POST OF THE DAY
Apple
The iPod Co.
(Previously Apple Computers Inc)

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By Plato90s
October 15, 2004

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Apple has turned in the highest revenue quarter since the dot-com era, aided by a huge burst in iPod shipment. Top line revenue growth exceeded all estimates, and the net profit margin increased a whopping 50% over Q3. All of the good news can be laid at the feet of a single product line - the iPod.

It's clear by this point that nobody can accurately predict where the iPod's unit volume is going. While estimates were as high as 3 million for the Christmas quarter, the upper end of estimates for Jul-Sep was in the 1.3 - 1.4 million range. The number of 2 million was never tossed out, and just about everyone (including myself) wouldn't have believed Apple could more than double iPod shipments in 3 months after going up 183% YoY already during Q3.

No question - iPod is a wildly successful product for Apple in the same way the original iMac was. When the iMac reached the ~350k/quarter shipment level, it was amazing. Then it climbed past it to a peak 100% higher. The iPod has achieved the same. At this point, that 1 million/month for Christmas looks plausible and may even be exceeded.

The iMac line suffered the expected double-hit from the late introduction as well as supply constraints of the G5 chip. At 229k, this is the 2nd lowest unit sales in iMac sales in the last 5 years. At $216M, it's also the 2nd lowest revenue for the iMac in the last 5 years. Apple continues to see major supply constraints despite holding back the introduction in order to build up inventory. Transitioning the iMac to the G5 at a time when IBM was not prepared to meet volume demands has contributed to further weakening of the consumer desktop line.

The iBook was solid, being nearly flat QoQ. Volume of 238k for $256M in revenue looks much better in the YoY context, being up nearly 70%. The continued strong sale of the iBook, along with the strong education sales by Apple, indicates that the effort to establish the iBook as an education product was successful. It also demonstrates that a G5 processor isn't necessary in order for Apple to continue to sell its consumer product lines, as iBook continues to hold its market position against the various Intel/AMD notebooks in the 1.8Ghz - 2.4Ghz range.

Like the iBook, the PowerBook was not affected by the G5 CPU shortage held up fairly well, dropping ~3% QoQ. This holds true despite the lack of refreshes for the PowerBook and the same competitive position as the iBook.

The last major product line, the PowerMac/xServe was hit particularly hard by the G5 shortage. For 3 quarters in a row, IBM was not able to supply Apple with the chips it needed. The pre-launch estimates of 200k PowerMacs per quarter have been achieved only once, and that was with some G4 models shipping in the same quarter. The unit shipments for the fiscal year is

Q1 - 206k shipped
Q2 - 174k shipped
Q3 - 173k shipped
Q4 - 156k shipped

The trend in the total number of PowerMac/xServes shipped indicates the severity of the shortage. We've now reached the point where Apple is no longer willing to tell analysts how many xServes have been shipped. The wisdom of siphoning off limited G5 production to put into G5-iMac is very questionable, especially since the G4-portable lines continue to sell well.

Granted, the iMac only require 1 CPU per unit sold compared to 2 for the PowerMac, but the customer base for the iMac are more likely to buy despite a perceived performance gap. While it may well be a more profitable move in the short term for Apple to direct a limited G5 supply to the iMac, driving performance-driven customers to alternate vendors is not a good idea. Apple's long delay in delivering a more-powerful desktop has already shrunk PowerMac volume by half in the last 5 years. This product line can't take many more hits, IMO.

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Financially, Apple's greatest achievement has been its net profit margins. At 4.5%, that's a good 30% higher than anything Apple has achieved since FY2000 era. Yet Apple gross margins, often repeated as an indicator of their profitability, is at a mediocre 27%. The peak in the last 2 years is 28.3% and the lows at 26.6%.

The difference is that Apple's cost structure is top heavy with fixed costs like R&D and capital expenses. The infrastructure of the company is built around the assumption of at least $8B in revenue, but Apple hasn't been at that level for 3 years. When top line revenue is in the ~$6.5B range, very small differences in revenue have a disproportionate impact on profitability.

Once Apple moves away from the tipping point into the range of $2B - $2.5B revenue per quarter, it realizes greater efficiency from its corp. cost structure. SG&A costs increased by ~5% even though revenues increased by 15%. Gross margins might be 1-2% difference in net income, but the cost efficiency of the SG&A structure has a much bigger impact.

In past years, Apple has seen the reverse. Revenues drop by 20% and SG&A only drop by 3%. The negatives are amplified the same way that positives are. So the further away Apple can move from the equilibrium point (~$1.5B/quarter), the better off they will be - even if gross margins are lower.

Taking a step back, the iPod exceeded expectations by at least 100%, and there are over 3.5 million customers of the iPod in the last 9 months alone. Has there been a "halo effect" extending to the other product lines?

Not yet. While the iMac and PowerMac's performance was obviously constrained by the G5 shortage, the PowerBook and iBook didn't show any increase in volume despite relatively easy availability of the G4 processor. This is despite the fact that Apple offered a promo tying the iPod with its portable line.

Foot traffic is up in retail, and there's definitely an iPod-flavored halo around the head of the Apple Store. It's just not hanging around any of Apple's product lines yet. 3.5 million iPod customers in 2004 - no significant evidence that it has increased Mac sales.

How about the iPod's contribution to the bottom line? Motley Fool has claimed that the iPod "makes more money" than any other product line.

But that's an interesting definition of "making money" because of the known profit margin differential. After removing the iPod, Apple's gross margins on its Mac + software/services products are 29%. After accounting for peripherals + services sale, let's say that the various product lines are at an average of 27.5% gross margin.

That means the gross income for the main product lines are

iPod -> $107.4M

PowerBook -> $115.2M
PowerMac -> $93.5M
iBook -> $70.4M
iMac/eMac -> $59.4M

If anything, the numbers underestimate the PowerBook because it should have higher margins than the iBook or the eMac. Even with that, the PowerBook remains the most profitable (i.e. making money) product line for Apple. That will change if the iPod does indeed reach 3 million+ units per quarter, but it isn't true today.

At this point, any attempt to prediction of the future of Apple is extremely difficult because the iPod distorts everything. It's pumping up the revenue, making Apple more profitable than it's ever been since September of 2000. It's pumping up the public perception of Apple, driving the stock price to incredible levels. The growth curve has turned discontinuous, and there's no way to accurately gauge where the iPod is going. I think even Apple executives were surprised by the level of iPod sales experienced.

At this point, Apple might as well rename itself the iPod Company.


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