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January 18, 2006

Previewing Apple's December Quarter Earnings

Apple Computer (AAPL) reports after the close today. Following Steve Jobs comments at MacWorld last week estimates have moved up sharply. Jobs guided to $5.7 billion in revenues for the December quarter and analysts who have adjusted their estimates are tightly clustered around this figure. There was no specific guidance on EPS at MacWorld so these estimates are more varied. The range is from 59 to 69 cents, up about 10 cents from before Jobs speech. Estimates have risen sharply for FY06 as well. The range of EPS estimates is now $1.95 to $2.53, up about 30 cents at the midpoint. Revenue estimates for FY06 range from $19.4 billion to $22.3 billion, up $2 to $3 billion.

I think the big question mark for the December quarter is how good were margins on the incremental $700 million in revenue AAPL booked relative to prior estimates. iPod shipments of 14 million accounted for the positive surprise as Mac shipments actually may have been 100,000 units under expectations. Recently, ASPs for Macs have been running around $1,400. Therefore, if units were 100,000 short, this might imply a revenue shortfall of $140 million in this unit. If so, that would mean that the extra iPod unit sales made up closer to $800 million in revenues. At 3.5 million units that implies an ARPU of $228 for incremental iPods. That feels a bit high to me, but I think the math suggests that sales of the new 30GB and 60GB iPods must have been quite strong in the December quarter. These units earn higher margins than the 2GB and 4GB nanos which were also strong sellers during the holiday season. The range of analyst estimates is most likely a function of how the mix of iPod sales is viewed along with the level of Mac sales which carry different margins than iPods....

Regarding the slight shortfall in Mac units, analysts seem unconcerned given the earlier than expected introduction of desktop and laptop Intel-powered Macs. I get the impression that analysts feel there may have been some lost sales to customers waiting for an Intel based machine. I think the shortfall was likely due to the overwhelming demand for iPods. Apple Stores were mobbed at Christmas and I think there was just less of a focus on selling computers and more a focus on getting iPods out the door. For example, each store set up a separate table just to ring up iPods.

Beyond the quarterly numbers, the questions for AAPL relate to future iPod and Mac demand. Analysts bumped up their iPod shipments for every quarter in 2006 and are expecting another year of big growth. Reports of unmet demand at many consumer electronics retailers has led to the assumption that a backlog in demand still exists at the consumer level. Given the strength in sales at the Apple Stores I wonder how much of that supposed demand has already been met. That said, with 42 million iPods sold, we are far from saturation. At most, U.S. penetration is around 10% and the rest of the world lags well behind. Also, AAPL did not introduce iPod upgrades at MacWorld suggesting that plenty of demand remains in the current form factors. It also leaves the ability to drive demand with further upgrades certain to come later this year.

AAPL also seems more focused on supplying its own iPod accessories. Accessories were a big seller during the holidays and MacWorld accessory introductions like the iPod FM Remote and iPod A/V Connection Kit tell me that AAPL wants to capture more of the multi-hundred million dollar revenue stream in accessories. Typically, accessory purchases carry higher margins so this could be a source of upside surprise in the future if my theory is correct.

As for Mac demand, I think the Intel transition and the halo effect will prove quite positive during 2006. AAPL has always had great success with new Mac introductions due to the willingness of its loyal customer base to upgrade. CSFB analyst Robert Semple has published some excellent research on this phenomenon and notes, "in the five major form factor upgrades since 2001 according to our criteria, Apple has averaged a 129% sequential increase in unit shipments along with a 26% ASP increase." Add in the much greater awareness of AAPL products today and this transition could be among the best ever. Plus, I continue to believe that in the consumer market the shift toward using computers for broadband internet and digital media has reduced the importance of the operating system and increased the importance of the application software. AAPL has a big edge in digital media applications so the leveling of the playing field against Windows makes a pickup in market share for Macs a real possibility.

With all that as background, being long AAPL I do worry that we could get a sell the news reaction to the earnings report particularly as it relates to margins and guidance. Heading into this week, AAPL is already up 19% this year after more than doubling off the summer low. My confidence in predicting the short-term reaction to AAPL's 1Q06 earnings report is low. However, based on my belief that demand for iPods and accessories will remain strong and Mac sales will boom, I think downside is limited. Based on what I know now, I'd be a buyer below $80 where I think 20% upside would exist for AAPL shares over the next six to nine months.

Posted by Steve Birenberg at January 18, 2006 09:36 AM in AAPL