Apple's Magic Act

Apple's (Nasdaq: AAPL  ) stock took a bit of a dive yesterday following CEO Steve Jobs' blockbuster presentation at Macworld. The reason was simple. Months of hyperactive speculation have priced the stock at an extreme premium. "Maybe Jobs will unveil an Apple media PC!" "Maybe the iPod will help Apple steal market share from Windows PCs!" "Maybe Jobs will announce an iPod that plays XM Satellite Radio (Nasdaq: XMSR  ) !" "Maybe Steve will give us all a free pony!"

Only the last of those farfetched hopes is something I made up. Worse yet, these rank rumors have been propagated by "analysts," bless their hearts, vying for the title of iBlodgett by pasting $100 price targets on a stock that's already trading for 90 times earnings at 65% of that goal. Pointing at the left field fence on your way to the plate worked during El Bubble, and it worked for Babe Ruth, but it makes for some tough expectations in today's somewhat-less-ridiculous market.

So, unfortunately for Apple shareholders, Jobs had to pull a rabbit out of a hat. He did yank out a couple of cute little white critters, but let's just say Dumbledore's position looks pretty safe for now. There's nothing particularly magical about either of these, and that may add up to trouble for everyone expecting Apple stock to continue its moon shot.

Mini me
The Mac Mini -- I'm pretty sure Minimac is something you get from Kraft -- is a cute little device. Yes, it cribs mercilessly from PC-based mini-ITX designs that have been around for over a year now, but it does put low-end Mac guts into a smaller, stylish little Mac package. The most interesting magic trick here is the illusion -- somehow completely lost on the mainstream press -- that this is really a $500 computer. Check out this sleight of hand.

It comes with no keyboard, no mouse, no monitor, no speakers. Kind of like Ford promising you a $7,000 car with no steering wheel or windshield. Long story short: Gathering the cheapest components I could find at Apple's online store, I came up with an $800 system before shipping (and the low-end monitor had a wait of six weeks). I think it's ludicrous to expect that someone buying a Mac -- and looking for Apple style, after all -- is going to want to plug in a pizza-stained, three-year-old keyboard and a mouse chock full of desk scum. Why not just shell out the extra $500 for the low-end iMac, which has more juice and comes loaded and packed inside a crisp, flat-screen monitor?

But this isn't about Mac fans, right? It's about "converting" the unrepented. Unfortunately, Apple won't be competing on price, contrary to Jobs' claims. Mac fans who've been sipping Steve's Kool-Aid have often claimed that price -- in addition to various Microsoft (Nasdaq: MSFT  ) conspiracies -- is the only thing keeping the masses from switching to their favorite brand, but take heed. Even if that were true, a quick online check shows you can get a comparable, full Dell (Nasdaq: DELL  ) system for $450. A quick peek at margins (Apple, 3.3%; Dell, 6.6%) explains why.

I'm sure Mac-happy Walter Mossberg will go into one of his uncharacteristic fits of apoplectic ecstasy when he gets his hands on one of these. (He must look like Bernini's Saint Theresa about this time every year.) And I'm sure the Mac masses will praise it to the skies. But I'm also pretty sure Ma and Pa Kettle can do the third-grade math that escapes the headline writers for now, which shows the cheapest Mac system you can build around this thing is still 78% more expensive than a comparable PC.

In other words, I don't think this is the key to those big improvements in market share that pundits have been promising. In fact, as we've discussed here in the past, the post-iPod record for Apple's computer sales remains decent, but uninspiring. For last year, they were up 10% by dollars, 9% by units.

iPod waffle
Jobs also introduced a cute little flash-based iPod subtitled the "waffle," I mean, "Shuffle." Silly me, where did I get waffle? Oh yeah, the famously opinionated CEO derided the need for a display and visual user interface on this model, saying that it would be too small to be useful. Need I point out the irony in that point of view? It comes from a guy who expects people to pony up $500 or $600 for the privilege of squinting at their photos on an iPod screen that's smaller than a credit card. Of course, Jobs once said that flash-based players weren't worth the trouble, but they are a big market, and the thought of leaving all that money on the table seems to have swayed his thinking. (That's a good thing.)

The problem is that faced with the challenge of trying to invent a decent, micro user interface, Apple just punted. Shareholders had better hope that music fans enjoy "shuffle" mode as much as Jobs says they must. The competition in this segment of the player market is fierce, coming from everywhere including SanDisk (Nasdaq: SNDK  ) and Nike (NYSE: NKE  ) . Most of the dozens of competitors allow you to see your tunes, and many have sophisticated interfaces for using and modifying playlists. They also work with Microsoft's Media Player.

Yes, yes, I know. "Boo! Hiss!" But the fact is, better interoperability with the world's dominant OS would help Apple make more money. I can't be the only Windows user out there who didn't get an iPod because he didn't want to reconvert his entire collection of music files and get locked into iTunes as his only online music source.

Of course, experience suggests that Apple fans are already writing me angry email about how Apple is somehow "not about making money!" "It's about freedom, about the alternate lifestyle, blah blah blah." That's an acceptable -- if tiresome and bogus -- point of view if you're just a fan of the gear, but it's a silly attitude for shareholders.

All about the Benjamins
It's not about iLife, folks. It's not about doing something, anything to avoid those icky Microsoft cooties. It's a little bit about fashion, but in the end, it matters very little how big you think the market for these new products might be. (Think Taser's (Nasdaq: TASR  ) excellent long-run potential is any comfort to those who took their first stake in early December?) Hopes and dreams are only worth so much. In the long run, it's about the bennies at the bottom line.

Yes, Apple's stock has clipped up a long way from when I last called it bloated, but then Mac aficionados have always been willing to sacrificing logic at the altar of Jobs. Frankly, I'm a bit surprised that Apple investors would make the same mistake, but, as I've posited, these days, many of them seem to be one and the same being. That doesn't mean they're always bringing their A-brain to this particular subject. A colleague of mine, a smart investor and Apple fan, swore up and down the other day that Apple's margins were better than Dell's, when the evidence is clearly to the contrary where it counts, at operating and net income.

Given the scales on these folks' eyes, I realize I have as much chance of changing their minds as I do of being invited to attend next year's Macworld -- unless they have a dunk tank. But to those investors out there who haven't run for the tar bucket and goose down and are still reading, I say only this:

Consider the possibility that the iPod can't carry Apple forever. Consider the mathematical certainty that its growth rates will slow. Consider the fact that, as much as you love your iPod, the competition's "copycat" players -- yes, I know, "Boo! Hiss!" -- have gotten to be good, with more memory, longer battery life, and cheaper price points than the iPod. Think about the unfortunate truth that the superselling iPod brings in lower margins than the computer business, and make sure you take that into account when you do your thumbnail sketches on the firm's future profitability. (You do do those, right?) Hint: So far it's meant decreasing gross margins for three years in a row.

Ponder the upcoming numbers on Mac's main unassailable product line: computers. If the firm's not doing better here, consider the possibility that it might not be worth the triple-digit P/E that analysts have suggested you pay, especially considering how much of your future earnings Apple gives away to employees. Luckily, the days are gone when Jobs would get minor perks like free jet airplanes or gigantic stock grants while claiming to work "for free." But the gravy train for the rest of Apple's insiders continues.

Fun facts for Apple shareholders: Apple diluted your stock 6.6% last year, and nearly a third of the cash the firm took in came not from operations, but from exercise of stock options. Given that people generally only pay to exercise an option when they're pretty sure they can sell the underlying stock at a premium, how do you think that changes the bottom line? For a clue, check the footnotes in the 10-K for the pro forma reconciliation of the result of the firm's generous options plan. For 2003, the $0.19 profit turns into a $0.27 loss. For 2004, the $0.71 profit shrinks down to $0.45. Oh my. Think that's just a little bookkeeping thing? Think again.

Why is it that Apple refuses to share some of its $5.3 billion in cash (and short-term investments) with shareholders via dividends? Saving it for a stormy day? Perhaps, but I'm guessing the disaster it's planning to clean up is the major wave of dilution that will continue as Apple insiders cash in on the rising stock price. If a share buyback is announced, remember: It would be your money being used to mop up for the compensation given to Apple employees. Stockholders deserve better.

If Apple can morph into a completely different beast and come up with the next great thing like the much-wished-for multimedia PC, then maybe this stock will live up to its current buzz. But that's a sucker's bet when, by some accounts, that future blockbuster is already priced in. If you really want to "think different," try thinking differently than the rest of the Apple herd. Stop cheering every little thing Apple does, put on a Fool's cap, and ask yourself, "Is this the best place for my money?"

For related Foolishness:

Contrary to the excellent defamatory rumors from iConspiracy iTheorists on the Fool's Apple board, there's only one iSeth Jayson, and at the time of iPublication he had no position in any firm mentioned here, except for owning shares of SanDisk. View his stock holdings and Fool profilehere. Fool rules arehere.


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