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October 24, 2009

Plenty of Upside Left for Apple

I was on my to O'Hare airport last Monday when Apple reported its 4Q09 results. The conference call occurred while I was in the air on my way to New York for business meetings. It was the first earnings conference call I have missed since my first purchase of Apple stock for clients in early 2005.

I think it is fair to say that Apple had an outstanding quarter. The fact that the stock jumper $10 in afterhours trading and added another $5 to gains during the rest of week pretty much tells you all need to know. Apple is hitting on all cylinders and the outlook remains robust. Fears that the global recession and very pessimistic consumers would hurt sales and profits have proved completely incorrect. Apple always provides lots of statistics and analysts like me parse them endlessly but two statistics from the latest quarter capture the Apple investment story. First, total corporate revenue grew 25% year-over-year. With the global economy at best just emerging from recession, the fact that Apple can grow at 25% is mindboggling. Second, sales of Mac laptops were up 35% in units on just a 6% drop in average selling prices.

Apple is rapidly gaining share and is not being forced to compete on price. Apple is being driven by a relentless pursuit of innovation, quality products, great customer service and a still underappreciated superb operating management. The company remains a market share gainer in Macs and iPhones and the runway in both product lines is long as current market share remains modest.

A few other key statistics form the quarter jumped out at me. iPod units were down 8% as the category is mature and the iPhone cannibalizes iPods. However, the incredible success of the touch allowed ASPs to reach their highest level since March 2008 so iPod revenue was flat.

Also contributing to the great quarter, especially at the margin level was a 30% surge in software sales. This reflects rapid adoption of Apple's latest operating system, Snow Leopard. Software has very high margins so this boost contributed to an all-time record operating margin for the quarter and the second highest gross margin in recent history.

On a geographic basis, strength was particularly evident in Europe and Japan with revenues up 45% and 36%, respectively. The extension of Apple's brand abroad, driven by the iPhone, provides more room for long-term growth as only in America could Apple's market shares even be argued to be near maturity.

Apple shares usually respond to guidance commentary on the upcoming quarter. For 4Q Apple guided to revenues inline with the current consensus. This is very unusual as guidance is almost always below estimates. For Apple, the guidance is the equivalent of a positive surprise making this the proverbial "beat and raise" quarter that Wall Street loves. EPS guidance was below estimates but better than expected and once again looks to have very conservative margin assumptions.

One final point…Apple's accounting for iPhones as deferred revenue has created some confusion though no controversy. To get a sense for how much Apple is understating its profits, consider that to date the company has shipped 33.8 million iPhones, recognizing $8.8 billion in revenue or just $258 per unit. However, Apple is probably receiving $600 plus per unit from AT&T and other wireless providers around the globe.

If Apple were to realize iPhone revenues when units ship, as do Nokia, Research in Motion, and Motorola, EPS in 2010 might be north of $12 per share. The company also has $37 per share in cash on its balance sheets that is contributing just 20 cents per share with interest rates near 0%. So at $207, the stock is really trading at $170 with maybe $12 in EPS in the year ahead. That leaves the P-E at a quite reasonable 14 times given the still excellent growth potential in iPhones and Macs. Recent analyst price targets in the $250 to $300 range seem quite plausible, representing a low 20s multiples of EPS unadjusted for the pristine balance sheet.

Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts.

Posted by Steve Birenberg at October 24, 2009 12:13 PM in AAPL