Google and Apple: A Tale of Momentum

Google (GOOG) and Apple (AAPL) reported in the past week, kicking off another round of quarterly earnings reports for stocks held in Northlake client accounts. GOOG and AAPL compete directly on operating systems (iOS vs. Android) and the desire to control the largest ecosystem of online consumers. Northlake will continue to hold both stocks in client portfolios, although as explained below there is currently a divergence in the near-term outlook for the two stocks.

GOOG’s earnings were slightly below Wall Street expectations for revenue and EPS with the major concern being a slowing in paid click growth to less than 20%. The stock fell about 3% after the report adding to the decline in the shares that was part of the larger correction in the market revolving around fears of slowing global growth, Ebola, collapsing oil prices, and ongoing geopolitical tensions related to ISIS and Russia.

AAPL had an excellent quarter and the stock is trading up about 2% after rising 2% the day of the report. Revenues and EPS came in above expectations driven by better than expected shipments of the new iPhones and continued strength in Mac sales. Guidance for the upcoming quarter was inline with analyst expectations. In Apple’s world that is better than expected guidance given the company’s history of providing a conservative outlook.

Both of these stocks are quite sensitive to the trend in growth. AAPL shares pulled back as earnings growth stalled and even went negative. The share recovery in the stock this year coincides with a return to earnings growth, up about 20% in the last two quarters. The outlook for continued double digit growth is good given the gradual global rollout of the new iPhones and the likelihood that margins benefit form economies of scale as the product transition matures.

GOOG has 20% growth and, in my opinion, reported a quarter that had little impact on the overall bullish thesis. However, GOOG is seeing slowly moderating growth as search battles for ad dollars with Facebook and in app searches on mobile devices. GOOG also continues to invest heavily to sustain its growth but that is serving to depress margins while new businesses develop.

Investors in growth companies like AAPL and GOOG pay for growth and are especially sensitive to momentum in growth in the short-term. For now, that means investors are willing to be optimistic toward AAPL but cautious approaching GOOG. Over the balance of this year, I think that likely means that GOOG shares continue to struggle while AAPL breaks out to new all-time highs.

For the long-term, I see both companies well positioned, with GOOG arguably in a better position given a clearer path to sustained and consistent double digit growth in revenue and earnings.

I see AAPL trading to north of $120 as earnings estimates for 2015 move toward $8.00. A 15X multiple plus a little credit for over $20 in pre-tax cash per share should support another 20% upside in the shares over the next six months.

GOOG now trades at 17X 2015 earnings estimates without given any credit to over $100 in pre-tax cash on its balance sheet. I believe it will take a slight reacceleration in growth for GOOG shares to move significantly higher and the catalyst for that is likely next quarter’s earnings report. If growth expectations firm up, investors will look ahead to 2016 earnings of around $35 and give the P-E multiple a boost, setting up a move to $600-700 over the next 18 months.

GOOG and AAPL are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake regulatory filings can be found at www.sec.gov. GOOG and AAPL are net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, communications, leisure, and related technologies. Steve Birenberg is the portfolio manager of Entermedia, has personal monies invested in the funds, and controls Entermedia’s General Partners.

Earnings Updates: Apple, Google, and Qualcomm

This quarter I am trying a different approach that hopefully saves clients time and increases readership of the quarterly earnings updates. I will write short paragraphs on several companies at a time as they report highlighting a few key items in the reports and looking ahead to future potential of each stock.

Earnings season is off to a mixed start for Northlake Capital Management. Google (GOOG) had a good report highlighted by improved revenue growth. The stock responded nicely. Apple’s numbers were pretty much in line with expectations during a transitional quarter ahead of new iPhones and many an iWatch to be introduced this fall. AAPL shares have moved up to a new recovery high, not far below the all-time high in the fall of 2012. Qualcomm (QCOM) spoiled the party as despite an excellent report, the company cuts its 2014 outlook due to conflicts with Chinese manufacturers over payment of license fees. QCOM shares dipped about 7% due to uncertainty about future growth in China.

Here is a bit more detail on each report.

The highlight of Google’s report was a pickup in advertising growth. Investors have feared that GOOG has reached a point where its revenue growth rate would gradually decelerate. This is partially due to the maturity of search and also to more competition for advertiser dollars form Facebook, Twitter, and other internet ad platforms. In the latest quarter, top line growth picked up to over 20%. Maybe more importantly, GOOG broke out data on its Google.com website vs. partners sites (partner sites have Google search embedded). Google.com search growth was above 30%. Finally, there was small improvement in ad pricing, which fell 6% vs. street expectations for a 7% decline. Remember that Google desktop ads are priced higher than mobile ads so as the mix has shifted toward mobile search (smartphones and tablets), pricing has come under pressure. Should pricing pressure alleviate as expected, GOOG will get a nice growth benefit. GOOG shares have lagged the market this year, gaining only 5%. I think a move to $630, or 20 times 2015 estimated earnings of $31.50, is in store now that investors are feeling better about sustained top line growth trends.

Apple reported a dull quarter by its usual standards. Actually, a better way to state it is that investors reacted little to Apple’s results, an unusual occurrence. Earnings came in slightly ahead of expectations with revenues just a bit below the Wall Street consensus. The implication here is that profit margins were better than expected and that was exactly the case. Apple shares have rallied sharply this year after a difficult period as investors anticipate a big upgrade cycle related to the larger iPhone 6 and a significant new product category for the iWatch. I believe the stability in gross margins is equally important as the bear case in Apple has been that its profitability would fall as the smartphone market matured and its premium prices would face pressure. Whether through sustained demand or effective cost management, gross margins have consistently held up better than expected over the past few quarters. Higher margins assumed in the future means more earnings power. It also undercuts the bear case which has helped increase confidence and allowed AAPL’s P-E to expand. I think the iPhone 6 upgrade cycle will surprise to the upside driving 2015 earnings above consensus of $7.00. A slight expansion in the P-E and credit for a bit of the balance sheet cash ($27 per share), should drive the shares to new all-time highs around $120.

Qualcomm’s report was particularly frustrating as the results were quite good with demand for its chips and the associated licensing revenue both coming in stronger than expected. Unfortunately, the company announced that disputes with the Chinese government and certain Chinese licensees would lower earnings power over the next few quarters. It appears that an ongoing investigation into Qualcomm’s “monopoly power” has given Chinese smartphone and tablet manufacturers an excuse to withhold license payments. China is QCOM’s most important growth market so even though the impact to revenue is small (Chinese companies use mostly low end chips), the long-term growth rate impact could be large. This has led to compression in QCOM’s multiple as the stock has fallen about 8%. This is an impossible situation to analyze but QCOM has faced license battles before in Japan, Korea, and with Nokia. In all cases, QCOM came out fine. China could be different and the stock likely is in limbo until the situation is resolved. There remains risk other licensees in emerging markets could follow China’s lead. I think the shares have compensated for the China risk as they now trade at less than 14 times forward earnings estimates. QCOM is buying back a lot of stock has a cash rich balance sheet. Northlake plans to wait out the China issues and looks to a very strong iPhone demand cycle to support QCOM shares while we wait.

GOOG, AAPL, and QCOM are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake regulatory filings can be found at www.sec.gov. GOOG, AAPL, and QCOM are net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, communications, leisure, and related technologies. Steve Birenberg is the portfolio manager of Entermedia, has personal monies invested in the funds, and controls Entermedia’s General Partners.

A Bubble in Stock Splits

Several companies held in Northlake client portfolio recently announced stock splits. Discovery Communications (DISCK) and Liberty Media (LMCA) announced stock splits that will become effective over the summer. Apple (AAPL) also announced a split effective in early June. These announcements follow Google issuing new non-voting shares as a 2 for 1 split. As a reminder, what used to trade as GOOG is now GOOGL and new non-voting GOOG shares were distributed to create a 2 for 1 split.

Discovery will complete a straightforward 2 for 1 split by issuing one new DISCK share for each currently outstanding share of DISCK and DISCA. DISCK is non-voting stock, while DISCA has one vote. There are also ten vote per share DISCB shares. Discovery has been a heavy buyer of its own stock, focused on the lower priced DISCK. The buybacks had reduced the liquidity in the DISCK shares which were recently trading at a wider discount to the DISCA shares. The plan announcement worked beautifully as DISCA, and DISCK both rose sharply with DISCK rising several percent more and reducing the discount. The new DISCK shares will be distributed on August 6th.

Liberty Media will distribute two shares of newly created, non-voting Class C shares for each share of LMCA and LMCB on July 10th. This is effectively a 2 for 1 split but instead of giving each shareholder an extra share of what they already own, new non-voting shares will be issued. This is similar to the Google split without the added complication of changing ticker symbols. The concept for both companies is to issue shares that do not dilute the control of current shareholders, in particular, the control of the founders. In the case of LMCA, investors are interpreting the issuance of new LMCC shares as a signal that Liberty may have a large acquisition up its sleeve where they would be willing to issue equity. In turn, that would mean, that management sees the current valuation of LMCA and LMCB as full --- you issue shares instead of paying cash when the shares are richly valued. The combination of issuing non-voting shares and the possible implications are contributing to lagging performance for LMCA so far this year.

AAPL is keeping this pretty straightforward by completing a 7 for 1 split. Yes, 7 for 1 is unusual but like most splits it just additional shares of what you already own and Apple only has one class of stock to begin with. Apple investors will receive 7 shares of AAPL for each current share they hold on June 9th. AAPL is signaling its confidence in the company’s outlook with the split and also bring the shares down to a more normal price (around $90 at today’s near $630).

Splits have no economic impact. You own the same value in the stock as you owned previously. Splits can signal confidence from management. Splits can also be used to accomplish other corporate purposes such as what Google, Liberty Media, and Discovery Communications did as described above.

AAPL, DISCK, GOOG, GOOGL, and LMCA are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. AAPL, GOOG, GOOGL, and LMCA are net long positions in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

Finally A Good Quarter for Apple

Apple reported its best quarter with revenues, earnings, profit margins, and iPhone sales all easily exceeding Wall Street estimates. In addition, the company materially increased its share buyback program, raised the dividend by 8%, and announced a 7 for 1 stock split effective in June. Finally, guidance was within an acceptable range with revenues a little below the Street but EPS in line. Not surprisingly, the shares are responding well, up 8%.

Last quarter when I wrote up Apple’s results, I expressed great frustration with progress the company was making in reinvigorating growth. I also noted that the frustration was coming from a long time Apple bull. I have thought for several quarters that the set up in Apple shares was good given what seems like relentless negative sentiment toward the company and the stock. Expectations about Apple’s growth had come way down and it appeared that many institution investors had sold their stock. What was lacking was a positive catalyst. I had been looking toward a resumption of growth in net income, a much bigger share buyback, the long promised new product category, or just better performance of the core iPhone/iPad/Mac business.

The just reported quarter gave us everything but the new product category. Net income grew 7%, the first positive result in six quarters. The share buyback was upped by $30 billion. iPhone surprised to the upside with units of 43.7 million vs. consensus of 38.5 million. Gross margins came in well above guidance and estimates at 39.3% vs. 37.5% expectations. Results in China improved and iPhone showed particular strength in emerging markets. CEO Tim Cook still is promising new product categories this year and a larger screen iPhone 6 has the potential to act like a new category giving consumer demand for large screen phones all around the world.

There were some blemishes in the quarter, especially iPad sales falling well short of estimates. Also, iPhone average selling prices fell sequentially by more than expected. iTunes and Software and Services also continued to see decelerating growth. Finally, as noted above, revenue guidance for the upcoming quarter was below consensus estimates.

The bottom line for the stock is that I think the coast is clear for the rest of this year with a potentially good setup to extend today’s gains. New products and the larger iPhone screen iPhone provide good outlook for the second half of the calendar year. The strong quarter, share buyback, dividend increase, and stock split provide support to get through the long feared June quarter.

Investors should have confidence EPS of $42.50 for this year and $46.25 for next year. If iPhone 6 is all in FY15 (released in October 2014) and share buybacks continue as promised, the $46.25 looks low. Given the financial strength and more confidence in growth for a couple of years, the P-E of 12x after today’s big gain still seems cheap. Adjust for $150 in net cash on the balance sheet, the multiple is more like 9x.

Apple is not out of the woods and a return to the glory years will not happy unless the company finds a new product category at least as big as iPad. However, a run at the all-time high of $702.10 is not out of the realm of possibility if Apple can string together three more good quarters this year. A new high would bring a gain of 25%, enough to justify owning Apple given the better fundamental support coming off the company’s first real good quarter in 2 years.

AAPL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. AAPL is a net long position in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

Sobering Quarter and Guidance for Long-Time Apple Bull

I often think that my best analysis comes from real-time commentary as I listen to the conference calls that accompany the quarterly earnings reports from the companies I follow. In the past, I have offered my twitter comments on Apple (AAPL). Below are my instant message comments sent to a colleague who helps me out with research on my Entermedia hedge fund. Apple is a holding for both Entermedia and Northlake.

The bottom line: this was a sobering set of data for a long-time Apple bull like myself. I still see value in the shares, driven primarily by the incredibly strong balance sheet and financial profile. However, the growth outlook is definitely less than I expected, leaving the company as a product cycle story. The product cycle seems unlikely to kick in until the second half of this year, whereas I had expected it be quite evident in the latest earnings and guidance.

I think the stock is likely dead money until we get some new positive datapoint and given that the latest iPhones and iPads did not do the trick in a seasonally strong period, it is hard to have confidence in the near-term outlook. AAPL shares need some clear and significant positive news to get the stock moving again. AAPL’s calendar of announcements suggests nothing is likely until the next quarter is reported, followed by a June product announcement. I believe the company may have reset the bar low enough that the quarter reported in April could be a positive catalyst. Longer term, the stock is only going to work if revenue and earnings grow consistently. They have not for over a year a now. I think the shares are worth holding after the 7% decline since the earnings were reported, but my bias would be to sell on strength. Previously, I had thought AAPL was a long-term buy.

Real-Time Earnings Conference Call Commentary:

4:36 CT: this AAPL really leaves the stk as a value play. no doubt future expectations too high based on current product lineup. still a ridiculously strong company but minimal growth with mgns to envy. I'd say this justifies the low P-E thesis and the post mkt reaction.

4:40 CT: looking ahead, it's another reset to expectations and with stock down here against a low $40s EPS number and cash, I'd say risk-reward is balanced. it's cheap and model is actually pretty stable, just not growing much. totally new product potential, a large screen phone, further growth in tablets can all be positive catalysts. so plus or minus 10%. blah. meh.

4:41 CT: furthermore I'd add this is the least optimistic call I can remember even when EPS and guidance were similar relatively to past Qs where the stk sold off.

4:43 CT: for example, they are taking pains to explain how one-time issues (or at least what other cos. would call one time) are masking an underlying double digit growth rate. that pretty much says it all.

4:45 CT: only question is whether this reset plus a 10% hit on the stock finally has set things up for renewed positive surprise. I'd say Icahn is gonna push again for buyback and from an "apple is mature" thesis he is right.

4:47 CT: only question is whether this reset plus a 10% hit on the stock finally has set things up for renewed positive surprise. I'd say Icahn is gonna push again for buyback and from an "apple is mature" thesis he is right.

4:53 CT: one positive is that gross margins are looking better than feared. stable in upper 30% range. only one question on this on conference call and considering it has been a primary portion of the bear case that is interesting. I think it supports this concept that it is largely mature cash machine.

4:55 CT: stock won't work unless they use balance sheet for shareholders. CSCO, MSFT, etc. have never done really done that and have never had anywhere near the financial firepower that AAPL has. Arguably no company has ever had this type of financial power.

4:57 CT: Gene Muenster with good question...are you still supporting your prior statements of new product categories coming this year and does that explain the higher expense level discussed earlier on the call. An emphatic YES followed by pause for effect from Tim Cook.

4:49 CT: Muenster follows up with another good question: "so new products come this year, setting up next fiscal year for good growth (remember fiscal year starts 10/1), what would you say to investors who state AAPL is just a product story?" Not much of an answer from Cook besides that he disagrees.

5:02 CT: and that is a wrap. I think the stk can bounce a little but until they announce either (1) new/upgraded products, (2) surprise to upside next Q, or (3) materially larger buyback and/or dividend, AAPL doesn’t have a lot of upside.

5:05 CT: I'll conclude by noting this running commentary is from a stubborn AAPL bull who has owned the stock since early 2005 around $40. that means either I have finally accepted a new reality or AAPL expectations have finally been reset to a level where disappointment is unlikely.

AAPL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. AAPL is a net long position in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

Another Solid Quarter and Guidance As Apple Ripens Again

Apple reported better than expected earnings for the second consecutive quarter. Guidance for the December quarter was confusing but ultimately better than Wall Street expectations. This sets the stage for a continued recovery in Apple shares into year end. Datapoints on product sell through for the new iPhones and iPads and a possible deal with China Mobile for iPhone distribution are catalysts most likely to move the shares.

The biggest risk relates to the outlook for the March quarter. The timing of the rollout of iPhones this year on a geographic basis may pull some demand into the December quarter that was in the March quarter last year. In particular, China shipped in the March quarter in last year’s product cycle.

Thinking longer term the two big issues remain whether Apple needs a truly low cost iPhone and where gross margins end up. The new iPhones and iPads appear to support gross margins but many analysts feel that Apple has saturated the high end of the smartphone market and can no longer grow consistently without a low-priced phone. Furthermore, there is a worry that if Android gains too much market share, Apple’s big advantage with app developers will be lost and the network effect that drives Apple’s business model will suffer.

For now, I think it makes sense to continue to show patience. After a year of declining earnings, Apple appears poised to show growth in the December quarter. Comparisons are much easier in the March and June quarters as those are the periods during which gross margins were declining sharply from peak levels in 2012.

A return to growth should allow some multiple expansion for Apple shares. At 12 times the 2014 consensus estimate of $47, the shares would trade at $564 giving no credit to $143 cash per share on the balance sheet as of September 30th. One more good quarter and decent guidance for the March quarter and the shares could reach well north of $600 within three months.

Clearly this is a bullish case and risk exists that products do not sell well enough to meet earnings estimates. However, two straight above average quarters, well-reviewed new products, early indications that sales are good, and a better product mix that helps margins, suggest near-term optimism is warranted. For Northlake clients, that is good enough. If the stock works to $600 and above, we can worry about the long-term issues.

AAPL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. AAPL is a new long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, communications, leisure, and related technologies. Steve Birenberg is the portfolio manager of Entermedia, has personal monies invested in the funds, and controls Entermedia’s General Partners.

Better Quarter Clears Deck for Apple New Products

Apple (AAPL) reported a better quarter although earnings are still down year-over-year. I expect that earnigns will turn positive again in the Decemebr quarter and growth will pick up as next year moves along, partially due to very easy comparisons beginning next spring. Renewal of earnings and product momentum is critical to get AAPL shares moving again.

The most recent quarter cleared the decks ahead of this fall’s new product launches and also contained a few pieces of good news. The summer and early fall can now play out bullish for the stock as investors can look ahead to new product introductions. Of course, those products will have to capture investor and consumer imagination. The stock has rebound over 10% in July and I think it has more upside heading into the product announcements. But I think $500 will be a topping area until we see the new products. In particular, we want to see the new high end iPhone and whether or not the the company introduces a lowe-end or mid-range smartphone for emerging markets.

In the June quarter, AAPL reported 1% revenue growth but EPS fell 20% as margins fell. One of the issues troubling AAPL shares is declining margins and fear that they could decline further if demand wanes for high end phones, pricing comes down, and the company introduces a lower margin, lower-priced phone. I have noted in the past that AAPL margins spiked way higher on introduction of the iPhone 4s. If you look at a trendline of margins it is clear that this period was unique. Margins have come down sharply since then (47% peak to 35% current). However, takeaway a couple of 4s quarters and margins have settled from the very low 40% range to the mid 30% area. The big question is what happens next. It is a tough call but I believe the street is too pessimistic. In fact, the caution now almost mirrors the optimism when the 4s performance and excitement over the iPhone 5 introduction drove the stock over $700.

Positives in the quarter included: (1) iPhone demand was well ahead of expectations at 31 million units vs. 26 million expectations, (2) margins came in at the high end of management guidance and ahead of street expectations despite lower average selling prices for iPhones as iPhone 4 and 4s drove upside in emerging markets, (3) software and services is becoming a big business, and (4) the company is very aggressively repurchasing its shares.

The big negative in the quarter was a material miss in iPad shipments. Management indicated that the comparison was tough vs. the iPad mini introduction a year ago but acceleration is necessary as iPhones alone are not enough to drive sustained long-term EPS growth.

Current consensus calls for AAPL to earn $39 in fiscal year 2013. Next year, the consensus calls for 9% growth to $42.50. Cash net of debt is $140 per share. This cash figure is unadjusted for taxes that would need to be paid on overseas repatriation. Adjusting for 100% of the cash, the shares trading are at less than 10 times for forward earnings estimates. Many hardware companies trade for similar multiples but I do not believe they have AAPL’s growth potential or financial power.

I can see the shares trading to over $600 on a little multiple expansion if AAPL gets back on an earnings growth track. Downside protection is offered by the aggressive share buyback that has shrunk shares outstanding by 3% in just six months. If Apple can just sustain 2014 projected earnings levels and uses its free cash flow to buy back stock, the company could reduce shares outstanding by 10% per year. Take into account the $140 in cash and the company could buy back all its shares just over 6 years.

The risk is that new products don’t sell well enough to drive revenue and competition drives margins significantly lower. With support from cheap valuation that seems to imply future growth will disappoint and the large share buyback, I think the current set up for the shares is favorable. Longer term the upcoming slate of products will tell the story and we will not see those for a couple of months.

Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. Apple is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

Apple: Complete Reset of Expectations Could Mark The Bottom

Apple reported its second quarter 2013 earnings at the high end of expectations and guidance. However, the real news surrounded the company’s guidance for the next quarter, commentary on future product introductions, and a large increase in the company’s capital allocation program to return cash to shareholders.

For the near-term, I see these factors in rough balance but not enough to lead to a major rally in the shares. If anything, the lack of near-term positive data points is likely to keep the shares near their recent lows. However, I do think the worst news is out and there is a good chance that positives emerge as we move into late summer and fall. As a result, I think the risk-reward tradeoff for the balance of 2013 supports holding the shares. If things go well, I think the stock can rally toward $500 later this year. Downside is now supported by the dividend increase and share buyback and reset of investor expectations. Barring a sharp market pullback, I think the share should hold in the mid $300s. That is a 2:1 ratio of upside to downside enough to keep me in the stock.

Revenues of $43.6 billion and EPS of $10.09 were at the high end of Apple’s guidance and street expectations. EPS fell 18%, the first decline in years. Gross margins of 37.5% were the culprit and came in at the low end of guidance and Street guidance. Declining gross margins reflect tough competition and a loss of product innovation leadership. This cuts confidence in Apple’s long-term positioning and keeps pressure on the shares even when the P-E ratio seems remarkably low. Unit sales of iPhones, iPads, iPods, and Macs were all inline to above expectations. Pricing was OK with iPhone average selling prices a little low as iPhone4 remains popular. This also suggests that the iPhone5 product cycle has been below expectations.

Guidance and the product roadmap is where the report fell short. Even with rampant fears of weak guidance, the company’s projection of $34.5 billion in revenue and 36.5% gross margins were well below the lowest estimates. The implication is that iPhone unit sales will be around 25 million, down vs. a year ago. EPS will be around $7.00, down 25% year over year. Making matters worse, the company indicated new products would not be coming until the fall. This suggests that the September quarter will be quite similar to the June quarter, pushing out the recovery in Apple’s growth profile to at least the December quarter. Previously, I had been willing to wait out the downside in the stock on the expectation that the June quarter would mark the bottom.

The capital allocation announcement was ahead of expectations with the company committing to $100 billion over 2013 thru 2015, composed of $40 billion in dividends and $60 billion in share buybacks. The big surprise was in the share buyback which previously was only at $10 billion. The dividend went up 15% and now sits at $12.20 for a current yield of 3% at today’s prices. Management clearly was sending a message that they think the future is bright and the stock is going back up. The company can buy back about 5% of its shares per year, a material amount and enough to boost EPS.

My overall takeaway is that this quarter marks a complete reset of expectations for Apple. The prior of Apple is over. In fact, I think one could argue that we should not even be comparing Apple of 2013 -2015 to Apple of 2005 – 2012. The company is taking an extra-long break on new product introductions; probably to market sure they get it right this time after the relatively poor reception to a complete suite of new products last December. Those products have not sold as well as expected and the company executed poorly in delivering them to market.

Apple will probably earn about $38 per share in FY 13, down from $44 in FY 12. The question now is what the earnings will be in 2014. Current consensus is around $44 and assumes new products are successful and rollout beginning this fall and thru 2014 in line with management’s comments on the conference call.

A bull case is that expectations have bottomed and investor confidence and sentiment and company growth will resume in the fourth quarter. Despite the crushing decline in the stock since last fall, I believe there is enough residual bullishness on Apple that if renewed growth becomes apparent this fall, the shares can rally sharply. This rally would be in anticipation of a new growth cycle. Ultimately, though, successful products are necessary to provide anything more than a relief rally. If new products fail to revive growth, Apple will look an awful like slow growth tech stocks such as Microsoft, Intel, and Cisco Systems. Those stocks never recovered from the collapse in their growth rates last decade.

With expectations reset to hopefully worst case levels , the share buyback and dividend increase announced, and minimal new products coming, I think Apple will be a boring stock over the next few months. Low expectations set the stage for better stock price performance as investors begin to anticipate the fall new products. Maybe the June software developer’s conference will provide some excitement with a new version of iOS hinting at a big IPhone launch in the fall. I am willing to bet that the next major move in the stock is up in anticipation of the fall product releases and resumed earnings growth in the December quarter. As a result, I am going to stick with Apple in client accounts but remember that Apple as we knew it is over and the story needs t be analyzed from scratch.

Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. Apple is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

Apple Earnings OK, Guidance Poor, New Controversy

Apple reported largely inline December quarter results. Revenues of $54.5 billion were barely shy of consensus and EPS of $13.81 were barely above consensus. Gross margins exceeded guidance and were close to the most optimistic street estimates. Product sales were about as expected except for Macs, which missed by lot.

Guidance was below the street as usual. There was hope that guidance would be closer to the analyst estimates which would have eased concerns about demand for iPhones and iPads, gross margins, and negative datapoints from the supply chain.

The actual earnings and guidance were greeted by a quick 6% drop in the shares. I'd call that fair as essentially the quarter and guidance left the recent controversies intact and provided no relief for the bulls. The way the street works that gets the stock back to the low end of the recent range. Not great but not a disaster if you believe as I do that underlying product demand is growing.

On the call, the company explained its new approach to guidance. Here is the exact quote:

“In recent years our guidance reflected a conservative point estimate for results every quarter that we have reasonable confidence in achieving. Going forward, we plan to provide a range of guidance that reflect our belief of what we are likely to achieve. While we cannot forecast with complete accuracy, we believe we are likely to report within the range of guidance we provided.”"

This comment dropped the stock another 6% to where it trades now as the conference call concludes, $459, down 11% from today's close. The issue here is that management seems to be saying that previously guidance was "conservative" and now it is "what we are likely to achieve." Management denied to expand on this quote when given a couple of opportunities in Q&A to admit that the shift still leaves guidance as "conservative." I do think the second attempt by an analyst left open the possibility that guidance is conservative.

The reason this matters is that low-balling guidance meant that this quarter's guidance disappointment probably wasn't that bad as the actual report would be close to analyst estimates. If this quarter's guidance is real, then analyst estimates are going to have come down sharply. Current FY13 consensus is $48. That would imply $24 in second half earnings if guidance is taken at face value, a 33% gain year over year.

However, with a just reported flat quarter, guidance for -20% quarter, and ongoing worries about demand due to the supply chain datapoints and production cuts, analysts and investors are never going to believe a quick rebound to 33% growth.

If this year ends up with EPS in the low $40 range, down 5%, the shares look pretty cheap as long as growth resumes. With $144 in cash, call it $120 after-taxes, the stock is trading at $340 against $40 in operating EPS. Very cheap if growth resumes. But we aren't going to know whether growth resumes for a few months.

I believe growth will resume. I also believe that guidance is going to prove conservative again. Underlying product demand looks a lot better than the stock price to me. Until I am proven right, however, the stock is in the penalty box with minimal upside. I think it is worth holding on but expect the bumpy ride to continue and when growth does resume think $500s not $700s.

Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Regulatory filings can be found at www.sec.gov. Apple is a net long position in the Entermedia Funds. Steve is portfolio manager of Entermedia, owns a controlling stake in the Funds' investment management company, and has personal monies invested in the Funds.

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Mixed Bag of Apples

Apple reported decent September quarter results against low expectations following lots of worry about demand trends and recent data that revealed iPad sales would be below expectations. Revenues of $36 billion were up 12% year over year and in line with consensus forecasts. EPS of $8.67 rose 23% vs. a year ago but slightly missed consensus estimate of $8.81. EPS would have been about 20 cents higher except for an unexpected and unusual negative swing in other expense related to foreign exchange hedging that should reverse next quarter.

At the product level, Mac sales of 4.9 million units were right on target. iPhone sales of 26.9 million units were ahead of expectations indicating that demand remained reasonable for the 4S even ahead of the launch of iPhone5. iPads came in at a disappointing 14 million units. An iPad shortfall was expected after Apple announced that it had sold its 100 millionth iPad earlier this week. iPad inventories were unchanged and management indicated that it saw a slowdown in demand in August and September as rumors mounted about the iPad mini. iPods, no long an important product at just 2% of revenue, were slightly below estimates at 5.3 million units.

Overall, the quarter was solid against low expectations by Apple standards. The much bigger news concerned guidance for the September quarter. Management forecast revenue of $52 billion and EPS of $11.75 against consensus estimates of $55 billion and $15.50. By Apple standards, the revenue guide was actually pretty good. However, EPS are way below estimates even by Apple's usual conservative standard. The issue is gross margins, which Apple forecast at 36% against 40% in the September quarter.

Gross margins have not been below 40% since the December quarter of 2010 and have averaged 42.1% in the past eight quarters. Management noted that newly introduced products would make up over 80% of December quarter sales and that costs are highest in the first quarter a product is introduced before economies of scale kick in. This is a legitimate point although it has not been as obvious of an issue in past quarters with heavy new products flow.

Apple shares are barely changed following the report after a 15% pullback over the past month. I think there are several takeaways from the quarter. First, the stock price action indicates that the stock already reflects the lower expectations. At $610, the shares seem to have discounted the weak EPS guidance. Second, I think we should start to accept that Tim Cook provides realistic guidance. Most of the quarters since he took over have been closer to company guidance than to analyst estimates. Analysts have been trained to view Apple guidance as extremely conservative. Maybe that is changing under Cook's leadership. Whether this is because Apple's financial momentum is waning is a key question.

Most importantly to me, Apple may have finally reset growth expectations (or the market have reset growth expectations for Apple). Trailing twelve month earnings growth over the past eight quarters has varied from 60% to 96%. If guidance proves correct, earnings growth in calendar 2012 will be just 20%. For a long time, Apple shares have traded at what seems like a very low P-E multiple relative to the growth rate of its earnings and to its product and market share momentum. This is because investors had long anticipated that the growth rate would slow if for no other reason than the law of large numbers. Apple sold 37 million iPhones in the December quarter a year ago. The guidance implies around 46 million this year. To sustain 20% growth means next year they must sell 55 million. At some point, the end market and Apple's market becomes mature.

Investors are smart and realized this was coming and kept Apple's valuation in check. Current controversy over iPad demand and corporate gross margins is likely to be what determines whether Apple shares get their upside mojo back. Management discussed the huge opportunity for iPads against 300 million PCs still sold each year (Apple has sold 100 million iPads in 18 months). iPhones still have growth as smartphone penetration continues to grow on a global basis but the sheer size of iPhone revenue ($29 billion in the most recent quarter representing 55% of sales) means that iPads have to pick up the slack. Broadening the product line with iPad mini makes sense in this regard.

Gross margins also have to firm up. Another key question is whether Apple has to accept lower margins to drive product sales. Maybe the competition is catching up? This is a fair interpretation of the guidance. Management indicated that margins should rise as production ramps and products mature. Apple does usually guide gross margins conservatively. If that proves to be the case this quarter then investors will be comfortable in the company's competitive position and the likelihood that future growth is sustained at 20% or even re-accelerates.

I believe that the combination of recent worries, the reported guidance, the acknowledgment of the slowing growth rate, and the 15% pullback in the shares have effectively reset the investment case for Apple. Backing out cash, the shares trade for less than 10 times forward earnings. Against 20% growth in FY13, this is a very reasonable valuation with much lower expectations on the part of investors.

A new catalyst will have to emerge to get the shares back on track. Signals of strong demand this holiday season and easing of supply constraints are the most likely until the company reports earnings again in January. I think both of those things will occur. If they do, then it will be clear that guidance is going to be comfortably exceeded. This is the bull case for the near-term. It is also the case I believe will occur. And never forget that as the largest market cap stock on the planet, Apple shares are going to be heavily influenced by sentiment and direction of the overall market.

Apple is widely held by Northlake Capital Management LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, a long only registered investment adviser. Apple is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, communications and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the funds' investment management company and has personal monies invested in the funds.

Apple Misses and Guides Lower

In an extremely unusual development, Apple reported revenues and earnings well below the Street's estimates. More normally, the company guided earnings for the September quarter below estimates. However, the gap to analyst estimates was unusually large, effectively making this quarter and a "miss and lower." In response Apple shares are trading down 5%.

Given the magnitude of the shortfalls in revenue, earnings, margins, and iPhone and Mac shipments, a 5% decline is quite modest. This is due to two factors. First, the news is not a shock. Most of the shortfall is probably related to a pause in iPhone demand ahead of the expected October launch of iPhone 5. Foreign exchange also played a factor along with some product mix shifts that cut average selling prices. Second, by all indications including many surveys, demand for the iPhone 5 is going to be extraordinary. Intent to buy measures are at all time highs among current and potentially new iPhone users. As a result, Wall Street is willing to cut Apple a lot of slack as it assumes that any shortfalls will be made up in the December 2012 and March 2013 quarters when iPhone 5 is released around the world.

I remain very optimistic about Apple shares. The stock is very cheap. After backing out over $120 in cash earning little with interest rates at 0%, the stock trades at just 10 times earnings. Even with the six month pause in iPhone demand (when the company will ship about 50 million phones!), Apple is growing at a rate of more than 20% a year, a growth rate that will accelerate later this year. I still see the shares having one more good run based on the current product lineup (Mac, iPhone, iPad, iPod, and integrated software) with a target of $750 easily achievable.

All that said, there were some troubling issues in the quarter not present in prior quarters where Apple disappointed the street. The product mix shift could be a sign that Apple's newer products are facing increased competition and losing market share. It is hard to tell if lower average selling prices were due solely to the fewer high end iPhones sold or if a clear customer preference for older models was responsible.

ASPs may also be feeling pressure from tighter upgrade and subsidy policies from wireless service providers around the globe. This impact will cycle through over three more quarters. I was surprised to hear minimal questions on this topic on the conference call. Follow-up analyst reports also touched on upgrades policies less than I expected.

Another issue was much lower margin guidance. Apple usually guides margins conservatively but the guide for the September quarter is still surprisingly low. Apple's margins are incredibly high on hardware, 3-4 times the best other hardware manufacturers. This is the result of Apple's tight integration of its best in breed software. However, as competitors catch up -- Samsung phones and Google tablets, in particular -- the long feared margin compression could be coming sooner than expected.

While I respect the greater competition argument, I suspect other things are at work. The global economy has weakened and this impacts even companies as strong as Apple. The company specifically pointed to negligible growth in Europe. Foreign exchange also took a bigger bite out of financial performance. The street should have figured this out given the massive overseas growth the company has enjoyed. It was unusual to hear Apple management discuss macroeconomic impact in such great detail. It is likely legitimate but still raises a caution flag.

Misunderstood inventory shifts as new products rolled out over the last year also may be at work. As Apple's market share has grown ever larger and its products have reached around the entire globe, the impact of a single new product on the company has also risen. Quarter-to-quarter volatility is going to be greater and even with Apple's regular discussion of channel inventories forecasting inventory shifts and thus shipments is going to be more difficult. I think that was the case in the most recently reported quarter.

To repeat, I still see Apple shares heading comfortably north of $700 within the twelve months based on the current product lineup and the still massive growth in penetration of smartphones and tablets. Less than 20% of mobile phones currently in use around the world are smartphones. To move significantly above that, I believe the company will have to find another new product that opens up a huge market opportunity. TV seems the most likely. Innovation in new product categories has brought Apple this far.

The next innovation will determine if Apple can be the first trillion dollar market cap company. That requires almost another doubling in the share price. I think the odds are in Apple's favor. Fortunately, as is, there remains 30% upside in the shares.

Disclosure: Apple and Google are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an Illinois-registered investment advisor. Filings can be found at www.sec.gov. Apple and Google are net long positions in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds.

Another Apple Blowout

Apple reported another quarter of stunning results. Not quite as good as the December quarter but still something to behold. Revenues of $39.2 billion exceeded consensus by about $5 billion. EPS of $12.30 compared to a consensus estimate of $10.04. These results also exceeded the "whisper" numbers which were 10-15% above consensus.

Apple's great numbers came against a backdrop of sudden worries about the stock and the business outlook. Those worries were likely exacerbated by the 50% up move in the shares into the early April peak. Including the day of the report Apple had fallen 12% in ten days with only one up day in the last ten.

Concern arose around the number of iPhones sold due to slightly worse than expected iPhone sales at Verizon and AT&T which reported before Apple (as they do every quarter). An equal worry was whether AT&T and Verizon would subsidize iPhone purchases to a lesser amount and tighten upgrade policies. Apple gets over $600 per iPhone from the carriers which sell them to consumers for $200 along with a 2 year contract guaranteeing 24 months of expensive monthly data plans. Verizon and AT&T have tightened upgrade policies which could slow demand for iPhones as many users upgrade every new generation. Any reduction in the subsidy could further reduce iPhone sales by raising the price to consumers.

At least for this quarter, these issues proved meaningless. iPhone sales soared past estimates driven by Chinese and other Asian demand. Apple's growth story is increasingly overseas, something analysts over focused on the US had forgotten. iPad demand met expectations, while Macs were a little light. The mix shift toward iPhones, falling commodity costs, and some one-time benefits sent gross margin surging to all-time record.

The shares bounced back strongly after the report, regaining about 2/3rd's of the recent losses. I think this quarter justifies Apple trading as high as $750-800 later this year based on 12 times calendar 2012 EPS of about $50 plus what will be around $140 in cash by year end. However, after the big run in the shares this year and with no obvious new catalyst until the fall launch of iPhone 5 (and possibly a smaller iPad and TV), I think the shares could stall in $600-$640 range for awhile. The Street is going to be concerned about slowing earnings momentum and a pause in iPhone sales ahead of iPhone 5 similar to early last fall ahead of the 4s launch. I suspect iPads will beat expectations over the next few quarters driven by education demand and broader geographic distribution. A refresh of the Mac line early this summer also could provide some upside.

The bottom line is the Apple story is not over yet although the stock could stall for a few months or even until fall. Let's not forget how far it has come this year. I long thought the market was significantly undervaluing Apple. The move this year leaves the stock just normally undervalued. This situation requires fresh catalysts. I expect them later this year.

Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Northlake is an Illinois registered investment advisor. Filings can be found at www.sec.gov. Apple is a net long position in the Entermedia Funds. Steve is co-portfolio manager of Entermedia, owns a stake inthe Funds' investment management company, and has personal monies invested in the Funds.

Another Blowout from Apple Supports Mobile Broadband Theme

Apple continues to amaze. Relative to expectations this is one of the best quarters I ever remember by any company. Damn, I am pretty certain I wrote that about Apple previously! In calendar 2011, Apple earned $35 a share. Guidance for the March quarter is up 32% and is probably conservative. The company could earn $45 per share in 2012. By the end of the year, cash per share will be near $130-140. Subtract that from this morning’s price of $450 and you get $320 and you still have an absurdly cheap stock at 7-8 times earnings. $500-600 is a very reasonable 2012 target for the shares.

The story at Apple is iOS. 37 million iPhones. 15 million iPads. 15 million iPods that are mostly touches. iOS is mobile broadband. It defines and leads the experience. Even if this growth came somewhat at the expense of Android last quarter, Apple’s health is the greatest testament to the mobile wireless broadband theme.

Mobile broadband is a key theme for Northlake’s individual stock selection. Recent purchases of Qualcomm (QCOM) and EMC Corporation (EMC) play right into this mobile broadband. QCOM chips power many high end smartphones, including from Apple. EMC data storage solutions enable smartphones, tablets, and laptops to access massive databases of content, information, and applications.

For more analysis on Apple’s latest earnings belo the Twitter comments I posted live during the conference call. The tweets are listed in chronological order from the start of the call to the end.

AAPL amazes again. EPS headed toward $45 for calendar year 2012. By this time next year AAPL has $140 in cash. 10X $45 EPS is $450+$140=$590. Still way too cheap.

Everything good. Even the supposedly dying desktop. iOS devices a total blowout. New iPad and iPhone 5 still to come this yr.

Guidance seems to imply 43% gross mgn, down 170 basis points. if iPad3 ships total guidance will be too low again as usual.

Inventories look good coming into March Q. iPhone below target. IPad in line. Adds visibility to guidance.

Guidance in line with Street on rev, better on EPS. For AAPL that is a guide up. Rare occurrence. Good old fashioned beat and raise.

$AAPL Starting Q&A. Looking for iPhone color on units guidance. Seems 20-25 million based on my spreadsheet. China just shipping 4S this Q.

"actively discussing uses of cash" Cook differs from Jobs here. Expect buyback or dividend this year me thinks. Another +.$AAPL China" "demand there has been staggering." No China shipments in Dec Q? That is what he said I think. If so, guidance gone be low.

positive comments on components. Supply > demand. Explains gross mgn guidance. Still down 270 bps seq on US$, one times, sales lev.

Half Dec Q gross mgn upside one time in nature. Sales lev and mix shift toward iPhone for rest. Makes gross mgn guidance impressive.

See iPad as different product category from Kindle. Multifunction vs. Limited Function.

Good Q on seq decline in gross mgn guide. Last 3 yrs was up 200 bps. With mgt explanation implies flattish. Could be source of upside.

Lots of questions about cash balance plans. Supply chain, acquisitions, and "otherwise."

85 million signed up for iCloud so far. Very important as "strategy for next decade."

130,000 points of sale for iPhone. "Nothing to announce today" on China expansion. China extremely important. Implies to expect more.

seq rev guidance: 1. extra week in Dec 2. has Xmas-NY week last yr 3. increased iPhone inventory yr ago 4. 4S channel fill 5. US $

acquisition strategy: bring in talent, engineering, technology. Seems to rule out large deal.

Good q on refresh rates. Accelerating? In Enterprise one product pulling others but Q is for consumers not skipping generation.

Call over. Stk hitting high while call occurs. Well deserved. $600 not a stretch for 2012. $500 should be now. Valuation crazy low.

Disclosure: Google, Apple, Qualcomm, and EMC are net long positions in the Entermedia Funds. Texas Instruments is a net short position in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds. Google, Apple, Qualcomm, and EMC are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor.

Less Shiny Apple Near-Term, Long-Term Still Golden Delicious

Yesterday, I wrote in a preview of Apple’s earnings for Wall Street All-Stars and Minyanville that the company needed to report over $8.25 in earnings with good guidance for the stock to respond positively in the very short-term. Consensus EPS was for $7.30. Honestly, I never even considered the possibility that the company would miss consensus. As result, despite the excellent guidance, the 5% decline in the shares this morning is not surprising. In fact, I am surprised it is not a little worse.

I think Apple remains extremely attractive for the long-term, a target over $500 in the next 6 to 9 months is easily achievable. In the near-term, however, I think the bloom is off the rose, or the shine off the apple. The stock is over owned and over weighted in most amateur and professional investor portfolios. I think this sets up a poor near-term supply demand balance for the shares with more risk to the downside. For Northlake clients, I am trimming positions slightly where they are dramatically overweighted. Basically, Apple has gone from golden delicious to just another attractive stock, at least for the short-term.

Looking more closely at the quarter, the shortfall against the consensus estimate and the much higher whisper numbers came primarily from iPhone sales. Despite management cautioning the Street on the last call to expect a slowdown in unit volumes as the launch of the next iPhone approached, analysts stuck with higher numbers. I think management was clear on last night’s conference call that this was a transition issue. Detailed figures on inventories and recent sales suggest the shortfall will be more than made up in current quarter.

Getting less attention was a modest miss in iPad unit volumes. Unit sales of 11.1 million feel short of consensus for 11.6 million. Given that Apple entered the quarter with too little iPad inventory, providing several million units of inventory build, I expected iPad units to exceed consensus. I suspect this will be a non-issue when we see holiday iPad sales but it adds another issue for the shares in the near-term.

Guidance was excellent. Some observers are noting that the quarter includes an extra week. Others think it is no coincidence that for once Apple guided above the Street and it just so happened to occur when the company missed earnings for the first time since 2004. I think this is an overly cynical view. Management noted the extra week between Christmas and New Year’s is not a big one historically. More importantly, Apple has guided above the Street a few times in the past.

As I noted, the shine is of the Apple story for short-term. However, the growth outlook is still excellent, north of 20% easily for 2012. Adjusting for $86 per share in cash, growing by about $20 a year, the shares trade at less than 10 times 2012 earnings estimates. The low valuation has been in place for a long-time, likely expecting a period when Steve Jobs passed away and the company’s growth rate disappointed. Assuming the December quarter beats estimates, I think the shares will rally to substantial new highs. But in the near-term, there is a good chance the stock struggles. Apple is different story depending on your investment horizon, your trading appetite, and your position size. A little caution in the near-term makes sense, however.

Disclosure: AAPL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. AAPL is a net long position in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds.

Another Apple Blowout as Emerging Markets Lead

Apple reported another blowout quarter. While that is never surprising, there was some reason to be concerned going into the quarter. Supply constraints have left uncertainty about the true level of iPad demand. Verizon iPhone sales have been good but not great. Pending product transitions including the new Lion operating system and iPhone5 could have served to slow demand. Alas, none of the worries were warranted. Massive upside in iPhone and iPad unit shipments and better than expected margins drove EPS to $7.79 vs. the consensus expectation of $5.85. My own spreadsheet was dictating $6.20.

The only issue that came up on the conference call or in the press release was guidance for the September quarter. Apple guided to EPS of $5.50 on revenues of $25 billion against consensus of $6.03 and $27.7 billion. Given that Apple's guidance has become a running joke, this is not a major concern. However, I have noticed that Apple shares tend to respond in the short-term to the guidance. When guidance is in line to ahead of consensus, the stock responds positively and vice versa. I think that the subdued reaction today to Apple's earnings last night is probably this relationship in action.

Working backwards from management comments on the conference call about iPad, iPhone, and iPod trends, I think guidance assumes iPhone 5 does not ship until the December quarter. Guidance also reflects the newly announced revenue deferrals across the product lines related to Lion and iCloud. Analysts are not lowering their estimates for the September quarter and are dramatically raising estimates for 2012. I don’t really care whether iPhone5 ships in September or October as the demand is clearly going to be sky high.

One other takeaway from the report and conference call is that Apple's business in emerging markets, most definitely including China, is booming. This geographic segment grew 247% last quarter and represented 22% of sales. In China alone, management indicated revenues were up six times from a year ago. While a lot of focus remains on iPhone vs. Android in the U.S. and the level of demand for iPhones at AT&T and Verizon, the real story is how well iPhones are selling in emerging markets. The bull case for Apple has always been relatively low market shares in very large and growing end markets defined by product. We can now expand the addressable end markets dramatically to include geography, specifically emerging markets.

I remain bullish on Apple. I think there is a good chance that fiscal 2012 EPS will exceed $35. Apple has $81 in cash today on its balance sheet and should have around $110 by this time next year. Put a 15 P-E multiple on $35 in earnings and add $110 in cash and you arrive at a target of $635, still more than 60% above current levels.

Disclosure: Apple is a net long position in the Entermedia Funds. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the Funds' investment management company, and has personal monies invested in the Funds. Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor.

Apple Continues to Amaze

I again tweeted comments as Apple held their earnings call. As a reminder, I find that my instant reaction is most valuable as I subsequently read through analyst reports.

It was another great quarter with iPhones and Mac laptops leading the way. iPads were supply constrained but management seems quite confident they are getting a handle on it which should show up in the next several quarters. Guidance was below the current consensus but better than many had been anticipating. Japan appears to be no issue. The bottom line is that the bull case for a $450-600 stock got a lot of support with this report.

Here are my tweets in chronological order:

I've been keeping a qtrly spreadsheet & writing EPS analysis on $AAPL since the start of 2005. There is really nothing left to say. Amazing.

$AAPL on Japan."some 2q rev impact. $200mm less in Q3 in guidance. did not have any supply or cost impact in 2Q or expected in 3q."

$ AAPL" "some LT supply risk from Japan beyond current qtr but impossible to predict."

$AAPL addressed two biggest issues, Japan/iPad supply, right off the bat in Q&A. All good. Stk pops $3.

$AAPL iPad 2 demand "staggering". Happy with mfg progress. Adding more countries. Confident can produce "a very large # of iPads for Q."

$AAPL $49 3GS iPhone price point very popular. But no hint of a lower $ iPhone.1st gen LTE chipsets compromised design. Not going there yet.

$AAPL guiding to 350 seq drop in gross margin. less operating leverage, more iPad in mix. Last Q benefited from iPhone beat/iPad miss.

$AAPL re Android, look at entire iOS platform, not just phones. also still like integrated vs. fragmented approach for user and developer.

$AAPL China is 10% of revenue. Been careful. Wanted to learn. Working. Will take knowledge to other emerging mkts.

$AAPL "see Jobs on regular basis. involved in strategic decisions. wants to return full time asap." more than they usually say. good sign?

$AAPL up $7 since call began. One bump on Japan, another on Jobs, more as call ends. Nothing to complain about here. $500 tgts get support.

Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake Capital Management, an SEC registered investment advisor. Apple is a net long position in the Entermedia Funds. Steve is co-portfolio manager of Entermedia, owns a stake in the Funds' investment management company, and has personal monies invested in the Funds.

Apple Reports "Beat and Raise" in an Unusual Occurence

Following the disclosure that Steve Jobs would take a medical leave of absence, Apple reported another in a string of incredibly strong quarterly earnings reports. The reported numbers easily beat expectations. Revenue upside came mostly from higher than expected selling prices with unit volumes in line with the high end of expectations. iPad volumes were a bit stronger than expected, while iPhones missed some whisper numbers.

iPad expectations had come in a bit on supply constraint concerns and worries that the new MacBook Air would cannibalize. Those issues did not appear. iPads look set to accelerate further as U.S. demand is robust and many new countries are being added. iPad 2 is also due and will have a few missing features likely to stoke demand further (camera, Facetime, bigger viewing area, even better display).

iPhone unit shipments would have been higher had the company been able to produce enough phones. Management admitted it is struggling to meet massive global demand for iPhones. The iPhone supply constraint was the only real negative in the quarter or the conference call. The issue would be that consumers would opt for an Android phone instead, losing a potential sale for several years at least and improving the Android ecosystem via more users. I do not consider this a big problem but when dealing with a high flying stock like Apple any minor issue deserves examination.

The bigger story for the stock coming out of the quarter was guidance for the March quarter. Management guided revenues and EPS above street estimates. This is a very rare occurrence for Apple, which usually guides conservatively and below analyst estimates (although ends up easily beating both). I only remember one other recent quarter when Apple produced what Wall Street likes to call a "beat and raise" quarter. The stock acted very well in response.

This time, however, Apple shares have retreated since reporting, something that seems to generally be the case. Apple shares often rally into the quarterly number, already building in the upside. That seems to be what happened this quarter, exacerbated by general selling pressure in the stock market, led by technology stocks. I also think the rally in the shares off the lows on Tuesday following the Jobs health news set up a second chance for investors who wanted to lighten positions on the health concerns.

I feel extremely strongly that Apple shares will move to significant new highs, $400 or higher, later this year. Earnings in fiscal year 2011 now look like they will be at least $23. Yearend cash on the balance sheet should be around $70. A P-E of 15 times just the earnings (cash is earning minimal amounts) gives the underlying business value of $345. Add in $70 in projected cash and $425 is a good target.

Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. Apple is a net long position in the Entermedia Funds. Steve is co-portfolio manager of the Entermedia, owns a stake in the Funds' investment management company, and ahs personal monies invested in the Funds.

Good Thoughts on Jobs and Apple

Walter Piecyk, an analyst I know at BTIG, wrote the following brief comment on Apple and published it this morning. The volume of Wall Street commentary on Apple this morning is enormous as expected. Walter's note best captures my thinking so I reproduce it here with the hope that Walter and BTIG don't mind.

"The knee-jerk reaction for a stock like Apple would be to buy on dips and that would certainly be following the advice of most analysts this morning. The chorus of buy on weakness calls could certainly temper the sell off today in front of a quarter when, as usual, the consensus is well above guidance. That sets up for a pretty risky 24 hours given how the stock has reacted in the past from slight deviations in items like gross margins and units not to mention the risk of any commentary on the call that provides more details about Jobs’ health or the coming quarter. We continue to believe that Apple is the best way to play the explosion of smart phone and tablet growth, but we don’t think investors need to be more aggressive than normal when the sell side is pounding the table the day of an EPS report.

Valuation multiples are driven by growth and risk and when you introduce increased risk, the multiple of a stock should contract. Steve Jobs’ medical leave increases the risk at Apple both in terms of near term execution as well as the long term growth potential of the company so investors should not be surprised by the sell-off in Apple’s stock this morning. Investors will soon have a new data point to consider when evaluating growth and risk this afternoon when the company reports its first fiscal quarter of the new year.

We are believers that one person, particularly the CEO, can make a material difference in an organization, whether that difference is for the good or the bad. In any organization the tone is set at the top. We have seen companies like Motorola and Sprint spend years and in some cases multiple CEO’s trying to undo a losing culture. We believe Jobs has installed a winning culture and a focus on quality that will have a lasting impact at Apple whether he returns or not. More specifically, product roadmaps are not developed overnight. Jobs product decisions and direction will be felt for at least six quarters before investors have to worry about the decisions made by any replacements but a stock like Apple might look out at growth estimates beyond six quarters."

Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC, inlcuding in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor.

Ignore the Apple Worries, Operating Mometum Remains Impressive

Apple reported another strong quarter but the stock sold off due to concerns about guidance for the December quarter and disappointment in iPad sales. The guidance issue relates solely to gross margins, which Apple guided to 36%, well below recent quarters that have averaged about 40%. The company attributed the guidance to mix issues. iPhones and iPads have lower margins and are becoming a larger and larger portion of total product sales. I find analyst concern on gross margins a bit absurd since these are the same analysts who used to complain that Apple charged too much for their products. Now, Apple is aggressively pricing iPhones and iPads with incredibly rich features, way more than competitors, and the analysts complain even as unit sales blow away expectations. After all, revenue in the just reported quarter beat estimates by about $1.5 billion.

On supposedly disappointing iPad, sales, Apple made it very clear that they sold as many as they could manufacture and that demand for iPads is unprecedented. The expansion of iPads to AT&T and Verizon stores and Target and Wal-Mart clearly signals that supply constraints have eased. Apple will sell as many iPads in the December holiday quarter as they can manufacture.

The stock remains attractive, especially after adjusting for $55 per share in cash on the balance sheet that is earning virtually nothing. The company earned just $14 million on its quarter end cash balance of $51 billion. In fiscal 2011, Apple is likely to earn around $20 per share, placing the stock at just 12-13 times earnings adjusted for cash. That is pretty darn inexpensive for a company that has grown revnues 67%, 61%, 49%, and 32%, over the most recent four quarters.

The stock traded down to $298 while the conference call was going on and has rebounded to $311, down just $6 a few hours into Tuesday's trading. A breather is nothing to be worried about given that the stock had run from $240 to $320 in since the end of August.

Below are the tweets I posted on Twitter as I was analyzing the press release and listening to the conference call. I find the exercise of live commentary useful as first impressions are quite important for constructing my big picture views. Please forgive the jargon and shorthand!

$AAPL fin'l statements look fine. Tax rate low. Adds 17 cents. Street wanted more from guidance. iPhones gr8 iPads/Pods lite. Macs in line

$AAPL guidance implies 35% gross mgn. Has not been that low since 2Q08. Nothing wrong here but a stock that went up already.

If $AAPL DecQ gross mgn is 37%, flat seq, EPS is $5.15 or consensus. Assumes no rev beat. If rev beats by $2B at 37% gross mgn, EPS is $5.75

$AAPL cash now $55 per share. Earned $14M interest last Q. Adj price is now $242 vs $20+ CY11 EPS. Stock remains cheap.

Jobs on $AAPL call. Staying for Q&A. Notes outsold $RIMM in units. Software poses challenge for $RIMM. 275,000 iOS devices per day >Android.

$AAPL Jobs talking about open/closed. Notes Android fragmented OS after handset manufacturers add software. Multiple app stores for Android.

$AAPL Jobs talking about benefits of closed strategies: integrated vs. fragmented. Now shifting to tablet competition.

$AAPL Jobs notes 7" screen is 45% as large as iPad. Will hurt tablet apps even at higher resolution. Small size hurts app development.

$AAPL calls 7" tablets tweeners. Why carry if you already have a phone? $GOOG says to wait on using Android because it is not ready.

$AAPL Jobs notes new tablets still pretty expensive and offer less for more. Sees 7" tabs as "DOA." Now starting Q&A.

$AAPL 1st Q: Supply constraints on iPad? Balanced in Sept. Expanded distribution as a result. 2nd Q: gross margin headwinds?

$AAPL Jobs notes iPad impact on notebooks. Education, health & Biz pulling. "I see it as really big." Doesn't see competitor tabs right now.

$AAPL Q&A: new iPods/iPad in Dec Q mix pressure gross mgn. Notes sharper pricing for more functionality in all podcuts as well as mix.

$AAPL Jobs wants to keep cash powder dry. "There are one or more business opportunities in future."

Excellent $AAPL analyst at Bernstein engages Jobs in discussion of approach to mkt: just share? price points? vs. competition. Good stuff.

$AAPL Q&A is focused more on gross mgns than anything else. 40% plus from 2Q09 to 2Q10 but now mid/upper 30% is confusing spreadsheets.

Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor.

Demand for Apple Products Supports Plenty of Upside for Apple Shares

Apple reported another great quarter. Below are the "tweets" I posted on Twitter as I as updating my spreadsheet model and listening to the conference call. For Apple, I continue to find that my first impressions are the most valuable so the Twitter comments capture my thinking well.

That said, after reading post call commentary from analysts and journalists, I feel more confident in the outlook and my call for the stock trade well north of $300. Apple needs a decent market to move up another 25-50% but if the market cooperates, I think the stock will make the move. Estimates already jumped over $17.00 for next year and given demand for iPads and iPhones, I think that will prove conservative once we see blowout back to school and especially Christmas sales.

The most important takeaway from this quarter is product demand. Mac laptops and iPhones are really strong and iPad is about to accelerate as supply constraints ease and new countries are rolled out. Apple sold 3 million iPads in the June quarter. It appears they are building to sell 3 million a month now! And iPads were supposed to cannibalize Macs, yet in the first quarter of iPad shipments when Apple fans rushed out to buy the product, Mac laptop sales soared above expectations. It wasn't that long ago when we were talking about the halo effect of iPods on Mac sales. Is it possible that iPads will have a halo effect rather than cannibalize other Apple products?

One final thought. The last few quarters, I find less and less to be surprised about as I input the reported numbers into my spreadsheet. I see this mostly as positive as the risk factors appear to be receding. Also, it reaffirms the still underappreciated operating execution by Apple's management team and employees. However, the Street is finally catching up to the upside potential and that reduces the positive surprise upside from the earnings figures. The shock factor is less. This slightly hurts the stock in the short-term though the next 6 months look great.

Here are my Tweets from yesterday afternoon:

• 1st Impressions off spreadsheets. Another Gr8 Q. Gross Mgn a bit less than I thought. iPads? Gross mgn guidance looks way low at 29%.

• So much for Macs being cannibalized. Macs very strong with laptops driving it.

• gross mgn guidance seems to be 34.4% vs. 39.1% last Q. Must assume lots of back to school iPads and new country iPads at lower mgn.

• FY10 heading to $14.50. At 20% growth FY11 goes to $17.40. Current consensus is 20% growth. Cash now $50 a share. $65 in one yr

• FY11 at $17.40. Cash in 1 year at $65. $260 - $65 is $195 or 11.2 P/E. Cheap. At 15 P/E plus cash, target of $325. Up 25% from here.

• 20% growth in FY11 is massive deceleration from current trailing 12 month growth of over 50%. Justifies $17 plus in FY11 EPS.

• Not getting much new info beyond initial impression on $AAPL conference call. One Q on iPad cannibalizing iPod touch hits home for me.

Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve Birenberg is sole proprietor of Northlake Capital Management, an SEC registered investment adviser.

All Good at Apple. Again.

Below are my Twitter comments in chronological order as I was listening to the Apple conference call. I find these initial reaction comments, which for most companies are handwritten notes, are usually my best analysis. Gut reaction plus objective analysis is reliable. Or to put it another way, I like to keep it simple and not overanalyze every last detail.

To reiterate, I think this was a very good quarter from Apple and justifies raising my 2010 price target from $265 to $350 based on the math below.

• All good at $AAPL. If I HAD to nitpick...tax rate of $23.7% added about 23 cents. Cash build less than usual. Inventories up a bit.

• $AAPL made an acquisition and inventory build is probably iPad. Mac shipments and ASP in line. iPod units BTE on ASP BTE.

• $AAPL iPhone shipments of 8.74 million is way BTE. Flat against seasonally strong Dec Q. Good for $T thohg big rev gains outside US.

• $AAPL US rev +26%, Europe +63%, Japan +51%, Asia Pacific +184

• Old consensus for $AAPL for FY10 is $12.06. Figure it goes north of $13 now. 20 times EPS before deducting $45 in cash. 16.5 times adj P-E.

• $AAPL rev +49%, net income +90%. Say what you want about P-E, but at 16.5 adj for cash or 20 times unadjusted you get a lot of growth.

• How about $15 EPS for $AAPL in 2011. 18-20 P-E plus what will be north of $50 per share in cash for target of $350????

• $AAPL explains lower tax rate as "true up" to change from 29% to 27% for yr due to greater intl mix. Legit explanation. + for estimates.

• $AAPL guidance on gross margin is for seq drop of 470 bps due to iPad, forex, mac transition, and unannounced transition. Unannounced :-).

• Gr8 Q from Bernstein analyst on $APPL guidance and iPad. Either iPad unit or mgn expectations way too low. Or gross mgn guidance too low.

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

Another Good Quarter Validates Apple Bull Case Despite Confusion

Apple reported another good quarter (revenue +32%, EPS +44%) although investor reaction was unusually muted as the company unexpectedly switched its revenue recognition policy for iPhones. Apple has been reporting “adjusted” results based on the new accounting for several quarters and most investors new a switch was in the pipeline. However the company gave no indication the change would come this quarter. As a result, there was no real way to compare Apple’s results or the March quarter guidance to estimates. This confusion I think led to a muted reaction.

After quickly updated my spreadsheet with the new historical reported results, it looks like another very good quarter although not a massive upside blowout compared to restated estimates. Guidance looks pretty good in that it appears to roughly match analyst estimates. Apple usually guides below the Street.

The quarter saw better than expected Mac units, which is always helpful as Macs sell at an average price of $1,324, or 8 times an iPod and 2 times an iPhone. iPod units were down 8% but this a little better expected and iPod revenue got a boost from 55% growth in the touch which boosted average selling prices to their highest level since the March 2008 quarter. iPod revenue was actually up 1% despite the 8% unit volume decline.

iPhone units were a bit below expectations at 8.7 million, up 100% from a year ago. On the call, management provided reassuring comments when it stated they could have sold “a lot more” but are managing inventory very tightly.

As to the accounting change, there is nothing negative to read into it. Apple has been deferring significant revue form the sale of iPhones to wireless companies like AT&T due to a strict interpretation of accounting standards. The change puts Apple in line with other cell phone manufacturers like Research in Motion (RIMM) and Nokia (NOK), whereby almost 100% of revenue is recognized in the quarter in which the phone is shipped. In other words, compared to its peers, Apple has been massively understating its iPhone revenue and earnings. This change actually increases transparency, which is always a good thing.

Based on restated numbers, Apple earned $9.13 in its fiscal year ending September 2009. 1Q10 EPS gained 44% and the company guided – likely conservatively – to 18% growth for 2Q10. Let’s say Apple’s EPS in 2010 rise 30% to $11.87. Within that EPS is less than 10 cents per share of earnings on $43 per share of current cash reserves. By year end, cash reserves should be north of $50.

At $205 in after hours trading, Apple trades at $155 adjusted for cash on an EPS estimate of $11.80. The P-E of 13 seems awfully cheap given the near-term operating momentum, still massive market share opportunities in Macs and iPhones, the tailwind of smartphone adoption, and potential new product categories such as the tablet to be introduced on Wednesday. Put an 18 multiple on Apple and add back the cash and you have a stock near $265, up 30%.

I actually think that $11.80 will prove low for 2010 and 2011 could be near $15. 18 times $15 plus $50 in cash equals $320. In a good market, that seems a reasonable target for this time next year.

Apple stock will always highly susceptible to profit taking and market pullbacks so timing is important. But current holders can feel very comfortable in the value of their shares and not worry greatly if the stock pulls back. The shares are still a buy at current prices but any pullback related to market conditions would be an ideal entry point.

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

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.

Apple Scores Again with Big Quarter and Good Guidance

Apple reported another great quarter with Mac and iPhone unit sales exceeding expectations and gross margins coming in well ahead of the most bullish estimate. The stock has come a long way and may stall after this morning's pop but I think over the balance of this year the stock can move to $180 to $200 assuming the economy and market pose no major obstacles. Analysts are effusive in their praise today and most have raised earnings estimates and price targets. All good but keep in mind universal praise often means in the short-term the good news is priced in.

Last night a good friend and hedge manager who has made money shorting Apple in trades asked me why the stock was up 5% after hours and how the stock could go straight up this year without a 20% correction. I should point out my friend covered his latest short yesterday at a profit before the earnings report. Here was my reply:

Apple soared because of guidance on gross margins reported. Guidance was almost equal to current consensus. For Apple that is an upside surprise. I read today that one analyst calculated that over the last 12 quarters the average EPS guidance was 12% below then current consensus. Furthermore, I read that some people though they might guide as low $1.00 yet they guided to $1.20.

Something new is going to have to pop up to trip it 20%. The economy has not hurt as badly as feared, the Jobs factor is less, Macs are still gaining share, and the iPhone is on fire. Besides another leg down in the economy or a market crash, tell me the new thing that is going to hit for 20%. I don't see it at least for the next 3-6 months.

After the report and during the conference call, I provided live commentary of my thoughts via Twitter. Here is recap of my tweets:

Big gross margin drives AAPL well above consensus EPS. Guidance closer to analyst estimates than usual which should be a positive.

iPhone boosting AAPL gross margin reversing gross margin worries from a year ago and cushioning currently rising commodity costs.

Apple Quarterly Earnings Preview

My friend and RealMoney.com colleague, Jordan Kahn, wrote the following preview of Apple's June quarter earnings which are due to be reported after the close tonight. Please check out Jordan's blog "In The Money" for more of his always excellent commentary.

I'd preface Jordan's comments by noting that the estimates and stock price targets for Apple have been rising along with the stock for the past month. This has raised the expectations bar as far as the immediate reaction in the stock after earnings are reported. As Jordan notes, guidance commentary is key, especially in lieu of the weak economy and premium price points on Apple products. In the long run, I think Apple still has substantial upside as there is plenty of market share still to be gained in Macs and iPhones and I expect both product lines to be expanded/refreshed regularly along with an eventual move into something akin to the currently popular netbooks. Adjusted for $32 cash on the balance sheet (producing just 20 cents if EPS), the stock is reasonably priced at 19 times 2010 consensus estimates which are probably conservative. Enough of me, here is Jordan's very well informed and insightful preview:

Apple (AAPL) will report earnings after the close on Tuesday. Consensus estimates are for EPS of $1.18 on revenue of $8.25 billion (according to Reuters). Apple has a long, long history of topping consensus estimates, so that is not really the question here. Whisper numbers are already in the low $1.20s. The key to the stock in the days ahead is guidance -- namely, how conservative management is with September guidance.

Piper Jaffray looked at the last 12 quarters and calculated that Apple management has, on average, guided forward EPS estimates 12% below Street expectations. Right now, the Street has next quarter's EPS number at $1.29, and many analysts think guidance could come in the range of $1.00 to $1.10. So watch this number as a key driver (I know it's a silly game of underpromising and overdelivering, but I don't get to make the rules.)

The company launched its third generation iPhone 3GS in June, which was met with very strong demand. Apple also cut the price of the old 3G iPhone to $99, which likely spurred demand for folks who have been waiting for a better price entry into the smartphone market. The company also lowered prices on refreshed Mac laptops. So unit sales for these categories should be good, and we will have to see if the company had to sacrifice margins. Gross-margin guidance from last quarter was 33%.

Other keys to the call will include the following:

* can iPhone units sold top the 5 million whisper number?

* can Mac shipments hit the high end of 2.3 million to 2.5 million units?

* update on iPhone release in China (and other foreign markets);

* comments on any upcoming iPod line-up refresh;

* comments on rumors of an upcoming "tablet" launch;

* update on Steve Jobs' status (will he get on the conference call?); and

* again, guidance -- how conservative will management be ahead of the back-to-school period?

Although most of the hype surrounds the iPhone, don't forget that the biggest driver of earnings is still Mac sales. There has been chatter that the shipping delays on the online store for Macs augurs well for demand currently outstripping supply, but expect Apple to ramp-up its builds over the next quarter.

Strong Hints Jobs is Back Working at Apple

Yesterday morning on Twitter I noted that Steve Jobs was quoted in Apple's press release announcing 1 million sales of the new iPhone 3Gs. I quickly completed a scan of Apple press releases going back to late March and found no other instance of Jobs being quoted.

This morning, AppleInsider.com reported the same and stated that this is the first time Jobs has been quoted in an Apple press release since he began his leave of absence in January. I think this is a very strong signal that Jobs has in fact returned to Apple. The extent of his participation is still up in the air as no one knows how much stamina he has following his recovery from his latest health issues. As widely reported, Jobs apparently had a liver transplant a few months ago.

Also worth noting it that there have been several sitings of Jobs on the Apple corporate campus.

Overall, Jobs leave of absence has diffused the impact of his health on the stock. Tim Cook and Phil Schiller both raised their profiles and were easily accepted by investors. Furthermore, the company performed well in Jobs absence on a fundamentla basis with product introductions and strong quarterly results.

I trimmed Apple a few months ago at $133 as I felt the risk-reward was more balanced following the 60% recovery in the shares. I maintain my 2009 target of $150 plus based on the assumption that reported earnings growth resumes in 2010.

Apple as Religion

SNL Kagan, which publishes the Dow of Steve blog, recently had an article discussing lower prices initiated by apple in the Mac and iPhone product lines. The article fairly noted that the price cuts were in response to the weak consumer environment and tough competition while also noting that Apple still maintains its premium pricing strategy.

I think Apple's go to market strategy remains smart and still believe upside remains in the shares. Nevertheless, I trimmed positions at $133 as the risk-reward is less attractive following the surge in the stock this year (up more than 50%).

The reason I mention the SNL Kagan is because it contained a really cute quote that made me laugh. The article quotes Martin Lindstrom, brand consultant and author of "Buyology" comparing Apple brand loyalty to religion. "He said that when a study he helped conduct scanned the brains of both Apple fanatics and people who professed a strong faith in Christianity, the same regions in both groups' brains were activated."

Kagan wen on to note that "Lindstrom polled 2,0000 consumers and asked if they would tatoo an Apple logo on their arm. 'And 6.7% of Apple fans said yes.'

Lots to chew on there for Apple lovers and haters and there are plenty of both!

Trimming the Branches on the Apple Tree

While I still think Apple (AAPL) has upside to $150 plus as the year unfolds, I trimmed positions across most Northlake client accounts this morning. Apple shares have performed very well this year as the company is seeing much better demand than many feared given the state of consumer spending around the world. As a result of a 50% increase in the share price in 2009, many client positions in Apple had risen to almost 4% of total portfolio values. Northlake closely monitors position sizes and usually cuts back near 4% to bring positions below 3%. This is a useful way to harvest gains or capture relative performance.

The bottom line on this Apple trim is that it is driven more by than position management than any change in my view of Apple's business trends or long-term stock valuation.

In addition, with the market having crossed the 900 level on the S&P 500, completing a rally of 30% plus off the 2009 lows, I want to rebuild cash positions which were lowered in mid-March. I think early May is a logical time for the market to consolidate recent gains as news flow will dry up after this week. My plan is to reinvest recent cash proceeds and invest additional cash reserves if the market pulls back 5-8%. Of course, I am always on the lookout for individual buying opportunities that are not tied to the overall market trend.

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

Another Blowout for Apple Supports More Upside

Apple reported another blowout quarter with revenues and gross margins far exceeding expectations and driving EPS to $1.33 vs. consensus of $1.09 and whisper numbers in the $1.15 to $1.20 range. Guidance is typically conservative and about 10% below current analyst estimates which is normal.

There is really very little to complain about. In my live Twitter commentary of the conference call I noted that the quarter was amazingly routine, especially given the economic headwinds. I see no reason the stock can’t move up toward $150 assuming the market cooperates. Positive catalysts ahead could include new products – iPhone and netbook, the return of Steve Jobs in June, and more positive earnings surprises.

I remain quite bullish on Apple but there were a few things worth pointing out on cautious side in the quarter. First, desktop ASPs fell sharply. Management attributed this to a mix shift as weakness was more evident in Creative/Professional and Education. Second, U.S. Mac market share fell. Management says that they focus on long-term trends in market share and don’t put much stock in any single quarter. Third, cash flow was less robust than usual. Management explained clearly that one-time items impacted the quarter.

Guidance is what really matters to short-term trading in Apple. I would have liked to see it stronger given that the past several years saw flattish March to June revenue and EPS. This would mean June should come closer to $8.2 and $1.33. Thus, I would have liked to see guidance closer to these numbers and above current estimates. One explanation is that Apple is not going to recognize any revenue from iPhones sold after March 17th until new software is released in July. I still expect 3Q results much closer to the March quarter.

Estimates will go up toward $6.00 for 2009. Excluding interest income the figure is around $5.75. Cash is no $33 per share and headed to upper $30s by fiscal year end. Stock is trading $90ish ex cash or 15-16 P-E. Adjusted earnings if Apple were recognizing iPhone revenue at sale instead of over two years is probably $9-10 putting the multiple at 10 times or in line with other large cap tech leaders. I think Apple deserves a premium. Looked at another way, these is a big cushion to estimates for the rest of 2009 and 2010 and 2011 from deferred revenues. That is comforting but product momentum is more important. For now, the pipeline looks good.

While the quarter was a blowout and reinforces my faith in meaningful further upside in Apple shares, I think the stock could be due for a rest after the huge move this year. I am not selling and would buy any significant pullback. A move $5 in ether direction on Thursday from the $124 after hours level as I type would not surprise me.

Apple Earnings Preview: Should Be Good But It's Always About Guidance

Apple reports its 2Q09 results after the close on Wednesday. As usual with Apple the stock will react to guidance unless the quarterly numbers are a major surprise. The stock has rallied sharply this year, up about 40%. This dramatically raises the expectations bar for short-term traders. In addition, good results and a huge stock pop for Research in Motion has raised the bar for Apple.

There has been little movement in Apple estimates over the last 90 days. Consensus estimates call for EPS of $1.09 on revenues of $7.94 billion. Nevertheless, commentary about the quarter has grown increasingly positive amid indications that Mac and iPhone sales have held up better than expected given seasonality and the tough consumer economy.

I maintain a simple spreadsheet on Apple that has been very helpful to me in gauging quarterly reported numbers and guidance. I can easily see the quarter coming in as high as $7.93 billion in sales and $1.16 in EPS. This would be inline with estimates on revenues and above consensus on EPS. My model likely is more positive on gross margins where I am looking for 35% vs. guidance of 32.5% and most estimates between 34% and 35%. I would not be surprised to see upside on revenues emanating from iPhones or better than expected iPod ASPs due to the touch. It should be noted that projecting iPhone revenue is a tricky exercise. EPS at or above the $1.23 high estimate is not a major stretch.

To satisfy the street, I think Macs must come in at 2.1 million plus units, iPhones at 3.8 million units, and iPods at 8.5 million plus units. Much will be made about a 20% drop in iPod units but I have always advocated for the idea that iPhones are self-cannibalizing iPods in a positive manner for Apple shareholders.

The guidance commentary may give some insight into the timing of a new iPhone model. If it ships in the June quarter, it would seem there would be some upside to revenue although it is important to remember that iPhone revenue is recognized over 8 quarters. Current consensus for June is revenue of $8.26 billion and EPS of $1.11. These estimates are up very slightly from March quarter estimates. This sequential pattern is consistent with the last few years. As a result, guidance for June will need to be close to flat sequentially to satisfy the street. Apple always guides conservatively so numbers 5% or so below whatever is reported in 2Q09 may probably good enough. Anything at or above what is reported, which is likely to be above the current 3Q estimate, should be greeted favorably.

Apple shares trade off following the earnings report more often than not. With the expectations bar at a high level that seems like the most likely scenario this time. However, I think Mac and iPhone sales are trending ahead of estimates. Macs due to market share gains and iPhones due to share gains and very strong smartphone penetration. Confirmation of these trends could take Apple shares higher.

My investment style is longer term. I've owned a core position in Apple since early 2005 and just trade around it, mostly by trimming positions on relative strength. Unless the quarter has negative surprise, I stand by my recent thoughts that the shares have upside to at least $150 this year.

Disclosure: Apple is widely held in Northlake client accounts including Steve Birenberg's personal accounts.

Apple Still Has Upside

Apple reports its March quarter next week. The stock sits near its 2009 high, up about 40%. Each time the stock has pulled back buyers show up and take it right back up.

Recently, the chatter on the street has been bullish as iPhone and Mac demand appears to be holding up better than expected. Apple seems certain to report a quarter better than its guidance. This is widely expected and analysts are ahead of guidance. Estimate increases are far outpacing estimate cuts.

Investors have been worried that Apple's premium priced products would falter in the tough economic environment. This does not seem to be the case, as market share gains continue to offset macroeconomic weakness.

Other factors helping the stock are Research in Motion's strong earnings report and less worry about the future of Apple without Steve Jobs. I think many investors are missing the big picture on smartphones – their penetration is rising so fast in the U.S. that the market is healthy enough to easily accommodate Apple and RIMM.

As for Jobs, I've noted before that Apple is at a point in its product lifecycle where changes are evolutionary. Even a move to a netbook is not much more than a larger form factor iPod touch. This is an ideal time for Jobs to be sidelined as it is even more about operational execution than usual. Furthermore, operational execution is massively underappreciated by Apple observers who focus on product rumors, unit volumes, and average selling prices. Those things are important but have always been in the stock price equation. Operational execution was not in the stock price. It is also Tim Cook's, the heir apparent to Jobs, strength so the timing for the stock is even better.

If the economy recovers into 2010, Apple shares could rise significantly as estimates begin to move up. The current 2010 consensus is $5.94 vs. $5.10 in 2009. If 2010 goes comfortably north of $6, I could see the stock nearing $150 later this year based on a 20 P-E and giving credit for what will be more than $30 in cash presently earning just 1%.

I'll be back next week with a detailed preview of the quarter but remember the stock will react to guidance much more than the quarterly results.

Apple is widely held by clients of Northlake Capital Management, including in my personal accounts.

Apple: New iPhone Rumors Heating Up Ahead of Earnings

Pretty much everyone is now expecting a June introduction of a new iPhone model. Most people expect an upgrade to the 3G but a few hold out for a second form factor that would have a lower price and allow cheaper data plans. Rumors are rampant about upgraded production schedules in the Far East. Most of these articles indicate that the production increases are dedicated to building inventory for the new product. That is most surely the case but I have been wondering lately about demand trends for the current version. Anecdotally, I see iPhones everywhere. I have to admit I look for them and I own one myself. I am also long Apple. I also live in the north suburbs of Chicago where Macs are hugely popular and every kid has an iPod. Apple reports 2Q09 shortly. As usual, guidance is what will drive the stock. But the quarter itself hinges on demand for iPhones and Macs. No doubt now that iPods are saturated and will suffer a significant sales decline (possibly next quarter due to new shuffle pipeline fill but ASP will be down). Many analysts have been expecting a weak quarter for iPhones and Macs. Could it be that iPhone 3G demand is strong and some of that production is to meet current demand? RIMM certainly indicates that smartphone demand is good. I believe smartphones are a rising tide lifts all boats story for 2009. Could Apple be in for beat and raise? OK, that is asking too much but how about a beat and guidance that matches analyst estimates?

Life at Apple Continues Sans Jobs

Bloomberg is reporting a March 17th event to provide a "sneak peak" at new iPhone software, version 3.0. The company introduced a new, next generation shuffle and is now updating iPhone software (the iPhone is all about software). This is being done with Steve Jobs nowhere to be seen and without a rollout at MacWorld.

It is worth mentioning again that Apple is at a point in its product development cycle where Jobs driven innovation is less important. The upgrade path is clear and can drive further market share gains in Macs and smartphones.

Apple is held in Northlake client accounts including my personal accounts.

Apple Acting Better

Apple is now up about 10% this year and almost 20% from just before it reported its December quarter. I think there a few things at work and that the stock still has "all clear" for another 60 days. That means I think AAPL can be a market leader and outperform the market over that time frame.

First, the good December quarter and more importantly the acceptably weak guidance reminded investors that AAPL is operating quite well in a tough environment. It also provided downside support for estimates eliminating the risk, for now, that numbers keep tumbling. Second, the great quarter on an operating level was evidence that for awhile at least AAPL can survive and thrive without Steve Jobs. I understand and respect the Jobs risk in the shares but I also think the focus on Jobs led many investors to ignore a talented bench that has been responsible to the incredibly consistent operating performance. With Apple in a product extension mode as opposed to a new product platform mode, the timing is as good as it can be for Jobs to be away.

As for Jobs, I stand by my earlier assertion that form a trading perspective the risk is now more balanced. Most people I talk to do not expect Jobs to be back. If he does come back in June or announces he is on schedule to do so it puts the shorts at risk. That is a change from where we were in 2H08.

The quarter had some blemishes. Most concerning is that iPhone sales were light. Desktops were weak but that is less of a problem given an old product line and market shift to laptops. The issue of margins also still overhangs the 2009 outlook. For now, however, I think the coast is clear. These issues will matter again as get deeper into current quarter and worries arise about current demand trends. I don’t think those worries happen for a couple of months so Apple goes higher.

Apple Comes Through

I have to admit a sense of great relief following Apple's December quarter earnings. The numbers were great and guidance for the March quarter was much better than feared. A lot of stocks I like, including Apple, are really struggling and it makes me question my analysis. In this case, I got it right and that increases my confidence in other stocks as well.

What follows immediately is live commentary I posted on Real Money.com prior to and during the company's conference call on Wednesday after the close. If you click "continue reading" you will find a more formal summary of the quarter and the call. Apple shares should re-emerge as market leaders on rallies thanks to this quarter.

1/21/2009 4:40 PM EST
December Q looks like a clean beat. Macs in line. iPods way ahead and flat with last year. Gotta be the touch. iPhone at 4.363 is a little light.

But is all about guidance. $7.6-8.0 billion revenue and EPS of 90-$1.00. Both of those are below consensus but not nearly as low as many feared. This is good news and is why the stock is trading over $91 as I type.

More after I fill in my spreadsheet.

1/21/2009 4:59 PM EST
With help from my updated spreadsheet...

December quarter is excellent. A clean beat. Revs higher, gross margin way above guidance. I thought this could happen given favorable input costs but very solid ASPs on Macs and iPods also helped. Desktop units light but laptop units better than expected. Apple made its Mac units without giving on price in a brutal environment when everyone else cut prices. Shows the power of the brand. iPod units were a blowout but just up tiny yoy. ASP for iPod is flat. Given speculation on strong touch sales they must also have had good luck with shuffles. iPhone units could have been better but my spreadsheet got the revenue close which gives me more confidence in future predictions.

Om March quarter guidance. Using midpoint on revenue guidance, similar qoq trends from last year on operating expenses, and lifting interest income very slightly form December quarter, I back into gross margin guidance of 30%. there is no regular pattern of qoq gross margin but this will be viewed as conservative.

That last point is what matters. If you assume rev guidance is conservative and give them a boost in gross margins to 32% you are at or above current consensus. In other words, guidance in Apple terms is good. Thus the stock is up another $8-10 bucks as the call is about to start.

1/21/2009 5:21 PM EST
Guidance assumes 32.5% gross margin and a huge step down in interest income. Should have figured that given short-term interest rates. Also, some of gross margin upside comes from a catch up from prior periods. Maybe 100 basis points?

I still believe my comment that in Apple terms guidance is in line with street estimates and a lot better than the whisper or feared.

The rest of my comments will be in my earnings summary.

Formal Summary of Quarter

Apple reported excellent December quarter earnings. Revenues and EPS easily beat estimates. Revenues were $10.17 billion and EPS were $1.78 compared to estimates for $9.74 billion and $1.39.

Mac unit sales were in line at 2.5 million with desktops light and laptops better than expected. ASPs held steady despite worries about the weak consumer spending environment.

iPod sales were much beet than expected at 22.7 million vs. estimates of 18.6 million. ASPs were steady. Nanos and the touch were singled out on the conference call. ASPs held steady. US iPod sales were down about 3%. International sales were up. The last week of the quarter saw a buying surge on a worldwide basis.

iPhone units of 4.3 million were at the low end of expectations. There was some inventory drawdown so shipments for the March quarter could get a boost as pipeline fills. But Apple remains publicly worried about demand given the economy and high price points for Smartphones.

The balance sheet looks great with $31 per share in cash after a big quarter for cash flow. Inventories look under control and within expectations for phones and Macs. For phones inventories are tricky because this is the first quarter with so many countries and so many channel partners.

Gross margins were 400 basis points ahead of expectations. One half of the upside came form component costs. The rest was evenly split between lower expenses for things like transportation and warranties and from what I think might be a one-time boost due to prior period adjustments. I may have misunderstood this last comment.

The big positive for the shares was guidance. Guidance of $7.6-8.0 billion in revenue and 90 cents to $1.00 in EPS is below consensus but not too far below. Apple normally guides conservatively and beats so in Apple terms this guidance is in line with consensus. Consensus had been coming down steadily and there was great fear guidance would fall way short. Guidance assumes a drop in gross margins sequentially and a big drop in interest income reflecting the unusually low interest rate environment on the short end of the yield curve.

This quarter and guidance should seriously relax investors. The valuation adjusted for a cash balance that is now generating a lot less interest income looks very good. Operating EPS seems set to be at least $4.00 and cash should end over $35 per share. AT recent lows around $75 that would leave the core P-E multiple at just 10 times. Quite reasonable given the still low market share in PCs and cellphones.

Apple also was once again very tightly and well managed. This should help to allay concerns about Steve Jobs health. Someone asked about Jobs health on the call but no new information was provided.

Finally, adjusting for the fact that Apple recognizes iPhone revenue over eight quarters, had they reported like RIMM or Motorola or Nokia, revenues would have been $11.8 billion and EPS would have been $2.55. That means that at a 4-5 million iPhone run rate Apple's earnings power is over $10 per share.

Apple Exits MacWorld

I believe the reporting of Apple's withdrawal form MacWorld after 2009 and Jobs lack of appearance this year was misreported. There is little doubt that it had a major negative impact on Apple shares, however. Here is my take on the situation.

The stock reacted very negatively to the MacWorld announcement, immediately falling about $4 in after hours trading on Tuesday and giving up another $3 during the day on Wednesday. Most commentary suggested the drop was due to either Jobs health or the lack of a new product introduction in January as if there were a big one coming surely Jobs would want to make it.

There is little doubt that these issues contributed greatly to the drop but I think a big part of the fall was a delayed reaction to the NPD data, Goldman Sachs downgrade, and other cautious analyst commentary. The stock held up well against those news items so the MacWorld announcement set up an easy sell/short opportunity. An imbalance occurred to the downside as there is enough legitimacy to the demand concerns to scare off bulls and the stock is already owned very widely. There probably aren’t a lot of new buyers out there, especially while concerns around current and 2009 demand for Macs and iPhones linger.

Getting back to MacWorld, I think it is highly unlikely that Jobs health would be the cause for the cancellation. Apple leaked to the New York Times about his health a few months ago – it was OK. Even a company as secretive as Apple is going to be hard pressed to not come clean in the current environment (Re: Madoff) and tell the truth if Jobs is actually too sick to appear. And if he is too sick to appear a month before the event, he is obviously really hurting and it would be hard to cover it up completely. A sickness related cancellation seems much more likely to be a last minute thing.

The new product issue seems more likely to lead Jobs to skip MacWorld....

....Jobs and the company seem satisfied with the current product lineup in their limited public comments. Apple clearly sees the iPhone having massive volume in front of it, possibly including new iterations. There is a developing netbook product category between Apple's laptops and iPhones but I believe Jobs when he thinks the iPhone is a netbook. Certainly that is the case if rumors of a $599 bulked up iPhone have any validity.

There is also the possibility that a material new product will be introduced but Apple wants to send a message by letting one of the potential Jobs replacements, Phil Schiller, make the announcement. The quick and dirty reporting on the MacWorld news conveniently left out that Schiller, COO Tim Cook, and other senior executives presented at Apple's most recent product announcement events. Maybe Apple is trying hard, in its own overly secretive way, to tell us that a leadership/succession plan is actually in place.

But by far the most likely explanation for the end of Apple at MacWorld and Jobs not appearing this year is that Apple really is pulling back from trade shows. Apple has announced many of its more recent product introductions at company-sponsored events and probably just wants to save the money, time, and effort while also controlling the timing of its product introductions.

Maybe plain, old politics is playing role. I'll bet that most people thought that MacWorld was an Apple event. It is actually run by a third party, IDG, which has done other Apple-based trade shows for years. Apple has already stopped attending those shows. Reading some articles about the MacWorld cancellation gave me the impression that there was some tension between IDG and Apple. Maybe Apple just wants to stick it to IDG by not sending Jobs to their final appearance at MacWorld

Supporting my view that Apple is simply ending its participation in third party sponsored trade shows is Alex Hesseldahl, a technology writer for News week who wrote on the Byte of the Apple blog:

"But Macworld costs Apple money. I’m told reliably that participating in Macworld costs Apple somewhere north of $2 million, and somewhere south of $5 million. Why spend that much when you can have the same kind of impact for a lot less without the need for a third party?
I suspect that when Apple throws a large-scale press conference at Moscone, it costs a lot less than $2 million, and even less for the announcements it does occasionally at De Anza Community College. Same impact, less money. What about this decision doesn’t make good business sense?
Macworld isn’t the only trade show from which Apple has backed away in recent years. Earlier this year Apple canceled its booth for the NAB show, in 2002 it walked away from Macworld Tokyo, nor did it participate in the Apple Expo in Paris this year."

As noted at the outset, legitimate concerns exist about demand for Apple products in this brutal economic environment. Those concerns set up a big sell reaction to the MacWorld news. But on its own there are plenty of legitimate reasons not to overanalyze the MacWorld news and assume the worst.

And if you do want to overanalyze it (just as I am doing!), then maybe the question we should be asking is whether Apple is undercutting support from software and hardware vendors partial to the Mac OS platform by pulling out of trade shows. With the Mac and iPhone going more and more mainstream it is these very supporters that Apple needs as it s forced to steal market share from tougher competitors like Nokia, Hewlett Packard, and Research In Motion. Now there is a story I'd like see discussed.

More Comments on Apple's Earnings

As I leave the office after the Apple call wraps up on Tuesday night, the stock is trading at $102, up a little over $10 from the NY close, regaining more than the $7 loss during regular hours.

I posted the big news on the call while it was still going on (immediately below). Steve Jobs made a very rare appearance and presented an enthusiastic outlook beyond the unpredictable economic climate. He was especially optimistic on iPhones and the App Store. He mentioned the virtuous cycle those two things create. He also said copying the App Store is not as easy as it looks. He downplayed a second iteration of the iPhone. He says smartphones are software driven which means that form factor can stay the same unlike voice only phones.

Guidance looks really poor. At the midpoint of assumptions I get $1.21 on $9.5 billion in revenues vs. consensus of $10.6 billion and $1.65. The guidance is characterized as conservative. I also believe the whole discussion of GAAP vs. Adjusted financials may have some impact on the guidance. It did not come up on the call but revenue recognized per iPhone unit looks awfully low. If that carries over to December quarter and analysts did not have it then part of the issue may be accounting related.

And since Adjusted EPS assuming no subscription accounting are $2.69 in the quarter it is clear that earnings power is immense. 4Q should be up sequentially implying earnings power near $10 per share. And cash is at $27 per share.

Even if you collapse the multiple because 39% of adjusted revenue is phones the stock looks awfully cheap. I think buys around $100 will look very good.

Big News on Apple Call: Jobs Makes Rare Appearance

He's alive. He sounds vibrant. Very upbeat on iPhone and notebooks. Discussing economy which he says is impossible to predict but company positioning provides some insulation.

Very confusing numbers because of subscription accounting. This could be impacting GAAP guidance based on a revenue per iPhone calculation.

Jobs mentions possibility of using cash on acquisitions. $25 billion cash on hand.

Regarding guidance, Jobs says October is a "foggy" month and "There is a lot of prudence built in."

Jobs strongly implies no stock buybacks.

Jobs on the call is definitely an attempt to send a positive message. Working so far with stock trading up $6. This is the first time he has appeared on a quarterly conference call in 8 years.

Bar Lower for Apple's Quarterly Earnings

Apple reports its September quarter earnings tonight after the market closes. However, the key to the stock price will be the December quarter guidance. Given that Apple guides below consensus most of the time, I think anything close to consensus of $10.57 billion in revenue and $1.65 in EPS will be well received. Obviously, the question is whether consumers will open their pocketbooks for Apple products during the holidays. The company certainly has a complete product lineup if consumers decide to spend. The iPhone appears to be especially well positioned as a holiday gift. A second question is whether Apple's product transitions support demand but at the expense of margins.

Consensus for the September quarter is looking for EPS of $1.11 on revenues of $8.05 billion composed primarily of 2.7 million Macs, and 10.8 million iPods. The financial expectations are above the disappointing guidance apple provided on its last call in July. I think it is noteworthy that iPod sales at this level would be up mid-single digits. I've seen iPhone estimates all over the place ranging from 4 million to 6 million. AT&T analysts are looking for over 2 million iPhone activations so a total shipment figure of twice that amount seems likely given the broad global rollout.

The last thing I would note is that estimates for Apple have been falling. Expectations for the quarter ahead (guidance) are much more subdued than at any time in the last few years. For example, when Apple last reported December quarter consensus was $1.80. Now the street is expecting $1.65.

Apple Guidance Is The Problem

Listed below is my live commentary which was posted on RealMoney.com from last night on Apple from before and during the conference call. Without reviewing analyst commentary from the morning after I'd add a couple of things.

On September quarter guidance, the gross margin would be the lowest since December Q 2006. The operating margin would be the lowest since September Q 2006. We'll see but that seems awfully conservative to me even accounting for a historical sequential downturn in gross margins in the September quarter.

Lots of questions on the 2009 gross margin guidance of 30% all of which surrounded Apple's pricing strategy. Seems to me quite clear that some major new products and maybe new price points are coming in that time frame. We already know that in the September quarter a "future product transition" will hurt gross margins (I'll bet that one is a big price cut on the touch). I'll repeat what I said last night: EPS estimates for next year are too high even if the new gross margin guidance is a 100-200 basis points too low unless new products ramp revenues materially beyond current estimates. Management is hinting this is the case driven by a new go to market strategy. We'll see.

On the stock, I have t admit that I am less optimistic than I have been in some time. These transitional issues on profitability seem to limit upside surprise potential. Then again, as I type this the stock is under $149. But if 2009 EPS are at consensus of $6.28, these issue make the premium multiple a little tougher to swallow. A big beat in the September quarter and/or the excitement surrounding these hints on new products are required now to get the stock turned back up.

Last night's comments...

....4:52 PM: It's all about guidance. The assumptions to get to the revenue guidance seem conservative given the usual sequential uptick in Mac sales for the back to school season. Then again, I really have no idea what to book for iPhone revenue. Similarly at the EPS line how to project margins is complicated by the gross margin related to component costs and again the iPhone. Given the guidance it will have to be clear that it is very conservative to reverse the after hours slide. The quarter itself looks very good. I have only a couple of questions. First, inventories are up. That very well could be iPhone stocking but I'd like to know for sure. Second, the iPhone ASP is just $152. I figured it would be flattish vs. a year ago instead of $152 vs. $159. Third, while ASPs look fine they are not as high as I would have projected. I'll trade a little price for a lot of units given the market share story at Apple but this is something that will come up on the call.

5:34 PM: The stock dipped a few more bucks just after a statement on the conference that "Steve's health is a private matter." Given the setup of the question allowing for a "Steve is fine" answer this is problematical to the rumor mill.

Also of interest and more important to me is a comment that 2009 gross margin will be 30%. Even if this is low by a few hundred basis points as gross margin guidance has been recently unless revenues jump sharply above current estimates, EPS forecasts would seem too high. This comment may have also contributed to the second drop in the stock referenced above. The gross margin guidance was stated due to product development related investments -- "state of the art new products that are competitors will not be able to match." Hmmm.

Apple Reports Tonight

I expect less positive surprise than usual for Apple when they report June quarter earnings tonight. But barring a major blowout or an unexpected miss, it is the guidance for the next quarter that will determine the immediate action in the stock price. Apple has a history of guiding below street estimates and then beating guidance and those original estimates. Thus even guidance in line with current estimates ($8.3 billion revenue, $1.24 in EPS) should be enough to drive the stock up.

A complicating factor in how the stock reacts is last week's bad reception to earnings from Microsoft and Google. Both reports had some issue but I don't think they were large yet both stocks dropped close to 10%. Also, the sharp rebound in bank and financial stocks indicates at least for the short-term their is rotation underway into beaten down stocks and away form recent leaders which include the leading tech stocks like Apple.

With those comments as background, click "Continue Reading" to see abiref preview of Apple's quarter as summarized by theflyonthewall.com.

"Apple (AAPL) is expected to report Q3 earnings Monday with a conference call scheduled for 5:00 pm ET. The consensus estimate is $1.08 for EPS and $7.36B for revenue, according to First Call. CFO Peter Oppenheimer said in April that the company expects to earn $1.00 a share in EPS on revenue of $7.2B. The "whisper" number is $1.11. The company is known for low-balling expectations and being conservative with its fiscal outlooks. Sanford Bernstein expects Apple to top the average estimates, and expects Apple to earn $1.12 a share on revenue of $7.6B. Bernstein said Apple's Macintosh and iPod sales likely were strong during the quarter, and that the company probably benefite d from U.S. consumers spending their economic stimulus checks on Apple products. The firm believes Apple will report Mac sales of 2.5M units, 10.3M iPods, and $400M in iPhone sales for Q3. As far as the iPhone is concerned, the new 3G model was released after Apple's Q3 ended in June, so none of the 1M devices that were sold in the first weekend of availability will have any effect on the upcoming results. Other Street thoughts: Piper reiterated its Buy rating ahead of Q3 results as it believes upside to Mac and iPod units may drive upside to the June quarter. The firm believes Mac units could reach 2.35M, above the Street's 2.2M estimate. Pacific Crest echos that sentiment saying that strong consumer demand for Mac and iPhone, along with an attractive component pricing environment, can drive near-term upside to estimates. Additionally, increasing enterprise penetration can add to near-term demand while extending Apple's growth period. Additionally, FTN Midwest's checks indicate Mac sales are above plan in June and July is off to a good start. Now that the initial hoopla surrounding the release of the 3G iPhone has settled down, analysts are more likely to keep their eyes on what Apple will have to say about the outlook for its current Q4. PacCrest believes Q4 guidance will likely be conservative. But, strong demand for iPhone along with a likely Macbook refresh during back-to-school should drive excellent Q4 growth". :theflyonthewall.com

Apple Earnings Set The Stage For More Share Price Upside

Apple reported excellent 2Q08 results with revenues and EPS exceeding estimates. Guidance is good by Apple standards with revenues above street estimates and EPS just 10 cents below the street. Analysts and investors will pick apart the numbers and conference call commentary but the bottom line is that this quarter, the conference call, and the guidance provide little to no ammunition for the bears. While there is similarly little for the bulls, especially in the short run, the fact that the bears can take away little makes this a win for the bulls – of which I count myself one.

This commentary and what follows is very consistent with my first impressions which I posted as soon as the numbers were released but before the call started. The bottom line, for the short-term, is what I noted in my first comment, "this stock is not going back to $120 but it isn’t going to see $200 either." Here's all the details in four times the number of words Apple used in their press release....

....Revenues of $7.5 billion easily beat street estimates of $7 billion. EPS of $1.16 beat street estimates of $1.07. The quarter lacked the huge upside to estimates because of less upside in gross margins than analysts estimated. EPS were helped by a lower than expected tax rate which boosted EPS by 4 cents. The tax rate will stay below prior levels so this may not be a one-time item. The lower tax rate resulted from more non-US profits and lower than expected interest income due to the very low short-term interest rates (this was below management guidance by about $40 million and should really be considered if someone complains about the 4 cent tax rate boost). It is also possible that a decision to forgo revenue recognition on iPhones sold after March 6th, the day of the iPhone 2.0 software announcement, until iPhone 2.0 software starts to ship in late June cost a very small amount on the EPS line.

Mac sales were stellar led by a 61% increase in notebook units. Desktops were no slouch, growing by 30%. Education sales were the best in eight years. Management seemed very confident in current momentum and the Air appears to be developing as more than just a niche product.

iPod sales rose 1% to 10.6 million units, ahead of expectations. ASPs were up but not as much I expected. Shuffles sales were down again but rose after the price cut probably impacting the mix and the ASPs. iPod revenue grew 8%. Some investors will still worry about slowing growth in iPods but touch still has upside and I continue to believe that old iPod numbers should be compared to iPod plus iPhone numbers today.

iPhones came in at 1.7 million which is the low end of expectations. Nevertheless, management very firmly reiterated 10 million in 2008 as guidance. The revenue recognition change mentioned above was the source of a lot question on the call but I didn’t get the impression that management felt it was material although I'll admit I didn’t understand the accounting implications completely. For what it's worth, the shares came off their after hours lows when management stated that they beat their internal unit target on iPhone sin the quarter which was the cause of the stock outs and missing iPhones late in the quarter. This suggests that we should have more confidence in the 10 million guidance.

The biggest source of questions on the call surrounded the gross margin which came in at 32.9% in the quarter versus guidance of 32% and analysts estimates of 34-36%. The reason that EPS were not the usual blowout vs. estimates was due to this "shortfall" in gross margin. Management said that relative to its guidance higher than expected revenues, the weak dollar, and lower than expected commodity costs led to the upside. Via Q&A it also became apparent that analysts may have underestimated the positive impact of Leopard on the prior quarter's gross margin. One analyst perceptively asked if the decline in commodity costs in the quarter evident in published pricing by suppliers may not have fully flowed through due to prior commitments made by Apple to buy inventory. The analyst did not get a clear answer which leaves open the possibility that gross margins may surprise to the upside in the current quarter. I am modeling flat gross margins on a sequential basis. It is worth noting that ever since gross margins exploded upward a year ago management has consistently guided analysts not to assume it was all permanent. Maybe this quarter proves the point. Maybe not.

I've adjusted my spreadsheet for the June quarter. I am now targeting revenues of $7.3 billion and EPS of $1.09, roughly in line with current analyst estimates but above guidance. The big swing factor is going to be gross margins. 100 basis points is worth 6 cents per share. Furthermore, gross margins reached an all-time record of 36.9% in the June quarter a year ago setting up a very difficult comparison that will limit the year over year growth in EPS. Nothing to worry about but worth noting as that is something bears will seize upon. I've got Mac units at 2.3 million up slightly sequentially. Sequential history would suggest a larger uptick. My estimate assumes unit growth at the low end of the recent range thus implying a deceleration that is not supported by current trends or buzz. I am assuming a 3% year over year decline in iPod units but a 5% revenue gain thanks to improved ASPs. I have iPhone units at 2.2 million assuming that the 3G phone ships late this quarter.

As noted, I think the bulls won this quarter because the bears lost but I don't see quick upward move in the stock. What I do see is upside as new products are announced/anticipated because the bear case is not very strong thanks to 2Q08 fundamentals and the relatively solid guidance. In the brief, Jobs says there are "some terrific new products in coming quarters." I think the stock works higher in May and June on investor enthusiasm for those products, especially the 3G iPhone.

Apple: After Earnings, Before The Call

Here is the series of posts I made on RealMoney.com yesterday after crunching Apple's numbers but before the conference call Q&A started:

4:49 PM EST: Good and and I like the guidance being in line with consensus. Tax rate was low adding 4 cents to EPS. That probably is why the stock has pulled back. iPhone at 1.7 million is on th low end. Gross margins did not surprise to the upside so operating margins not as good as hoped but top line offset thanks to Macs. iPod units fine but ASPs not up that big so it was probably the shuffle price cut. More later but I'd say this is a win for the bulls because it takes away potential form the bears. I wouldn't expect a huge response form the stock in either direction unless the conference call surprises. In the near-term, this stock is not going back to $120 but it isn't going to see $200 either.

5:08 PM EST: Stock now down a bit. Guidance on revenues is inline. EPS guidance is $1.00 vs. consensus of $1.10. Consensus was looking for 3% sequential revenue growth in June but guidance is for -4%. That of course is only a problem because 2Q revs were well ahead of expectations. My spreadsheet suggests June quarter guidance is conservative unless management is expecting a major step down in yoy notebook sales growth rate. That is doubtful given momentum, market share gains, and past sequential performance.

I suppose the lack of a blowout in the March quarter may have caused some consternation. I stand by my first impression: very solid quarter and guidance with little for the bears but not enough for the bulls in the short-term. I plan to hold my shares and will add in new accounts at current prices now that the quarter is out of the way.

5:33 PM EST: I should have noted this in prior quarters but Apple's press release is only 238 words. I challenge subscribers and contributors to find a similarly short press release from such a meaningful company or any company. And my editors (and readers) can just ignore the jokes about my word counts!!!!

Apple Earnings Preview

Apple reports 2Q08 earnings after the close on Wednesday, April 23rd. I'll be covering the conference call for RealMoney.com. Here is the preview I wrote for them which was published today:

Before Tuesday's shellacking I was planning to say that the sharp upward move in Apple shares had raised the bar unrealistically high heading into 2Q08 earnings report. With some steam out of the stock, I think it is now a coin flip as to which way the stock trades off the report. One good adage passed along to me by my friend and institutional salesman JK is "Macs drive earnings, iPhone drives the multiple." Keep that in mind as you analyze the results and guidance.

One thing we know for sure is what will determine how the stock responds: guidance. Analysts are looking for a flat sequentially in the June period, in line with recent sequential patterns for the June quarter. Current consensus for the next quarter is EPS of $1.10 on revenues of $7.15 billion. AAPL probably needs to guide within 5 cents and $100 million of these figures to clear the way for the shares to move higher.

Something that could provide upside in 3Q08 is laptop sales. These have shown a strong uptick in June quarters in the past and if the multi-quarter run of 40% unit gains holds, Mac sales could drive higher than expected guidance. If management guides to flattish sequential revenues, a good question would be "Doesn’t this imply a slowing in the rate of growth of laptops? If not, then where else would offset the rising revenues from laptops?"

Also likely to have a big impact on guidance is the gross margin assumption. Apple has been very conservative about gross margin guidance since the huge jump in 2Q07 from about 30% to 35%. Since then guidance has generally been for low 30s but the actual quarters have ranged from 33.6% to 36.9%. I see little reason to assume that gross margins would contract from 2Q to 3Q based on current evidence so keep an eye on the 2Q gross margin which analysts expect to be around 34%.

Looking at the current quarter....

....consensus is calling for EPS of $1.07 on revenues of $6.95 billion. Several recent estimates have been increased above consensus. My own spreadsheet has EPS of $1.13 on revenues of $7.15 billion.

Mac sales are expected to drive EPS quarter rising to at least 2.1 million. Mac estimates have been rising so any shortfall here is going to be greeted rudely. Look for desktop growth of 30% and laptop growth of 40% with stable ASPs.

iPod and iPhone estimates are more controversial. iPod units are projected at 10 to 10.5 million but a number in the 9.5 to 10 million range would not be a surprise. Watch ASPs to see whether a surge in shuffle sales since the price cut is the reason for units to hit the high end. Last quarter, a 5% unit gain translated to a 17% revenue gain because of rising ASPs as the mix shifted to nanos and the touch. I'd expect a 1200 basis point bump for revenue relative to units again this quarter. That would sooth worries over iPod units if they fall short.

Most analysts expect iPhone units to come in below 2 million, with some estimates as low as 1.8 million. A few analysts are more bullish with numbers at 2.2 million. The recent case of the missing iPhones was interpreted differently by analysts. Trends in sales in the US and Europe may be as important as the actual figures. Of course, there will be plenty of questions about the timing of a 3G introduction and its potential impact on current demand.

The margin environment for AAPL in the quarter was favorable. Management guided to just 32% gross margins but component costs and firm ASPs suggest that a number north of 34% is possible.

Thinking About Apple

Apple has staged a strong recovery, rising 33% from its 2008 intraday low in late February. The beta effect during the recent rally certainly has helped but continuing good news on Mac sales and speculation over the 3G iPhone have been equally responsible. A long-time friend and institutional salesperson, JK, recently IM''d me noting that "Macs drive earnings, iPhones drive the multiple." I think that is a good observation and wanted to pass it along.

I have a couple of other thoughts on Apple. First, Don’t forget the ASP uplift in IPods coming from a mix shift in favor of the Touch and nanos at the expense of shuffles. Last quarter iPod units only rose 5% but iPod revenue rose 17%. I expect a similar uptick in ASPs this quarter which should provide comfort to worries about iPod units.

Second, I subscribe to the Lefsetz Letter written by music industry expert, Bob Lefsetz. It's a free service that our old pal, Cody Willard, turned me onto. Bob has pretty strong opinions on the music industry and the disaster it has become for the record companies even as iPods have driven music listening to all-time highs. Bob also occasionally writes about Apple, often to show how a company with the right view of its markets and customers can prosper. His latest post on Apple touches on the MySpace Music deal announced last week, the record industry, and Apple. It's a good read. I especially liked this excerpt: "The vibe in the Apple Store was palpable. It was akin to that at the gig, decades ago, when music was the most exciting art form, when you used to have to listen to the record to know which way the wind blew. Sure, Apple cares about Wall Street, but when the stock tanked, there was no excuse, no crying, no explanation…Once again, there was no access, just a focus on the underlying business, and a resultant mystique."

Missing iPhones Found at Sundance

I've been reading up on the phenomenon of the missing iPhones and the only thing I can conclude is they might all have been at Sundance. Honestly, it seemed every line we were standing in had multiple iPhones in use. I know that speaks more to where Apple has mindshare than anything else, but I can confidently state that iPhone market share among movie fans and Hollywood types is at least meeting expectations.

On a serious note, I think there are two issues. First is whether demand for the iPhone at current prices and as currently configured is less than expected. Second is whether meeting unit volume expectations through sale of unlocked phones is positive or negative for Apple.

The answer to the first question may be yes, particularly in Europe. However, enough phones have been sold and current customers are satisfied enough that demand issues can be solved with a 3G phone, a lower-priced unit, lower prices, or increased functionality. Say what you want but the activation of over 2 million phones in seven months suggests that the iPhone is here to say.

As for unlocked phones, Bernstein did some interesting work, suggesting that there is earnings downside if a higher-than-expected portion of the unit volume is unlocked due to the loss of carrier payments. Carrier payments might be as high as $20 a month at close to a 100% margin. Bernstein believes that if 3 million of the 10 million phones that might be sold in 2008 are unlocked, Apple would earn 37 cents less in EPS this year and next year. That works out to 8% and 6% of current 08 and 09 EPS estimates, respectively....

....I think that Bernstein was already assuming that as many as 2 million phones were going to be sold unlocked. In other words, the fact that it appears that an incremental 1 million phones are going to be sold unlocked is what generates the 37-cent shortfall. I may be misreading the report, however, so if you think I got it wrong, please let me know.

I don't know exactly what assumptions all the analysts are making about unlocked phone sales in their models, but in October, Apple itself estimated publicly that unlocked phones were 22% of sales. If analysts took the company at its word and built that or higher into its models for 2008, then the 37-cent penalty might not be fully realized. Then again, some analysts may have underestimated unlocked phones in their models

The final piece of the puzzle is how this impacts Apple shares looking forward. If estimates need to fall by 6% to 8%, the current drop in the stock seems to have captured it. The issue is then with the multiple as a less successful iPhone cuts into the company's long-term growth rate.

I think Mac momentum alone justifies the current stock price, which is about 20 times 2009 estimates before adjusting for $20 in cash that will be near $30 at the end of 2008. However, the stock is broken, and the rebound will be slow until iPhone, iPod and Mac demand trends for early 2008 are clearer or more new product introductions are made. The shares are over-owned, leaving demand lacking relative to supply as long as a confidence crisis exists concerning Apple's fundamentals.

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.

Apple: Not Good Enough For This Stock

I am not going to recap all the numbers from Apple as you can read that elsewhere. The December quarter was very good but not without issues. Mac and iPod sales came in a little below aggressive estimates. This was easily made up by better than expected ASPs. A bigger issue will be that US iPod units were flat and were a little weaker in the holiday season than the first part of the quarter. Be ready for the iPod is dead headlines. Management said it was happy to trade units for ASP and this was part of the strategy behind the Touch. I see nothing else to quibble about in the December quarter.

Guidance for the March quarter is the real issue that took the shares down 10% after hours. 94 cents on revenues of $6.8 billion is below the $1.09 and $6.98 billion consensus. In its last quarterly report Apple actually guided above consensus so while they are very conservative, there is some precedent to interpret this guidance unusually negative.

The guidance assumes much worse sequential performance than has occurred the last two years....

....Revenues are projected to drop 29% vs. drops of 26% and 24% the last two years. EPS are expected to decline 47% vs. 24% and 28% the prior two years. On the call an analyst pointed out that last year management guided to a 52% sequential drop in EPS and came in at 24%, thus he asked what has changed to prevent this from happening again. I think he has an excellent point with one caveat. Last year's March quarter was the first one where gross margins exploded due to collapsing component costs. That said, gross margins in the December quarter were just 40 basis points below the March 2007 quarter and on the call management said that component costs looked pretty similar for March 2008 as December 2008. They pointed to fewer Leopard sales and less cost of goods sold leverage due to lower sales as the reason for assuming a 250 basis point sequential drop in gross margin. The gross margin guidance seems conservative on this basis and more so when remembering that Macs are gaining in the sales mix and have higher margins than iPods.

The next thing I did was try to plug in unit volumes and ASPs for Macs, iPods, and iPhones to get to the $6.8 billion revenue guidance. I couldn’t do it. I consistently come up slightly north of $7 billion. I am using similar sequential moves in units and ASPs as prior quarters. Given momentum in Macs, I think this is conservative.

The stock now trades at 20 times 2008 estimates which I still think are going higher given that Apple beat 1Q consensus by 25 cents and 2Q guidance is only 15 cents light (and ridiculously conservative). EPS rose 55% in the December quarter. The current consensus for 2008 implies 25% growth. I think the shares are offering an attractive entry point. However, there is just enough here for the bears to make hay so I do not expect a quick rebound from the $138 after hours level.

Best Case For Apple

I’ll be covering Apple’s earnings call after the close. Here is my preview. I decided to look at aggressive assumptions to see where a best case scenario might be for the December quarter. Since the stock needs both a substantial beat and decent guidance I wanted to see what the beat might look like.

Here are the assumptions I used: (1) 2.5 million Macs sold with ASPS up about $75 sequentially, (2) 25 million iPods with ASPs up to $175 vs. $163 last year, 2.5 million iPhones shipped generating $315 million in revenue, a 30% increase in all else driven by Leopard sales, and a 100 basis point sequential uptick in gross margins.

These assumptions lead to revenue of $9.85 billion and EPS of $1.88 versus the current high estimates of $9.96 billion and $1.77....

....With the exception of the iPhone revenue I actually think my assumptions are quite achievable. They are consistent with demand trends in the quarter and the ASPs are similar directionally from prior December quarters. The one big swing factor is gross margin. Each 100 basis point swing is worth 7-8 cents. My thinking is that Macs and Leopard gained in the mix from the September quarter and component costs were pretty similar. This would add up to margin expansion but in the last two December quarters gross margins fell sequentially.

Given the state of the market, there may be a little more riding on Apple that usual. I hope my preview and this note help.

Apple 1Q08 Preview

Another Apple earnings report comes after the close today, so time for lots more overanalysis and outsized volatility in the usually volatile shares. Estimates have been rising as the quarter went along since it became apparent that Mac sales were booming. News from MacWorld that Leopard and iPhone sales were ahead of expectations in the December quarter raised the bar further. The only product line with any concern is iPods where there is some worry about unit volumes relative to high expectations....

....For the first quarter, the current consensus is $1.51 on revenues of $9.46 billion. This would represent EPS growth of 41% and sales growth of 33%. The high estimates I $1.77 which may give some indication of where the whisper number resides. Mac sales are expected to be around 2.4 million units. iPhones were already announced at 4 million units. iPods are expected at 24-25 million.

Variance could come from better than expected Mac ASPs, a mix shift in iPods favoring nanos and the touch at the expense of the low priced shuffle, and more high margin revenue from Leopard that expected. In addition, component pricing, particularly memory seems to have been very favorable again in the quarter after some signs early in the quarter that memory prices were firming. Finally, the financial model for the iPhone remains unknown and could provide a surprise.

For the March quarter, current estimates call for EPS of $1.09 on revenues of $6.98 billion. This would represent EPS growth of 26% and revenue growth of 33%. The sequential decline from the December quarter is in line with the last few years. The assumption that margins may fall from the year ago quarter seems conservative to me given the dramatic margin expansion over the second half of 2007.

Even though Apple shares have gotten nailed since the start of the year, I don’t think it is fair to assume the bar has been reset lower. Apple must have good results and guidance with no blips for the stock to work from any level. For Tuesday’s report I think the most likely reactions will come from iPod sales, international iPhone sales, operating margins, and Macs. I am long and would be long into the report if I were a trader. Obviously I expect upside pretty much across the board and acceptable guidance built off the strong momentum in Macs.

Another Blowout Quarter For Apple

Apple reported another great with upside to Mac unit volumes and operating margins producing much better than expected EPS of $1.01. Numbers had been rising recently such that analysts were looking for mid to upper 80 cents. Even more impressive than the September quarter results was the fact that Apple provided December quarter guidance which slightly exceeded Wall Street forecasts. Heading into the report, the consensus estimate for the December quarter was $1.39. Apple guided to $1.42. If memory serves, this is only the second time in the last three years where Apple provided guidance at or above Wall Street forecasts. Given the company guides conservatively, the forecast implies another very strong quarter.

The shares now trade on 2008 and 2009 prospects. For 2008, the current consensus is $5.00 with many estimates in the $5.15-$5.20 range. For 2009, the forecast is for over $6.00. Even taking into account over $15 per share in cash on Apple's balance sheet, the stock carries a high valuation with a P-E ratio of 36 times 2008 estimated earnings. Apple's recent huge upside surprises probably mean that 2008 estimates are way too low. This is almost certainly the case if iPhone sales meet company targets of 10 million units in 2008. The iPhone is very profitable thanks to revenue sharing on monthly bills of cell phone subscribers. Thus, despite the momentum in Mac sales, the refreshed iPod lineup, and likely continued significant share gains in Macs, the iPhone has become more important as a driver of Apple shares now that they have moved up to new highs in the $180s.....

....I suspect Apple shares can move significantly higher as long as earnings momentum continues and the stock market cooperates. I reduced positions in the $160s with an eye on $180-200 as another point to trim. The strength in the September quarter earnings and clear momentum in product sales should allow the shares a little more upside. As a result, my strategy now is to trim again as the shares firmly cross $200. Nothing wrong with taking a profit, especially in a high multiple stock where risk is significant if an earnings or growth hiccup occurs.

Trimming The Tree of Apple Profits

With the market ramping and Apple and other tech stocks leading the way, I sold a portion of Apple in many client accounts on Friday as it crossed $160. I completed sales only in accounts where the position size was pushing towards 4%.

I have a detailed spreadsheet on Apple and no matter how much I tweak it, I have a hard time getting to a target price too much above $160 based on assumptions about sales, earnings, and cash flow that I am willing to use right now. Another way of saying this is that Apple has reached my stretch target based upon my current estimates. When that occurs, my portfolio management discipline is to trim the position and capture some profits. Clients who have been with Northlake since early to mid-2005 will find this strategy to be familiar. In fact, for clients where I was buying Apple in the $30 in early 2005 this marks the third or fourth time I have trimmed it. Sure, with the benefit of hindsight I regret trimming it at $48, $71, and $110. However, there are no sure things on Wall Street and it never hurts to pocket some of your gain.

One legitimate question is whey I wouldn’t sell the entire position at $160 if it has reached my stretch target....

....The reason is that my target is based on conservative assumptions. To help control risk and find really attractive stocks, I use conservative earnings estimates in my spreadsheets. If a stock looks attractive on conservative numbers then there may be even more upside and less risk that I assume. That is always a good combination.

Apple has consistently beaten estimates over the past three years. I think that is likely to be the case through 2008 as the market share gains for Macs and iPhones continue. If I do plug in higher estimates, I can get to $180-200 for Apple. The upper end of that range now becomes my new stretch target and the next place clients should look for their positions in Apple to get a trim.

About That iPhone Price Cut

The following quotes come from a new report on the iPhone from Bernstein Research: "Apple could conceivably sell iPhone hardware at a substantial loss while generating greater profit per iPhone than it does from the highest end iPod…..this potentially gives Apple a storng incentive to price the iPhone aggressively to drive sales, even at the expense of cannibalization of the iPod business where ASPs and GMs (gross margins) are notably lower."

I don’t mean to flippant or a bull with my head in the sand but this analysis is hardly consistent with all the doom and gloom from last week when the iPhone price cut supposedly indicated the product was a flop, or as Tero Kuittinen of RealMoney.com called it, "a platinum turkey." On the day the price cut was announced I wrote, "since we don't know how the revenue share works with AT&T on iPhone sales and subscriptions, the financial impact of a price cut, particularly if it stimulates demand, is hard to gauge, even more so with the deferred revenue accounting."

Capturing the bearish spin that dominated coverage of the price cut, the next day Bernstein issued a bearish report on the price cut titled, "Big iPhone Price Cut and iPod Touch Product Positioning Both Raise Meaningful Questions." To Bernstein's credit, as usual they completed thorough analysis to answer the "meaningful questions" and published the results even though they appear to conflict with their initial assessment. This is a good example of why Bernstein's research is highly valued on Wall Street.

I know Apple is way overanalyzed and I am more guilty than most in that regard. I also know that we all tend to talk our book. Again, I plead guilty. But the universal assumption that the price cut represented a problem and the skepticism of Jobs statement that Apple really wanted to accelerate sales and establish the iPhone ecosystem in the US as quickly as possible appears to have been misplaced. Or at least wrongly or insufficiently analyzed.

New iPods Overshadowed By iPhone Price Cut

As the Apple iPod event was going on yesterday, I posted this comment on RealMoney.com:

"New colors for the Shuffle, a redesigned Nano focused on an improved video experience, higher capacity classic iPods topping out at 160GB, and iPod Touch - it seems like an iPhone without the phone. Seems like a very good lineup for the holiday season to me. Something for everyone. After last year's 21 million unit holiday iPod blowout a fully refreshed and upgraded lineup was necessary to maintain growth in iPods. Regardless of where the stock goes in the very near-term, I think this new iPod lineup is as good as anyone could have hoped. With Mac sales booming, fresh iPods, reasonable iPhone sales, and the new operating system coming, I think the Apple earnings story is shaping up very well. I remain a bull on AAPL."

The stock sold off sharply once the event concluded keying off the $200 price cut on the 8GB iPhone. Investors interpreted this as a sign that demand was dropping off quickly. I probably can’t argue with those who want to interpret it as a negative datapoint as far as demand goes. However, the only two major complaints about the iPhone since its introduction have been the price and the AT&T network. Morgan Stanley wrote yesterday that they have seen studies that a price cut of this magnitude could stimulate demand by as much as 30%....

....With holiday season coming, the iPhone at $599 would have been out of line with the new high capacity iPod Classic and iPod Touch (an iPhone without the phone). I think the Touch is going to be a home run product and easily outsell the iPhone. It seems logical that Apple promised AT&T the price cut if they could offer the Touch this holiday season. Additionally, somewhat lost in the commotion was that Apple will be selling ringtones for the iPhone and songs via wifi over the iPhone. AT&T won’t be sharing at all in that revenue so cutting prices to stimulate demand which in turn drives sales of revenue that belongs 100% to Apple was probably a key part of the decision-making process. Also, since we don’t know how the revenue share works with AT&T on iPhone sales and subscriptions, the financial impact of a price cut, particularly if it stimulates demand, is hard to gauge, even more so with the deferred revenue accounting. Finally, Jobs reiterated yesterday that the iPhone will launch in Europe in the fourth quarter. Maybe that price cut is part of the deal to get it done. Or maybe the price cut is a prelude to a $499 or $599 iPhone 3G? The point is that the initial reaction to the price cut might have been one-sided.

I stand by my bullish outlook built primarily on Macs, secondarily on iPods, and boosted by iPhone and upcoming Leopard sales. No one is disputing the strength of Macs this back-to-school season. The new iPod lineup hits all price points and offers functionality for everyone. The iPhone is now better positioned as a holiday item (mobile phones have been popular Christmas presents for years). With the product lineup and pricing clear, the risk to demand for Apple products over the critical next fourth months has moderated. I was mostly recently a buyer of Apple at $123 and then $114 for clients whose position sizes were too small or newer clients who did not own yet own Apple. Yesterday's news makes me comfortable paying a higher price next time I need to add to adjust client positions.

Apple iPod Event on September 5th

Earlier this week, Apple sent out invitations to a "special event" on September 5th. The invitation clearly signals iPod related announcements. The better websites in the Apple rumor mill are suggesting that the company will convert all iPods to flash, a new flatter and wider nano (presumably to offer better video capabilities), and touchscreen video iPod modeled after the iPhone. In addition, the Mac operating system in use on the iPhone will be used on the new iPods (which may mean the end of the infamous and highly successful click wheel in some models). The last few words of the invitation copy the final words of The Beatles last press release so Beatles music on iTunes seems like a possibility as well.

As you know, I have been a vocal Apple bull and I am a big believer in the Mac market share story and think that the software side of Apple is underappreciated asset. I've been long Apple for Northlake clients since January of 2005, while both trimming and adding to positions on the way up. My most recent trades were to add shares in the past two weeks in the range of $114 to $123. On Street Insight and Real Money, I have actively and readily defended the shares and regularly reminded readers of the bull case.

The iPod rumors are consistent with my own expectations. In fact, I think the rumors are a minimum requirement for Apple bulls in the near-term. December quarter iPod comparisons are extremely difficult as last year the company sold 21 million iPods, up 50% from the blowout 2005 holiday season. iPhones will help, especially due to the high average selling price (last year the phenomenal success of the Shuffle caused a serious drag on ASPs), but strong demand for traditional iPods is necessary to keep the over 30% of revenue driven off the music platform growing at a solid clip. iPod revenue was down 1% in the March quarter and up just 5% in the June quarter...

...I think that Macs will be really strong in the September and December quarters, enough to meet and beat street estimates. However, for significant upward momentum in Apple shares to be sustained at significant new highs, iPods must be contributing as well. For that reason, a strong new product lineup on September 5th is critical to the near-term investment case for Apple shares.

At a minimum, maybe the passing of September will usher I calmer era for Apple shares. 22 of the $29 trading days since July 19th have seen the shares have a daily range of at least $4, with many days reaching $4-6 or more.

Brief Apple Update

I have been waiting to round out long positions in Apple and build new positions for clients. SInce the stock brokedown and the market collapsed, I had been targeting $125 for Apple but decided to wait and with the stock decisively breaking that level I decided to make the move. I am optimistic about near-term trends in Mac sales. I am counting on an iPod refresh for the holiday season. I believe those who are saying iPhone sales are on track.

The stock is trading at 27 times 2008 estimates. It is a little cheaper adjusted for $15 per share in net cash on the balance sheet that has been rising by over $1 per quarter. Given my comfort with a 20% EPS growth rate for several years off the FY07 base, I think the valuation is reasonable. I know that the technicals stink and that the stock tends to move in major multi-month cycles but sometimes value wins out over emotion.

Apple 3Q07 Earnings Preview

My friend and Real Money colleague, Bob Faulkner, is handling the Apple conference call for the website this quarter. Bob specializes in technology so his input is especially interesting. I'll be listening to the call as well.

In the "Continue Reading" section I have reporduced Bob's preview. I generally agree with him across the board. Beyond what Bob has mentioned, key things to watch are Mac and iPod unit sales and ASPs and comments surrounding margins and memory pricing. Estimates for Mac sales are around 1.6 million units while iPod estimates have been drifting lower to 9.0 to 9.5 million. On margins, expect cautious commentary toward 4Q due to the recent increases in memory pricing. I think this area represents the greatest risk to Apple shares in the near-term.

Here is Bob's preview....

APPL will be reporting FQ3 results after the close tomorrow night with a conference call at 5:00 PM EDT. The expectations are high and there will be more eyes focused upon these results then the new Harry Potter book. Current consensus is for revenue of $5.28B (+21% YY; flat QQ) and EPS of $0.72.

In the prior quarter, the company reported revenue of $5.26B (+21% YY; -26% QQ) and EPS of $0.87. GM was 35.1% up 530 bps YY and 410 bps QQ primarily the result of low component pricing, product mix, lower services cost and leverage. OM was 18.7% an increase of 660 bps from last year and essentially flat sequentially. Cash from operations was a very solid $700M versus cash used in the year ago period. Total cash and equivalents increased about $700M to $12.6B. A/R declined about $700M dropping DSOs to an amazingly low 16 days (-5 days). Inventory fell $100M putting DOI at 5 days, down one day from FQ2.

The driver for the top-line last quarter was essentially the notebook business with revenue up 82% and units up 79% versus the year ago period. While iPod units were strong (+24% YY), revenue actually declined 2% YY on lower pricing.

Guidance for FQ3 was for revenue of about $5.1 billion with GM of about 32% (increasing component prices). Opex should be about $915 (including iPhone launch expenses) with other income of about $150 million and a 32% tax rate. This translated into EP of approximately $0.66.

Some people (myself included as you can see from the put position below) expected a sell-off in AAPL’s stock following the introduction of the iPhone. Obviously that didn’t happen and it has continued to ratchet higher fueled in part by four “target price” increases in the month of July alone. Add to that various stories about market share gains for Macs in the quarter, difficulty meeting demand for the new LED-lit notebooks and record sales at retail stores.

All that plus the iPhone too, this quarter is going to be a BOOMER, isn’t it? Well, yes, no and maybe. APPL will easily surpass it’s own guidance since its guidance is usually low-balled. But how high is up?

The iPhone sales will be tricky for a number of reasons. First and foremost is the subscription accounting. The company will recognize revenue from these products over 24 months, not all in the quarter of sale. While that is well understood by the street, I can’t say that it is by the investing public. A possible partial offset of this issue is how many were sold? There have been a wide variety of estimates of what went out the door in those last two days of June but from APPL’s perspective, that’s not the point. Products that were sold by AT&T well into the following week were likely shipped to the carrier before the close of the quarter so the actual number of units “sold” could be higher than many expect.

Certainly the last big issue will be the impact on iPod sales. Yes, there probably was cannibalization by the iPhone but it’s not a perfect world. Anyone expecting otherwise is probably living in a fantasy world. What’s more important is that the profitability on the iPhone will eclipse the iPod but without damaging the iTunes revenue stream. That works for me.

In reality, I’m not certain it matters what AAPL reports as long as it’s above their own estimates. There is so much enthusiasm for the stock right now given the potential for the iPhone and its various relatives that any attempt to take the stock down will be met solidly by dip-buyers who thought they’d missed out on this name.

Lots of Shine to Apple

Apple (AAPL) 2Q07 results were spectacular and the feared "even more conservative than usual guidance" failed to materialize. I think the shares should be higher and my only concern is technical in that the muted upside suggests the massive battleground that has become AAPL will continue. I was especially pleased with Mac sales which showed a little upside in the quarter. I don’t think the upside was any more meaningful than the slight downside last quarter but the trend is unmistakable: Macs are gaining share. iPod sales were also solid although they were effectively preannounced. Growth in non-US markets continues strong (ex-Japan) which is key as iPod market share is much lower abroad. Assuming a decent stock market I think AAPL shares are entering a new higher trading range of $95-115 ahead of the iPhone launch. I have little fear about initial iPhone demand. What will matter is product reviews. I am perfectly happy to have so many bashers of the product out there as they are keeping expectations in check.

There is really a lot to say about AAPL this quarter than in the past. The quarter was fantastic and there is virtually no reason to complain. EPS came in at 87 cents easily beating consensus of 64 cents and the whisper number of 70 cents. Part of the upside came from better tan expected revenues due to an extra 100,000 Mac sales and stable average selling prices on iPods.....

The real upside though came from margins as sharply declining component costs, especially for memory, led gross margins to come in at 35%, fully 5% ahead of management guidance and 3% ahead of street estimates. Management noted that they are starting to see some firming in component prices and guided June quarter gross margins to 32%.

Overall, it was a great quarter and the shares should settle in a new higher trading range as the iPhone launch is anticipated. There are many skeptics on Wall Street about the iPhone who complain about battery life, slow internet connection speeds, high pricing, lack of a keyboard, and the dirt that will accumulate on the touchscreen. No one has ever used or held an iPhone so we shall see. I do think that expectations are more subdued due to all the skepticism so a smooth launch could be a big positive for the stock. Also, the September quarter brings the back to school season where Mac sales should boom and then December might see new iPods incorporating the larger, touchscreen display on the iPhone. In other words, AAPL has lots of momentum and the shares could go much higher.

San Jose Mercury News Clears Jobs of Criminal Activity in Options Probe

In a lengthy article, the San Jose Mercury News is reporting that it is unlikely that Steve Jobs will be charged with a criminal offense in the Apple (AAPL) options backdating scandal. The article leaves open the possibility of SEC action but SEC action would not require Jobs to leave the company.

The article contains a timeline of Board actions that seem to exonerate Jobs. We won’t know the outcome of the investigations by the US Attorney’s office or the SEC until they are announced but for the short-term the market is likely to be very happy about the article.

Timing on this article is good as AAPL reports after the close on Wednesday.

Apple Acting Well

Apple (AAPL) held up well during the market pullback and now is leading to the upside, trading at its highest price since the breakdown following the December quarter earnings report in mid-January. I've written endlessly on Apple, as you can see if you click the AAPL link immediately below, so for another perspective here is a link to a well-written and well-reasoned bullish article that appeared on theStreet.com:

Jon Markman's Article on Apple

Interesting New Report on Apple

Bear Stearns is out this morning with a detailed new report on Apple. Bear is not changing its buy rating or earnings estimates. Instead, the report lays out Apple's growth profile focusing on four areas: Macs, iPods, Apple TV, and iPhone. The overall theme is that Apple is not a one product company but rather has multiple platforms for growth. This is new for Apple compared to its history. Bear Stearns goes on to outline the likely product development paths for each of the four platforms.

If you want to read the report, click "Continue Reading...." for a link to a PDF file.

Download Bear Stearns Report on Apple

A Look at Apple's Valuation

After reading through a lot of analyst comments about Apple's earnings, I think I captured the general consensus well with my follow-up piece. Most analysts agree with my bullish view and the fact that numerous catalysts exist over the balance of 2007, particularly as the June and September quarters become the focus of investor attention. As far as the March quarter, most analysts think that the guidance was conservative, especially as it relates to margins.

Following the big EPS beat in 1Q07, the consensus estimate has moved up to $3.18 vs. about $2.80 previously. Apple ended the quarter with $13.44 per share of cash. Extrapolating interest income from recent quarterly reports indicates that the cash balance might contribute about 43 cents to earnings in fiscal 2007. Adjusting the current price for the cash balance and its contribution to EPS reveals that APPL is trading about 27 times projected 2007 earnings. The multiple comes down another point if AAPL gets credit for its probable calendar year end cash balance. 2008 consensus is now at $3.75. Adjusting this figure for cash balances and interest income puts APPL about 21 times 2008 estimates.

As a comparison, Google trades.....

at 35 times current year estimates, Microsoft trades at 20 times, and Cisco Systems trades at 20 times. Hewlett Packard, the other company gaining share in PCs, trades at 17 times. Looking at other growth stocks, Starbucks trades at 40 times, Disney trades at 20 times, and Whole Foods trades at 30 times.

I'd argue that AAPL that has as good as or better 2007/08 fundamentals than any company on this list except GOOG. Therefore, I think 27 times 2007 earnings is at worst a fair valuation, and in reality a cheap valuation for AAPL. And if APPL executes over the balance of 2007, the stock looks extremely attractive on 2008 estimates.

With AAPL shares giving up the bulk of their post iPhone related gains while 2007 estimates, with a minimal iPhone contribution, moved up sharply, I think an attractive entry point is at hand. Furthermore, based on my extensive reading of Real Money, Street Insight, other investment sites, technology/gadget sites, and blogs, it is my opinion that sentiment toward APPL shares is cautious. In fact, there is an overwhelming sense that APPL is going to fail either with the iPhone, iPods, Macs, or all three. I think the combination of cautious sentiment, the recent pullback, increased estimates, and a series of positive catalysts over the next six months reinforces that now is a good time to be long AAPL.

And for those of you who just can’t get enough, rumors are that AAPL has bought a Super Bowl ad. Speculation is that the ad will feature a deal that will give iTunes a three month exclusive on the first ever legal digital downloads of The Beatles catalogue. Other speculation focuses on whether a Beatles specific iPod is coming, including the possibility that a Beatles deal will be announced along with a long awaited touchscreen video iPod. I'd bet that the ad is iPhone related. Regardless, just when I was hoping the chatter around APPL might die down, it looks like we got another week to go before things calm down a bit.

Many Bullish Catalysts For Apple Over Next Six Months

Apple (AAPL) shares continue to pull back sharply following release of the company's latest quarterly earnings report. I remain surprised by the size of the pullback as well as the large amount of negative press Apple is getting surrounding the introduction of iPhone. I think a major disconnect has developed as many bullish catalysts exist over the next six months. Here are some follow-up comments to my earnings coverage now that I have had a chance to review analyst commentary:

First, I think comments that Mac sales were disappointing are fair. The number isn't bad and the market share gains are large, but a major thesis for Apple bulls, myself included, is that Mac sales would cover for any maturing in iPods or even disappointment in the iPhone. Mac sales will still cover these risks but maybe not as much as previously thought at least for 2007. In the short term, you can score that one for the bears.

However, I think that is about all you can score for the bears, leaving aside any debate over the iPhone.....

Estimates are rising by 25 cents to 30 cents. It looks like iPods might be able to sustain a higher profit margin than previously expected. It also looks like iPods are gaining traction in Europe, a market that bears had previously pointed to as indicating that iPods were going to mature more rapidly that expected. Macs also appear to be gaining share in Europe. Mac average selling prices look to be settling at a higher level than expected which provides a strong boost to profitability. Operating expenses may be under better control than previously thought. March quarter guidance looks like it is based on conservative assumptions. The June quarter could be huge with initial iPhone shipments, stronger Mac shipments to the professional market when Adobe ships the latest Creative Suite, and the launch of the extremely high margin Leopard operating system upgrade for Macs. The September quarter is shaping up well for Macs with signals from management on strong educational and institutional demand and rising "student intent to buy" measures.

I think those bullish factors outweigh the risks and will serve to contain the weakness the shares are again exhibiting this morning. I'm not a trader, so I have no opinion if the shares are a buy right now, but I am highly confident that come late spring, summer, and fall, Apple shares will be significantly higher than where they are trading today.

Apple December Quarter: Great But Provides Some Ammunition For Bears; Bears Will Run Out of Ammo, However

What follows is my analysis on Apple immediately following completion of the company's conference call to discuss December quarter earnings. I'll have more to say once I review analyst commentary but I am surprised that the shares are trading off sharply this morning. I think the drop will prove temporary – the results were good and there are plenty of positive catalysts ahead. This is a good example of short-term emotions and technical day trading driving a stock independent of long-term fundamentals.

Apple (AAPL) reported a great quarter, blowing away estimates. Revenues of $71 billion beat consensus of $6.4 billion and EPS came in at $1.14 versus estimates of 78 cents. Great gross margins and expense control allowed the excess revenues to flow through to net income. A slightly lower than expected tax rate added 2 cents.

As far the stock goes, I'd say the quarter leaves the debate over AAPL in pretty much the same place as before they reported. The company beat by 34 cents. Put a 30 multiple on that and you add $10 to the stock price. That is basically the increase in the AAPL shares heading into earnings and coming off MacWorld.

I think it is fair to say that analyst estimates won’t go up by much, probably by less than the beat. This factor will limit gains in the shares that would otherwise be expected by such a large beat. Management noted that unusually favorable commodity pricing boosted gross margin and that is unlikely to prove sustainable. Also, the massive beat on iPod units and good but not great Mac units will flow through analyst models in a way that limits EPS upside over the next three quarters.

I think the biggest issue that caused the stock to pullback off its initial post earnings spike was disappointment with Mac unit sales. The number was good at 1.6 million units but below many estimates, including my own, calling for 1.7 to 1.8 million. The effect on the income statement of any shortfall was mitigated by much better than expected ASPs which was a contributor to the gross margin beat.....

Apple had a good explanation for the Mac units, which beat internal goals. Management pointed out that extrapolations from the September quarter were biased by unusually strong educational and institutional demand, including two very large orders of 50,000 units. This was news to me. The next and obvious question was does this indicate that the "halo effect" is not as strong as expected. Here is the company's answer from the transcript:

There are several things that I feel really indicate there is a halo affect. One, we've grown at three times market. Two, that in the U.S., we've grown at 31% versus a market of 3%. Three, if you look at the latest student monitor information, the intent to buy a Mac is up substantially. As an example, the intent to buy a Mac portable went from 17% to 28% in a year. Also, my view is that we have significant momentum on the Mac. This is the eighth quarter of the last nine that the Mac outgrew the market. And I don't think a lot of people can say that. And so we are thrilled with this number. It is higher than what we projected. I can't speak to the models that you guys have worked, but we are thrilled internally on the number.

We can debate this all day. I'll take management's side based on my own observations of the halo effect and the data.

The music business was astounding in the quarter with 21 million iPods. The ASP came in as expected, under pressure due to the shuffle. But an inline ASP on blow away upside units means that strength was across all products, not just the shuffle. Music was also boosted by very high sales of gift cards, up two times versus a year ago. Analysts will clearly say this is the peak for the iPod. Could be, but they said that last year. The "iPod growth is going to slow dramatically" camp is a secondary but real reason why the shares pulled back in after hours trading.

Guidance will also be hotly debated and is probably the second biggest reason for the after hours action. The company guided below street estimates for the March quarter. That is not unusual but there was a feeling that analysts had it right this time. APPL explained the guidance on numerous occasions and my conclusion is that it is customarily cautious. Key issues for guidance include product mix, operating expense leverage, commodity input pricing, software sales, and expected heavy gift card redemptions. Each of these items is expected to put pressure on gross and/or operating margins relative to the December quarter. Seasonality on iPod and Mac sales is expected to be normal implying about 9 million iPods and 1.4 million Macs. iPod growth would be mid to upper single digits but last year had some unmet demand spillover from the holiday. Mac units will grow by 20-30% indicating the halo effect is healthy.

In summary, APPL is an overanalyzed stock (yours truly included). It is high profile, leading to a lot of posturing by bulls and bears alike. Analysts were tougher than usual on the call, which I think is because of bears accusing bulls of iPhone hype. Add the tough questioning to questions that will be raised about Mac units and guidance and a muted reaction the blowout earnings is not surprising.

I think the cautious posturing is healthy for the shares as is the overly critical analysis of the iPhone that is becoming conventional wisdom. As I began, the blowout earnings totally justify the latest $10 move in the stock. That leaves us right where we were before MacWorld. I think the caution will give way to bullishness, especially as approach what could be a big June quarter with initial iPhone shipments and a huge bump in high margin software sales when the new operating system is released. That will be followed by another big back to school season in the September quarter. Seems like a real good setup for the bulls to me.

Apple December Quarter Earnings Preview

Despite the sharp advance in Apple (AAPL) shares over the past week, I think the setup is favorable heading into the company's earnings report after the close on Wednesday. I expect better than expected Mac sales, solid results in iPods, and March quarter guidance no worse than the cautious commentary everyone is expecting. If I am correct, I think the shares can avoid a sell the news reaction and sprint to new highs across the $100 barrier.

Strong Mac sales have been key to my bullish stance on Apple for the past year. One Mac equals seven iPods at a higher margin so continued share gains for Macs really drives APPL's income statement. I expect December quarter sales to exceed estimates which call for 1.6 to 1.8 million units and flats ASPs. Stronger than expected Mac performance will support recent gains in the shares and leave the iPhone introduction as truly additive. Within the Mac line look for notebooks to be especially strong, potentially producing Apple's first ever quarter with over 1 million units. Desktop units are likely to be flat with the uptick awaiting the June quarter introduction of Adobe's new Creative Suite to drive an upgrade cycle for professionals....

iPods face a tough comparison vs. the astounding 14 million unit quarter a year ago which was boosted by an extra week and an unusual 10% sequential jump in ASPs. After some mid-year worry about iPod demand, it appears sales were very healthy this holiday season and many recent estimates call for 17 million units. Anything at 15.5 million or greater is probably good enough. The bigger question for iPods surrounds ASPs. Most estimates range from $155 to $170 per unit, down sharply from $208 a year ago and $179 last quarter. The culprit is a heavy mix shift in favor of the $79 shuffle, which appears to have been a huge seller during the holidays. With units up 20-30% and ASPs down 20-25%, it is possible that iPod revenue could actually be down year-over-year. This would come as a shock to some investors and could emerge as a key negative talking point following the earnings. On the flip side, although management does not breakout margins by product line, it is my belief that the shuffle is the highest margin product in the iPod family.

Modest growth in other music, peripherals and other hardware, and software will support EPS growth but aren’t expected to provide a positive or negative surprise. These line items are expected to contribute about 20% of quarterly revenue. Software is expected to provide a big boost to the June quarter when the latest version of the Mac operating system, Leopard, becomes available.

Consensus estimates for the December quarter call for revenues of $6.42 billion and EPS of 78 cents. Both estimates are well above APPL's normally conservative guidance. Hitting guidance would be very bad news for APPL shares. In fact, a little bit of upside to consensus is probably expected. Most analysts feel AAPL is being especially conservative in its gross margin guidance and are assuming a mix shift toward Macs will boost operating income.

APPL usually provides guidance for the next quarter. Presently, analyst estimates
are $5.22 billion for revenue and 60 cents for EPS, representing gains of 10% and 25%, respectively. Lack of new product introductions in the quarter are holding back the gains and the possibility of a pause in video iPods ahead of the iPhone introduction in June is plausible. I believe that cautious commentary on the March or June quarters is the biggest risk to APPL shares coming off the report.

Investors may also hope to hear something on the options scandal or new products. I think they will be disappointed. However, I do think that the possibility of exciting new iPod products for next holiday season exists. Imagine an iPhone without the phone as the true video iPod. Make it a 30GB or 60GB machine and you have a full video iPod with a touchscreen interface and wifi for internet connectivity including web mail and text messaging. Throw in photos, contacts, and a calendar and you have a product that would witness huge demand. If the Cingular deal prevents all that functionality, just a new touchscreen true video iPod would still be immensely popular.

Finally, there will likely be comments on the iPhone, specifically addressing the many questions raised about functionality, battery life, and additional versions of the product. I am not sure if APPL will comment but some indication about the product path, especially the integration of 3G wireless technology, would be well received by the investment community.

Apple's iPhone: Initial Impressons

There is no doubt that the new iPhone from Apple, Inc. (AAPL) – they officially changed their name yesterday by dropping "computer" – has a serious WOW! factor. The product is substantially beyond any expectations and easily supports the 8% gain in APPL shares yesterday.

Make sure to head over to Apple's website and check out the various demos on the music, video, telephone, internet, email, and text messaging capabilities of the iPhone. It really is amazing. Something as simple as rotating the iPhone from portrait to landscape and watching a photo automatically reorient itself will make you go WOW!

Or better yet, watch this 4 minute live demo of the phone courtesy of CBSNews.com and YouTube.

Beyond the iPhone as a product, I tried to take a stab at what it could mean financially….

I started with Bernstein's 2008 revenue breakdown. Bernstein's new research on AAPL was cautious but incredibly through and well reasoned so I figure their numbers might be a good place from which to benchmark.

Bernstein is using an estimate of $26.8 billion, a little below the current consensus revenue estimate for 2008 which stands at $27.8 billion. Of that $26.8 billion, Bernstein currently assumes that the iPhone will bring in $1.2 billion with Macs and iPods each generating $9-10 billion.

In his keynote, Steve Jobs said that APPL is targeting a 1% share of the phone market in 2008, equating to 10 million units. Pricing for the two versions of the iPhone was announced at $499 and $599. Presently, a nano plus a Blackberry will cost you about $500. Assuming that APPL sells 10 million units at $550 per unit, the revenue will be $5.5 billion. So even if Bernstein's concerns about iPhone cannibalization of iPods prove correct, there appears to be plenty of upside for APPL in 2008 if the iPhone meets initial expectations.

Assuming the iPhone produces an incremental $3 billion in revenue at an iPod-like 20% margin, AAPL is potentially looking at an incremental $600 million in operating income. Subtract taxes and you are looking at more than 45 cents in incremental EPS. Current consensus EPS for 2008 is $3.29.

I'd call that significant. Even more important, the iPhone along with AppleTV (formerly iTV) look like they are opening up massive new markets for APPL. This should improve investor confidence in the company’s long-term growth rate which in turn helps to support the premium valuation on APPL shares.

I am staying long AAPL with my focus now on next week's earnings report. I expect good numbers from both Macs and iPods. My only real concern at this point is how much the growth rate will slow on iPods in 2007 and beyond. With the iPhone likely to be very popular and highly priced, I am not too worried but it is worth keeping an eye on.

MacWorld Preview: How Expecations Impact Apple

MacWorld convenes next week and expectations of investors for good news out of Apple Computer (AAPL) are high. The shares have bounced significantly off their late December lows following what appears to a great reduction in risk related to the options backdating issue – in other words, investors are betting that Steve Jobs is safe even in the face of shareholder lawsuits and the distinct possibility of a formal SEC investigation.

Despite the pop, I think the trading ahead is subdued and sentiment is not particularly bullish. In fact, I think many investors are assuming that MacWorld is going to be disappointing and lead to a sell-off in the shares. I don’t know how to game it for trading purposes but I do the know the much bigger news for AAPL shares will be December quarter earnings and March quarter guidance which are due later this month.

As far MacWorld, rumors are running fast and furious....

The latest is that Apple will introduce a tablet Mac. The sourcing on this seems good but I see a tablet as a niche product with limited stock market and financial implications. I do think a tablet is a good idea for Apple as the design factor plays to the company's strength and ultimately a tablet could morph into a home controller for networks and various other devices. That fits in with the digital content strategy that is the core of Apple's strategy (sorry, bad pun.).

The real big news investors are looking for out of MacWorld surrounds the iPhone. I think to satisfy investors, at a minimum, Apple must formally introduce the product and explain how and when it will come to market in the first half of 2007. Will Apple go it alone as an MVNO? If not, what deals are in place with current mobile operators? Additionally, I think investors will be looking for the product development path. For example, is a Blackberry type device in the future? In terms of actual introductions, I believe expectations exist for a candy bar phone that essentially combines an iPod nano with a cellphone. Apparently, Apple has resolved power issues by having a battery for each device built right in. Also, unlike most music phones on the market, storage capacity is supposed to be significant – 4GB and 8GB. Disappointment related to the iPhone is a significant risk for Apple shares next week. My pal Cody Willard from Real Money is long and Apple and thinks iPhone related disappointment is a real possibility.

On iPods, expectations are more varied. Some observers are looking for a "true video iPod" which moves video to the core of the device at the expense of music. This would not just be an upgrade of the current video iPod but instead a completely new design incorporating a large screen and unique video technology such as touch screen controls. I don’t think lack of a true video iPod at MacWorld will cause much consternation among investors but it does raise the stakes for later this year. iPod sales during the holidays were great but even optimistic estimates have the growth rate slowing to 25-30% year-over-year. Without a true video iPod analysts would be unlikely to assume more than a 10% for next holiday season. Even with soaring Mac sales, which I expect will continue, a complete loss of iPod momentum is a problem unless the phone rollout goes without a hitch.

Investors are also expecting the formal introduction with product availability of Apple's iTV device that was introduced last fall. I see this product as evolutionary and central to Apple's digital content strategy but I don’t think it is likely a home run from a financial perspective. The easy movement of downloaded content from a Mac or PC to the family room TV is critical to any digital content strategy. I just don’t think even Apple can make it simple enough yet for most households to make it a breakthrough product for 2007. And don’t forget there are issues with the quality of downloaded video relative to what consumers are used to seeing on their TV sets, even before HD is considered.

Finally, beyond the tablet Mac, I have read little about the possibility of new products in the Mac line. Some people believe that a smaller 12 inch version of the MacBook is a possibility but maybe that is the tablet. I do think a really portable laptop would be a winner especially as digital content plus email and internet connectivity is a very large market. Heck, that is all most consumers need in a personal computer.

Hopefully, this post provides a baseline against which to judge the hype and hyperventilation that will occur next week. I remain long Apple across the board based on my belief that 2007 is shaping to be another great year driven by Mac sales to consumers. And don't forget much of the creative market won’t upgrade to Intel-based Macs until Adobe issues its next generation Creative Suite this spring. I think December quarter earnings are a better catalyst for Apple shares than MacWorld but for this massively analyzed stock and company (count me as guilty!) anything can happen.

Apple Files 10-Q With Options Update

In hindsight, it appears that some of December's weakenss in Apple shares (down about 10% prior to today's open) was due to speculation about developments in the options back dating scandal. It is likely that prior to the publication of articles in Law.com and the Financial Times some investors may have gotten wind of the gist of the content. This is purely speculation on my part but it fits the profile of the stock trading in which the decline from $93 to $81 went far beyond concerns about the current quarter or the iPhone.

Apple is rebounding strongly today following the release of the company's restated 10Q and Annual Report. The 10-Q has a lengthy discussion of the options issues including a thorough recap of the internal investigation. My conclusion is that Apple is not out of the woods on this issue but investor concerns should decline dramatically.

Apple admitted that it screwed up and even the lawerly language used in the 10-Q does not cover up that fact. Two things are clear. First, Apple conducted a very thorough investigation. Second, Apple is going to defend Steve Job's actions. I still expect the SEC to pursue a formal investigation but I doubt that they will find anything more damning than what Apple has now admitted.

I expect investor attention towards Apple shares to largely refocus on fundamentals. That means a very strong December quarter earnings report and new product introductions at January's MacWorld. But the options issue will hang in the background until the SEC wraps up its investigation. And reporters will still dig around for incriminating info about Jobs related to the options issues.

Apple is way overanalyzed and investors have very strong emotions about the company. This means trading is likely to remain even more volatile that usual. But I expect the upward trend to resume and a move to over $100 is very plausible if my expectations about the December quarter, MacWorld, and the 2007 outlook are met.

Not surprisingly, I am staying strong across the entire Northlake client base and in my personal accounts.

Apple Shares Remain Unusually Weak

The point of my post about the Forrester report on Apple's iTunes sales was not really to discuss AAPL. Instead, I was trying to point out how the type of analysis can impact the conclusions drawn. In other words, good inputs lead to useful outputs and vice versa.

When I posted this piece on StreetInsight.com, two contributors, Scott Rothbort and Jeff Bagley, responded to my post and reiterated their own bullish views on Apple. I am in total agreement and remain long as ever, including adding the stock to new accounts last week (Northlake owns pretty much the same portfolio for all individually managed accounts but client agreements usually allow ample flexibility as to the timing of the transition to Northlake's investment strategy.)

Similar to Scott and Jeff, the basis of my bullishness on Apple is Macs, not iPods or iPhones or iTV. I believe Apple's market share gains in Macs are just beginning and will go beyond most current estimates and be persistent and sustainable. Apple has bet the company on management of digital content. The operating system, the applications, and the hardware (Macs and iPods and the soon to be iPhone and iTV) are all built around the idea that PC use, particularly among consumers is being dominated by the need to manage the digital lifestyle. Apple is miles ahead of Microsoft on this front, providing a competitive advantage vs. all the windows-based PC manufacturers including Dell Computer (DELL) and Hewlett Packard (HPQ). Given the small share Apple has on a global basis, the rapid developments in digital content, and the increasing use of digital content in the business world, Apple has made the right bet and will reap the benefits for several years....

I believe that December quarter Mac sales will be very strong. Coming on the heels of the great Mac sales in the September quarter and a strong holiday season for iPods, I believe the shares are undervalued based solely on Macs, iPods, accessories, and software.

I think recent weakness in Apple shares has as much do to fears the iPhone will fail as fears it will be late to market. Getting the iPhone to market in mass quantity is tricky and just a few percent market share of the global phone market has huge positive implications for Apple's financial performance. However, I think investors were a little too matter of fact about the sure fire success of the iPhone. The decline in the stock during December has reset the bar on the iPhone and set up a positive reaction to the good news that is coming on Mac sales.

iTunes Sales Are Not Collapsing

Leaving aside the debate concerning why Apple Computer (AAPL) shares have been acting so poorly and whether it is deserved, I think it is fair to say that the Forrester report that said iTunes sales were plummeting was the start of the severe downward pressure. As you might recall, the Forrester report generated a huge amount of publicity and critics noted it was flawed and completely inaccurate.

Last week, the Wall Street Journal had an article discussing the report. It turns out that what Forrester measured was iTunes download activity comparing January 2006 to June 2006. This is a far different methodology than would be used on Wall Street, which deciphers growth trends by looking at year-over trends.

In this case, Wall Street's approach is correct as the Forrester methodology fails to address significant seasonality in digital music sales. January is a high point, especially for iTunes, because of the popularity of iPods and other MP3 players as holiday gifts. iTunes seasonality was probably greater than usual last January as the blowout iPod sales of 14 million units in 4Q05 arguably represented the peak of iPod mania. Add in the iTunes gift cards received in December 2005 and is it any real surprise that June 2006 iTunes sales were below January 2006?....

The headlines on the Forrester report would have been much more effective if they noted that in 2006, June iTunes sales were off 65% from January while in 2005, the comparable decline was just 39%. This data still fails to note that year-over-year growth in iTunes remained strong and that December 2006 might surely represented the peak of iPod growth acceleration, but at least it would lead investors to ask the right questions about a possible slowing in the growth rate of iTunes sales.

And that is the real issue. Sales at iTunes are not keeping up with the growth of the installed base of iPods. That means that either new iPod buyers are purchasing fewer music tracks and videos from iTunes or early adopters are slowing their rate of purchases.

This strikes me as more of an issue for the content companies as digital downloads are supposed to take over and provide a revenue stream to replace lost physical sales. But for Apple, it could be an issue if it indicates that consumers are seeing less utility in their iPods. That might slow the sales of iPods and also could be a sign that Apple's strategy to build an operating system around delivery and manipulation of digital content might have less traction than expected.

I don’t believe that and see Apple's operating system and integrated digital content applications as the company's key competitive advantage that will drive better than expected market share gains for Macs, and, in turn, the stock price.

Some folks might take the other side of that bet. But one bet we would all agree on is that Forrester would have done a much greater service to followers of Apple, the music companies, and digital content in general, had they better framed their conclusions rather than look for lots of free press by drawing in accurate conclusions from a flawed analysis.

Recent Apple News

Lots of Apple Computer (AAPL) news today. UBS is out with a note claiming that Apple will enter the wireless via a mobile virtual network operator (MVNO). UBS Telecom analyst John Hodulik was discussing this in the hallways of their conference last week but went public with his thoughts today. Given a loyal Mac user base and the built-in distribution system of Apple Store's, I think that this MVNO stands a better chance of success than others that have generally underperformed expectations in the U.S. market. I think the parallel here is Virgin Mobile in the U.K., not ESPNMobile in the U.S. While this news, if accurate, will give a small boost to Apple due to recent concerns that the launch of the iPhone would be delayed, a greater impact might be on the major wireless operators in the U.S. Hodulik notes that Apple would be entering the high-end market with an unsubsidized handset, and he believes that Sprint Nextel (S) with its high data usage is most vulnerable....

Separately, Morgan Stanley sharply raised its 2007 and 2008 earnings estimates for Apple due to an "expanding product portfolio, growing distribution engine and market share opportunities." Morgan Stanley also raised its target on Apple from $90 to $110.

I remain very bullish on Apple as it is one of the only large-cap stocks that offer 20% earnings growth over the next few years. I used yesterday's weakness related to an odd report claiming that iTunes sales were collapsing to add Apple to several new accounts. I continue to own the shares across the entire Northlake client base and in my personal accounts. I think the shares could reach new highs over $100 in the run-up to MacWorld in January. My current trading strategy might lead me to again trim positions in Apple at that time if my forecast proves accurate.

Follow-Up Comments On Apple

I have a few follow-up comments to my earnings call coverage of Apple Computer (AAPL). First, analyst commentary fell along the lines I expected. Estimates are going up, bullish analysts are reiterating their recommendations, and cautious analysts remain worried about valuation. So far I don’t see any upgrades or downgrades. Second, analysts are saying that the lower tax rate added 6 cents. My analysis indicated 4 cents. I assumed a slightly lower 30% tax rate was expected while analysts were at 32 cents.

My earnings commentary was lengthy so I left a few things out....

I did initially find some questions beyond the tax rate when I plugged the numbers into my spreadsheet. Both inventories and accounts receivable seemed a little too high relative to the last couple of years. The ratios weren’t bad, just elevated. This came up on the call and management stated very firmly that channel inventories are a little low for Macs and right on target for iPods. The increased inventory was attributed to 41 new Apple Stores plus a desire to meet excellent demand and not let shipping times get stretched out. Comments on receivables were limited but the CFO said they were in line with his expectations.

Also on the balance sheet, I noticed a large increase in other current assets. This did not come up on the call. This line has been rising rapidly but the increase was unusually sequentially at least compared to a year ago. I’ll try to follow-up on this with the company. Payables were also up sharply, likely reflecting the receivables increase. Management noted that they felt working capital management was a strength in the quarter and were proud of the cash flow generation.

The Other Music line which reflects iTunes sales, Apple branded accessories, and accessory licenses was flat sequentially. Since more than doubling in the December 2006 quarter, this revenue line has stalled on absolute basis (although it was still up 70% yoy). In response to a question, management indicated that iTunes sales are seasonally weak in the September quarter due to lower PC use in the summer and a weak album release schedule. Additionally, accessory inventories were reduced ahead of the introduction of the new nanos and shuffle. Sequential growth should reappear in the current quarter.

iPod market share in the UK, Canada, Japan, and Australia is 40-50% according to management. In France, German, Italy, and Spain, the company said its market share has grown by 6-7 points. These markets are important as there is some evidence of maturity in the US market where iPod penetration is highest and AAPL has a market share of 75%.

The Mac distribution test with Best Buy appears successful as it will be expanded form 7 stores to 50 stores. There is also a test under way with Circuit City but it is just getting started in a few stores. My sense is that management is willing to look a more favorably on distribution outside of internal efforts.

Management provided no numbers but the new shuffle will ship before the end of the month and I sense expectations are very high for this time. It is a sexy little package and buzz is good. At under $100, it will be a very strong holiday item. Also, it makes a great second iPod for all the heavy users out there who want something new but don’t want to drop several hundred bucks. Could unit shipments of shuffles reach 5 million or more all by themselves this quarter?

Finally, as usual, management provided no insight to the new product questions which were heightened by Jobs press release comments. They did say that they are “very confident” in the product pipeline.

Hopefully, I can join in others in reducing my obsession with all things Apple until the Christmas selling season begins in earnest. Until that time, the outlook remains very bullish.

Apple Reports Another Great Quarter

Apple Computer (AAPL) reported another excellent quarter. There is absolutely no reason that anyone who was bullish prior to the quarter should change their opinion. And there is reason to believe bears might have to rethink their position. Estimates will rise by about the same 5% increase in the stock price after hours so the stock is no more expensive that it was prior to the report.

The quarter was very strong at 62 cents on revenues of $4.84 billion. Consensus was 51 cents on $4.64 billion in revenues. An unusually low tax rate helped significantly by a one-time credit helped EPS by about 4 cents but even at 58 cents it was a superb quarter from an earnings standpoint.

Revenue upside came from better than expected unit sales of Macs and iPods. For Macs, notebooks were the star at almost 1 million units. I found the ASP to be quite good as well. I had modeled it down by a $100-200 after watching the new Macbooks priced at $1099 fly out the door. I guess they sold plenty of black ones and MacBook Pros which sell at premium prices.. Desktops were actually not bad at up 4% considering the massive shift industrywide in favor of laptops. Desktops should pick up next Spring when Adobe releases new software that runs native on the Intel Macs.

iPods also were better than expected as unit sales of 8.7 million exceeded management guidance and were ahead of recent downwardly revised estimates. The $10 ASP decline was more or less expected. On the call, management characterized demand for the new nanos as “excellent” and said that there was a noticeable pickup in demand after the new nanos were announced.....

Gross margins of 29.2% beat guidance by about 100 basis points and were generally in line with analyst estimates. Some analysts were at 30%. Any variance was likely explained by component pricing and product mix.

Operating margins were superb as operating expense growth was flat sequentially against a 10% sequential increase in sales. This fact along with the revenue upside explains the EPS surprise.

Guidance of $6 to $6.2 billion in revenue and 70-73 cents was slightly below consensus as usual. When the media reports that AAPL lowered guidance what they are really saying is that guidance is below consensus as there was no prior 1Q07 guidance. This news as is as expected and not any worse as some analysts recently had worried. Commentary related to unit shipments, gross margins, and operating expenses for next quarter was constructive.

Let’s say AAPL is at mid-point of their revenue guidance. That would mean that revenues grow $1.3 billion sequentially. Last year, the company shipped 14 million iPods. That figure was boosted by 1 to 1.5 million by a 14th week against just 13 this year. Let’s say that this year we get 15.7 million units, or a sequential gain of 7 million units. Management cautioned that ASPs will come down in 4Q. Let’s call it $170 or down 10% year over year. 7 million incremental iPods at $170 is $1.1 billion in revenue.

If that is the case then revenue growth from Macs and all else needs to be only $200 million to meet guidance. That should be a layup. On the call, management noted that seasonality and the non-recurrence of an inventory drawdown should lead to an uptick in Other Music sales which is the iTunes Music Store and accessories. Year over year growth was 70% on this line in the just completed quarter. Last Christmas was when this segment really ramped so let’s call it a 20% year over year gain this year and you got another $100 million in incremental revenue.

That leaves Macs needing to be up just $100 million to meet the midpoint of revenue guidance. Last year, sequential growth in Mac revenue was 7% or $100 million. Mac revenues in the September quarter were $2.2 billion. Leaving aside the fact that we just completed the highest unit quarter for AAPL in 6 years and that the company is clearly gaining significant market share and that seasonality provides a tailwind, Mac revenues need a sequential gain of just 5% to meet guidance if my prior assumptions are correct. That seems awfully conservative given that MacBooks will be a hot Christmas item.

So the bottom line is that guidance appears conservative unless there is a sudden shortfall in Mac or iPod demand. It seems unfathomable that Macs will fall short so that leaves iPods. I guess it is possible that there is a miss as Zune will be out there and music phones are gaining popularity. But even if there is a 1 million unit shortfall, that is made up by just 125,000 extra Mac units. I think that is likely, probably conservative.

I know that AAPL has to beat the number again next quarter to drive the stock but hopefully this analysis shows that is likely. And if next quarter comes through, the story seems clean for calendar 2007 as the press release quoted Steve Jobs as saying it will be “one of the most exciting new product years in Apple’s history.” Hmmmm.

I am staying long and still expect the shares to make a new all-time high by Christmas.

Apple September Quarter Earnings Preview

While Apple Computer (AAPL) shares are always volatile around earnings, I think the set up heading into this quarter is unusual. On the one hand, it is AAPL. The expectations are high and the company might receive more scrutiny than any other. The stock has rallied 50% from the summer lows following the excellent June quarter report that showed that Mac sales were finally taking off. So, based on history, AAPL probably needs to beat and raise to juice the stock.

On the other hand, the stock has largely sat out the recent rally as it is just barely higher than its early September level. Furthermore, there has been lots of cautious commentary about iPod shipments and the likely fourth quarter guidance. So, maybe just an inline report with as expected guidance will be good enough for the bulls.

For the September quarter, which is 4Q06 for AAPL, consensus calls for EPS of 51 cents and revenue of $4.66, up 34% and 27%, respectively. Growth will be driven largely by increased shipments of Macs, especially notebooks....

Analyst estimates look to be close to 1.5 million units, producing revenue of just short of $2 billion. There is lots of anecdotal evidence of strong Mac sales for back to school as the new MacBooks were a must have item. A small uptick in desktop sales is possible as the company introduced an Intel-based system. Desktops are more likely to get a boost when Adobe upgrades its software early next year. Overall, Mac sales are the story this quarter. Look for lots of excited comments if the company passes 1 million units in notebooks this quarter.

iPod sales are tougher to gauge. As with last quarter, as the quarter moved on expectations fell. I have seen estimates for units of 8.2 million up to about 8.7 million. Last year, the September quarter saw units of 6.5 million, so growth is still around 30%. ASPs will probably be down about $10 from last year’s $188.

The bigger question for iPod sales, and for AAPL shares, surrounds the December quarter. Seasonally it is a big quarter. iPods are a popular holiday gift item but last year the company completely blew away estimates with 14 million units. Sequential unit growth last year was 115% with ASPs rising $13. My long standing fear for AAPL shares has been that this comparison would lead to a miss for iPods and a return of the bear thesis that AAPL is blowing it again. My sense is that current estimates call for iPod shipments of 17 million units for sequential growth of 100% and year over year growth of 20%. Plus last year’s fourth quarter had an extra week that added 1 million units. Normally unreliable indications from the supply chain suggest AAPL might be preparing to ship as many 21 million units this year.

What worries me is if the figure comes in at 15-16 million. This would be accompanied by lots of stories about the end of the iPod phenomenon and how music phones are replacing iPods. In the end, I suspect that December iPod shipments won’t fall short as music players will get a boost as a category from the new product introductions from Apple, Microsoft, and Sandisk. So one more big Christmas for the category will likely occur.

Analysts will get a sense of iPod shipments for December from AAPL’s guidance. Presently, consensus estimates are for EPS of 57 cents on revenues of $6.45 billion. I hope that AAPL’s guidance is close to these figures. I think it will be because I expect MacBooks to be an extremely popular Christmas item. Remember that Macs have an ASP 7 times an iPod at a higher margin. A 1 million unit shortfall in iPods is made up by an additional 133,000 Mac units in terms of revenue and fewer in terms of operating profits.

I am long AAPL and as usual nervous ahead of the quarter. I remain steadfastly bullish over the next couple of years as I think the market share gain in PCs is for real and has lots of upside. Additionally, I am optimistic that additional revenue streams will develop from phones or smart phones or the iTV device or software. Apple remains a long-term growth stock regardless of quarterly fluctuations. There aren’t many real growth stocks with market caps as big as AAPL so I am willing to tolerate the volatility surrounding quarterly results.

More Apple Cell Phone Rumors

ThinkSecret.com is reporting that Apple Computer (AAPL) will be launching a cell phone through Cingular early in 2007. The report says that Cingular will have a six month exclusive. This report is just a rumor and based on my own perusal of the ThinkSecret website I wouldn’t put a lot of stock in it.

However, if it is true it raises a couple of interesting points. First, most analysts had assumed that AAPL would launch be a mobile virtual network operator (MVNO), leasing spectrum from someone like Sprint and then reselling it. Current MVNO’s in the US have not been very successful. If AAPL avoids MVNO, is that a positive for wireless operators? Second, the phone is supposedly to be tightly tied to iTunes. If so, that means users will expect iTunes pricing, meaning 99 cent over the ari downloads. After all, the phone will surely have a USB connection so you can hook up to your computer just like an iPod. Presently, mobile operators charge $1.99 or more for downloaded songs and ringtones. It seems like an Apple iPhone could collapse this pricing structure. Ringtones are already a big business so this could have negative ramifications for mobile operators. Then again, if Apple can upgrade the music phone experience (so far music phones have not received good reviews in the US), the market could grow much more rapidly offsetting any pricing compression and igniting another round of phone replacements....

For Apple, the upside in a phone venture is based on the number of units it sells and how the phone protects the company’s domination of the digital music business. ThinkSecret says the company expects to sell 25 million units in the first year. That seems high given that Motorola (MOT) has sold a little more than 50 million RAZRs so far. For sake or argument, 25 million units at $150 per unit is $3.75 billion in revenue. This year is Apple is projected to have $19 billion in revenue so a phone could be a big deal. And 25 million phones is not that much in a market that sells over 900 million phones globally. Put a 15% operating margin on that revenue and you have $562 million in operating income. The tax rate has been running around 32% with a slowly rising share count of 875 million, producing incremental EPS of over 40 cents per share vs. current 2006 estimated EPS of $2.15. The 2007 consensus estimate is $2.64 but probably contains some cell phone EPS, though probably not too much.

As I have said many times, AAPL is one of the few large cap growth stocks that has real double digit growth. It is worth a premium multiple as long as momentum is sustained. With a cell phone, a set top box device, ongoing iPod upgrades, and significant market share gains in laptops, momentum seems likely to be sustained through at least 2007. I think the shares are headed for a new all-time high ($86.40) during the upcoming holiday season.

Zune Not A Near-Term Threat To iPods

Apple Computer (AAPL) shares have continued to rise following the introduction of Microsoft's Zune music player. Apple has benefitted from growing recognition of the company's outstanind momentum in Mac sales, excitement over the previewed iTV device, and the introduction of updated iPods for the holiday selling season. Additionally, the Zune has been met with a yawn from previously worried observers. I think the momentum will hold and AAPL shares can make a new all-time high in the nex several months.

Given the recent focus, here are are some thoughts on the Zune player written from the perspective of the impact on Apple shares over the next three to six months. Obviously, Zunes and iPods will both develop their capabilities and ecosystems, so I am keeping my mind open on a long-term basis.

I see three differentiating factors for Zune vs. iPod. First, the wireless capability. Second, the subscription model. Third, the larger screen. For this holiday season, I see minimal value in wireless, potential value in the subscription model and real value in the larger screen....

As far as I can tell, the key wireless feature is that Zune lets you do is receive songs from someone else's Zune (with limited playback). Microsoft (MSFT) appears to be placing a lot of emphasis on this "connected entertainment," relating it to the success of MySpace. It doesn't seem to be a big deal to me. Until there are tens of millions out there, your friends have to have Zune unless you want to approach somebody on the street you happen to notice has a Zune.

I suppose Microsoft thinks the MySpace concept will drive groups of friends to buy Zunes so they can share. Anecdotally, I asked my son, who is freshman at NYU, how many people on his floor had an iPod. He said virtually 100%. That would seem to be the target market for the "connected entertainment" concept. Are these kids going to dump their hundreds to thousands of dollars in investment in an iPod and iTunes downloads just so they can share?

Also, does anybody know if Microsoft has any kind of patent on this sharing technology? If not, I've got to think that Apple would respond quickly if it took off.

I guess wireless also means syncing Zune with your library without wires. Again, I say big deal. It's really not very hard to attach your iPod to the USB port. Finally, I'd expect wireless to hurt battery life. Cody Willard seems to see other potential uses for the wireless capability but Microsoft doesn't seem to be mentioning anything else.

Some folks will like subscription if it is accompanied with a solid player, so some value exists there. The larger screen is good for video, assuming the picture quality is not compromised. That seems like something Apple could have done unless maybe the part of the click wheel we can't see gets in the way. I wonder if flipping the Zune portrait and landscape for music and movies might cause some issues with the controls? Also, when I read Apple blogs, folks are really hung up on picture quality. Is there a risk of degradation when you flip it? I wouldn't expect so but something to think about. We also need to see whether Microsoft will offer a better library of video downloads. I thought the interview on CNBC with the head of Zune left open the possibility that it would launch with minimal video downloads available.

As to disadvantages, I personally think it looks clunky and early blogger comments indicate it is bigger and heavier than an iPod. Zune doesn't have a click wheel. Apple has that ergonomically friendly feature patented. We don't yet know about pricing but I think Apple upped the ante there with the new iPods. Also, the ecosystem of accessory suppliers for iPods is huge and provides a competitive advantage. Will Zune be able to ramp accessories quickly?

Finally, and probably most important, will the Zune store, apparently named Argo, match iTunes? iTunes is the part of the Apple ecosystem that is underappreciated by investors. And the latest version improves on an already great program.

The bottom line is that if Microsoft wants to sell units, they can probably get it done. They could steal a little market share from Apple but most likely its market share gains will come from the 25% Apple doesn't have. And Zune better get a cool factor quickly or at least for this Christmas, it won't be under the tree. Someone on RealMoney or Street Insight said that you don't want to open a Zune and have to fake your excitement because you really wish it were an iPod.

I am staying long Apple and watching booming Mac sales while CNBC and too many others are focused on music players.

Impressions of Apple's Product Announcements

Overall, the Apple Computer (AAPL) announcements were in line with my expectations. I almost got right the new wireless device that will get the video you download to iTunes over to your TV: It's not a MacMini; it's just half the size. This product, due in the first quarter of 2007, is probably the most important announcement on a long-term basis. But I wouldn't overlook those new iPods and the upgrade to iTunes. (I've already installed it in a Windows PC, and it has some nice enhancements in navigation and offers free album art for all the CDs you've ripped into iTunes previously.)

The iPods are basically double the capacity in slimmer, smaller and similar forms, with improved screens, all at the same or lower price points. There was not an introduction of a true video iPod, which I guess means even better resolution on a larger screen, with a movie-like aspect ratio.

The reason the iPod refresh is important is because one of the few blemishes in the near-term story for Apple is the incredibly difficult December quarter comparison against last year's 14 million unit quarter. I've long feared the screams of joy from bears when iPod sales this holiday season didn't grow or even fell short vs. 2005.

The refresh seems to offer a good reason to upgrade for current users, which, along with latent demand from those still looking for their first MP3 player, ought to give a nice push to unit sales. Even better, the refresh should set the stage for solid year-over-year growth as 2007 unfolds.....

The bottom line from today's announcements is that the big picture remains the same: AAPL has opportunities to add billions and billions of good margin revenue as it grows iPod and Mac sales, possibly introduces a cell phone and enters the living/family room. As I've said often, there aren't many mega-cap stocks that offer real prospects for 15%-20% annual growth. Apple does, and on that basis, the shares deserve a premium valuation and should head to new highs over the next three to six months.

New Products Due Today From Apple

Sometime later today, Apple will unveil its long awaited new products and services. Consensus seems firmly to predict that new higher capacity iPod nanos with new outside covers will be introduced. Consensus has also coalesced around the launch of an iTunes movie store. The remaining question is what else might be coming. The invitation apparently uses the “and one more thing” language which in the past has been a tip that something big is coming. Speculation has surrounded a true video iPod, a cellphone or PDA, and a piece of hardware that enables videos, TV shows, and movies purchased from iTunes to be played on your TV.

The best informed speculation I read was on AppleInsider.com in an article which contained this nugget:

” Just as he asserted that consumers are more eager to own their music tracks for 99 cents a piece rather than rent them on a monthly basis, he realizes that few are willing to plunk down ten bucks for a two-hour movie that they'll have to watch with their neck cranked towards a miniature screen resting in the palm of their hand. As someone at the forefront of the motion picture industry, he knows films are designed for the big screen and later adapted for the home living-room theater.

For these reasons, Jobs many months ago commissioned an elite group of Apple engineers to get the ball rolling on an intuitive hardware solution that would more closely tie the company's digital media strategy to the living-room. And so AppleInsider has been told, Apple has been quietly developing a video streaming device that will interface with an updated version of its iTunes jukebox software.”

If such a product were introduced that COULD BE big but only if the solution is SIMPLE. I’ve been speculating for over a year that Jobs real goal was the living/family room.....

Apple already has a huge growth opportunity by gaining market share in PCs or by introducing a cellphone or PDA. Both of thse markets are enormous and dwarf the annual market for iPod music players. Just 1% market share in those markets is billions of dollars in annual revenue. If the living/family room is opened up with each households thousands of dollars of investment in TVs and stereo, Apple could not only sell products for that market but could also reinforce its market share gains in PCs and maybe even next generation PDAs.

I suspect that “one more thing” will address this PC/TV convergence. And the opportunity is huge is Apple can offer a SIMPLE solution. I mean really SIMPLE. Right now, the iTunes broadband connection is coming into the home from a phone or cable jack that is very often not situated anywhere near the primary TV. The problem in search of a SIMPLE solution is how to get the video downloaded from iTunes over to the TV. It seems that wireless is the only way and Apple already has Airport Express as a solution to build upon. Will the MacMini be reworked into a receiving device that attaches to the TV and receives a wireless feed from an iTunes enables computer somewhere else in the house?

I am not a tech person so I don’t know the answer but I do know the opportunity for Apple is huge and I know that to really capture a mass market opportunity the solution has to be simple, like iPod + iTunes.

I’d encourage you to read the comments section of the AppleInsider.com post linked above and read the comments in this post as well.

As for Apple stock, it has had a good run so today’s announcements already build in something special. Anything short of special seems likely to lead to a sell-off. But if a sell-off comes keep your eye on the big picture….billions and billions in high margin revenue from the computer, cell phone, and digital home markets. This where the second leg of the Apple story has always been and this is the lens through which today’s product introductions should be viewed.

Dell Blows Up - Little Impact on Apple

Apple Computer is trading off over 1% pre-market due to Dell Computer’s ugly preannouncement. While the health of the PC market is clearly in question, I would note this from Dell’s press release:

"These estimates primarily reflect aggressive pricing in a slowing commercial market worldwide"

For the time being AAPL’s fundamentals are driven by market share gains in consumer PCs. In fact, I know over a half dozen individuals and families who have switched from windows machines to Macs in the past two months. Purely anecdotal I know but combined with AAPL’s incredibly strong laptop sales in the last quarter, I don’t think there is necessarily a read through from Dell to Apple. In fact, maybe Apple is part of Dell’s problems.

Some More Thoughts on Apple

My friend Jeff Bagley did his usual great job covering the Apple Computer (AAPL) earnings release and conference call. I fully endorse his bullish view but since I've written extensively on AAPL, I wanted to offer a few observations of my own.

As I have been saying for some time, I think the key to the quarter and the outlook is Mac sales. And the news from the June quarter is very good. MacBook unit volume was 798,000, a 61% increase vs. a year ago. There was plenty of anecdotal evidence that laptop sales were strong but this is really a good figure. I think it is 100,000 or more units ahead of some analyst estimates. The momentum appears very good and the next two quarters will show similarly huge increases. To put the 798,000 in perspective, in the seasonal strong September and December quarters of 2005, AAPL averaged about 600,000 laptop sales.

Despite the huge increase in laptops, overall Mac units were up only 12% because desktops down 23% from 2005. It still isn’t clear when the new Intel desktops for the professional market will ship but I think the huge jump in laptop sales last quarter bodes very well for the quarters after the desktops finally ship. So if you believe that MacBook momentum will be sustained for at least several more quarters, overall Mac growth will get a huge boost when the new professional desktops ship. This should give some comfort to the 2007 growth profile.

As for iPods, there was clearly relief when the unit figure came in at 8.1 million.....

I suspect that iPods got a boost from MacBook sales, as at least for college students, there was a buy a MacBook, get a free nano promotion. ASPs were flat vs. a year ago, so this promotion doesn’t look like it was too damaging and it was probably a good way to clear inventory ahead of the update to the nano line that is due anytime.

Looking ahead, in the September 2005 quarter, iPod shipments were 6.5 million, so the product line should show continued growth if shipment and demand levels just hold steady. Even without a refresh, that seems plausible given back-to-school demand. Things get much tougher in the December quarter, however, since AAPL shipped 14 million units a year ago. I suspect the next scare for AAPL shares will come when analysts begin to point out the possibility of no growth or negative growth for iPods in the December quarter.

Two other issues that created a problem in the second quarter looked a lot better last quarter. First, much concern was expressed 90 days ago when units and revenues at the company's retail stores saw growth of just 7% and 11%, respectively. In the September quarter, growth returned as units rose 50% and revenues climbed 29%. Similarly, last quarter's quarters slow growth rate in Japan reversed, as revenue growth accelerated to a year over year gain of 14% vs. just 8% in the March quarter.

Accessory growth remains on fire, up 90% year over year. This remains an underappreciated part of the Apple story and likely provides a nice boost to margins that is less dependent on volatile component pricing.

Lastly, software, another high margin business is set to contribute to the next couple of quarters. In the June quarter, software sales were down 9%. In 2005, I believe that the last big upgrade to the Mac operating system came in the June quarter so it was a tough comparison. That upgrade is due in the current quarter, so look for a big acceleration in software for the next few quarters. Sequential growth in software upon the introduction of the last OS was over 40%.

Put it all together and yesterday's big gains in AAPL are totally justified. I think the coast is clear for more gains as MacBooks continue to gain market share, new professional desktops are introduced, the operating system upgrade is launched, and the iPod line is upgraded for the first time in a year. All that should power the shares for the next several months. And as Jeff points out, AAPL has plenty of room to gain market share and expand its share of the consumer electronics wallet, so the multiyear growth story remains completely intact.

Apple is Back and There is More to Come

Thanks to my friend and fellow StreetInsight.com contributor, Jeff Bagley, for again allowing me to reproduce his excellent summary of Apple's June quarter earnings report and conference call. All is well for Apple as I have been repeatedly saying despite all the gloom and the declining stock price. The shares have lots of upside left even after today's 11% gain. Here is Jeff's summary:

Once again, Apple Computer (AAPL) blew away analysts' estimates, with most key metrics above expectations. Although guidance was muted, as usual, the stock was up substantially after hours as investors breathed a sigh of relief that Apple's resurgent growth will likely continue apace.

Higher Gross Margin Fuels a Huge Earnings Beat

The company reported earnings of $0.54 a share, up 46% over the same period last year, and a whopping $0.10 ahead of analyst expectations. Revenue was essentially in line with expectations, at $4.4 billion, but the company posted a gross margin of 30.3%, up sequentially and well ahead of management guidance and consensus of 28.5%. Management noted that the component commodity environment was very favorable for Apple in the third fiscal quarter, and should remain so in the September quarter.

Sigh of Relief on Unit Shipments

Importantly, Mac shipments of 1.327 million units outpaced expectations of about 1.2 million to 1.25 million units. iPod units shipped, meanwhile, totaled 8.11 million, ahead of lowered expectations. These numbers came as a great relief to investors, as there was an incredible amount of hand-wringing regarding unit shipments throughout the quarter.

Uptake for New Intel Macs Very Encouraging

The "halo effect" is alive and well. Management is "thrilled with the growth of our Mac business," indicating that 75% of the Macs sold throughout the quarter had Intel (INTC) inside. Based on a survey at the company's stores, almost half of customers buying a Mac were new Mac users. That's huge, and supportive of my thesis that Apple has a tremendous market share opportunity ahead of it.

The company is very well positioned for increased sales for the back-to-school season now that the Intel chipset transition is nearly complete. (The transition will likely be 100% complete by year-end.) Management noted that sales to the education market were extremely robust in the quarter.

Look for New iPod Products Soon

Apple is very secretive about its product pipeline, so little was said in terms of timing or specifics of new iPod products. Steve Jobs, in the press release, did note, however, that they "...are extremely excited about future iPod products in our pipeline." I don't believe he would say that if new product introductions weren't imminent.

Recall that some analysts were speculating that they wouldn't have an iPod product upgrade in time for the back-to-school selling season. While that still might turn out to be true, I and others are looking for new product announcements in early August, when the company holds its developers conference. Apple stock has typically performed well as new products are announced....

Retail Store Rollout Very Successful

The company added 14 new retail stores in the quarter and now has a total of 155 stores in operation. Customer interest has been phenomenal, with customer traffic of 17 million people (not all buyers, of course) through the company's stores during the quarter. Management noted that the new Manhattan store already has had a half a million visitors.

About half of Apple's sales came from direct channels (Apple stores plus on-line stores) during the quarter, up from 44% in the March quarter. This is encouraging, but the company still appears committed to expanding its distribution to non-Apple locations, which I believe is a sound practice. There's a lot to be said for product ubiquity.

Options Overhang Greatly Reduced

The company noted that based on its investigation, there will likely be no material adjustments to financial results included in the third-quarter earnings release. They said nothing about prior periods, but given that they are looking at the time period from 1997 to 2001, I believe the options issue is a nonevent for Apple.

Balance Sheet Remains Pristine

Apple's balance sheet remains pristine. A little too pristine, if you ask me. The company had about $9.2 billion in cash and short-term investment on its books at the end of the quarter and no debt. That's about $10.47 a share in cash. Sure it's great to have such a cash cushion, and interest rates have risen, but that cash would be better off in shareholders' hands in the form of a dividend or share repurchase. (I like dividends!)

I doubt the Board will change in its aversion to share repurchases, but all that cash creates a great deal of uncertainty that they might do a big, stupid acquisition. Remember the rumors that Apple might buy Disney?

Stock Poised to Outperform

Although I've been accused of being married to this stock, I still firmly believe that Apple represents an incredible opportunity for long-term capital appreciation. The Mac business is in the early stages of its resurgence, and new product introductions will likely fuel a healthy new product cycle for iPods.

Apple is at the forefront of the digital revolution, with its products fast becoming the de facto standard for the legal distribution of music. Significant opportunity exists for video as well, especially as the masses upgrade to higher Internet speeds.

What do you pay for such an opportunity? That is, of course, open to debate. But estimates will likely once again continue to trend up, and the company has a boatload of cash. With new products in the pipeline and investors now reassured about the company's growth, I believe long investors have an excellent setup with Apple stock. It remains my largest holding, for both my clients and my personal account (at Northlake, Apple is a large but not the largest holding and it is one of the largest positions in my personal accoutns as well).

Some Thoughts Ahead of Apple's Earnings

I wrote the following before my Barron's showed up on Saturday with a bullish cover story on Apple Computer (AAPL). Barron's has previously written negatively on AAPL so it shouldn't come as a surprise that AAPL shares have firmed up this week. The story is consistent with what I have been writing about AAPL.

I'll have more comments about AAPL after the company reports earnings Wednesday after the close. The comments below provide some perspective on what to expect and how the shares might react.

In a note from last Friday, UBS discussed whether the steady and large decline in AAPL shares discounts slower iPod growth, the options backdating controversy, and delays in shipments of new versions of the iPods. UBS and most other analysts acknowledge that Macs are selling very well, ahead of estimates entering the soon to be reported 3Q. The bullish theory would be that if the shares are discounting the known weaknesses then a relief rally could occur after AAPL reports next Wednesday afternoon.....

UBS noted one thing that might work against the relief rally: current estimates for 4Q ending September seem likely to be well above guidance the company will provide on its conference call. Right now, consensus calls for a 12% sequential gain in revenues and with just a few cent uptick in EPS. UBS thinks that AAPL is likely to guide for flat to up revenues especially if long rumored delays in the introduction of new iPods are confirmed. In 2005, APPL guided for flat sequential growth in the September quarter and then came throughh with growth of over 4.5%.

The flip side of the lower 3Q revenue due to new iPod delays is that new iPods will ship mostly in the December quarter which is 1Q07 for AAPL.

So the question becomes, has the market gotten ahead of analyst estimates and already discounted guidance that will probably be below consensus? Bulls also have to hope that commentary from management and analysts supports a strong December quarter with likely spillover into the March quarter.

I remain long AAPL anticipating better than expected Mac sales in the September and December to be the driver of the shares. I also think the upgrade to the Mac operating system due in August will help drive results, especially profits, as software carries very high margins. Finally, iPods could again become a positive catalyst if new models are shipped in plenty of time for the holiday season.

I’ve been wrong to hold AAPL so far this year but I do not plan to throw in the towel when I believe that sentiment is overly negative relative to the fundamentals I expect over the next several quarters.

Apple Implicated in Stock Options Scandal

Analysts are predictably defending Apple Computer (AAPL) on last week's news that the company is caught up in an options backdating scandal. Merrill Lynch did a good analysis showing that options granted very close to the annual low in the share price were only 5% of total options. None of these suspect options were granted to Steve Jobs. Excluding Jobs, a larger 15% were granted within 5% of the annual lows.

According to Apple's press release, Jobs did receive one huge grant of 20 million options in 2000 which was apparently cancelled and provided him no financial benefit. However, the New York Times noted that in 2003 when Jobs options were cancelled they were worthless. Further, the options were replaced by a stock grant worth $75 million dollars that had a three year vesting period.

10 million shares of the Jobs grant were announced on January 19th, 2000 in a press release issued by Apple. The press release said that the exercise price was about $87 as of the date of the grant which was January 12th. On January 19th, Apple already was trading at $106, giving Jobs a $190 million paper profit. The gist of the options scandal is that company's were granting options after the fact and backdating them to the lowest prices of the past year providng no risk profits to managers while diluting shareholders. It is not clear if Apple did any backdating in this case. An internal investigation will be conducted to determine if any impropreity occurred.

Analysts are focused on whether the investigation undercuts shareholder support for Steve Jobs and Tim Cook. Assuming management is left in place, analysts seem unconcerned. Apple longs are lucky that the company is something like the 50th to be implicated rather than the 1st.

Mac Sales Looking Good For Apple

News broke last week that Microsoft (MSFT) won't have a fresh operating system or a fresh update to Office for the Christmas selling season. On the other hand, all indications are that the new consumer laptops from Apple (AAPL) are selling above initial analyst estimates (which were probably conservative).

APPL shares are trading near their 2006 low. The stock's weakness has been mainly related to fears about iPod sales. While I would prefer to see stronger iPod sales, I stand by my bullish thesis built on accelerating Mac sales. One million iPods are worth $200 million in revenue to Apple. With an ASP of $1300, or over six times an iPod, it takes only an incremental 150,000 Mac sales above expectations to make up any revenue shortfall from iPods. And Macs have higher margins.

I've been wrong on Apple this year but I think the setup is good heading into the company's seasonal strong period driven by back-to-school and holiday sales. Most analysts have reduced iPod shipment and earnings estiamtes. The expectations bar has been lowered so that a decent earnings report and in line guidance should support the shares. Positive news about better than expected Mac sales and/or a refresh of the iPod line could boost the shares.

I am sticking with AAPL but expect lots of volatility surrounding the company's June quarter earnngs report.

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.

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.

A Debate Over Apple Computer

Over and StreetInsight.com, where I write daily commentary, there has been a series of posts debating the value of Apple Computer (AAPL) shares. A StreetInsight colleague got the ball rolling with a cautious post. Another colleague and I took up his challenge and responded. What follows is the exchange as it is currently archived on the website:

We had an exchange on our site (March 29 and March 30) regarding methods for valuating Apple Computer's stock. Tom Au got the ball rolling when he posed the following open question to AAPL bulls: "Does anyone think that Apple's return on equity could go as high as 30% in the next year or so, based on a book value today of about $11 a share?" To which Apple bull Jeff Bagley replied that "any valuation method that depends primarily on ROE is mostly meaningless when it comes to Apple Computer." Jeff admits that it has been a painful few months for AAPL bulls, but he puts his valuation in the company's positive free cash flow yield of more than 4.0%. The following day, Steve Birenberg also weighed in by agreeing with Jeff. Steve pointed out that an ROE-based valuation doesn't mean all that much because AAPL is a momentum stock.

Click "Continue Reading" below to see what Tom, Jeff had to say....

Tom Au
Open Question for Apple Bulls
3/29/2006 10:04 AM EST
This article was originally published in Market Insight on March 29, 2006.

On March 10, I placed a "pan" (don't buy) comment on Apple Computer (AAPL) (in the mid-60s), a weaker rating than an outright sell. This elicited comments from others that I have read with interest as to why the stock should stop going down. In particular, Steve Birenberg, a tough and worthy opponent on the Comcast (CMCSK/A) debate (where we're basically tied), published on Apple today. Since early March, the stock drifted downward to below $60.

The question: Does anyone think that Apple's return on equity (ROE) could go as high as 30% in the next year or so, based on a book value today of about $11 a share? It's now in the low 20s, a very good, but not stellar figure. This correlates closely with the 22% growth rate used in, for example, Bloomberg's dividend discount model (DDM). (If a company pays no dividends, as is true of Apple, the ROE is sometimes a fair proxy for the company's medium-term growth rate.)

Based on 22% growth, Bloomberg's DDM indicates a fair value of about $45. The break-even growth rate would be about 25%, based on price of $60. With a 30% growth rate, the implied price would be $87.

Using my modified investment value metric, my buy price would be (30/15)-squared * book value or 4 * 11 = 44. This would represent a situation in which investors observed a 30% ROE, but doubted that it (or its corresponding 30% growth rate) would be sustainable. It's noteworthy that Apple pays no dividends, and hence, the modeled stock price does not benefit from a 10 times dividends term.

My target selling price would be 30 times the resulting earnings of $3.30 a share, or $99 a share. This is an application of the PEG rule, P/E ratio  ROE, in which ROE is substituted for the growth rate. In fact, the ROE is more often a cap rather than a proxy for a sustainable growth rate. (Companies like Apple can temporarily grow faster than their ROE as this metric ramps up from a lower to higher level. For instance, a rise in the ROE from 2%, where Apple started several years ago, to as little as 4%, would represent 100% growth off a depressed base.)

The range of 44 to 99 is a bit wider than usual, occasioned by the highly hypothesized ROE, but value investors often look to buy at 50 cents on the dollar and sell at 100. From a price of $60, the downside risk would be about $15, and the upside about $39, a risk-reward ratio of better than 2.5 to 1.

Even with an ROE target that I find aggressive (30%), I could see my way to losing money with the current entry price, below $60, (although the potential reward would more than balance it). Can Apple's ROE in fact get that high? I'm a bit skeptical, but certainly willing to listen to arguments from the other side.
No positions, pending some answers

Jeff Bagley
Apple: I See Incredible Value at These Levels
3/29/2006 11:37 AM EST
This article was originally published in Market Insight on March 29, 2006.

I'll be the first to admit that being an Apple Computer (AAPL) bull has been painful this quarter, and with the benefit of hindsight, I was a pig in the stock. But our clients enjoyed a great run with this stock last year, and I'm fairly confident that the company continues to represent a great long-term holding. Note that many insiders effectively increased their stake in the company yesterday, so I guess I'm not alone in my bullishness.

Return on Equity Is a Mostly Meaningless Metric for Apple

To answer Tom Au's question, I point out that any valuation method that depends primarily on ROE is mostly meaningless when it comes to Apple Computer. Before I'm called crazy, let me point out that the company has too much cash on its balance sheet and no debt.

If it so chooses, Apple can lever up using debt, buy back shares and/or pay a special dividend. The immediate result would be a huge increase in return on equity. A huge increase! Accordingly, I view your model, in this case, as a good illustration of garbage in, garbage out.

Management Silence, in Words and in Action, Doesn't Help

But will the company lever up, buy back shares or pay a special dividend? No, and that's part of the problem. The company has refused to defend its stock at all, and that's surely contributed to the sickening decline.

Management's silence in the face of all the negativity --Intel (INTC) transition, iPod seasonality, France, etc. -- along with insider selling by Jobs, makes investors fear the worst. The stock trades like death. Who can blame anyone for selling? The "playbook" says that this thing has negative preannouncement -- or something similar -- written all over it.

Company Policy Is Company Policy

The company does not comment on fundamentals during the quarter, except for milestone announcements (e.g., the billionth iTune downloaded) along the way. And the board of directors is dogmatically against share repurchases. That leaves the Apple shorts with plenty of ammunition -- Carte Blanche, if you will -- and the Apple longs wondering why the heck they're still long this canine-like stock that with few exceptions, goes down every single day.

Insiders Exercised Options, Increasing Their Stake

Although much of the insider trading activity has focused on Steve Jobs, I point out that last Friday, eight executives exercised options underlying 1.9 million shares. They surrendered 864,264 to the company to cover the cost of exercise, effectively increasing their stake in the company by more than a million shares, representing more than $61 million.

Now I realize that they didn't put up cash to purchase the shares. But they could have sold the stock. It looks to me as if they see a bargain, and this is at the end of a very tumultuous quarter.

Valuation Especially Compelling

I know you've heard it all before, but I view Apple shares as especially compelling using my favorite metric: free cash flow. On a trailing 12-month basis, which I believe is a conservative way to approach it, the company generated approximately $1.759 billion in free cash flow. Adjusting for the $8.7 billion (about $10 per share) in cash and short-term investments on the company's books, this yields a free cash flow yield of more than 4.0%.

That's very attractive given the current level of interest rates and the company's torrid growth. The company's excellent market position in the evolving digital revolution, as well as the incredible resurgence of its computer business, will likely enable Apple stock to once again regain its high-flying status.

Note, also, that the company bounced nicely off its 200-day moving average this morning. The technically oriented crowd has been all over this stock, so we'll see if the 200-day moving average represents real support. I sure hope so.

Steve Birenberg
My View on Apple Valuation
3/30/2006 8:44 AM EST
This article was originally published in Market Insight on March 30, 2006.

Current Consensus

The current consensus estimates for Apple Computer (AAPL) in 2006 and 2007 are $2.14 and $2.62. The high estimates are $2.41 and $3.05, respectively. AAPL has been easily beating consensus estimates for much of the last two years, although I believe part of the reason for the sharp pullback in the shares is a fear that that this trend is over. In fact, estimates have been coming down some recently as analysts have adjusted their own numbers to be more in line with management guidance due to the Intel (INTC) transition for Macs and the seasonality of iPod sales.

Apple Won't Quite Make a 30% Return on Equity

Tom Au asked if the company could earn a 30% return on equity in the "next year or so." When I look at stocks and try to determine upside/downside targets, I typically look at next year's earnings on the upside and current year earnings on the downside. On that basis, at the consensus estimate, the answer to Tom's 30% ROE question is not quite, even if the high estimate were earned. Of course, if the high estimate is earned, this debate is irrelevant as the stock would soar to Tom's bullish target of $99 on the renewed confidence in earnings momentum.

As Jeff Bagley pointed out, the ROE debate on AAPL is complicated by the fact that the company has $8.7 billion in cash and no debt. Both those things serve to reduce ROE, although neither is a financial or fundamental weakness.

Cash Could Contribute 28 Cents of 2006 Estimate

Let's stipulate that AAPL can earn 4.25% on that cash. Taxed at the recently reported quarterly rate, cash could contribute 28 cents of the 2006 estimate and a larger amount of the 2007 estimate as free cash flow builds the cash balance.

Hypothetical Buyback Results

As noted by Jeff, the company could easily bump its ROE by levering up to buy back stock. Even though, for whatever reason, stock repurchase is off the table at AAPL, let's look at what would happen if AAPL spent all its cash to buy back shares. The current cash balance would buy 150 million shares if the company paid $65, bringing shares outstanding down to 730 million. Subtracting lost after-tax interest income leaves $1.65 billion in net income in 2006 and about $2 billion in 2007. Using the lower base for shares outstanding, EPS would be $2.26 and $2.80, making the share buyback accretive by 12 cents and 18 cents, respectively.

If the current book value were adjusted to the share buyback and 2006 and 2007 net income, book value would drop to about $3.4 billion or $4.65 per share. ROE would now be 60% in 2007 and the answers to Tom's question would be a resounding yes.

AAPL Is a Momentum Stock

What does this prove? Absolutely nothing. For a stock like Apple, Jeff is right that ROE-based valuation doesn't mean all that much. Apple is a momentum stock. Most value-based approaches won't work in guiding the stock price. Rather, investor sentiment and earnings momentum work interchangeably to determine the price of the stock.

Right now, sentiment is poor, and earnings momentum could be slowing. My argument in many posts has been that there is plenty of revenue and earnings growth ahead driven by new iPods, rising sales of Macs, and an increasing contribution from high margin iPod accessories. Also, the revenue upside from an Apple phone is enormous relative to current APPL sales. Where I have been wrong is expecting the stock to pay for this growth now when sentiment is poor and earnings momentum is slowing. Where I will be right is when the earnings come though and sentiment improves. I believe that time is not far away.

Apple and France

There continues to be a lot of chatter about Apple Computer (AAPL) and the potential French law that would force the company to open up its iTunes digital rights protection. One thing that I think is misunderstood is that the law will only really impact AAPL by forcing it to withdraw iTunes from the French market. The company can continue to sell iPods in France if it chose to do so.

The issue that is bugging the French lawmakers is that music which is downloaded from iTunes can not be transferred to a digital music device other than iPod. The lawmakers note that when a consumer buys a physical CD they can load the music onto any device. Therefore, the lawmakers wonder why shouldn’t music purchased online from iTunes store be transferable to any other device?

The problem with the French lawmakers is that they are totaling misunderstanding the music market and how iPods +iTunes fit in. Today, most of the music that is stored on iPods or within iTunes on Macs and PCs has come from one of two places: illegal free downloads and uploads of physical CDs. For example, the Birenberg family iTunes library has over 8,000 songs. Roughly 6,000 songs have come from uploading physical CDs which we already owned or have purchased since we started using iTunes. I added about 1,000 songs by attaching a hard drive full of MP3s owned by a friend and just dragging what I wanted into iTunes. Another 500 or so have come from purchases via iTunes. The balance have come from non-iTunes downloads (overwhelmingly legal), borrowing CDs from friends, or copies of CDs friends burned for us.

Most importantly, I can load anything I want into iTunes. It doesn’t have to be digitally encrypted to Apple's proprietary digital rights management software. So the iPod is already encryption free. Only the music that comes from iTunes is digitally encrypted and non-transferable....

What the lawmakers and many investors are missing is that all the French are really talking about opening up is the iTunes digital rights management system. This will only directly affect music downloaded from iTunes (and other similar sites that use proprietary encryption technology). So how does this impact the music industry and AAPL?

For the music industry, opening up iTunes, by far the most popular legal, for profit, music download site will merely mean that future sales will be sacrificed. If everything that I have ever downloaded from iTunes can just be copied over to any other device owned by any other person, the result will just be lost sales. Sales of digital music over platforms like iTunes are actually allowing revenues for the music industry to grow again even as physical sales continue to dwindle. Opening up iTunes, the dominant legal download site, will cut off or limit the new revenue growth vehicle. Why pay when you can get it for free from someone else? Is this really what the music labels want? Shouldn’t they be helping AAPL to build the market for legal, for profit downloads?

As for AAPL, I am assuming that all that would happen were France to enact this law is for the French version of iTunes to be shut down. I see no reason why they would stop selling iPods in France. After all, French folks who wanted to buy an iPod could still load it with all the CDs and free downloads and iTunes downloads they want. Additionally, they could just point their browser to an iTunes site in another country and download and purchase from iTunes. Would the French buy fewer iPods? I suppose that is possible but the question is why are they buying iPods in the first place. Is it because they want to gain access to iTunes downloads? Or is it because iPod + iTunes offers the best user experience for managing and listening to your music library? I'd suggest the later.

The question you should ask if you are an APPL investor is will iPod sales slow if the iTunes digital encryption system is forced open. I’d argue that iPod + iTunes has already won the battle, not because of access to iTunes downloads -- iPods drive iTunes demand, not vice versa -- but because the iPod is a better music gadget. iPods, not iTunes, drive profits for AAPL.

Another Trip To The Apple Store Reinforces Confidence

It's been a rotten year so far for shareholders of Apple Computer (AAPL). AAPL shares have fallen almost 10% against a gain of close to 6% for the S&P 500. I've felt the pain as all clients of Northlake and my own accounts own AAPL. My pain was lessened a bit this weekend when I made a trip to my local Apple Store at Old Orchard Mall in Skokie, IL. The store caters to the well-to-do North Shore of Chicago where I'd make an educated guess that Macs enjoy a much better than average market share and every kid has an iPod. In other words, this store ought to be crowded with long lines at the registers if momentum in iPods and interest in Macs is continuing.

That was definitely the case on Sunday. I got in line to buy a Mac Mini as an upgrade for my daughter's computer. There were at least a dozen folks in line when I started and when I finally checked out. An unscientific survey showed people buying Macs, iPods, and accessories. Furthermore, the store was crowded with people looking at all the products on display. If I had to choose one area of particular customer interest it would be iPod accessories, with lots of people looking at the new iPod Hi-Fi boom box. The product was displayed right next to the hot selling Bose iPod boom box. AAPL was asking $350, a $75 premium to Bose. I was glad to see the big premium because while I see accessories as an area of big upside for AAPL in 2006, I have a mild concern that as AAPL introduces more of its own accessories it could lose the support of some of its partners. These partners have been critical in developing the dominant market share for iPod + iTunes....

As for the Mac Mini, it was a wonder to take home and set up. It comes in a little box, not much bigger or heavier than four boxes of checks sitting 2-by-2 so getting it to the car in the far corner of the crowded parking lot was easy. Once I got it home, I unpacked it, plugged in my old monitor and my old USB keyboard (by old, I am talking five years at least), and I was up and running with the latest Mac OS. When the system booted for the first time, it asked me if I wanted to hook up another computer to transfer files. I said yes and a SetUp Assistant popped open. It gave me instructions to connect a cable between the two machines and then scanned the old computer looking for users, network connections, documents, and applications. A window asked me what I wanted to transfer and I checked off several items. Less than 10 minutes later, I had everything I needed except for my daughter's 5,000 song iTunes library. I launched a separate program called Migration Assistant to bring over her library because the SetUp Assistant didn’t allow me to transfer just her library without the rest of the library that includes my own tunes and my son's tunes.

So for $599, I upgraded to the top of line AAPL system. From the time, I sat down to turn on the Mac Mini for the first time, in one hour I had it up and running and had transferred all the files and applications I needed from the old machine. Then just for fun, I pulled out the remote control and launched Front Row from across the room while my daughter was typing a paper. Up popped iTunes with the same interface as an iPod. I loaded some Bob Marley and we were jamming.

I believe AAPL shareholders will also be jamming again soon. The products are still in heavy demand, more innovative products are coming, and lead times on shipments of the new Intel-based laptops are starting to come down. Analyst estimates have moderated and are now close to management guidance. Probably in the July quarter, but certainly in the October quarter, demand will once again rule, and investor concerns will moderate. A move to new highs heading towards late summer education related demand should be in order.

Apple Anounces New iPod nano

AAPL shares are set to bounce at the open following some supportive analyst commentary and the introduction of a 1G iPod nano. The new nano will be priced at $149 while the shuffle line will continue with prices dropping to $69 for the 512K model and $99 for the 1G model. AAPL now has iPods prices at $69, $99, $149, $249, $299, and $399. The big jump in value comes with the 30G and 60G video iPods priced at $299 and $399 and holding 7,500 and 15,000 songs, respectively. The highest priced and capacity nano is $29 for 4G, storing 1,000 songs. This product lineup has something for everyone and seems to support upgrade and downgrade demand which helps margins.

It will be interesting to see if the early share gains hold. Lately, that has not been the case and every light has been met by heavy selling. One concern has been a sharper than expected seasonal downturn in iPod sales in the March quarter. I think the 1G nano will sell-through well and AAPL will ship a lot units. Availability is immediate.

My addition of AAPL shares in the mid to upper $70s has been wrong so far. I think it will prove correct later this year when confidence in the long-term growth story overwhelms near-term concerns about iPod seasonality and the Mac transition.

Why Apple Is Still A Growth Stock?

Over on Street Insight, my fellow contributor Jeff Bagley and I have been tag-teaming the defense of Apple Computer (AAPL) since the company reported its December quarter EPS. We were both bullish prior the earnings release and I really feel Jeff has hit it on the head with his long-term bullishness based upon the unusually large opportunity for AAPL to enhance revenue and profits. Basically, Jeff, along with Cody Willard on Real Money, has noted that AAPL is one of the only really big cap stocks that offers the prospect for sustained 20% plus earnings growth over a multi-year period; sustained on top of the huge earnings gains being driven recently by the success of the iPod. Due to AAPL's unique status as an actual mega cap growth stock, Cody, Jeff, and I are willing to live with the high valuation and occasional significant downside volatility. And speaking for myself, trimming the position on the way up makes the downside periods less painful.

To give you some sense of why AAPL may offer such a high level of sustainable growth, consider the company today against the potential opportunity the company could have in PC and cellphone sales. Last year, AAPL sold almost 32 million iPods generating $6.2 billion in revenue with an ARPU of $195. Additionally, AAPL sold 4.7 million Macs, pulling in $6.4 in revenue at an ARPU of $1,350. Put those two together and you get $12.6 billion in revenue....

Last year, 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, 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 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.

AAPL hasn’t introduced a cellphone yet but many investors and analysts think that is where the company could go next. According to Strategic Analytics, in 2005, global handset sales grew 19% to 810 million units. Handsets outsold MP3 players like the iPod by more than 15 to 1 last year. Let's guess that AAPL could maintain an ARPU similar to the $145 earned by Motorola (MOT) on its handset sales in 2005. MOT's ARPU was heavily influenced by the high end RAZR and given AAPL's history of innovative design and premium pricing, you would have to expect any cellphone issued by the company to be a high-end product. Let's stipulate further that AAPL could gain a 5% market share of global handset shipments. That would work out to 40 million units at $145 or $5.8 billion in revenue. At that level, handsets would almost match the size of the current iPod and Mac businesses. In other words, the top line could grow by almost one-third from a successful handset product. Granted operating margins in this business are below Mac, and probably iPod, levels but the revenue potential is huge.

Gaining market share in PCs and cellphones is incredibly difficult. Competitors are entrenched and top notch. AAPL could fail. But as an investor, how many opportunities really exist in mega cap stocks for the type of growth AAPL could sustain? Very few. And don’t forget, iPods are still a growth industry with unit volume growth north of 40% likely in 2006. Plus iPod accessories. And maybe that digital media hub. You get the idea.

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.

What To Look For In Apple's Guidance

In my preview note on Apple Computer (AAPL), I failed to provide an update as it relates to March quarter guidance. What the company says about guidance is probably more important for the stock price than what they report for December.

Among just those analysts who have adjusted since Jobs MacWorld update, EPS estimates for March range from 41 cents to 60 cents. Consensus is 48-49 cents whether you include the outliers or not. Estimates among this group of analysts rose anywhere from 2 cents to 10 cents with the average increase up 5-6 cents.

Revenue estimates for the March quarter range from $4.44 billion to $5.23 billion with a consensus of $4.84 billion. Revenue estimates rose anywhere from $275 to $900 million since MacWorld.

Read on for guidance relating to iPod and mac shipments....

iPod shipments are forecasted to decline sequentially as is normal coming off the holiday season. However, due to a perceived backlog in demand the decline is expected to be less than normal. For example, last year December quarter iPod shipments were 4.5 million and March fell to 3.6 million. Complicating matters last year was an additional 1.7 million Shuffles that shipped in the March quarter that are EXCLUDED from the comparison I just made. Using a small sample, it looks like the consensus for March quarter iPod shipments ranges from 9 to 11 million versus the 14 million shipped in the December quarter. The biggest portion of the decline is expected to come in 30GB and 60GB models while nano shipments decline but hold up better. This is consistent with reports of nano shortages at Christmas.

December quarter Mac sales are expected around 1.25 million. The ramp off this figure due to the transition to new Intel-based Macs should begin in the March quarter but it appears most analysts are assuming a gradual build over the course of 2006. A sequential gain of 100,000 units in the March quarter is expected to accelerate to a sequential gain of 200,000 units in the June quarter.

I think guidance as it relates to Mac shipments may be more important that iPods as far as the stock is concerned.

Previewing Apple's December Quarter Earnings

Apple Computer (AAPL) reports after the close today. Following Steve Jobs comments at MacWorld last week estimates have moved up sharply. Jobs guided to $5.7 billion in revenues for the December quarter and analysts who have adjusted their estimates are tightly clustered around this figure. There was no specific guidance on EPS at MacWorld so these estimates are more varied. The range is from 59 to 69 cents, up about 10 cents from before Jobs speech. Estimates have risen sharply for FY06 as well. The range of EPS estimates is now $1.95 to $2.53, up about 30 cents at the midpoint. Revenue estimates for FY06 range from $19.4 billion to $22.3 billion, up $2 to $3 billion.

I think the big question mark for the December quarter is how good were margins on the incremental $700 million in revenue AAPL booked relative to prior estimates. iPod shipments of 14 million accounted for the positive surprise as Mac shipments actually may have been 100,000 units under expectations. Recently, ASPs for Macs have been running around $1,400. Therefore, if units were 100,000 short, this might imply a revenue shortfall of $140 million in this unit. If so, that would mean that the extra iPod unit sales made up closer to $800 million in revenues. At 3.5 million units that implies an ARPU of $228 for incremental iPods. That feels a bit high to me, but I think the math suggests that sales of the new 30GB and 60GB iPods must have been quite strong in the December quarter. These units earn higher margins than the 2GB and 4GB nanos which were also strong sellers during the holiday season. The range of analyst estimates is most likely a function of how the mix of iPod sales is viewed along with the level of Mac sales which carry different margins than iPods....

Regarding the slight shortfall in Mac units, analysts seem unconcerned given the earlier than expected introduction of desktop and laptop Intel-powered Macs. I get the impression that analysts feel there may have been some lost sales to customers waiting for an Intel based machine. I think the shortfall was likely due to the overwhelming demand for iPods. Apple Stores were mobbed at Christmas and I think there was just less of a focus on selling computers and more a focus on getting iPods out the door. For example, each store set up a separate table just to ring up iPods.

Beyond the quarterly numbers, the questions for AAPL relate to future iPod and Mac demand. Analysts bumped up their iPod shipments for every quarter in 2006 and are expecting another year of big growth. Reports of unmet demand at many consumer electronics retailers has led to the assumption that a backlog in demand still exists at the consumer level. Given the strength in sales at the Apple Stores I wonder how much of that supposed demand has already been met. That said, with 42 million iPods sold, we are far from saturation. At most, U.S. penetration is around 10% and the rest of the world lags well behind. Also, AAPL did not introduce iPod upgrades at MacWorld suggesting that plenty of demand remains in the current form factors. It also leaves the ability to drive demand with further upgrades certain to come later this year.

AAPL also seems more focused on supplying its own iPod accessories. Accessories were a big seller during the holidays and MacWorld accessory introductions like the iPod FM Remote and iPod A/V Connection Kit tell me that AAPL wants to capture more of the multi-hundred million dollar revenue stream in accessories. Typically, accessory purchases carry higher margins so this could be a source of upside surprise in the future if my theory is correct.

As for Mac demand, I think the Intel transition and the halo effect will prove quite positive during 2006. AAPL has always had great success with new Mac introductions due to the willingness of its loyal customer base to upgrade. CSFB analyst Robert Semple has published some excellent research on this phenomenon and notes, "in the five major form factor upgrades since 2001 according to our criteria, Apple has averaged a 129% sequential increase in unit shipments along with a 26% ASP increase." Add in the much greater awareness of AAPL products today and this transition could be among the best ever. Plus, I continue to believe that in the consumer market the shift toward using computers for broadband internet and digital media has reduced the importance of the operating system and increased the importance of the application software. AAPL has a big edge in digital media applications so the leveling of the playing field against Windows makes a pickup in market share for Macs a real possibility.

With all that as background, being long AAPL I do worry that we could get a sell the news reaction to the earnings report particularly as it relates to margins and guidance. Heading into this week, AAPL is already up 19% this year after more than doubling off the summer low. My confidence in predicting the short-term reaction to AAPL's 1Q06 earnings report is low. However, based on my belief that demand for iPods and accessories will remain strong and Mac sales will boom, I think downside is limited. Based on what I know now, I'd be a buyer below $80 where I think 20% upside would exist for AAPL shares over the next six to nine months.

Will Apple Provide Your Cellular Service Soon?

Blogs, press reports, and analysts are all noting that AAPL has received trademarks and patents on a series of products and services under "Mobile Me" branding. According to Pacific Crest Securities:

A series of trademarks and patents filed recently indicate that Apple is preparing a connected ecosystem consisting of a mobile product and/or service. These filings consist of an antenna apparatus within a laptop, a method of data transmission using a portable device, and a trademark/service mark for the phrase….Applications and services highlighted in the Mobile Me trademark filing include telecommunication services, and retrieval of data, images, audio and video through global communication networks, including the Internet, TV, cellular and satellite networks.

Who knows where this is going or if it will amount to anything? However, Pacific Crest speculates that APPL is thinking about a MVNO service (mobile virtual network operator). This might be similar to what ESPN is launching. Any mobile wireless service rises or falls based on establishing a subscriber base. One thing I like about this concept for AAPL is that the installed base of Mac users has shown incredible loyalty to AAPL and it is fair to assume that a large number would switch to AAPL for mobile wireless service for their phones and laptops. If iPods were enabled to use the service, either directly or through laptops and cellphones (maybe an iTunes enabled phone from AAPL), the potential user base grows dramatically given that over 30 million iPods have been sold in the U.S. alone. Pacific Crest notes that 4 million subs at $55 per month is a $2.6 billion revenue opportunity. Add in device sales stimulated by a mobile wireless service and you could get another couple billion in sales of phones, laptops, and iPods. As Doug Kass likes to say, "makes you go hmmm."

To reiterate my current stance on AAPL, I am raising my target for the next trimming of my position to the mid-$90s based on the increased estimates, the momentum of iPod sales, and the coming surge in Mac sales due to the transition to Intel (INTC) chips. I also believe further new product introductions throughout 2006, including for more iPods, additional Intel-powered Macs, and possibly digital media and mobile services and products, will sustain the multiple and keep growth investors excited.

iPod Sales Explode: How Much Upside Is Left in Apple Shares?

Lots of news from Apple Computer (AAPL) this week coming from its annual MacWorld convention. Steve Jobs introduced new Intel-based Macs six months ahead of schedule and there were lots of upgrades to iPod accessories and applications within AAPL's iLife suite of digital media and internet products and services. Most importantly for the stock, Jobs announced that during the fourth quarter the company shipped 14 million iPods, way ahead of analyst expectations of 11 million. Jobs also announced that revenues for the quarter will be $5.7 billion, again well ahead of analyst estimates which averaged $5 billion. We will get a lot more information from AAPL when the company reports earnings after the close next Wednesday, however, I wanted to provide a few thoughts on this week's news before it becomes stale….

Estimate increases were a lot more than I expected. FY06 was around $1.80 prior to yesterday and many analysts are now going into the $2.20s. FY07 was at around $2.20 and now many estimates are moving to $2.50 to $2.80. Analysts massively increased iPod assumptions across the board and in general are looking for shipments to more than double in 2006 to 45 to 50 million units. I also think the earlier introduction of Intel (INTC) based Macs led to increases in Mac shipments assumptions.

The estimate increases put AAPL just under 40 times this year's earnings without adjusting for the $10 in cash on the balance sheet. This multiple is consistent with valuation levels for the shares even before two major surprises since summer: the nano introduction and the huge upside surprise in iPod shipments and revenues just announced. So on the one hand, you could argue that not much has changed. EPS have actually kept up with the stock price increase.

On the other hand, I think AAPL stock faces some challenges once this move levels off. Mostly, it is the same old fear about slowing momentum of iPods. Analysts seem comfortable that iPod shipments have moved to a new, higher base level. I thought the write-ups were vague as to why that would be the case. Some noted that there was backlog of nano demand. I presume this is based upon the lack of supply at many retailers during the holiday season. It is possible, however, that this demand was diverted to AAPL's stores and website.

Of course, AAPL has sold only 42 million iPods so far. In the broader picture of 300 million U.S. population and multiples of that abroad in developed economies the penetration remains low. Additionally, the larger the base, the greater the potential replacement demand. For example, our family upgraded a shuffle to a nano and replaced an iPod with a vPod. Remember AAPL did not introduce new iPods at MacWorld. I'd take that as an indication that they have plenty of demand and see no need to stimulate sales at this time. Also, the addition of more accessories allowing greater functionality for current iPods increases the potential audience. Turning your nano or vPod into an FM radio or easing the ability to hook it up to your stereo are great ways to convince new users to come aboard and old users to upgrade.

Despite my focus on iPods, I think the next move in AAPL shares will hinge on the new Intel-based Macs. AAPL has always seen a surge in demand when significant new form factors were introduced. Sales volumes have tripled or more in the quarters following prior shifts and that was when you just had the dedicated Mac users upgrading. Now, you have tens of millions of households that never used a Mac at least aware of the Mac platform. Furthermore, developments in broadband technology, digital media, and internet usage have changed the consumer experience with PCs and reduced the importance of the operating system. It is applications based now.

I think the halo effect will appear and that AAPL still has a ways to go. 2007 numbers could end up near $3.00 by the middle of 2006. On that basis, the shares could head well north of $100. I've trimmed AAPL positions twice already, once at $48 and again at $71. When I trimmed at $71, I said my next target was $88 to $90. Given the good news recently, I am going to look for a mid-$90s target now. Holding the multiple on the new higher estimates gets me there and as outlined above I think the Intel-based Macs insure good numbers for the next couple of quarters. A target in the mid-$90s is worth holding for current positions but doesn't produce enough upside to buy more stock in light of the risks created by the enormously high expectations and valuation for the stock. I do think the latest news provides great downside support so adding shares on a pullback at around $80 is something I am considering.

Trimming, Rather Paring, Apple Again :-)

On Monday, I trimmed client positions in Apple Computer (AAPL). The reasoning was similar to the decision to sell in September when the stock first crossed $48: maintain discipline and take some money off the table when a stock reaches an established target price. At the time of the September sale, I decided my next target would be in the low to mid-$60s. I was thinking that 2005 would end strongly for the company but like everyone else on the planet except Steve Jobs I did not expect the iPod nano introduction. Estimates have risen since the nano was introduced but at the time I was thinking the company could make around $1.70 in FY06 ending next September (consensus was only $1.62) . Cash was about $9 per share producing 15 to 20 cents of the earnings. Thus, to reach the mid $60s, the stock would need to trade at 35-40 times current years earnings adjusted for interest income plus the $9 in cash. In a growth starved world, that seemed like a reach but possible. As a comparison, today's most popular growth stock, Google (GOOG), trades at 47 times the current 2006 consensus earnings estimate....

Since the introduction of the nano, the consensus estimate for AAPL in FY06 has risen to $1.79 with a high estimate of $1.95. Use the same math and the extra 10 cents in EPS adds $3.50 to $4.00 to the target price. Thus, beginning early last week, I decided to lighten again if the stock crossed $68. Lucky for me, my initial open order was not filled and I left for the Thanksgiving holiday. I spent Friday sitting in a Panera Bread (PNRA) in Northern Kentucky using the free high speed wireless service. The stock was up a lot and nearing $70 but I made an educated guess that analysts would be positive on the company's initial holiday sales and decided to wait until Monday morning to lighten. Due more to good luck than good analysis, on Monday morning I sold down client positions to a 2% holding just short of $71.

To justify a target above this price requires either significantly higher FY06 estimates or a look out to FY07. Current consensus for FY07 is $2.10 with a high estimate of $2.30. Use the same 35-40 multiple and add back what will then be over $10 in cash and a target close to $90 can be established. For now, I've decided that is my next target to trim the position or exit completely.

Another reason I wanted to trim the position is that I am getting a little worried that expectations for AAPL are getting out of hand. This sets up a dangerous short-term reaction to the next earnings report similar to what happened in October when AAPL initially sold off sharply when it reported quarterly earnings. At the time, I thought that the selling was an overreaction. Now the stock is up another 50% and almost everyone has raised iPod shipment forecasts and earnings estimates.

On the flip side, AAPL is still gaining market share in PCs and rumors of an early introduction of the Intel-based Mac are gaining credence. This might allow calendar 2006 to be the year the halo effect finally takes over from iPods in driving AAPL's share price and fundamentals. Nevertheless, the risks are up relative to the reward so a more cautious approach is warranted.

One thing I have learned during my 24 year investment career is that if you ring the register occasionally on winning positions, you can take the risk of riding momentum. The prior sale of AAPL and similarly reasoned trimming of Motorola (MOT) and Sears Holdings (SHLD) earlier this year, are all examples of ringing the register. While AAPL and MOT have continued to work significantly higher, SHLD has dropped sharply since it was trimmed. However, because it was trimmed the pain of the decline has been lessened and the overall return on the original position has held quite high.

An Exciting and Illuminating Week for Apple Computer

In the extended comments section at the bottom of this post is the commentary I wrote for StreetInsight.com immediately following Apple Computer's conference call discussing its September quarterly earnings. As it turned out, I was right that the Street was overreacting when the shares were trading down 10% in after hours trading during the conference call. The next day, when the market opened, AAPL never traded down less than 6% and closed the day with a loss of just 4.5%. The volatility continued on Thursday when AAPL shares gained 9%, closing more than $2 above the pre-earnings close, after the company announced new iPods with video download capability and a refreshed iMac computer that comes darn close to merging your TV with your computer....

As noted in my initial post earnings commentary, the fact that iPod shipments fell short of expectations in the September quarter was the key source of the initial decline in APPL shares. I attributed the shortfall to the slowing of iPod mini shipments in anticipation of replacement of the mini line by the nano. Remember that the nano came as a total surprise to Wall Street as no one anticipated the radical redesign and the elimination of the mini line. Obviously, AAPL management knew this and thus was unconcerned about the iPod shipment figure since they knew that nano demand was "staggering." On the call, management further explained the shortfall in iPod shipments by noting that initial nano shipments were constrained by component supply issues. I'd guess that AAPL could obtain only much flash memory from Samsung given the surprise introduction of the nano.

More of the supposed iPod shipment shortfall came into focus with Thursday's introduction of the new video-enabled iPods. As with the mini, AAPL probably limited shipments of the old 20GB and 60GB iPods in order to clear the channel for the October launch of the Video iPods. This past Saturday I visited my local Apple Store and learned that 20GB iPods are being discounted by $50 to fully clear inventory ahead of stocking of the new 30GB and 60GB iPods. Although I heard no statement of fact, I also think that my discussions indicate that shipments of old iPods had tailed off in September.

The bottom line from all this is that iPod shipments were not an issue in the September quarter. The market figured this out on Thursday and thus revalued AAPL shares off the earnings report to ahead of prior prices. This makes sense because as I noted in my original StreetInsight.com piece, "an objective read of the press release and analysis of the financial statements and conference call suggest that the company's competitive positioning and long-term fundamentals look better than ever."

Somewhat lost in the media coverage of the "Video iPod" was the introduction of the new iMac. Analysts have been speculating that AAPL is heading toward a digital media/entertainment center for the family room. The new iMac is a good signal that the speculation is correct. A remote control (with just 6 buttons!) and a new software interface allow you sit across the room from your iMac and play any music or video that you have loaded into iTunes. You could also watch a DVD you rented or own or any home video you have uploaded and edited using APPL's iMovie or iDVD software (head over to Apple's website and tour the new Front Row software).

With the simultaneous announcement that through iTunes you will be able to download hit shows like Desperate Housewives and Lost, short films from Pixar, or music videos it seems clear that it won�t be long before your computer is really functioning as digital media center allowing your TV and computer to finally merge. I am sure we will be seeing lots of announcements about more TV shows and eventually movies (note that Front Row has a movies section) that will be available over the iTunes platform. It doesn�t seem much of a stretch to ultimately have the iMac or the digital media server receive the cable or satellite wire currently attached to your TV. At that point, you have a single unit that controls your TV viewing, your music listening, your family photos and home videos, and allows you to surf an internet rapidly filling up with high quality streaming video content and podcasts to meet any consumers personal interest.

The path to this convergence is why AAPL is one of the few large cap companies that can really be classified as a growth stock. Not only is there near-term momentum from continual upgrades of the iPod family and ongoing market share gains in the personal computer market but AAPL also potentially is heading toward a massive replacement cycle of the equipment (and the wires) that is stuffed inside your family room cabinets. When TV is added, the home entertainment opportunity dwarfs the market that AAPL is accessing in digital music. It is also larger than the multi-billion opportunity AAPL has if it continues its market share gains in personal computers.

AAPL the stock is different from AAPL the company. Valuation and momentum in the stock over any near-term period will be volatile relative to the where the company is headed strategically over the long-term. I think AAPL shares are well-positioned for the next quarter as the controversy over the September quarter has cleared the decks for short-term. Nevertheless, AAPL is presently a momentum stock so managing long side exposure aggressively makes sense. AAPL is not the largest position in client portfolios and I have no regrets that I held discipline and sold almost half the position about 10% below current prices. The action after the close last Tuesday in response to AAPL's latest quarterly earnings shows the risks that exist in a momentum stock. However, the new product introductions on Wednesday also show that not all momentum stocks are just hype.

Original StreetInsight.com Earnings Commentary - October 12, 2005

I think the stock reacted as it did due to the intersection of high expectations, a stock price that rose over 40% in the third quarter, and nervous investors following a week plus of sharp declines in the major market averages. In other words, I think an objective read of the press release and analysis of the financial statements and conference call suggest that the company's competitive positioning and long-term fundamentals look better than ever. Investors will choose to put whatever multiple they want on the shares but I don�t see anything here that requires a significant re-pricing of the premium AAPL has earned.

The issue this quarter is iPod shipments. Rising estimates off the nano introduction got ahead of what AAPL could deliver due to self-proclaimed shipment constraints and a purposeful drawdown of iPod mini shipments in anticipation of the nano introduction. Management claims nano demand is "staggering." Either you believe that and accept the reasoning why iPod shipments were up to 1 million light of estimates or you believe management is lying and that iPod demand has slowed. I believe demand is fine and I challenge anyone to head to their nearest Apple Store and tell me otherwise.

Lost in the panic over iPod shipments is another stellar quarter of computer sales. Computer units were up 48% in the quarter due to a big bump in laptop shipments. The IDC forecast is for low to mid-teens gain in the quarter so the market share gain is clearly continuing. As noted by management, computers have higher margins than iPods. In fact, computer revenue is one-third larger than iPod revenue. One reason for the sequentially lower December quarter gross margin forecast is a shift toward music due to iPod demand.

My takeaway from the quarter is that both sides of the company are on track. AAPL shares are correcting to 21 times EPS adjusting for almost $10 of cash on the balance sheet. I find this valuation reasonable for one of the few real large cap growth stocks.

My Take On The Merrill Lynch Downgrade of Apple Computer

I am not sure if it was the Merrill Lynch downgrade from buy to neutral or the iPod nano screen problems that led to the sharp decline in Apple Computer (AAPL) but the reaction was sharp with the shares dropping close to 5% on well above average volume. I'm no technician but the chart definitely looks broken, at least for the very short term.

I read through the new Merrill report. It is very well done. It is also not really a negative piece.....

....Merrill transitioned AAPL coverage to a new analyst who decided to move to a neutral opinion. The core of the downgrade concerns the risk of slowing momentum and how it relates to what the analyst sees as a full valuation. That said, the analyst notes that fundamentals are quite strong and that he is adopting what he sees as a conservative view relative to the halo effect. On iPod penetration, he just seems worried about to how to factor a slowing growth rate due to the rapidly growing installed base. Estimating a slowdown off of a growth rate in excess of 100% is difficult and in consumer electronics there is a pattern of rapid and unforeseen shifts in demand for certain products.

Getting back to the Merrill report, I found the data on the halo effect most interesting. The analyst believes it is real but due to the upcoming Intel transition and Microsoft's introduction of the big Windows upgrade, he is assuming the halo effect may pause slightly as measured by gains in PC market share for the Mac platform. Here is some data from the report:

� Over the 8 quarters spanning from March 2003 to June 2005, Mac unit share increased 40 bps and Mac revenue share grew 80 basis points, while iPod shipments grew to 20 million units
� Every half point gain in revenue share of PCs boosts AAPL sales by $1.5 billion including peripherals and software and adds 25 cents to EPS.
� AAPL's projected 2005 revenue is $14 billion with consensus EPS of $1.47.

Most analysts project that the iPod installed base will grow by 50 million units to 80 million by the end of 2007, up from around 28 million presently. This would imply the potential for 200 basis points of revenue share expansion for AAPL. Since a half point gain of revenue share is worth 25 cents, the concept is that the halo effect could add $1.00 to EPS in 2007.

The Merrill analyst discounts these numbers due to the Intel transition and the upcoming Windows upgrade. He also notes that AAPL may have gained share independent of iPods due to the success of the Mac mini and the flat panel iMac.

All of this analysis seems fair to me and it is clear the downgrade is driven by the fact that the margin of error for estimates related to the iPod sales and the halo effect is large in terms of units, revenues, and EPS. Nothing wrong with that. What he seems to be arguing is that he doesn�t see further multiple expansion given the margin of error and he is not will to raise estimates. He also seems unsure of how much of a potential $1.00 boost to 2007 EPS due to halo effect is already in consensus estimates. Both of those positions are understandable but I wouldn�t call them negative.

I think AAPL has great fundamentals and that 2005. 2006, and 2007 EPS estimates will prove low. I also recognize the risks of owning a momentum stock, arguably the momentum stock of this market. That is why I reduced my position in the upper $40s. I can live with the risk that momentum falters more quickly than I can expect. I can also still participate nicely against my benchmark if I am right that the AAPL story has several years to run. With a stock like AAPL you have to choose sides. I choose long.

Apple Introduces the iPod Nano

Today I contributed the following commentary on Apple Computer to StreetInsight.com, the professional service of theStreet.com. Since Northlake clients are long Apple in their portfolios, I thought the note might be of interest. I have also included the text of two other comments on Apple that were contributed by other money managers who contribute to the various websites owned by theStreet.com:

Based on reports from various Apple Stores around the country it appears the iPod nano is major hit. Numerous stores had lines at the cash register and traffic was extraordinary. At the Apple Store where I bought my nano, the sales people reported that much of the initial traffic was from people who already own iPods. I think that the nano will drive a major "upgrade" cycle for current iPod owners in addition to bringing even more buyers (according to AAPL only 6% of the people in the United States own an iPod). The nano, with 500 or 1000 song capacity is a nice compliment to a currently owned 20 or 40GB model. It is also a nice upgrade over a shuffle. I think the nano will be the hot product this Christmas and current estimates for total iPod unit shipments over the next two quarters are low....

....Last quarter, AAPL reported a gross margin just short of 30% and SG&A as a % of sales of 13.4%. For sake of argument, let's say AAPL ships an incremental 1 million iPods due to the popularity of the nano. Using the average retail price of the 2GB and 4GB versions of $225, AAPL would realize an incremental $225 million of revenue. Applying a 30% gross margin, a 15% SG&A ratio, and a 33% tax rate, an incremental 1 million iPods would produce $22 million in net income and 3 cents per share in earnings.

I believe this math could be conservative. First, I believe iPods have a higher than corporate average gross margin. Titus Menzies (another contributor to Street Insight) calculated that AAPL might earn a 43% gross margin on the 2 GB nano. Second, I believe an incremental 1 million shipments may prove low. Through the end of last quarter, AAPL had shipped more than 21 million iPods (another 6 million or so likely in the quarter ending 9/24/05). I think at least 10% of those iPod owners will add a nano to their collection. Even if some of those folks would have bought another iPod, there will clearly be first-time buyers attracted to the nano sooner than expected due to the incredibly positive product reviews and word-of-mouth.

So let's say Titus is correct and the gross margin is 43% on an incremental 2 million nanos. Keeping SGA% and the tax rate constant, that creates an additional 10 cents in EPS.

I believe AAPL books revenue based on shipments, not final sales. It is hard to guess how many nanos will be shipped by the end of the fourth fiscal quarter on 9/24. However, I think it s fair to guess that estimates for the fiscal year that begins on 9/25 will rise by about a dime. Consensus is presently $1.63 with the high estimate at $1.75. So assuming current estimates are accurate, at $51, AAPL trades at 29 times forward earnings. There is almost $9 per share in cash on the balance sheet generating 15-20 cents in EPS, so alternatively AAPL is trading at an adjusted price of $42, or 26 times cash adjusted EPS.

I don�t want to call that cheap but given the momentum in earnings and the upside from the halo effect (Macs cost 4 to 10 times nanos), I don�t find that an unreasonable valuation. I sold half of client positions in AAPL last week when it reached my initial target. I don�t regret that but if I was privy to the nano, I wouldn�t have sold. It is that good of a product and another game changer for the digital music industry. It also reinforces the halo effect and extends and acclerates the window for AAPL's momentum at least another couple of quarters. So for now, I'm content holding the shares but I'd have no problem buying them around Friday's close if I didn�t own an average size position already.

If you want to read some more on Apple, here are a couple of other comments on Apple from my fellow contributors at Street Insight:

Posted By Cody Willard on Friday, September 9:
Apple (AAPL:Nasdaq) announced two very different products Wednesday, each of which has very different implications for the company.
� The iTunes Motorola phone is a strategic advancement of Apple's de facto standardization of legal MP3 music.
� The iPod Nano is an earnings and revenue driver for the next year.
First, the phone. After all the hype, excitement and tensions around the Apple and Motorola (MOT:NYSE) announcements on Wednesday, the companies jointly rolled out a single handset for Cingular's and O2's network, as I'd been reporting on these pages before the news actually hit.

The phone isn't exactly the coolest piece of technology I've seen rolled out this year (that award now goes to the iPod Nano, as I'll detail below). But simply because it's got the iTunes technology and brand, people are going to be buzzing about the phone this holiday season, and it's sure to be a hot item on a lot of Christmas lists.

The biggest knock against the phone in the mainstream press and by some on these pages is that it "only" holds 100 songs. To be clear, this is not an item that is supposed to replace an MP3 player. It's supposed to complement the iPod, which is now in the hands of more than 21 million Americans. That is the single most important aspect to the rollout, and it's been completely missed by everyone.

This phone isn't targeted for the hundreds of millions of Americans who have yet to purchase an iPod, and it's not supposed to be the introduction of MP3-playing cell phones. It's targeted for those who already have or are about to buy or receive an iPod. Sure, there will be those who will use this phone as their first MP3-playing device. But that's not the key demographic.

Apple's music business strategy from the beginning has been to establish itself as the de facto standard for legal music downloading. I've repeatedly said that Apple had essentially accomplished that, but that it has been a nebulous concept. However, Apple's licensing its technology to these three giant wireless companies -- enabling them to become the first movers for downloading music over wireless networks -- crystallizes Apple's dominance. The rollout of this product marks its victory in the digital music wars.

The next question is, why did they cap the phone at 100 songs? Apple is making millions of dollars in earnings by selling iPods. The last thing they want to do is cannibalize that product with a competing cell phone manufactured by another company. Thus, the cap at 100 songs. That cap makes this phone a phone and not an MP3 player. You want a true MP3 player? Buy an iPod. Simply another brilliant strategic move by Apple in its music strategy.

Then there's the Nano. Millions of Americans who don't yet own an iPod were ready and willing to buy one before the year-end or ask for one for Christmas. And the iPod Nano is going to be a hot item for those non-iPod-owners. Even better for Apple, it's revolutionary enough that it's going to drive a major replacement cycle among current iPod owners.

Anecdotally, many iPod owners, myself included, have already ordered their own iPod Nano. The iPod shuffle was cheap enough that it opened up a whole new low-end consumer market for Apple's platform. The Nano simply recreates the marketplace for the early adopters and wannabe fashion folk.

Did I mention that the halo effect from Apple's already-loved iPod is now heading for overdrive, as the Nano takes cool to new levels? So many ways to win with Apple. I'm sticking with my sizable long position.

Posted by Jeff Bagley on Monday, September 12:
Steve Birenberg beat me to the punch on commenting on Apple Computer's (AAPL) new iPod nano. I agree with most everything he said, and I believe this will be the single hottest product to hit the shelves in years. Steve also does a good job in analyzing the earnings impact that the nano might have on Apple's financials. Judging from the early acceptance of the product, Steve's margin assumptions are likely too conservative. Also, I believe the "halo effect" is very real.

I purchased my iPod nano on Friday at the King of Prussia mall here in suburban Philadelphia. It was a fairly sleepy day at the mall, with unimpressive foot traffic. Suddenly, I found where all the people were hiding: in the Apple store. The place was jamming!

There were people everywhere, and the lines at the counter were fairly long. The place was well staffed with a very knowledgeable sales crew. Everyone was in a good mood, even waiting in line. In less than 24 hours, they were already out of the 4GB nano in black, so I had to settle for the white. (It's still really cool!)
I couldn't pin anyone down on the actual number of units sold, but I received replies such as "flying off the shelves" and "steady stream of customers" and "it looks as if this product will be big ... real big!"

The iPods weren't the only things selling. Folks were buying laptops and all other sorts of Apple products and accessories. A couple of salesmen indicated that sales of laptops have been "very strong" for a while now. The halo effect is alive and well.

For those of you who are not familiar with the new nano, I urge to you go to an Apple store -- or perhaps there are units now available at your local Best Buy (BBY) or Circuit City (CC) -- and take a look for yourselves. The nano is tiny, holds about 1,000 songs, and is the most user-friendly thing I've laid my hands on in a long time. It's flash-based, which means you can take it jogging. The interface with iTunes is seamless.

I have a nice gain so far in Apple stock, but stepping into the Apple store on Friday made me want to go out and buy more. I hate chasing, so I'm going to scale into Apple stock at these levels. Hopefully, it will come in a bit after such a huge run. I don't believe it will come in all that much, however. Estimates will be going up, and this stock will garner increasing mindshare, especially on Main Street.

Products such as the iPod nano are what growth stocks are made of.

Taking Partial Profits in Apple Computer

There is a lot of anticipation and excitement surrounding this week's official announcement of the iTunes phone combining the efforts of two companies owned by Northlake clients, Apple Computer (AAPL) and Motorola (MOT). I think the iTunes phone launch is a positive for both companies and might be significant for the mobile phone industry as well. It appears the phone will launch at Cingular in the United States and at T-Mobile and O2 in Europe. Each of these operators is moving outside the walled garden approach which I think makes it more likely that cell phones move to the next level and become the dominant all-in-one device carried by individuals....

....As far as the stocks go, part of client positions in MOT were sold in late July when the shares first broke into the $20s, which was the initial target for the shares. Today, a similar trade was made in AAPL as the stock reached my near-term target in the upper $40s. The 52 week high of $48.33 was my target for reducing the position and shares were sold today at $48.31. AAPL's stock chart will look real good if it makes a new high but it is important to maintain discipline and take some money off the table as a stock hits your target price. This was the same rationale for the sales of MOT and Sears Holding (SHLD) earlier this year.

Consensus estimates for AAPL are $1.45 and $1.62 respectively, for the fiscal years ending September 2005 and 2006. I think 2006 estimates are low because I am a big believer in the halo effect and the coming boost in market share for the Mac platform. AAPL has about $8.75 per share in cash which produces around 15 cents per share in EPS. At $48, AAPL shares are trading at about 25 times earnings after adjusting for the cash balance. This strikes me as a fair price and thus was how I calculated a target price for today's sale.

For some clients this marks the second sale of AAPL shares. Initial purchases were made in January 2005 at about $35.25. The initial position size was moderate and a small amount was sold just over a month later at $45.07 for most clients. After the shares pulled back due to fears of slowing growth for the iPod, additional shares were purchased in mid-April at about $38.25. This second purchase made AAPL one of the larger individual stock holdings in client portfolios. Today's sale represented approximately half of client holdings bringing AAPL back down to a normal size position representing a little over 2% of most client portfolios.

Please note that due to the timing of account openings and other unique client circumstances, not all client portfolios hold the exact same securities. Therefore, any individual account may not have completed the transactions outlined in the previous paragraph. The purchase of this note, and other posts about trades, is to inform clients of the rationale supporting a particular trade and to give clients a better understanding of the investment process used in management of their accounts.

Apple Shines

Apple (AAPL) shares were trading up sharply during its conference call last night and look even higher in pre-open trading today. The gains are well deserved as the earnings report and the tone of the call were both excellent. iPod shipments easily exceeded expectations and computer shipments were at the high end of expectations. Gross margins were better than expected due to strength in software sales, declining commodity costs for storage, and maybe even average selling price declines that weren't quite as bad as feared....

Most of the tough questions on the call were related to the September quarte rguidance, which is very slightly below current analyst estimates. Management stated that history suggests a 60% drop in Tiger sales in its second quarter. Further, education sales had their best-ever June quarter. Additionally, management said it had no evidence of slowing computer demand due to the MacTel transition but that it was "prudent" to be cautious. I believe these expectations suggest management is being conservative. There is no indication in the guidance of any problems.

I think this quarter shows the AAPL story has legs. The halo effect is in place with computer shipments growing three times the industry rate. Additionally, if management is to be believed, iPod sales are still very strong as sell-through is matching shipments. Overall, management is very confident across all measures and consistently reminded analysts how strong the business is and how it is pressing its leadership position with big investments in new products.

...The bottom line on this quarter is that there is very little for the bears to chew on, particularly given the high expectations that there would be problems in iPod numbers this quarter. I think traders were positioned for a downdraft in the shares so with the strength in shipments of iPods and Macs and management's comments on strong sell through and under control channel inventories, the shares are positioned to move higher.

Remember, the shares are not that expensive given the growth rate after adjusting for the cash balance. Growth appears intact, and the fourth quarter especially should be seasonally strong.

I am holding all client positions in Apple and expect AAPL shares can trade to new highs in the upper $40s over the balance of the year.

Previewing Apple's Earnings

Apple Computer (AAPL) reports after the close tonight. Consensus expectations call for revenues of $3.34 billion and EPS of 31 cents. Consensus is above management guidance of $3.25 billion and 28 cents. Full year 2005 EPS estimates are $1.33 with 2006 at $1.54, or 16% growth. Current 3Q consensus estimates for revenues and EPS are $3.6 billion and 33 cents, respectively.

Other key metrics to watch include iPod shipments, computer shipments, inventories and receivables. iPod shipments are forecast in the 5.2 to 5.5 million range, flat with last quarter's 5.3 million. Computer shipments are forecast at 1.1 million also flat with last quarter. It is worth noting that AAPL reports shipments into the distribution channels not final sales for these measures.

AAPL shares could be volatile in either direction depending on the details in the quarterly report and the guidance and commentary about current and future trends. Northlake is long AAPL and thus optimistic but cautious optimism is a fairer characterization regarding Wall Street's short-term reaction....

....Regarding guidance, which will be key to the Street's reaction, AAPL is entering a seasonally strong with computer shipments to the education market followed by holiday sales. Management will probably provide just third quarter guidance which is noted above.

The halo effect will also be carefully analyzed. Last quarter, AAPL computer shipments grew 43% vs. industry growth of 12%. This quarter shipments are projected to grow 26%, about twice the industry average. Both quarters have received some benefit from pipeline fill as the company pushed the MacMini to market. Interestingly, various analyst surveys say it�s the iMac that is showing the strongest sales at the retail level.

AAPL clearly faces high expectations and slowing growth off of unsustainable 60-70% revenue gains. However, I don�t think the stock is priced for hyper growth at $38. On 2006 estimates, the stock trades at a P-E of 25. However, cash is over $8 per share and heading up. Cash probably accounts for 12-15 cents of next years' estimates, so back that out and you got a $30 stock trading at a multiple of 22. I don�t find that horribly expensive or out of line with other tech names.

I'll post a summary of AAPL's earnings on Thursday after the conference call and the initial Wall Street reaction. I'll be providing live commentary of the call this afternoon for Street Insight.com

Holding Apple Despite Concerns

Apple shares have struggled for the last few months due to fears of slowing demand for iPods due to competition. Yesterday, those fears got some fuel when the supplier of flash memory drives for the the iPod Shuffle dramatically lowered its current quarter sales outlook. This has led investors to believe there may be too much inventory in the distribution channel. This news came on top of a negative article in Barron's over the weekend noting the iPod could face serious competition from music enabled cellphones.

I am holding AAPL depspte some anxiety. The comapny reports earnings on July 13th. I had been fearing that the quarter could not possibly live up to expectations given the bar was set so high. This is what happened last quarter. However, with the stock toward the bottom end of its recent range, I think the street may be able to find satisfaction in the numbers. Assuming iPod numbers are just inline, the tell will be sales of computers. Based on industry reports, I think Mac sales will be surperb and investors will finally transition from a music-centric veiw of Apple to a holisitc view of the entire company. If that happens, the shares offer considerable upside. I am willing to make that bet as of now.

Earlier this week, AAPL announced upgrades to the iPod line, incorporating color screens and podcasting (a form of internet radio broadcasts). I've already downloaded the new iTunes and checked out some podcasts. Not surprisingly, it is a smooth process with the podcast directory on iTunes being easy to use and having loads of content.

As mentioned above, I'm a nervous long on AAPL. I fear there is no way the quarter can satisfy the Street, but I think the company is very well positioned and the stock is not as expensive as folks think, with over $8 a share in cash to be on the books as of June 30.

Additionally, I think the Barron's article could be a sign of "group think" toward AAPL. Everyone is skeptical and waiting for the company to screw things up again. And, at least of late, the fears about iPod competition are starting to repeat themselves. Not a lot of new ground being broken in recent research and commentary.

Apple: Investor Focus May Be Shifting To Macs

I was surprised by the market's strong response to the news story that Apple Computer (AAPL) was considering using Intel (INTC) chips in future Macs. I think part of the upside was short-covering as the stock was gapping up above its highs since the collapse after the last quarterly earnings report. The gap up also brought the shares back above their 50-day moving average for the first time since April 13, the day after the earnings report...

....However, what I really think was going on was a shift in the Apple debate from digital music to the "halo effect." AAPL shares bottomed on May 11, the day after Yahoo! (YHOO) announced its Yahoo!Music initiative under a subscription model. On that day, AAPL closed well off its lows on huge volume exceeded only about five times this year. So that was likely the day that fears about iPod volumes and the digital music market share peaked.

Lost in the postquarter selloff was the fact that Mac sales rose over 40% against single-digit growth for the entire PC market. Now a story leaks that AAPL is considering using INTC chips and may be pretty far along in porting its operating system to the INTC platform. I think the market is finally starting to give respect to the halo effect thanks to the INTC news.

The AAPL-INTC story leaked right when consumers have opened their minds to buying a Mac. According to analysts, AAPL could lower prices considerably and possibly upgrade speeds in laptops if it shifted to INTC chips. This would close a perceived value gap faced by Macs. I say "perceived" because I've read that comparing processor speeds between Macs and Intel machines is not really comparing apples to apples (sorry). Imagine if Apple Stores, flooded with people looking at iPods, have a new low-priced tier of machines to choose from.

I suspect that any issues with iPod shipments or inventory will still rattle AAPL shares. However, we may have shifted toward Mac shipments as the key determinant of trading levels in AAPL shares. The focus of investors will be no less intense with every wiggle in shipments being exaggerated in the stock price. If the focus has shifted to Macs, I think the recent strength in AAPL shares will be sustained and extended as I am a believer in the halo effect.

A Visit to an Apple Store Keeps Me Bullish

The following entry is cross-posted from Street Insight. As some clients and friends of Northlake Capital Management know, I write a brief daily commentary for StreetInsight.com, the professional version of The Street.com. Street Insight is an expensive service targeted at money managers. Along with another two dozen money managers, I contribute commentary on the stock market and individual stocks. The following comments on Apple Computer were posted last week...

I've been long Apple Computer (AAPL) since mid-January following the pullback after the company's blowout fourth quarter 2004 earnings report. After my Sunday afternoon visit to the Apple Store in Skokie, Ill., I plan to stay long through the first-quarter earnings.

I walked in with my daughter whose 10-month-old 20GB iPod had jammed. The place was mobbed. I am certain there were over 100 people in the store, with every product area covered with people. The line for the cash register was easily 20 customers deep. Virtually every person in line had either an iPod or an iPod shuffle. Many also had iPod accessories.

We signed up for the Genius Bar (in store technical help) and learned that the hard drive on the iPod had gone bad. We waited about 30 minutes to get help, but once we were served, the problem was diagnosed within five minutes. The iPod is still under its one-year warranty, so we received a replacement. My daughter just had to go home, attach the iPod to the Mac and download her library of a couple of thousand songs. Ten minutes later she was right back where she started, jamming to the Clash, the Cure, and to make her Dad happy, the Grateful Dead and Bob Dylan.

While the "genius" who was helping us was filling out the online paperwork, I asked about sales of Mac minis and shuffles. He said both were selling well. He also said Mac Mini sales were fairly evenly split between PC owners. (Mac people call Windows machines PCs and Apple machines Macs). Among Mac owners the genius said most Mac mini buyers were looking for a second Mac and adding extra RAM.

I know AAPL is an expensive stock, but I'm willing to stick with the momentum until proven wrong. I took some profits when the stock crossed $45 as I want to keep the position from growing too large. AAPL's run will end some day, and I expect the end to be a spectacular decline. Thus, controlling position size and taking profits on the way up is important. The biggest risk the shares face is that expectations are so high for the coming quarters. Anything short of great numbers is unlikely to satisfy the market. However, based on everything I read and my experience Sunday, I think another great quarter is in the cards.

More Shine Left For Apple

Despite the fantastic performance of shares of Apple Computer, including today's big run-up on the company's outstanding fourth quarter earnings results, I believe the opportunity for substantial further gains exist. Consequently, client portfolios purchased a trading position in Apple shares (AAPL) after some of the morning enthusiasm wore off. The investment thesis is that the operating momentum generated by the success of the iPod will be sustained and carry the shares to $85 to $100 in 2005....

...Apple has struggled for many years to convince the mass market to buy its high quality, innovative, easy to use, and well designed products. With over 10 million iPods sold, including 4.5 million during the holiday season, the mass market has now been exposed to Apple. The wall created by the Windows monopoly is beginning to crumble.

My family has used Macs since we bought our first home computer. Presently, we use the swivel screen iMac, own two iPods, and use an Apple Airport wireless router. We use Office for Mac to access Excel, Word, and PowerPoint. I also use a Dell laptop for work. The Dell works seamlessly with the Airport router for wireless internet access and I pass files back and forth between the Mac and the Dell with no difficulty.

For some time, I have thought that home computer use was shifting due to the adoption of the digital lifestyle. Home computer use is increasingly focused on internet browsing, email, photos, music, and calendars. The widespread adoption of broadband has accelerated the shift to a digital lifestyle. For Apple, this transition is critical because these applications reduce the importance of the computer operating system. In turn, the fear of the Mac and desire to standardize on Windows is lessening.

As a Mac user, I enjoy the seamless interaction between Apple's software for browsing, email, photos, and music. Each program has the same look and feel and is driven by the same basic menus and commands. Consumers who are using iPods are seeing the ease of use of Apple's products for the first time because Apple has just a 2% market share of personal computer shipments. Further, with Apple stores popping up all over, consumers also get to easily see how the entire suite of digital lifestyle applications work. The Windows wall crumbles further and Apple is now poised to gain home computer market share as the halo effect of iPod success translates to increased iMac sales and easier introduction of other new digital lifestyle products. (such as the new $499 iMac or $99 iPod Shuffle).

While I had been developing this thesis for some time, I had not owned Apple shares because there had been no evidence that the halo effect would work. Now, with fourth quarter 2004 iMac sales up 26%, more than twice the PC industry growth rate, evidence exists. Therefore, despite the upward movement in the shares today, I believe they are more attractive than they were before the earnings report.