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October 16, 2005

An Exciting and Illuminating Week for Apple Computer

In the extended comments section at the bottom of this post is the commentary I wrote for StreetInsight.com immediately following Apple Computer's conference call discussing its September quarterly earnings. As it turned out, I was right that the Street was overreacting when the shares were trading down 10% in after hours trading during the conference call. The next day, when the market opened, AAPL never traded down less than 6% and closed the day with a loss of just 4.5%. The volatility continued on Thursday when AAPL shares gained 9%, closing more than $2 above the pre-earnings close, after the company announced new iPods with video download capability and a refreshed iMac computer that comes darn close to merging your TV with your computer....

As noted in my initial post earnings commentary, the fact that iPod shipments fell short of expectations in the September quarter was the key source of the initial decline in APPL shares. I attributed the shortfall to the slowing of iPod mini shipments in anticipation of replacement of the mini line by the nano. Remember that the nano came as a total surprise to Wall Street as no one anticipated the radical redesign and the elimination of the mini line. Obviously, AAPL management knew this and thus was unconcerned about the iPod shipment figure since they knew that nano demand was "staggering." On the call, management further explained the shortfall in iPod shipments by noting that initial nano shipments were constrained by component supply issues. I'd guess that AAPL could obtain only much flash memory from Samsung given the surprise introduction of the nano.

More of the supposed iPod shipment shortfall came into focus with Thursday's introduction of the new video-enabled iPods. As with the mini, AAPL probably limited shipments of the old 20GB and 60GB iPods in order to clear the channel for the October launch of the Video iPods. This past Saturday I visited my local Apple Store and learned that 20GB iPods are being discounted by $50 to fully clear inventory ahead of stocking of the new 30GB and 60GB iPods. Although I heard no statement of fact, I also think that my discussions indicate that shipments of old iPods had tailed off in September.

The bottom line from all this is that iPod shipments were not an issue in the September quarter. The market figured this out on Thursday and thus revalued AAPL shares off the earnings report to ahead of prior prices. This makes sense because as I noted in my original StreetInsight.com piece, "an objective read of the press release and analysis of the financial statements and conference call suggest that the company's competitive positioning and long-term fundamentals look better than ever."

Somewhat lost in the media coverage of the "Video iPod" was the introduction of the new iMac. Analysts have been speculating that AAPL is heading toward a digital media/entertainment center for the family room. The new iMac is a good signal that the speculation is correct. A remote control (with just 6 buttons!) and a new software interface allow you sit across the room from your iMac and play any music or video that you have loaded into iTunes. You could also watch a DVD you rented or own or any home video you have uploaded and edited using APPL's iMovie or iDVD software (head over to Apple's website and tour the new Front Row software).

With the simultaneous announcement that through iTunes you will be able to download hit shows like Desperate Housewives and Lost, short films from Pixar, or music videos it seems clear that it won’t be long before your computer is really functioning as digital media center allowing your TV and computer to finally merge. I am sure we will be seeing lots of announcements about more TV shows and eventually movies (note that Front Row has a movies section) that will be available over the iTunes platform. It doesn’t seem much of a stretch to ultimately have the iMac or the digital media server receive the cable or satellite wire currently attached to your TV. At that point, you have a single unit that controls your TV viewing, your music listening, your family photos and home videos, and allows you to surf an internet rapidly filling up with high quality streaming video content and podcasts to meet any consumers personal interest.

The path to this convergence is why AAPL is one of the few large cap companies that can really be classified as a growth stock. Not only is there near-term momentum from continual upgrades of the iPod family and ongoing market share gains in the personal computer market but AAPL also potentially is heading toward a massive replacement cycle of the equipment (and the wires) that is stuffed inside your family room cabinets. When TV is added, the home entertainment opportunity dwarfs the market that AAPL is accessing in digital music. It is also larger than the multi-billion opportunity AAPL has if it continues its market share gains in personal computers.

AAPL the stock is different from AAPL the company. Valuation and momentum in the stock over any near-term period will be volatile relative to the where the company is headed strategically over the long-term. I think AAPL shares are well-positioned for the next quarter as the controversy over the September quarter has cleared the decks for short-term. Nevertheless, AAPL is presently a momentum stock so managing long side exposure aggressively makes sense. AAPL is not the largest position in client portfolios and I have no regrets that I held discipline and sold almost half the position about 10% below current prices. The action after the close last Tuesday in response to AAPL's latest quarterly earnings shows the risks that exist in a momentum stock. However, the new product introductions on Wednesday also show that not all momentum stocks are just hype.

Original StreetInsight.com Earnings Commentary - October 12, 2005

I think the stock reacted as it did due to the intersection of high expectations, a stock price that rose over 40% in the third quarter, and nervous investors following a week plus of sharp declines in the major market averages. In other words, I think an objective read of the press release and analysis of the financial statements and conference call suggest that the company's competitive positioning and long-term fundamentals look better than ever. Investors will choose to put whatever multiple they want on the shares but I don’t see anything here that requires a significant re-pricing of the premium AAPL has earned.

The issue this quarter is iPod shipments. Rising estimates off the nano introduction got ahead of what AAPL could deliver due to self-proclaimed shipment constraints and a purposeful drawdown of iPod mini shipments in anticipation of the nano introduction. Management claims nano demand is "staggering." Either you believe that and accept the reasoning why iPod shipments were up to 1 million light of estimates or you believe management is lying and that iPod demand has slowed. I believe demand is fine and I challenge anyone to head to their nearest Apple Store and tell me otherwise.

Lost in the panic over iPod shipments is another stellar quarter of computer sales. Computer units were up 48% in the quarter due to a big bump in laptop shipments. The IDC forecast is for low to mid-teens gain in the quarter so the market share gain is clearly continuing. As noted by management, computers have higher margins than iPods. In fact, computer revenue is one-third larger than iPod revenue. One reason for the sequentially lower December quarter gross margin forecast is a shift toward music due to iPod demand.

My takeaway from the quarter is that both sides of the company are on track. AAPL shares are correcting to 21 times EPS adjusting for almost $10 of cash on the balance sheet. I find this valuation reasonable for one of the few real large cap growth stocks.

Posted by Steve Birenberg at October 16, 2005 12:09 PM in AAPL