« Motorola: Mixed Quarter, Negative Reaction Deserved | Main | Analysis of Apple's Earnings »

April 19, 2006

Apple Computer Earnings Preview

Apple reports it second quarter earnings for the period ending March 31, 2006 in less than two hours. The stock is likely to have a signficant reaction to the earnings and to the guidance the ocmpany provides for its June quarter. I am very confident that Apple shares will agian trade up sharply before the end of 2006. As seasonal demand for computers and iPods kicks in staring with the back-to-school season, I think investors will return to Apple shares. As for what happens tonight and in the next few months, barring an unusual surprise in either direction, I don't think it really matters. You will hear lots of chatter tonight and tomorrow about iPod demand, Mac sales, new product introductions, margins, and channel inventories. I think it will mostly be just noise, at least as it relates my longer term bullish view.

Despite my best efforts to get you and myself to ignore tonight's action, I want to provide a more detailed preview. Once again, I am going to lean on my friend and fellow StreetInsight.com contributor, Jeff Bagley. Jeff and I trade-off coverage of Apple's earnings for StreetInsight. This quarter it is his turn, so rather than reinvent the wheel, I'll just post Jeff's outstanding preview comments in the "Continue Reading" section.

Courtesy of Jeff Bagley and StreetInsight.com:

Expectations have been coming down for Apple Computer's (AAPL) March and June quarters, based on slower growth projections for the ubiquitous iPod and a slow launch of the new Intel (INTC)-based notebook computers. As a shareholder of the company, which is in the process of revolutionizing the delivery of entertainment content, lowered expectations are music to my ears.

Apple Stock: Highflier Status Suspended

The trouble with Apple stock all started early this year with the Macworld Expo. It was then that the company alerted the world that iPod demand was not only strong for the just-ended Christmas quarter but that iPod shipments blew away even the most optimistic forecast. Analysts raised their estimates across the board, and the stock rallied strongly, reaching the mid-$80s.

But then the actual earnings release came. The results were essentially what Wall Street was looking for, but forward guidance was significantly below recently increased estimates. Specifically, management guided to $0.38 on revenue of $4.3 billion. Given the spike in estimates following Macworld, analysts were looking for the company to earn far more: $0.48 on revenue of $4.7 billion.

Low-balling guidance had been management's forte for some time, given that Apple has trounced its own projections for several quarters in a row. Accordingly, many investors, including myself, thought that this was standard operating procedure. But as the quarter unfolded, it became apparent that there were good reasons why the company would have a relatively soft quarter.

The company, transitioning to Intel-based chipsets for its PCs, was facing a slowdown in its legacy system sales. Also, a seasonal slowdown in iPods was not longer merely a dream of Apple bears; it was almost a certainty following a 14.5 million-unit Christmas quarter. And worse yet, new products came out slower than expected. The stock fell sickeningly for almost the entire quarter, shedding about 30% from its high to its low. The stock's chart became broken, and sunk until it bounced off its 50-day moving average.

iPod Shipments Down Sequentially

Analysts are now looking for Apple to earn $0.43 a share on revenue of $4.5 billion, representing year-over-year growth of 26% and 39%, respectively. As mentioned, most estimates for the company have come down during the quarter. Most analysts are looking for iPod unit shipments in the range of 8.8 million to 9.6 million units. The average forecast is probably about 9.6 million units, but most fresh estimates are below that.

The company probably benefited from some channel fill, as it shipped a large amount of product to the normal retail channel following the Christmas selling season, in which it kept a great deal of product for its own Apple Stores in the face of extremely high demand.

Most channel checks indicate significant iPod inventory, and supply chain checks corroborate most analysts' views that iPods faced a fairly substantial decline in final demand. This has led many to believe that the June quarter guidance will likely be subdued as the retail channel works off its significant inventory.

PC Shipments: A Transition Quarter

Product transitions wreak havoc on any company's operations, and Apple is no exception. As a result Apple's transition to Intel-based chipsets for its PCs, consumers have held off their purchases of legacy (i.e., soon to be obsolete) Mac laptops and desktops in order to get the new, new thing.

Of course, product transitions never go that smoothly, and Apple was rather slow in rolling out its new MacBook Pro. With only two SKUs with the new chipsets -- and one of them didn't ship until the middle of the quarter -- expectations for CPU units have been reined in considerably. Most analysts are now looking for PC unit shipments of about 1.0 million to 1.1 million.

Beware of Weak June Quarter Guidance

There is some good news and some bad news regarding forward guidance. The bad news is that in the June quarter, earnings growth will likely be held back by the same culprits that conspired to slow its March quarter growth. Especially burdensome is the stuffing of the iPod retail channel.

The good news is that there aren't many investors out there who aren't already aware that third-quarter guidance will be punk. This, again, sets us up for low expectations, and that, again, is music to my ears.

Investors Will Likely Begin to Focus on the Second Half
Insofar as the market is a discounting mechanism and as investors tend to anticipate changes in fundamentals months before they actually occur, Apple stock should start to regain its luster. There are many catalysts for the stock, but most of them are based on continued new product innovation.

First, there is the video iPod with a larger screen. Put some downloadable movies on the iTunes Web site, and the digital revolution takes another step forward.

Then there's the continued transition to the Intel chipsets. I believe there will be a variety of new Macs to choose from for the all-important back-to-school selling season. With the delay in the consumer version of Microsoft (MSFT) Vista, and to a lesser extent the release of "Boot Camp" software, Apple is in an excellent position to gain share.

And finally, there is the holy grail of Apple longs: the long-awaited iTunes Cell Phone. Forget being constrained to only 100 songs, which was the case with the Motorola (MOT) ROKR cell phone, which fell flat. Combining the iPod and a cell phone could well be the silver bullet. That is, the next new, new thing that could be even bigger and better than the iPod.

Therefore, while Apple bears grouse about peaking penetration rates, Apple bulls take comfort in the fact that the company is doing the right things. And that's creative destruction. A necessary ingredient to successful long-term growth of any product portfolio is the ability to render old products obsolete with genuinely new and improved products. One can't be afraid to cannibalize sales. If you don't do it, your competitors will.

So while we have a couple of tricky quarters to get past, the future looks bright for AAPL, especially since the current valuation -- with $10 a share in net cash -- discounts many investor concerns that appear mostly short term in nature.

Posted by Steve Birenberg at April 19, 2006 02:01 PM in AAPL