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April 24, 2006

Analysis of Apple's Earnings

I believe the reason why the AAPL earnings report was initially greeted with enthusiasm was better than expected Mac sales. Since it's AAPL and overly analyzed and picked apart by shorts, longs, analysts, investors, and day traders, there is lots of noise today about the future growth rate of iPods and the retail stores. However, I think it is clear that the next big move in AAPL, if it occurs, will be because of accelerating in Mac sales.

Last quarter, total Mac sales grew 4% year-over year with ASPs up about 1% to $1,413. Notebooks led the way with units up 8%. Notebooks probably benefited from an overall industry in their favor, introduction of the MacBook Pro, and the still attractive $999 iBook. Desktops grew just 1% year-over year.

I think that 4% growth in Mac sales came as a relief to investors. Given all the chatter about the transition and the fact that iPod shipment estimates had dropped sharply in the last month, it was in Macs where the risk existed. With new products set to ship within the next few months, investors can now look forward to accelerating Mac sales over the balance of 2006 due to new products in seasonally stronger quarters (first back to school then holidays)....

In the March quarter, total Mac revenue was a little under $1.6 billion. I think that will rise to over $1.7 billion next quarter and maybe $1.9 billion or more in the December quarter. Off the March quarter total revenue base of $4.35 billion, just the acceleration in Mac sales adds about 4% to sequential revenue growth. I think that is significant and shows why the decent March quarter Mac sales were so well received. One thing often overlooked in discussions of AAPL's revenue growth is that ASPs for Macs are almost 7 times higher than ASPs for iPods. That means 1 million iPods equals 142,000 Macs. So even as iPod sales growth steadily decelerates, if Mac sales grow off the 1.1 million quarterly pre-Intel unit base, AAPL still grows nicely overall. A few months ago I wrote this and it resonates again as the key takeaway from the March quarter:

Last year (2005), according to Gartner, worldwide PC sales grew to 218.5 million units, up 15.3%. On the basis of that data, AAPL had a market share of 2.2%. Assuming flat PC sales, each 50 basis points in market share is worth 1.1 million units, nearly a quarter of AAPL's total 2005 unit volume. Assuming the company can maintain an ARPU of $1,350 that works out to $1.5 billion in revenue, for a growth of 12% off the iPod plus Mac 2005 revenue base. If you believe the halo effect is worth anything, gaining 50 basis points of market share on a global scale each year is not such a stretch. And don't forget, margins on Macs are higher than margins on iPods, so on the operating income line, any market share gains in PCs will be magnified.

Two other things in the quarter looked good to me. Other Music sales which includes iTunes Music Store and iPod accessories and licensing was really strong again, seeing virtually zero decline against the holiday driven December quarter. Accessories are really high margin and remain an area underappreciated by investors.

Software sales were also strong, up 35%. This is a high margin business so incremental growth relative to expectations is worth a lot to the stock. This business jumped to a new level in the June 2005 quarter (new operating system issued) so comparisons toughen from here on out. However, software sales are attached to Mac sales to some degree, so if accelerating Mac sales materialize, another underappreciated business will be contributing.

As for iPod sales, 8.5 million was on the light side. Management seemed to support analysts who calculated that seasonality was normal if some channel fill and an extra week in the December quarter are taken into the account. AAPL's guidance suggests that iPod sales will be flat sequentially, which will drop year-over-year growth to 38%, down from 61% this quarter. New products and back-to-school should cause a sequential pickup in growth in the September quarter. Then things get really interesting as the 14 million unit December 2005 blowout comes into play. This will cause concern over decelerating iPods sales to come to the fore. Once again, it shows why Mac sales have moved to the forefront of the AAPL story.

Posted by Steve Birenberg at April 24, 2006 02:06 PM in AAPL