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Apple
Drifting in a Sea of Mediocrity

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By Plato90s
January 17, 2003

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Apple has now announced its results for the just-closed Christmas shopping season. It's a middle-of-the-road quarter in almost every way. Revenues as expected - not good but not too bad. Income prior to one-time charges is as expected - not good but not too bad. Unit shipment trends up a little here, down a little there. Forward revenues as expected.

Apple is just adrift in a sea of mediocrity.

Not so bad considering how the last quarter was one of missed expectations.

iMac shipments are down slightly QoQ, although revenue held up slightly better. The disparity was explained by Fred Anderson to indicate a greater mix of high-end LCD iMac's sold with a drop in eMac sales due to education sales falling off from Q4. YoY comparisons may look favorable, but should be taken in context with the fact that Q1 '02 was the last CRT-iMac season and the low-tide of the consumer desktop segment. The trend of consumer desktop sales over the last 5 quarters has been

233k ..... 372k .... 378k ..... 318k ..... 298k
204M ... 448M ... 424M ... 372M ... 356M

So after peaking to the 370k+ level in the first 2 quarters after the introduction of the LCD-iMac and eMac, volume has decayed for 2 quarters in a row. Apple's statement of greater focus on the consumer segment can't be substantiated by the fact that the consumer desktop lines are selling at levels below what it was in 1998-2000, both on an absolute and proportional basis. In 2000/2001, Apple stated it would focus on education. We know that Apple has continued to lose market share in education and that Fred is concerned about future sales in that segment. That's not a good omen for what Apple's "focus on consumer" may mean.

iBook unit shipments have held steady, and this is the product line where the trade-off between education and consumer sales is handled well. While education purchases fell off from Q4, consumer sales from the Christmas made up for the deficit. That's much better than last year, when volume collapsed by 26% during the same period.

It shows that Apple is doing much better with its iBook message and product line up - with the $999 model being the best move of all. Given the volume was up 2% QoQ while revenue declined by 8%, the intro-level iBook had to be proportionately a larger slice of total iBook sales - contrary to Fred Anderson's claim on the popularity of the 14" iBook. If there was a greater bias toward higher-priced models, revenue should have increased.

On the PowerMac front, the wave of early-adopters for the dual 1.25Ghz model has passed and Apple suffered a drop in both volume and revenue. Like the iBook, revenue dropped off more than unit volume (16% vs. 10%), indicating a shift in buying toward lower-priced models. The product line now returns to an ASP of ~$1800 (vs. $1965 at the peak) at a lower volume.

The erosion of volume at the PowerMac level is more dramatic than the desktop lines because the pro users are more sensitive to performance gaps than consumers or education buyers. The claim by Apple that pro users are waiting for Quark is the same line repeated in past quarters about OS 10.2, Photoshop, etc.... The credibility of the claim is sorely tested by the fact the arrival of all those software didn't affect volume, but the 1.25Ghz G4 did improve revenues.

Finally, we have the PowerBook, which has recovered to a more usual level of 101k units shipped. It did so with the same symptoms as the iBook, with ASP's dropping. The ASP for the line is now at ~$2,326 compared to nearly $2,450 the previous quarter. The drop suggests cutting the price of the entry-level PowerBook was the critical factor - not the introduction of the SuperDrive.

Along those lines, the entry-price level of the new eBook (aka 12" PowerBook) at $1899 should help to boost the total unit volume of the line, while depressing the ASP further. There might be some offsetting factors with the 17" 1Ghz PowerBook, but the $500 premium for the new features (Firewire800, Airport Extreme, Bluetooh, and nVidia video] may drive customers to the 15" 1Ghz model instead.

Overall, unit shipments of up to 120k is certainly possible for the next quarter in the PowerBook segment.

------------------------

From a business perspective, Apple is doing only mediocre. There was 9% QoQ growth in Americas excluding education, even though overall sales dropped. That shortfall was covered by the significant growth in Europe, most likely due to the drop in price in the PowerBook.

So excellence in one part of the business is matched by a below-par performance in another segment, rendering the overall results... mediocre.

The Retail segment continues to operate with no rhyme or reason. In Q4, Apple recorded a "loss" of $3M and a "manufacturing profit" of $20M. This is a new term, as Apple previously referred to the same budget item as "offsetting benefit" in its 10-K.

In any case, Apple recognized a net profit of $17M on 37k units shipped during Q4.

In Q1, Apple recognized a net profit of $19M ($1M "loss" + $20M "manufacturing profit") on 47k unit shipment. 12% gain in "profit" on 27% gain in shipment.

It's not capital expense from new store openings, because Apple absorbs that directly into SG&A. So the disparity would appear to defy conventional logic. Given we don't know anything about the accounting model Fred Anderson uses to address the Retail segment, maybe it makes sense to Apple.

When it comes to net profits, Apple has stated that it met the target of $0.03/share profit before one-time charges. It's a good thing Apple didn't say the profit was reached before one-time events because it might have to count the $4M one-time gain from closing out some of its derivative instruments into the mix. That would have dropped Apple's net profit to $0.02.

With the opening of Apple Retail as well as the increasing number of peripherals being sold via Apple Store, the revenue levels are starting to be distorted. With 3 out of 4 product lines showing dropping ASP, and the iMac line up ~2% in ASP, the disparity between the 27% unit increase and 37% revenue increase of Retail points to more of revenue being driven by 3rd party products.

That inflates Apple's revenues while reducing net profit margins because a reseller typically makes a small margin compared to the manufacturer. If we look at revenue coming only from Mac's, Apple only achieve a 0.54% increase in QoQ revenue, not 2%. On the YoY basis, Apple saw a 2.7% revenue increase, not 7%.

In the long term, it appears that Apple is trapped in the situation of knowing that lower prices will generate higher volume but unable to implement sweeping cuts due to profitability concerns. In a direct response to the comment that Apple has the cost structure of a $8B company despite having only $6B in revenue, Fred Anderson stated that Apple will not "mortgage its future for short-term profit maximization".

The idea being promoted is that cutting Apple's SG&A and R&D to match a lower cost structure would reduce Apple's competitive ability in the future. That's a valid stance, but I believe Fred and Steve are already mortgaging Apple's future by refusing to cut prices to grow volume.

Apple has skated on the thin edge of profitability for nearly 2 years now, losing market share slowly and steadily. By persistently refusing to take losses to establish a substantially larger base of OS X users, Apple is mortgaging its future to keep the present level of profitability.

I'm more and more convinced that Apple should take massive ($100M+/quarter) losses by flooding the market with affordable Mac hardware. If there are an additional 2 or 3 million Mac users out there, more software sales and more peripheral sales will follow. Adding new iApps won't increase the user base as surely as low prices.

If Apple loses $800M in cash over the course of 2 years but increase its user base back to 5% global market share, it would be worth it. Once users have been converted to the Mac, they have proved to be a very profitable installed base. Through the iTools/iApps program, Apple already knows what to expect when they increase prices on its user base - a substantial portion of people will pay for what was free.

So Apple, with its massive cash reserve, could afford to sell at a loss for 2 years and then jack prices up to return to profitability. The massive losses of 1996-1997 helped to pave the way for the profits of today by establishing the user base, which Apple is capitalizing on today. The stock price is already at rock bottom levels, and there was no problems with having it more than quadruple in 1999/2000 despite the fact that Apple's losses for '96-'97 nearly cancels out the profits for '99 -'00.

Apple needs to take the long-term view and stop thinking "If you build it, they will come".


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