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January 19, 2006

Apple Computer Earnings Summary

Apple Computer (AAPL) reported excellent quarterly earnings as expected. The shares are trading lower, however, due to some controversy over APPL's guidance for revenue and earnings in the current quarter. I believe the decline in the shares sets up the first decent buying opportunity in the stock since last spring as upside of at least 20% now exists and reasonable expectations for the company's financial performance. Here is my summary of the conference call including discussion of the issues that are apparently bothering investors:

The tone of the Q&A on the call clearly implies that top line revenue guidance is built on conservative assumptions. Most of the conservatism is coming on the Mac side as management is once again building in a demand pause related to the Intel transition. Remember that only 2 SKUs have so far been announced for Intel. It sounds like that may be it for this quarter which means no iBooks will be available. Additionally, the MacBookPro laptops won’t ship until February and management is not sure it can ship enough to meet all the initial orders. There is also likely caution built in as it relates to discount pricing to clear remaining non-Intel inventory. I want to stress that management stated that the new Macs introduced at MacWorld were "very well received." I take this to mean that actual orders are very strong....

The March quarter revenue for iPods is harder to gauge. Analysts asked a lot questions to try to get at a unit number but management dodged them all. This is not unusual as AAPL is very tight lipped on all things iPod for competitive reasons. Several answers to questions concerning inventory and pent-up demand leads me to believe that a drop of as much as 40-50% from the 14 million units in the December quarter is baked into guidance. That would imply units of 7 million to 10 million. I believe analysts were assuming anywhere from 9 million to 11 million. Each 1 million represents over $200 million in revenue and gross profit of $40 million. Forgetting the issues with higher margin Macs and right there you probably can explain much of the guidance shortfall. One other interesting tidbit related to iPods in the current quarter relates to the fact that AAPL got the week after Christmas for the December quarter and management characterized the iPod demand that week as "very strong" and "a big week." I am just guessing but if AAPL sold more than 1 million iPods in the week after Christmas it wouldn’t be too surprising for management to assume they had met some of the pent-up demand.

So far I have focused on revenue because a big part of the guidance shortfall on EPS likely relates to operating leverage assumed by analysts. One analyst, whose name I did not scribble down, asked a very astute question when he noted that the guidance implies that operating expenses will grow 29% year-over-year, almost matching the 33% growth in revenues. This would mark a dramatic drop in operating leverage from the prior two quarters. In the December quarter, sales grew 65% vs. a 37% gain in operating expenses. In the September quarter, sales grew 83% vs. a 27% gain in operating expenses. I think this clearly implies that if revenues surprise to the upside in the March quarter, the marginal profitability will be very high.

I am not going to recap the headline financial figures but a couple of other things on the call were worth noting. First, cash was up $400 million despite a prepayment of $750 million for flash memory. Another $500 million payment will hit in the March quarter. Nonetheless, cash ended the quarter $8.7 billion or $9.96 per fully diluted share. Second, as alluded to in my preview, I think an emerging story at AAPL could be iPod accessories. AAPL reported $491 million in revenue for iTunes, iPod Services, and Apple-branded and third-party iPod accessories. That is an 85% sequential increase, much greater than the 56% sequential growth in total sales. On the call, management noted that initial demand for the accessories introduced at MacWorld was quite strong. In most industries accessories carry higher margins than base products. I suspect this will be the same for AAPL so as the company focuses more on accessories and the ecosystem of iPods doubles again in 2006 and more new iPod form factors are introduced this could produce a positive surprise.

A quick word on valuation to wrap things up. Despite the cautious guidance I think 2006 EPS estimates will settle near $2.20. Assuming the $8.7 billion in cash grows through the year and earns 4%, interest income could produce 30-35 cents of that EPS. Let's call it 40 cents. Back that out of $2.20 and you got $1.90 in operating EPS on a non-GAAP basis (ignoring stock option expense). Back $10 out of the stock price and you have a P-E of 36. Cheap? Definitely not. Risky? For sure, we learned that lesson on Yahoo yesterday. Does it provide upside? I'd say yes because fundamentals are outstanding, estimates could have upside and the opportunity in front of AAPL for digital media and increased PC market share is enormous. There are very few really large cap growth stocks. The ones that exist deserve a premium. AAPL deserves the current quote and then some. Below $80 I am a buyer of the shares with 20% to a mid-$90s target.

Posted by Steve Birenberg at January 19, 2006 12:58 PM in AAPL