extends and acclerates the window for AAPL's momentum at least another couple of quarters. So for now, I'm content holding the shares but I'd have no problem buying them around Friday's close if I didn’t own an average size position already.

If you want to read some more on Apple, here are a couple of other comments on Apple from my fellow contributors at Street Insight:

Posted By Cody Willard on Friday, September 9:
Apple (AAPL:Nasdaq) announced two very different products Wednesday, each of which has very different implications for the company.
• The iTunes Motorola phone is a strategic advancement of Apple's de facto standardization of legal MP3 music.
• The iPod Nano is an earnings and revenue driver for the next year.
First, the phone. After all the hype, excitement and tensions around the Apple and Motorola (MOT:NYSE) announcements on Wednesday, the companies jointly rolled out a single handset for Cingular's and O2's network, as I'd been reporting on these pages before the news actually hit.

The phone isn't exactly the coolest piece of technology I've seen rolled out this year (that award now goes to the iPod Nano, as I'll detail below). But simply because it's got the iTunes technology and brand, people are going to be buzzing about the phone this holiday season, and it's sure to be a hot item on a lot of Christmas lists.

The biggest knock against the phone in the mainstream press and by some on these pages is that it "only" holds 100 songs. To be clear, this is not an item that is supposed to replace an MP3 player. It's supposed to complement the iPod, which is now in the hands of more than 21 million Americans. That is the single most important aspect to the rollout, and it's been completely missed by everyone.

This phone isn't targeted for the hundreds of millions of Americans who have yet to purchase an iPod, and it's not supposed to be the introduction of MP3-playing cell phones. It's targeted for those who already have or are about to buy or receive an iPod. Sure, there will be those who will use this phone as their first MP3-playing device. But that's not the key demographic.

Apple's music business strategy from the beginning has been to establish itself as the de facto standard for legal music downloading. I've repeatedly said that Apple had essentially accomplished that, but that it has been a nebulous concept. However, Apple's licensing its technology to these three giant wireless companies -- enabling them to become the first movers for downloading music over wireless networks -- crystallizes Apple's dominance. The rollout of this product marks its victory in the digital music wars.

The next question is, why did they cap the phone at 100 songs? Apple is making millions of dollars in earnings by selling iPods. The last thing they want to do is cannibalize that product with a competing cell phone manufactured by another company. Thus, the cap at 100 songs. That cap makes this phone a phone and not an MP3 player. You want a true MP3 player? Buy an iPod. Simply another brilliant strategic move by Apple in its music strategy.

Then there's the Nano. Millions of Americans who don't yet own an iPod were ready and willing to buy one before the year-end or ask for one for Christmas. And the iPod Nano is going to be a hot item for those non-iPod-owners. Even better for Apple, it's revolutionary enough that it's going to drive a major replacement cycle among current iPod owners.

Anecdotally, many iPod owners, myself included, have already ordered their own iPod Nano. The iPod shuffle was cheap enough that it opened up a whole new low-end consumer market for Apple's platform. The Nano simply recreates the marketplace for the early adopters and wannabe fashion folk.

Did I mention that the halo effect from Apple's already-loved iPod is now heading for overdrive, as the Nano takes cool to new levels? So many ways to win with Apple. I'm sticking with my sizable long position.

Posted by Jeff Bagley on Monday, September 12:
Steve Birenberg beat me to the punch on commenting on Apple Computer's (AAPL) new iPod nano. I agree with most everything he said, and I believe this will be the single hottest product to hit the shelves in years. Steve also does a good job in analyzing the earnings impact that the nano might have on Apple's financials. Judging from the early acceptance of the product, Steve's margin assumptions are likely too conservative. Also, I believe the "halo effect" is very real.

I purchased my iPod nano on Friday at the King of Prussia mall here in suburban Philadelphia. It was a fairly sleepy day at the mall, with unimpressive foot traffic. Suddenly, I found where all the people were hiding: in the Apple store. The place was jamming!

There were people everywhere, and the lines at the counter were fairly long. The place was well staffed with a very knowledgeable sales crew. Everyone was in a good mood, even waiting in line. In less than 24 hours, they were already out of the 4GB nano in black, so I had to settle for the white. (It's still really cool!)
I couldn't pin anyone down on the actual number of units sold, but I received replies such as "flying off the shelves" and "steady stream of customers" and "it looks as if this product will be big ... real big!"

The iPods weren't the only things selling. Folks were buying laptops and all other sorts of Apple products and accessories. A couple of salesmen indicated that sales of laptops have been "very strong" for a while now. The halo effect is alive and well.

For those of you who are not familiar with the new nano, I urge to you go to an Apple store -- or perhaps there are units now available at your local Best Buy (BBY) or Circuit City (CC) -- and take a look for yourselves. The nano is tiny, holds about 1,000 songs, and is the most user-friendly thing I've laid my hands on in a long time. It's flash-based, which means you can take it jogging. The interface with iTunes is seamless.

I have a nice gain so far in Apple stock, but stepping into the Apple store on Friday made me want to go out and buy more. I hate chasing, so I'm going to scale into Apple stock at these levels. Hopefully, it will come in a bit after such a huge run. I don't believe it will come in all that much, however. Estimates will be going up, and this stock will garner increasing mindshare, especially on Main Street.

Products such as the iPod nano are what growth stocks are made of.

Posted by Steve Birenberg at September 12, 2005 04:15 PM in AAPL