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January 24, 2008

More Thoughts on Apple

In my Apple (AAPL) earnings summary on Tuesday, I said there were enough issues to prevent the stock from staging a quick rebound. Those issues don't justify the type of decline we saw yesterday (down big intraday), but the stock is overowned, and as Jim Cramer pointed out, the big money is rotating away from tech, industrials and energy to financials, retail and other early-cycle stocks.

Morning-after analyst commentary was predictable. Many analysts defended the stock, with several increasing estimates given the big beat in the fiscal first quarter. Most noted that guidance seems unusually conservative and that the company should still at least meet the consensus for the March quarter.

Also predictably, there were a few downgrades. The downgrades were based on loss of momentum for the stock and iPods and general worries about consumer spending (that, of course, brings up the question of whether Apple is a retailer or a tech stock).

Few would argue that Mac momentum remains robust and will have an outsized positive impact on financial results as Mac sales becomes a larger percentage of revenue due to the higher margins.

iPods, on the other hand, are creating real concern given the "non-linearity" of U.S. demand in December. In fact, U.S. iPod units were flat in the fiscal first quarter. International sales must have been better than expected given the overall numbers and management's comment that despite the slow December in the U.S., overall linearity for iPods was as expected in the December quarter....

....iPod trends are a real challenge for the shares. I am not denying that. However, there are some offsets to consider. First, despite a disappointing 5% increase in unit volumes, revenues rose 17%. This is the best growth in four quarters -- a marked acceleration from
-1% to 5% growth in the last three quarters. The reason is a sharp increase in average selling prices: $181 this quarter vs. $163 a year ago and $159-$160 for the last three quarters. The mix shift in favor of Nanos and the Touch at the expense of Shuffles was something management planned and executed.

Second, one of the big fears about iPods over the last two years was that the category would lose out to phones. This is why the iPhone was so important. Why shouldn't we consider the iPhone an iPod variant?

Some significant percentage of iPhone sales likely would have been larger-capacity iPod sales. Last quarter saw 2.3 million iPhones sold. If 1 million were iPod cannibalization, iPod units would have grown 10% and revenue would have grown 23%.

Apple shares were very volatile yesterday, partially due to slower iPod growth forecasts. But shouldn't management get some credit for expanding the iPod footprint to phones and Wi-Fi handhelds (the Touch)? Defending your turf and self-cannibalizing while still significantly growing your revenues and profits is what good management is all about.

I believe Apple's earnings growth, product volumes and ASPs will still at least meet analyst estimates in 2008. If so, EPS will grow 30% this year. 2009 consensus calls for EPS growth of 25%. The balance sheet has $20 a share in cash with another $7+ coming in 2008. The cash is severely underearning relative to the operating business. Adjusted, the shares are trading at less than 20 times earnings.

The stock is broken. It will have an uphill climb to rebound. But as new products are rolled out and indications on March quarter operating trends reveal the guidance is overly conservative, confidence will return. That makes Apple a good buy right here.

Posted by Steve Birenberg at January 24, 2008 12:26 PM in AAPL