Daily Double
Apple Computer

Ticker: (Nasdaq: AAPL)
Phone: 408-996-1010
Website: http://www.apple.com
Price (9/22/99): $70 5/16

By Louis Corrigan (TMF Seymor)
Thursday, September 23, 1999

How Did it Double?

For a while, everybody just wanted to know whether Apple co-founder Steve Jobs would drop the "interim" from his title as CEO and get serious. Then everybody got swept up by Internet mania -- and then Internet panic -- and kind of forgot about Apple's terrific turnaround story.

In the meantime, the story got even better.

Apple's candy-colored iMac consumer desktop computers further jazzed up the consumer market re-energized months earlier by the first teal iMac. The enthusiasm showed. Third quarter FY99 results reported July 14 revealed that Apple's unit growth soared 40% versus the year-ago period -- double the PC industry's growth rate -- with the iMac accounting for 54% of the company's unit volume. Gross profit margins increased to 27.4% from 25.7%.

Market data suggested that a broad group of consumers were ignoring the PC price wars to pay a little more for a souped-up iMac because Apple made it easy for them to hop online. About a third of iMac buyers are getting their first computer and some 90% now use their iMac to surf the Web. By selling cool design, ease-of-use, and dynamic performance, Apple has reached folks looking to get in on all the fun.

By early July, the stock had bounced off its March low of $32 and spurted to the mid-$50s, a six-year high. More good news was around the corner with the July 21 introduction of the iBook, a consumer notebook with a clamshell design that comes in two flavors, blueberry and tangerine. The iBook filled the last slot in Apple's four-pronged product lineup, so the company is now operating on all cylinders for the first time in years.

Yet what really wowed the folks at MacWorld Expo was that for $99 the iBook can be easily equipped with a card for wireless networking. That makes it perfect for classrooms and dorm rooms and emphasizes how well Apple understands the Net-centric nature of computing today.

What sent the stock to a new all-time high, though, was Jobs' August 31 speech at the Seybold conference. Not including Japan, Apple already had orders for 140,000 iBooks, he said, and the portable wasn't even due to ship until mid-September.

And well ahead of schedule, Jobs also introduced the new Power Mac G4 computers. These 400 MHz and 500 MHz machines are billed as running twice as fast as PCs using Intel's (Nasdaq: INTC) 600 MHz Pentium III chips. Indeed, Apple's new ads play up the fact that the U.S. government classifies the G4 as a supercomputer that can't be exported to certain countries because it's too powerful.

While most major personal computer manufacturers have enjoyed a nice run over the last six months, Apple shares have risen an especially tasty 116%.

Business Description

Apple designs, manufactures, and markets the Macintosh line of personal computers. Its G3 and now G4 desktop machines and G3 Powerbook notebooks target graphics and publishing professionals. The iMac desktop and new iBook notebook mainly appeal to consumers and the education market.

Unlike other PC manufacturers, Apple is also a major software company. Macs use its unique operating system, which offers the most viable mainstream alternative to Microsoft's (Nasdaq: MSFT) Windows.

Apple QuickTime 4 multimedia player and its open-source QuickTime streaming server software pits it against Real Networks (Nasdaq: RNWK) in the market for streaming software. QuickTime TV aggregates audio and video content from companies like Disney (NYSE: DIS) and Viacom (NYSE: VIA). More than 12 million copies of the software have been downloaded since April.

About 45% of Apple's sales come from international markets, led by Japan. The company has also come to rely more on overseas contract manufacturers. Apple invested $100 million in bonds to help Samsung Electronics expand its LCD flat-panel display production capacity.

Insiders own less than 1% of the stock.

Financial Facts

Income Statement*
12-month sales: $6,354.0 million
12-month income: $596.0 million
12-month EPS: $3.69
Profit Margin: 9.3%
Market Cap: $12,280.1 million
Enterprise Value: $9474.1 million
(*As reported. Includes restructuring charge of $9 million but also a $188 million gain from the sale of ARM Holdings shares. Also, the FY99 tax rate has been just 11%.)

Balance Sheet*
Cash: $3,106 million
Current Assets: $4,298 million
Current Liabilities: $1,539 million
Long-term Debt: $300 million
(*Long-term debt in the form of convertible preferred.)

Ratios*
Price-to-earnings: 19.1
Price-to-sales: 1.9
EV-to-sales: 1.5
(*P/E based on reported earnings.)

How Could You Have Found This Double?

I've been an ardent Apple bull since early 1998 when it became clear to me that Jobs was making the tough decisions necessary to refocus operations, decisions that only he had the moral authority to make. The successful launch of the G3 desktops along with the new "Think Different" branding campaign further announced that Apple was back.

Apple had a ready market among professionals desperate to upgrade their Macs. It also had a massive and fiercely loyal Mac installed base. The question was, could the company capitalize on its consumer-friendly brand? The iMac, introduced a year ago, settled that question, and the iBook's introduction solidified the answer.

The revamped product line-up and the efforts of CFO Fred Anderson and operations man Timothy Cook have also helped Apple operate more efficiently. By using more industry standard parts and by outsourcing most of its manufacturing, the company has radically reduced its inventories over the last two years. It closed the June quarter with just $7 million in inventory (less than one day's supply) versus $129 million at the end June 1998.

Moreover, it has managed its distributors and vendors well, with the former paying faster and the latter waiting longer to get paid. At the end of Q3, days sales outstanding had dropped to 52 from 59 a year ago. Meanwhile, payables had increased to 64 days from 57 days.

All of that has led to a surge in cash flow well beyond what the improving earnings alone might suggest. As a result, Apple called its $661 million in outstanding 6% convertible debentures in April, with nearly all holders opting to convert to stock at $29.21 per share. On July 14, the board announced it had authorized a $500 million stock buyback because it believed the stock was "a good long-term investment."

Since most Wall Street pros live in a world dominated by Wintel boxes, many have remained way too skeptical of Apple's turnaround. Consumers at home really had the edge on this one.

Where to From Here?

All was looking sunny for Apple until last Monday. Some analysts were talking about the early rollout of G4s hurting September period earnings a bit due to clearance sales on the G3s. Still, Wall Street seemed to have caught up to the story. In just a few weeks, for example, Warburg Dillon Read twice upped its price target, from $65 to $75 and then to $90.

However, on Monday, September 20, Apple warned that it would badly miss estimates for its Q4 September quarter. Due to lower-than-expected shipments of G4 chips from sole supplier Motorola (NYSE: MOT), units, revenues, and earnings will all fall below last quarter's levels.

Earnings are now expected to come in between $75 million and $85 million, or $0.43 to $0.49 per share. That's well below the prior consensus estimate of $0.77 per share and less than the $0.68 per share recorded in Q4 FY98.

The good news is that Apple has received orders for 150,000 Power Mac G4s in just the three weeks since they were unveiled, so it will end the period with a substantial backlog. "This is a temporary issue," Jobs said in the press release, "and we hope to catch up early in the coming quarter."

There's no question that Jobs goofed. He shouldn't have announced the product until he was confident Motorola could meet G4 demand sufficient to make up for the inevitable drop-off in G3 unit sales and profits. Due to the necessarily fast product cycles, Apple must manage these transitions smoothly. This time they didn't, and it's painful.

Yes, the December quarter now promises to be a real blockbuster, assuming Motorola can deliver the goods. iBooks and upgraded iMacs should fly off the shelves. Also, the Mac OS 9 software upgrade will be available in October, boosting margins substantially in Q1. Thus, many analysts seem content to look past this screw-up, as they probably should.

Yet, trading near $80 a share on Monday, Apple looked more fairly valued than it has at any time in the last two years. Indeed, the stock was beginning to factor in the belief that Jobs could do no wrong. The nearly $10 sell-off on Tuesday partly reflected investors' recognition that Jobs is fallible.

In any case, none of the previous estimates ($2.86 per share for FY99 and $3.07 for FY00) looked clean to me. Investors should note that Apple has been cashing out its stake in ARM Holdings, recording substantial one-time gains. Also, losses in previous years have trimmed Apple's tax bill. The FY99 rate should be about 11%, but that rate will increase substantially next year.

Apple's fully taxed (35%) trailing 12-month earnings from continuing operations is $316 million, or $1.81 per share. If you back out the company's cash and ignore the convertible preferred, you see that Apple exited June with about $18 a share in cash. Back that out of the current quote, and the stock now trades at 28 times fully taxed earnings.

Execution risk isn't going away. Short product cycles require constant innovation and execution simply to maintain current sales levels. Also, Apple still operates in the price-competitive consumer space, the education market where others have made inroads, and in a small niche of the business market. Whereas a Dell (Nasdaq: DELL) can prop up margins with server sales, Apple doesn't have that option.

Still, I think Apple remains a compelling story. It's still the best consumer brand in the personal computer market. And Jobs, also Chair of animated film producer Pixar (Nasdaq: PIXR), has a great talent for combining performance, design, and marketing.

Moreover, the OS 9 upgrades the Sherlock search feature so that it can act like a flexible Web meta-search engine and even a comparison shopping "bot." Then there's QuickTime, a sophisticated platform for streaming multimedia that Apple has only begun to focus on.

As a shareowner, I'm holding. December period results should erase this week's sell-off. The company's solid balance sheet and software platforms give it options to pursue for the future. Of course, if Motorola has more problems, look out.

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