Technology

That New Shine on Apple's Stock


Since he put out a sell recommendation on shares of Apple Computer last January, Merrill Lynch's Michael Hillmeyer has been one of Wall Street's biggest bears on the company. But Hillmeyer has been softening his tone of late. He upgraded his recommendation from sell to neutral in early July. And after the Cupertino (Calif.) Mac maker announced a surprisingly strong third quarter on July 16, Hillmeyer conceded that Apple (AAPL) had caught a little more momentum.

After seeing the quarterly numbers, Hillmeyer now looks for Jobs & Co. to bring in $6.75 billion in sales in fiscal 2004, vs. a projected $6.14 billion in the year that ends this September -- and up 10% from his previous forecast. Hillmeyer also has boosted his earnings-per-share projection for fiscal 2004 by 16%, to 32 cents. "If demand picks up more than people are expecting, there's a lot of leverage in Apple's model," he says.

EXCEEDING EXPECTATIONS. Historically, Apple has often been the computer industry's tightrope walker -- depending on one hot new product or another to help it meet quarterly earnings expectations, only to see sales dim. But at the moment, good news is flowing from multiple parts of Apple's business. In its third quarter, ended June 30, sales of its PowerBook notebooks grew 71% year-over-year. That drove up the overall profit margin, since these portable machines are more profitable than standard desktops.

Sales of the iPod music player hit 304,000 in the quarter, far higher than expected, thanks in part to consumers' love affair with Apple's new iTunes Music Store, a service for downloading songs online. All told, Apple brought in $1.54 billion in sales in the quarter, vs. Wall Street's expectations of $1.49 billion, and earnings of 5 cents a share surpassed expectations of 3 cents.

"Apple may never reach its goal of once again being a top-five PC maker, but it will continue to surprise us with innovation and diversification," says Tim Deal, an analyst with market researcher Technology Business Research.

"POSITIVE EFFECT." The Music Store has certainly helped change investors' tune about Apple from something akin to a dirge to more like a feel-good Jimmy Buffett ditty. Since it announced the online service on Apr. 28, Apple's stock has jumped from $13.35 to $21. After selling 5 million songs during the quarter at 99 cents a pop, Apple says it's already approaching breakeven on the new business.

And that from Mac aficionados alone. Apple says it intends to do a version of the Music Store that works on Windows PCs by yearend. It will have plenty of competition by then, including a new music site from Buy.com. Still, the Music Store has been a pleasant surprise. "It wasn't intended to be a big source of revenue," says Deal. "But over time, it will have a positive effect on margins."

Maybe the best news of last quarter was a product announcement that could resuscitate Apple's business with creative professionals such as graphics designers, ad agencies, and publishers. This segment, once Apple's most profitable, has been battered by slowed customer spending and by a lack of key software titles for its newest Mac operating system, notably Quark's QuarkXPress page-layout software. But this month, Apple will begin selling a new G5 PowerMac featuring IBM's PowerPC 970 chip. The machine will be Apple's first that's capable of running 64-bit software, similar to that run on more powerful Unix machines.

WORRISOME ISSUES. And Quark has said it will finally come through with a version of its software for Apple's OS X operating system -- the basic software that runs a computer. "Apple was on a long-term downward trajectory in market share and needed to find a way to be more profitable in its core businesses," says Hillmeyer. "That's why the G5 is significant. It's a new product in Apple's most profitable business."

Of course, Apple never lacks issues for investors to worry about. Some question whether IBM (IBM) will be able to satisfy demand for the PowerPC chips at the core of the G5 should sales of the new Macs take off. That's fuel for the hottest rumor among Mac-erati these days: that Apple will sooner or later have to make the jump from PowerPC to Intel chips.

For now, the biggest concern is falling sales of plain old desktop Macs. While the G5, which will sell for more than $2,000, may help regain ground with so-called power users, sales of the six-year-old iMac are flagging with both consumers and educators: Unit sales fell 24% last quarter.

BARELY IN BLACK. Partly, that's because of continued erosion of Apple's former stronghold in education, where makers of Windows PCs such as Dell (DELL) are taking share. While sales in Apple's chain of stylish retail stores are up 100% over the past year, they're still bringing in just 5% of total revenues -- not enough to prevent an overall decline in total units sold.

So despite Apple's "Switcher" ad campaign, aimed at winning converts from the Windows world, not enough consumers are making the move to the Mac for it to gain overall market share. And the stores are still losing money.

In fact, given its large investments in research and development and ts retail-store chain, Apple is just barely in the black on an operating basis. Its operating margins in June were just 0.6%. That's the second profitable quarter in a row after two in the red -- but hardly worth crowing about. And with the stock up 57% since the unveiling of the Music Store, investors have already factored in much of the good news.

Still, Apple's roller-coaster story seems to have taken an upward turn. At the moment, even skeptics like Hillmeyer can't ignore that. By Peter Burrows, who covers technology from BusinessWeek's Silicon Valley bureau


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