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January 13, 2006

iPod Sales Explode: How Much Upside Is Left in Apple Shares?

Lots of news from Apple Computer (AAPL) this week coming from its annual MacWorld convention. Steve Jobs introduced new Intel-based Macs six months ahead of schedule and there were lots of upgrades to iPod accessories and applications within AAPL's iLife suite of digital media and internet products and services. Most importantly for the stock, Jobs announced that during the fourth quarter the company shipped 14 million iPods, way ahead of analyst expectations of 11 million. Jobs also announced that revenues for the quarter will be $5.7 billion, again well ahead of analyst estimates which averaged $5 billion. We will get a lot more information from AAPL when the company reports earnings after the close next Wednesday, however, I wanted to provide a few thoughts on this week's news before it becomes stale….

Estimate increases were a lot more than I expected. FY06 was around $1.80 prior to yesterday and many analysts are now going into the $2.20s. FY07 was at around $2.20 and now many estimates are moving to $2.50 to $2.80. Analysts massively increased iPod assumptions across the board and in general are looking for shipments to more than double in 2006 to 45 to 50 million units. I also think the earlier introduction of Intel (INTC) based Macs led to increases in Mac shipments assumptions.

The estimate increases put AAPL just under 40 times this year's earnings without adjusting for the $10 in cash on the balance sheet. This multiple is consistent with valuation levels for the shares even before two major surprises since summer: the nano introduction and the huge upside surprise in iPod shipments and revenues just announced. So on the one hand, you could argue that not much has changed. EPS have actually kept up with the stock price increase.

On the other hand, I think AAPL stock faces some challenges once this move levels off. Mostly, it is the same old fear about slowing momentum of iPods. Analysts seem comfortable that iPod shipments have moved to a new, higher base level. I thought the write-ups were vague as to why that would be the case. Some noted that there was backlog of nano demand. I presume this is based upon the lack of supply at many retailers during the holiday season. It is possible, however, that this demand was diverted to AAPL's stores and website.

Of course, AAPL has sold only 42 million iPods so far. In the broader picture of 300 million U.S. population and multiples of that abroad in developed economies the penetration remains low. Additionally, the larger the base, the greater the potential replacement demand. For example, our family upgraded a shuffle to a nano and replaced an iPod with a vPod. Remember AAPL did not introduce new iPods at MacWorld. I'd take that as an indication that they have plenty of demand and see no need to stimulate sales at this time. Also, the addition of more accessories allowing greater functionality for current iPods increases the potential audience. Turning your nano or vPod into an FM radio or easing the ability to hook it up to your stereo are great ways to convince new users to come aboard and old users to upgrade.

Despite my focus on iPods, I think the next move in AAPL shares will hinge on the new Intel-based Macs. AAPL has always seen a surge in demand when significant new form factors were introduced. Sales volumes have tripled or more in the quarters following prior shifts and that was when you just had the dedicated Mac users upgrading. Now, you have tens of millions of households that never used a Mac at least aware of the Mac platform. Furthermore, developments in broadband technology, digital media, and internet usage have changed the consumer experience with PCs and reduced the importance of the operating system. It is applications based now.

I think the halo effect will appear and that AAPL still has a ways to go. 2007 numbers could end up near $3.00 by the middle of 2006. On that basis, the shares could head well north of $100. I've trimmed AAPL positions twice already, once at $48 and again at $71. When I trimmed at $71, I said my next target was $88 to $90. Given the good news recently, I am going to look for a mid-$90s target now. Holding the multiple on the new higher estimates gets me there and as outlined above I think the Intel-based Macs insure good numbers for the next couple of quarters. A target in the mid-$90s is worth holding for current positions but doesn't produce enough upside to buy more stock in light of the risks created by the enormously high expectations and valuation for the stock. I do think the latest news provides great downside support so adding shares on a pullback at around $80 is something I am considering.

Posted by Steve Birenberg at January 13, 2006 09:31 AM in AAPL