Apple's Overlooked Upside


By Alex Salkever Steve Jobs has been on a roll. His iPod music player is the hottest product in the consumer-electronics market, selling a jaw-dropping 733,000 players in its first fiscal quarter, ended December 27, 2003. Apple's new deal with Hewlett-Packard (HPQ) to sell HP-branded iPods and put the iTunes Music Store on the default desktop of all HP consumer machines was a major coup.

And on Jan. 14, Apple (AAPL) posted its strongest quarter in two years. Revenues hit a four-year high of $2 billion, 36% above the same quarter in 2003. Apple shipped 829,000 computers, a 12% increase from the same quarter last year. And where it saw a net loss of $8 million during this period in 2003, it pumped out net profits of $63 million in the first fiscal quarter of 2004. Earnings per share of 17 cents slightly beat analysts' estimates, something Apple hasn't done much of lately.

So why was Wall Street only lukewarm after this seemingly strong performance? Apple shares fell 5.6% the day after the earnings report, from $24.20 on Jan. 14 to $22.85 on Jan. 15 (and closed on Jan. 23 at $22.56). True, the stock had run up in anticipation of solid numbers. But the rapid retreat surprised many, even though the logic behind the move is clear: The Street had been hoping for bigger sales numbers on PowerMac G5 desktops.

WRONG TREND. These powerful machines have earned many solid reviews. And Apple has ruled the creative sector with its PowerMac line. But even the addition of hot new 64-bit G5 chips that promise to blow the doors off the old G4 line and finally make Apple competitive with top-level Intel (INTC) chips didn't lure enough buyers to satisfy analysts.

While year-over-year increases of 30% and 36% in unit sales and total revenues for the PowerMac line looked impressive, those two measures actually worsened from the fourth quarter of 2003, falling 7% and 5%, respectively. That's not exactly the trend you want to see for a hot new offering.

At the same time, the troubles in the aesthetically groovy iMac line deepened. Unit sales and revenues both declined 10% from the past quarter, and 24% and 29%, respectively, from the same quarter last year. Many analysts believe that's because the iMacs look pricey in the over-$1,000 desktop category. The topper was a decline in gross margins from 27.6% to 26.7%. That came largely due to unexpected warranty costs arising from fixing problems with the logic boards of iBook laptops and the display screens of PowerBook laptops.

APPEAL TO UNIX JOCKS. The Street's short-term logic is easy to understand. But investors with a longer-term horizon might want to look closer at Apple. For starters, worries about sluggish sales on the PowerMac line aren't justified. The main buyers of these high-end machines are creative professionals in advertising and media. While that sector is looking stronger by the month, it's still far from the salad days of the dot-com boom when buying a new computer hardly required any thought. The real return to strength in the ad and media biz will come in 2004, and that's when Apple should start seeing stronger sales of these machines.

Further, Apple is developing a strong niche in the scientific computing market as more Unix jocks at institutions of higher learning decide to combine their workstation and their PC into one box. That's likely good for sales only in the tens of thousands of machines per quarter. "But that can make the difference between a good quarter and a ho-hum quarter for the PowerMac line," points out veteran Apple watcher and Needham & Co. analyst Charles Wolf. He further notes that PowerMac sales in the past had run at around 350,000 in strong quarters.

Although CFO Fred Anderson indicated that Apple expected to sell only 200,000 or so PowerMacs on a quarterly basis going forward, Apple's assessment looks conservative should buyer behavior in sectors favoring PowerMacs return anywhere close to the mean between the highs and lows of the past three years.

100 MILLION DOWNLOADS. Then there's the iTunes Music Store. Jobs has admitted that Apple makes no money selling digital downloads. That may be true for now. But the legions of Apple watchers who have already decided that this will always be the case are wrong. With the HP distribution deal, Apple's iTunes Music Store will appear on the desktops of about 25% of all consumer PC purchased in the coming year because HP is tops in consumer PC market share.

Considering the growth of the iTunes Music Store and downloads in 2003 without the assistance of any marketing by a PC partner, Apple still managed to clock 30 million downloads. Adding HP to the mix could easily push the total to over 100 million in 2004 and well above that in the future. At those types of volumes, Apple will make money.

Here's another thing: From a third to a half of those downloads are album sales. Apple makes more money on those because it's paying a smaller percentage per dollar of transaction costs to the credit-card companies. Those transaction and processing fees are largely fixed on a per-transaction basis. So in the not-so-distant future. Apple could well pull in profits in the low double-digits from iTunes.

RECURRING REVENUE. The biggest shocker in Apple's latest numbers was $238 million in revenues under the "software and other" category. That's up 53.5% from $155 million in the same period last year. A huge chunk of that came from purchase of the upgraded Panther version of the OS X operating system. Apple reported $60 million or so on that front, with 600,000 Macheads buying Panther.

Apple is onto something here. Each OS upgrade runs $129. The new iLife suite costs $49. The iChat audio/visual software costs $30. And hundreds of thousands of Mac users are paying $99 per year to subscribe to the .Mac program, which offers online backup and storage, calendar syncing, and free e-mail accounts.

Jobs & Co. is clearly in the process of building a recurring revenue stream of hundreds of dollars per customer. Granted, not all Apple buyers will bite, but if even 10% of the faithful buy in each year, that could mean hundreds of millions in new revenues.

"JUST TOO EXPENSIVE." Of course, Apple could stumble any number of ways -- and trip up investors. iPod competition could heat up and put the brakes on Apple's rapid revenue growth in that area. Sales of the iBook, which had defied gravity despite the platform's dated design, could plummet amid new and intense laptop competition. And Apple's much touted growth in laptop sales could turn tepid in a hurry if the appetite for laptops plateaus.

Then there's the old argument, which still holds more than a grain of truth: "They're just too expensive. They have a nice niche on the creative side, but it's a matter of time until Wintel [the combination of Microsoft's (MSFT) Windows operating system running on machines with Intel chips] offers a better deal," says Eugene Walton, founder of independent equity research firm Walton Holdings. However, he acknowledges that Apple has a new growth path in the iPod and that it has managed to keep its operating margins on the high side compared to other PC makers.

All told, though, the Street might be missing the forest for the trees in Apple's latest numbers, and lots of green could shake loose if Jobs & Co. realize even a little bit of the upside that investors seem to have overlooked in the earnings report. Salkever is BusinessWeek Online's Technology editor


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