Catalysts That Make Apple Computer (AAPL) A Buy- Revisited

By Yaser Anwar, CSC of Equity Investment Ideas

This post is going to be an Apple Fiesta- I’m going to include my own take but this time also some very smart comments of readers & Wall Street analysts’ take too. Brace yourself its going to be a very long post.

Yaser’s Take

• While other PC OEMs have struggled with running their own retail operations, AAPL stores have been highly successful and their productivity has been nothing short of stunning. AAPL has devised a retail strategy that uniquely complements the company’s strengths in product innovation and marketing, making it a model not imitable by other PC OEMs.
• The stores annual sales per square foot, $4K, exceed those of other consumer electronics retailers like Best Buy, $930, as well as luxury retailers such as Tiffany & Co, $2.6K. Apple stores having boosted revenues and margins over the last five years, although perhaps not to the degree that many investors may realize, as our analysis points to share shifts from indirect outlets, rather than incremental share gains.
• Apple Stores have helped dramatically increase Apple’s overall brand awareness, creating impressions equivalent to hundreds of millions/year from traditional advertising. Apple’s retail Mac units grew 57% YoY in Nov. with NBs up 107% which benefited from new Core 2 Duo MacBooks & MacBook Pros.
• Demand continues to be solid for Macs into the holidays, which could lend upside to Street estimates of 44% unit growth estimate for 1Q07 as sales accelerate from here. iPods grew 33% YoY in Nov.

Readers Take (very partially edited)

I always like to tell my buddies how smart my blog’s readership is. Today I’m going to re-print some very smart comments by readers proving that point!

First of Kris Tuttle (Ex-VP of Institutional Sales at S.G. Warburg in NYC)

1) Having looked at Vista, albeit briefly, it’s a yawner.

2) An increasing number of "must have" software components are filling in the gaps on OSX.

• There are still some holdouts like Intuit and other financial software providers but it’s just about all there. Plenty of people are still brainwashed about Windows being the "compatibility" choice but it will fade with time.

3) Apple is a brand. Zune might be a decent product but people want Apple. When I visited several NYC electronics stores and the Apple store at 59th and 5th. All I can say is Wow! (I have pictures which I will post later.)

• In contrast to an absolutely overrun Apple mecca the Zune appears in deserted aisles in cages so you can only touch them, not pick them up. No positive buying environment there. Apple still has plenty to do and not all of it will be easy but all the momentum is with them. It’s theirs to lose at this point.

Reader David on iPhone

• When Apple came out with the first iPod there were already a boatload of competitors in the mp3 player market. Apple was the only one that saw the need for a really spiffy high-end mp3 player with large capacity and long battery life. The press greeted the first iPod with hisses and boos, called it overpriced, and dismissed it rather abruptly predicting an early demise.
• I see a parallel in the smart phone space (with keyboard please). The current big players have names like Treo and Blackberry. There really isn’t anyone in Apple’s league in terms of engineering and product design capabilities. That’s the way it was with mp3 players when iPod happened on the scene.
• There is a problem with the current telephone offerings that Apple might see as an opportunity (as they did with iTunes). First of all you have the Cell Phone service providers who like big monthly subscription style payments, long term contracts, and high priced per minute usage charges. At the same time you have the emergence of Internet phones, WiFi phones, and much much much much more attractive and flexible pricing.
• Services like Skype and Jajah lack the ‘anywhere accessibility’ of regular cell phones but they do present a compelling set of economics. iChat could be extended to become a Skype competitor.
• Who better than Apple to simplify the rate/pricing picture and to integrate internet phones, cell phones, and computers using a smart phone device as the portal?
• There is a further rumor that there are two phone models in the works. When they introduced the first iPod it was pretty basic. Pictures and video came much later. The real beauty was the iTunes integration. Remember how late they were getting out a Windows version of iTunes too.

Like the iPod, the first product introduced may not be the ultimate. The question is what sort of a road map will they show us?

Think about what’s wrong with the current offerings:

1. PDA’s keep track of your calendar, to do list, and notes but isn’t that too limited for something you have to buy and carry around?

2. Cell phones are really great devices except for one thing: The pricing models really suck with high monthly charges and per minute pricing.

3. Internet phones like Skype and Jajah are really super in terms of cost and reach but you have to be on your computer, have the application running, be connected to the

Internet or at a WiFi hotspot?

4. Using your laptop with WiFi is really great but pricing is a royal pain for temporary access. Pull out your laptop at the Airport in Paris and you can connect but they want $10 for a few hours of connect time.

• Put together a system that solves those four problems and you have a winner even it there is a $1000 up front hit.WiMax is coming which means WiFi like Internet access over about a 30 mile radius. A smart phone is really a computer with a cell phone attached.
• Would I pay $500 or $1000 for a smart phone? Yes but only if it could wean me from T-Mobile, Verizon, etc. and their monthly plans. Give me a device and a supporting network that would pay for itself by giving me better telephone economics. I think Apple could have a big impact if they could do that.

We’ll soon see what they’ve been up to.

Mr. Anonymous (feel free to identify yourself if you will)

• I had been about as against Apple as anyone could be for a long time. I’ve been a Windows network engineer, developer, etc. for many, many years. I’ve used a Mac maybe twice. I saw very little value in Apple other than good hardware and a better image…but the pricing and compatibility made it a poor choice for business (and in my opinion…pretty much anywhere).
• My mind has changed drastically over the past couple of years. I can’t abandon Windows because all my clients use it, but for web development and personal use, I’ve made up my mind that my next purchase will be a Mac (probably a laptop).
• Yeah, Mac has had fewer options when it comes to ALL the software out there, but do we really need ALL the software out there? It’s just simpler, and I think we’ve hit a saturation point where people are overwhelmed by choices, people want to be able to do stuff and enjoy their computers…not fix them…and most things are moving to a web-based application model…so Windows isn’t really going necessary, and there is also a lot of demand and support for open source: Unix, apache, and php (which run native on the Mac).
• At the same time, all the latest hardware and software seem to have everything built in and require less components and setup. People are tired of so many vendors. Still, the comfort of knowing I can run Windows on a Mac – that’s a winner…a computer I can use for business and pleasure.
• I am starting to use less of the Windows features and more things like Firefox – they’re just better. My wife and I both own iPods, which are like sculpture that just happen to play music and movies and podcasts. I can only see this improving as they add more content.
• My kids will start using a computer soon, so combined with all the new gadgets that are out there and soon to be developed…why not start them out on Apple – easier, less viruses, better hardware.
• Everything else is a commodity, and the commodity play for technology and life has run its course. Windows IS boring. It is not capturing people’s imaginations. Outside catalysts are driving more interest in Macs. It is a brand. It is a high-end purchase, and people want that. People are willing to spend more on computers these days if they consider it as a part in a sum of goods that play movies, music, make phone calls, record TV programs, etc. Everything is becoming one system…and nobody does it better than Apple.
• Hollywood makes Apple sexy – nobody in the movies uses an HP, Windows, or some random MP3 player. So who do you think will get the distribution? Who already has a nice grasp on the distribution already?
• I think a good bit of the support in the stock and some of the future potential is based on increased market share for the Mac, which I don’t think anybody ever expected would happen. Apple’s margins are better, too. They have such a small share right now…why couldn’t they double it in a few years? Wouldn’t that be nice for the stock? iPod sales are still strong and will maintain their strength for quite some time. There are still a lot of people out there that don’t have iPods and will get them. There are also a lot of people out there who think their current MP3 player stinks and will switch. The iPod is the leader. It is the Windows of it’s class.
• Nobody else is in a position to take advantage of the Internet/TV/Phone/Entertainment revolution that is underway either. Once people see EVERYTHING Apple comes out with and how it all works together – I think there will be an epiphany.
• Finally, the iPhone. I know very little about it, but I’ve been expecting Apple to make a phone play for quite some time. I just figured it would be a phone with an iPod or something. Maybe a little bit more. I’ve been dying for a reason to dump my crappy cell phone and service. There are no good plans out there…and I don’t want to talk to my computer…I want to use the phone. I considered buying a Treo or Blackberry, but I simply don’t need all the features.
• However, if Apple could come out with something that had those features PLUS iPod, internet calls, and have some sort of integration with their other multimedia products…I’d buy it. There definitely is a void in the phone space, and I hope Apple fills it. I don’t know what the impact would be on their core business, and I don’t know what they’re chance of success is, but they usually don’t do things unless they’re ready, and they’re product is perfect.
• So circling back the long way, what’s the stock worth? I started buying in the low 50s back a few months ago. I expected the stock to be around 82 by the end of the year. I raised my expectations…figuring it would be mid 90s towards the end of January…maybe 100. Then I figured there would be some profit-taking at the time. I actually took a little off the table already, but I made my last purchase at 82. I still think it’s a buy though.
• It’s not much higher than it was earlier this year…and it is a far more attractive company than it was then. Was it overvalued then? It is definitely a sexy stock that everybody wants to get into. I also think it is a good long term investment – face it…there’s not a lot of big tech names out there people want to buy hand over fist.
• Obviously, the upside goes down as the stock goes up.I believe that a lot of the current catalysts, good news, holiday bump, and expected earnings for the next quarter or two are pretty much built into the stock (or at least will be in a few points). With this momentum, I could see Apple easily at 120 in a year…a good investment.
• I’m just curious about what next year will bring. Some nice catalysts could run the thing up to 150. I just wonder when it becomes too expensive…and where it’s market cap can go. How much of the recent buying is due to the iPhone…which has always been an "urban legend" as some people say.
• With increased roll out of sexy gadgets (especially overseas), I think they can also gain market share in all their products/services internationally, which would be nice.

Mr. Anonymous- you’ve stolen words from my mouth, needless to say I concur!

Extending an open invitation to all 3 readers- if you ever want to be a guest author feel free to let me know. Excellent insights & I’m proud to have you guys read my blog.


Wall Street Analysts

Bernstein Research

• The Apple Stores have clearly proven themselves to be successful and profitable, but does this justify Apple’s getting into the retail business? In our view, Apple’s retail strategy truly makes sense only if it adds incrementally to the company’s core business of selling iPods and Macs.
• We believe the Apple Stores have had a positive incremental impact in three ways. First, the stores help increase Apple’s overall brand awareness and facilitate the halo effect, whereby the iPod’s immense popularity leads to greater interest in the Mac platform. Second, the stores boost Apple’s reported revenues by (a) capturing the retail markup on Apple products that would otherwise be pocketed by resellers, and (b) selling third-party products such as software and peripherals (printers, digital cameras, speaker systems, etc.) that Apple would otherwise not sell.
• We estimate that during fiscal 2006, the retail segment added 5%, or nearly $900 million, to Apple’s total revenues. Third, the stores help boost Apple’s reported gross margin for similar reasons: (a) Apple products sold at the store carry higher prices but the same COGS as those sold through resellers, and (b) third-party products typically carry relatively high gross margins (we estimate 40% on average).
• We estimate Apple’s gross margin has benefited by roughly 40 basis points per year due to the stores. Note that the positive impacts on revenues and gross margin would generally apply to any OEM that decides to run its own retail operation.
• We also see at least two important areas where the Apple Stores do not make a significant contribution, but where many investors appear to believe they do. First, while we believe the stores help increase Apple’s overall brand recognition, there is little evidence that they have directly driven incremental sales of Macs and/or iPods.
• This is important because it suggests that the opening of additional stores will not necessarily lead to further Mac and/or iPod sales growth, except to the extent that the additional stores drive additional brand awareness and capture the retail margin. Second, while the stores materially boost Apple’s overall revenues and gross margin, we believe their impact on overall operating margin is much smaller, because of the stores’ elatively high operating expenses.
• We estimate the retail operation has boosted Apple’s reported operating margin by less than 10 basis points per year.

PiperJaffray

Contrary to recent reports suggesting sales on iTunes are declining rapidly, my analysis of Apple company data regarding iTunes sales shows strong growth y/y.

1. From Jan. to Sept. in 2005 Apple sold 10.4m songs/week and in 2006 that number was up 78% to 18.5m songs/week over the same 9-month period.
2. iTunes sales peak after the holiday shopping season, and then decelerate slightly throughout the year. We expect another strong uptick this January.
3. We continue to believe the shift to online distribution of media is in its infancy.
4. We estimate 5% of worldwide music sales were online in 2006.

• iTunes Sales Up Y/Y. In light of recent media reports of slowing iTunes sales, we analyzed music sales data and saw strong y/y growth in 2005 and 2006. Specifically, we compared total sales between Jan. and Sept. of ’05 and ’06 and saw 78% growth during that period. From Jan. to Sept. in 2005 Apple sold 10.4m songs/week and in 2006 that number was up 78% to 18.5m songs/week.

I wish I could do more such posts- Wall Street, Readers & I

Disclosure: I own AAPL

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