BUSINESSWEEK ONLINE : JULY 26, 1999 ISSUE
COVER STORY

As Compaq Slumbers, Apple Soars


For the better part of the past decade, Compaq Computer (CPQ) has been a favorite of investors, while Apple Computer (AAPL) has looked full of worms. Well, take a look at what's happening now. In the past three months, Apple's stock is up 55%. By July 14, it had rocketed to 55 15/16, its highest closing price since early 1993. Meantime, the market value of Compaq Computer (CPQ) has fallen to about half what it was earlier this year.

One reason for Apple's recent runup was high hopes for fiscal third-quarter results -- which came through with flying colors. After the close on July 14, the Cupertino (Calif.), company reported net income of $114 million, or 69 cents a share (not counting a one-time gain from a sale of shares in ARM Holdings, a British microchip designer).

That solidly beat consensus analyst estimates of 64 cents. Driven by the trendy iMac, overall unit sales were up 40% from a year ago -- twice the PC industry's growth rate. Gross profit margins improved to 27.4% from 25.7%, thanks mainly to lower component prices. According to market researcher PC data, Apple garnered 11.5% of retail and mail-order computer sales in the first two months of 1999, up from 6.3% a year ago.

Apple also announced a $500 million stock buyback program on July 14. "Apple's board believes that the company's stock is a good long-term investment," said Steve Jobs, interim CEO. The buyback should help reduce volatility in the shares, which some investors have used as a trading vehicle, says BancBoston Roberson Stephens analyst Alex Mou.

SKEPTICS. Despite all the good news, Apple shares fell 2 11/16 points, or 4.8%, to close at 53 1/4 on July 15. Many investors were likely taking profits. But some skeptical analysts picked apart the earnings report and raised concerns about slowing revenue growth and pricing pressures facing the company going forward.

"The revenues weren't that impressive," says Megan Graham-Hackett, an analyst with Standard & Poor's equity research group. Given that June ends a traditionally strong quarter when schools do much of their buying for the next year, and that Apple lowered the price of the iMac and increased the speed of its higher-end G3 computer, she expected unit sales to be stronger. Revenues grew far slower than unit sales because the iMac, the company's fastest seller, is among its cheaper products. Apple's third-quarter revenues totaled $1.6 billion, up only 11% from $1.4 billion a year ago. Plus, management told analysts that sales would be only slightly higher next quarter.

Long-term, Graham-Hackett worries that Apple won't be able to compete against supercheap PCs. James Johnson, an analyst with A.G. Edwards, was pleased with Apple's results, but he maintains his accumulate rating because of "shakiness" in a computer market plagued with pricing pressures. "A modest sell-off was pretty reasonable," says Hackett, who maintained her hold rating on the stock. The average analyst rating on Apple remains a weak buy, according to First Call Corp.

Are some analysts focusing too much on the nitty-gritty and missing the big picture? Michael Tucker, an analyst with Federated Investors, believes they are. "We're well into the turnaround at this point," he says. "Every quarter I get more and more convinced." He thinks some analysts got burned supporting Apple's stock five years ago, with the result that today their support is hard won.

THINK DIFFERENT. Apple's ace is that in a PC environment where computers are generic, it has come up with a product that stands out. Says Mou: "The Apple product really is different from the rest of the world. It has a different look, feel, color, software." Moreover, he says, consumers believe that it's easier to use. That gives Apple pricing power that commodity-PC makers lack (the recent price cuts on the iMac notwithstanding). In fact, Apple may not need to convert PC owners to the Mac, says Tucker. It can grow fast by catering to its current market and winning a share of first-time buyers, who will choose a slightly pricier Apple they trust over a no-name cheap PC, he believes.

While some investors worry about Apple's weak presence in the corporate market, Tucker sees its focus on consumers and its core designer and education markets as key to its successful turnaround. Not only has that focus led to imaginative products and good execution but it has also allowed the company to avoid getting too caught up in cutthroat competition with the likes of Dell, Gateway, and Compaq. "I think to step out of that market is very good," says Tucker.

Mou, who has a $75 price target for the stock, thinks analysts who criticized Apple's recent quarter missed some finer points. First, he says, unit growth matters more than revenue growth. Apple is also a software business (because it makes its own operating system, rather than licensing one from Microsoft) and can profit in the future when customers upgrade their software.

Plus, he was not discouraged by the fact that Apple guided analysts to lower revenue projections for the fourth quarter. He thinks sales will be strong anyway. He points out that management believes revenue growth will be strong in 2000. "I think that is a very bullish statement." Finally, he considers Apple's stock cheap. Stripping out its nearly $3 billion cash horde, he says the stock trades at a forward p-e of only about 12.

Near-term, Apple investors have the MacWorld trade show to look forward to next week. Apple is widely expected to launch a new iMac-style notebook computer at the show. In his July 21 keynote speech, Jobs may also announce a new Internet strategy for Apple, possibly involving a partnership with an Internet service provider. "There will be a lot of buzz, and the stock could retrace the ground it lost" following the earnings announcement, says Graham-Hackett.

Ultimately, shareholders should be glad that Wall Street still has its worries over Apple's future. As long as the company keeps executing its turnaround strategy, it means there's still upside on the stock as it wins over more skeptics.

By Amey Stone in New York

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