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Apple
Q2 '04 - Not the Same Apple as Yesteryear

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By Plato90s
April 15, 2004

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One day before the earning release, the estimate was lifted on Apple's earning estimates. It turns out that Morgan Stanley's estimate $0.10 per share was too conservative, as the actual profit was $0.12.

Across the major product lines, the iMac/eMac line suffered a slight loss (10k) in unit volume to 217k units, but did so without losing revenue at all. Given no product refreshes or MSRP changes during the 3-month period, it suggests either a reduction by Apple in rebates/discounts or greater sales to Europe, where currency effects will have greater revenue benefits. The former seems more likely, because European segment sales suffered this quarter.

The opposite will happen in the next quarter, as the recent change in the eMac lineup will push the ASP lower. In a best-case scenario, Apple might get volume back up to the 250k+ region. Yet the price cut was not extended to the LCD iMac line, suggesting there is no pressure to back off from the profit margin earned by the premium-priced consumer models.

On the iBook, both volume and revenue held steady. A fairly impressive act given that calendar Q1 doesn't have holiday shopping or back-to-school effects. With ASP in the $1100 range, it's only a matter of time before the 800Mhz iBook is either phased out or Apple does an eMac-style upgrade on the iBook line.

For the PowerBook, volume dropped off much more than the iBook, although it's still at a historically high level. The drop-off suggests an interesting phenomenon, where the PowerBook has actually become a consumer-item. With the 12" PowerBook being priced at $1600, it's now in the affordable range for high-end consumers, not just professionals. With the expected deployment of the new model of G5 into the PowerBook, the next 6 months should be fairly bright for this line.

Finally, we have the PowerMac. The decision to offer the xServe with only 2Ghz option was almost certainly the bottleneck, but even then, Apple's sales of the xServe has always been significantly smaller than its desktop sales. Even the original Apple estimate in the 194k range should still be considered as under performing.

Expectations for the PowerMac was in the 200k/quarter range, and after 3 quarters, it's obvious that there is no pent up demand of the level that Apple expected. Much of the user base who bought PowerMac year after year has moved their business elsewhere. Some of them went to the PowerBook, but most of them must have switched to Windows, Linux, or other *nix brands.

Overall, Apple posted healthy results for the 3rd quarter in a row and blew past the revised analyst estimate by 20%. It's got the #1 selling MP3 player and the #1 online music store. The retail stores are going international, and expanding faster than Apple itself expects. With revenue now projecting to a full-year level of ~$8B, this is not the same Apple as before.

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What about market share, that item which Apple no longer focuses on? In a quarter where global unit count in computers is estimated to have exceeded 9% YoY, Apple's unit growth is 6%. That means another quarter in which Apple lost share.

That's why, as stated during the con-call, Apple now focus on revenue.

At the same time, Apple's claim that the market growth is happening at the unprofitable low end is directly contradicted by AMD's statement that its per CPU selling price has increased, among a 70% YoY increase in revenue. There are indeed many markets where Apple is poorly positioned to compete, but it's not limited to the low-end desktop. There's also the desktop-replacement laptop, the high-end consumer desktop, etc....

An alternative explanation is that Apple's statement that they drew down channel inventory this quarter, which contributed to the drop in unit shipments as below-market-growth in revenue. It's a very odd statement because there is no sign of any such action in the financial statement. In Q1 '04, accounts receivable (the amt owed Apple by distributors) was $586M. In this just-closed quarter, it was $585M.

A difference of $1M is just a rounding error, when we consider that $26M reduction in Apple's on-hand inventory is stated as 1 day's worth of sales. There is certainly no sign of a significant draw-down in channel inventory.

There is a 9% drop in the account-payables section, but that's where Apple owes money to its suppliers. It's indicative of the increasingly positive cash-conversion cycle which Apple referred to.

So where is the 10% channel inventory draw-down?

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In the wave of positive publicity, thanks to the highly positive YoY improvements, Apple is being hailed for diversifying its revenue stream. Apple itself reinforces that view by stating it's now more interested in revenue growth instead of growth in the core Mac business.

Yet is this really a choice by Apple, or was it a choice forced on Apple by circumstance? The profit margin as a reseller and in consumer electronics stink. The iPod's gross margin is 22%, but Apple's operating expense level is 25%.

If the R&D expenses were eliminated, the net margin of the iPod remains in the 4% range, which is normal for consumer electronic manufacturers. What happens if we quantify the effects of iTunes' barely profitable level, the R&D costs of developing the iPod, and the fact that overall margins of the iPod line will be negatively impacted by iPod-Mini? The iPod line itself may be only generating net margins in the 1% range.

By comparison, once the iPod's effects are eliminated, Apple's gross margin on hardware/peripherals/software is 28.7%.

In short, the iPod is adding to top line revenue growth while dragging down Apple's profit margins.

Profit margins will be a major hurdle to share value growth, especially if Mac unit shipments continue to lag behind iPod unit growth. AAPL has a P/E of just over 70 right now. Even if Apple blows out all analyst estimates by 30% for the next 2 quarters, a share price of $30 will still show a P/E in excess of 60, far above the historical level for both the industry and the size of the company. There could be a painful fall if investors come to believe that the music business won't deliver profits commensurate with the premium placed on AAPL share prices.


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