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September 29, 2005

My Take On The Merrill Lynch Downgrade of Apple Computer

I am not sure if it was the Merrill Lynch downgrade from buy to neutral or the iPod nano screen problems that led to the sharp decline in Apple Computer (AAPL) but the reaction was sharp with the shares dropping close to 5% on well above average volume. I'm no technician but the chart definitely looks broken, at least for the very short term.

I read through the new Merrill report. It is very well done. It is also not really a negative piece.....

....Merrill transitioned AAPL coverage to a new analyst who decided to move to a neutral opinion. The core of the downgrade concerns the risk of slowing momentum and how it relates to what the analyst sees as a full valuation. That said, the analyst notes that fundamentals are quite strong and that he is adopting what he sees as a conservative view relative to the halo effect. On iPod penetration, he just seems worried about to how to factor a slowing growth rate due to the rapidly growing installed base. Estimating a slowdown off of a growth rate in excess of 100% is difficult and in consumer electronics there is a pattern of rapid and unforeseen shifts in demand for certain products.

Getting back to the Merrill report, I found the data on the halo effect most interesting. The analyst believes it is real but due to the upcoming Intel transition and Microsoft's introduction of the big Windows upgrade, he is assuming the halo effect may pause slightly as measured by gains in PC market share for the Mac platform. Here is some data from the report:

• Over the 8 quarters spanning from March 2003 to June 2005, Mac unit share increased 40 bps and Mac revenue share grew 80 basis points, while iPod shipments grew to 20 million units
• Every half point gain in revenue share of PCs boosts AAPL sales by $1.5 billion including peripherals and software and adds 25 cents to EPS.
• AAPL's projected 2005 revenue is $14 billion with consensus EPS of $1.47.

Most analysts project that the iPod installed base will grow by 50 million units to 80 million by the end of 2007, up from around 28 million presently. This would imply the potential for 200 basis points of revenue share expansion for AAPL. Since a half point gain of revenue share is worth 25 cents, the concept is that the halo effect could add $1.00 to EPS in 2007.

The Merrill analyst discounts these numbers due to the Intel transition and the upcoming Windows upgrade. He also notes that AAPL may have gained share independent of iPods due to the success of the Mac mini and the flat panel iMac.

All of this analysis seems fair to me and it is clear the downgrade is driven by the fact that the margin of error for estimates related to the iPod sales and the halo effect is large in terms of units, revenues, and EPS. Nothing wrong with that. What he seems to be arguing is that he doesn’t see further multiple expansion given the margin of error and he is not will to raise estimates. He also seems unsure of how much of a potential $1.00 boost to 2007 EPS due to halo effect is already in consensus estimates. Both of those positions are understandable but I wouldn’t call them negative.

I think AAPL has great fundamentals and that 2005. 2006, and 2007 EPS estimates will prove low. I also recognize the risks of owning a momentum stock, arguably the momentum stock of this market. That is why I reduced my position in the upper $40s. I can live with the risk that momentum falters more quickly than I can expect. I can also still participate nicely against my benchmark if I am right that the AAPL story has several years to run. With a stock like AAPL you have to choose sides. I choose long.

Posted by Steve Birenberg at September 29, 2005 02:09 PM in AAPL