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Q2 '05 - Punishing Anything Short of Perfection

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By Plato90s
April 21, 2005

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Apple's most recent quarter showed both signs of great strength as well as some interesting changes in its product mix. On the up side, the financial performance is clearly superior as profit margins and revenues are near all-time highs. At the same time, the valuation of AAPL is also at all-time highs, and justifying that value requires perfection from Apple.

The last quarter was great, but not the impossible levels of perfection the market expected.

The iMac product lines (iMac G5, Mac Mini, and eMac) show a mixed picture. During the Christmas quarter, Apple introduced the iMac G5 and saw a huge jump in shipments as well as 40% increase in revenue. That reversed a trend where the Average Selling Price (ASP) of the iMac line had declined below $1000, indicating most people were buying eMacs and avoiding the first-gen LCD-iMacs. In most cases, a product line release is expected to have high volumes for at least 2 quarters, but the result of Q2 didn't indicate it. The ASP dropped by nearly $200 while the unit shipment count increase by only 2%.

It's known that the Mini was very popular, and the attendant drop in ASP would suggest that iMac G5 volumes have decreased by at least 30% since the first quarter of its introduction. Given the known product mix in Q1 vs. Q2 as well as suggested retail, Q1 '05 should have contained at least 350k+ iMac G5's in order to balance out the lower ASP eMacs. In this past quarter, probably less than 220k iMac G5's were sold.

That would suggest there was an enormous pent up demand for the iMac G5 and the true steady-state level for per-quarter sale is more in the ~220k range. The worry is whether the combined product line will show a significant decline in unit shipment next quarter once the Mini drops down from its initial introduction volume level.

The iBook product line remain essentially unchanged. There was a slight drop of volume which would most likely be seasonal in nature. This line may be benefiting from the fact that the Wintel notebook market has fractured in half, with half of the market featuring Pentium-4's in the 2Ghz+ range and the other half with Centrino/Celerons in the 1.4Ghz to 1.7Ghz range. The voluntary splitting of performance versus power saving makes the iBook look better, because the visual differential in Mhz rating is now less than 15% in most cases.

The PowerMac and xServe product line's problems are well understood at this point. Apple needs to update the product line with new CPU's or there will be little incentive for people to purchase upgrades. With Intel and AMD going to dual-core 64-bit CPU's, and IBM's evident lack of interest in expanding its hardware business, it's questionable whether the PowerMac has the potential to rebound over the long term. There's little doubt that Apple will sell 250k+ PowerMacs as soon as it comes out with the 1.5Ghz+ CPU, but power users requires frequent updates that the PowerPC market doesn't appear to be able to provide.

The PowerBook line is what looks best about the performance this past quarter, and the least mentioned. Thanks to the introduction of a 1.67Ghz CPU as well as dropping prices on the lower end, Apple achieved nearly 40% increase QoQ. Given the known higher profit margins of the professional laptop line, this move is has contributed significantly to the overall profitability of the 2nd quarter. With another jump to the G5 processor still pending, the PowerBook will most likely be the main driver of profitability for the remainder of 2005.

Finally, the iPod line shows some of the same mixed results as the iMac line. 16% QoQ growth in unit shipment should have been extremely impressive given how large the unit shipment has grown over the last year. It is unrealistic to expect the same kind of 100%+ QoQ growth seen in the second half of 2004. At the same time, the product mix does point to questions of where the iPod line is growing toward. Assuming the the mix of the HD-based iPods didn't shift significantly between Q1 and Q2, the number of Shuffles sold during this past quarter is between 2 million to 2.4 million units.

An extremely impressive jump out of the gates for the Shuffle, but it also points to the HD-based model losing 27% to 32% in unit volume over a single quarter. The big question is how many those lost sales represent a shift from a potential iPod customer to a Shuffle customer or just an indication of market saturation. The former means Apple is successfully transitioning its market base; the latter indicates a potential problem. There's no way to tell except with time.

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When it comes to gross margins, Apple's gain is the loss of flash and DRAM makers like AMD who suffered a horrible quarter as competition and over-supply drew prices down. Assuming Apple did sell over 2 million Shuffles, even a small drop in flash memory prices could have a large effect on the bottom line.

More importantly, Apple's combined fixed costs (SG&A and R&D) comprise a dropping percentage of revenue. In Q2, it was 17.45%, compared to over 28% two years ago.

On a geographical basis, the largest drop in revenue QoQ is in the Americas and Retail - suggesting that Shuffle and Mini sales are stronger in the US. Japan sales have recovered from its historic lows last quarter, and the even nature of growth suggests a significant portion of the unit sales improvement is in PowerBooks to balance out Shuffle/Mini sales.

Music sales are up 22%, which is the historical norm confirming that the 81% QoQ increase during the Christmas quarter was a seasonal aberration rather than an inflection point in the growth of the iTunes Music Store.

The prediction of a "halo effect" hasn't materialized for the various Mac product lines, because all the variations in product shipment can be accounted for in terms of product refreshes. In the last 6 months, Apple has introduced 2 new consumer desktops as well as a major shakeup of the professional laptop line. That's a better rate of product introduction that all of fiscal 2004. Assuming the halo effect exists, it's no more than a 3% conversion rate, and that requires we assume all 3 product refreshes has zero impact.

More likely, the iPod halo hangs mostly around AAPL share prices and translates to ~1% conversion rate. Still a worthy gain, but far short of the overly optimistic estimates of 6% to 10% proposed by various analysts.

Because AAPL's share valuation was priced for perfection, even a great quarter, which falls short of perfection, will cause the share price to fall. The projection for the coming year is accurate to the extent that Apple probably has detailed information on the drop off in orders for the iMac G5 in the past quarter as well as the anticipated unit shipment decay for the Mini.

The major factors will be how the HD-based iPod sales trend in the coming 6 months, given there will be stiff competition for the consumer electronic dollars in the form of the Playstation Portable and a new XBox. People generally start with a certain amount of money they're willing to spend on "toys", rather than specific budgets allocated to music players and other desirables. While not competing directly with Apple, both Sony and Microsoft will be trying to draw money out of the some of the same target audiences.

Another major factor is whether there will be a PowerBook G5 and faster CPU's for the PowerMac lines. The 1.8Ghz CPU's are overdue already, as is the introduction of the G5 to notebooks. Both should add significantly to the bottom line as soon as they are introduced.


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