Financial Alchemist

My Comments on Bloomberg TV Interview with Apple Analyst

2009-11-24T12:56:00.001-06:00

Broadpoint AmTech analyst Brian Marshall recently appeared on Bloomberg TV to discuss Apple’s iPhone exclusivity agreement with AT&T. Marshall believes that Apple should move away from its exclusive AT&T agreement and begin offering the iPhone through Verizon. He believes adding Verizon could boost iPhone unit sales by 14M. Marshall states that AT&T’s exclusivity ends in June 2010, and explains why Apple would benefit by offering the iPhone through Verizon. Fortune’s Apple 2.0 and Silicon Alley Insider summarized several of Marshall’s points, which I believe aren’t entirely accurate.

Here is a video of the Bloomberg TV Interview

1) Apple receives a $450 subsidy.

Incorrect: Apple receives a $400 subsidy.

I know from talks with Best Buy managers that the subsidy is $400. Best Buy purchases a 16GB iPhone from Apple for $542, and sells it for $199 with a 24 month service contract. AT&T reimburses Best Buy $400.

A 16GB iPhone without a contract commitment costs $599. If the subsidy were $450, then that price should be $650, or AT&T would be leaving $50 on the table. In addition, the math suggests $450 subsidy is too high given the ASPs implied by the cash value of iPhones sold reported by Apple.

2) After AT&T loses exclusivity that subsidy will drop to $300 for all carriers, domestic and international.

Incorrect: Subsidy shouldn’t change.

Tim cook addressed this issue on Apples Q4 2009 conference call (from Seeking Alpha):

Gene Munster – Piper Jaffray

We’re looking at the iPhone, it’s pretty clear we’re still in a greenfield opportunity here, but if you start to go to multiple carriers can you talk a little bit about the pricing of the phone when you go from exclusivity to multiple carriers? And obviously, not specific but any sort of color we can have in terms of pricing dynamics change on the phone from you to the carrier?

Timothy D. Cook

Our pricing is confidential, Gene, so it’s not something I could comment on in detail but generally speaking from markets where we’re already selling I would not expect to see a wholesale price difference as we bring on other carriers. However, the end user price is really set by the carriers themselves so you may or may not see a street price difference.

Gene Munster – Piper Jaffray

So when you go from exclusive to multiple carriers, you wouldn’t necessarily see change in pricing that you are charging the carrier? Is that correct?

Timothy D. Cook

That’s correct.

Handset subsidies are a function of ARPU, or a subscriber’s monthly service bill. The ARPU across all AT&T customers is ~$51 compared to iPhone ARPU of nearly $100. Since the ARPU is nearly double, this allows a greater degree of subsidy recapture, thus allowing for a higher subsidy to applied to a mobile device.

3) iPhone users represent 4% of total AT&T subscribers.

Incorrect: iPhone users represent about 14% of AT&T’s total wireless customer base.

AT&T has roughly 11.3M iPhone users. On the June call, AT&T said it had nearly 9M iPhone customers. AT&T has 81.6M wireless subs, with 63.4M being postpaid.

Brian Marshall stated: “roughly 4% of the AT&T users of the iPhone, consume about 40% of the overall network bandwidth.”

It’s not clear exactly what Marshall was referring to when he mentioned 4%, but most people took it to mean iPhone users constitute 4% of AT&T’s customer base. I assume he got his figures mixed up. The 3.2M iPhone activations in September period would equate to 4% of AT&T’s subscriber base. If he meant 4% of iPhone users, or about 450K, consumer 40% of AT&T’s bandwidth, then I would think AT&T would address those users since they represent 0.6% of AT&T’s wireless subscriber base. It wouldn’t make any sense to allow such a miniscule portion of customers affect the quality of service of the overall network.

4) iPhone activations from new AT&T customers made up more than 90% of postpaid net additions in September quarter.

Not Meaningful: Gross additions not net additions should be used as the metric.

iPhone activations from new AT&T customers totaled approx. 1.28M. AT&T reported 1.39 postpaid net additions. However, AT&T attracted 3.57M new postpaid customers, and 2.18M postpaid customers left AT&T, resulting in 1.39 net additions.

Comparing iPhone activations from new AT&T customers versus net additions is a faulty metric, since net additions is dependent on gross additions and the number of disconnects (churn). The more meaningful metric is comparing new iPhone additions to postpaid gross additions, which was 36% (1.28M / 3.57M). Using net additions is meaningless.

To imply that the iPhone was responsible for 92% of AT&T’s increase in postpaid customers is inaccurate. The 1.28M figure represents a portion of AT&T’s gross sub additions, therefore, it shouldn’t be used in a comparison of net additions. Subscriber churn affects subscriber net additions, and isn’t directly related to the iPhone’s ability to attract new customers.

Let’s say AT&T activated 2.28M Blackberry devices from new AT&T customers. That would equate to 165% of postpaid net adds, whereas iPhone was 92% of postpaid net adds. Is that meaningful? Not really, since it’s possible that the figure can exceed 100%. Let’s say 2.28M iPhone activations were from new customers, then that 92% would be 165%. Since the ceiling can exceed 100%, we don’t know is 92% or 165% or whatever the figure, is good or bad.

5) AT&T’s contract ends in June 2010.

Unknown: I have heard from sources at AT&T the contract runs until the end of 2010.

Neither AT&T nor Apple has publicly commented as to when the exclusivity ends. It was reported last year that Apple and AT&T extended their agreement until the end of 2010. It would make sense that the agreement runs until the end of the year since it commenced in the beginning of 2007. Even though the iPhone didn’t go on sale until June 2007, it was announced that January, allowing AT&T marketing rights for the time preceding the actual product launch.

Many assume that the deal will end mid-2010 since Apple introduces new iPhone models during that time of year. However, all we know is that the exclusivity agreement will end at some future time, but when that is exactly is anyone’s guess.

Disclosure: Long AAPL

Apple Inc (AAPL): Weaker Dollar Will Benefit Revenue Growth and Margins

2009-11-03T07:45:00.001-06:00

Apple Inc. (nasd:AAPL) Rising gross margins stemming from increased recognition of deferred iPhone revenue has been a key factor in propelling Apple’s share price and EPS. I believe the next major tailwind will be increased revenue growth and higher margins arising from the falling U.S. Dollar. In 2009, 46% of Apple’s total revenue came from overseas, up from 43% in FY08 and 41% in FY07. Including European Apple retail stores, revenue generated in Europe was roughly 30% of total revenue in FY09. International markets are a key source of Apple’s revenue and growth, and a declining dollar is beneficial for the firm. Apple’s performance for the past several quarters was challenged by headwinds from the strengthening USD. Going forward, Apple should benefit from the dollar’s decline. This will lift international revenue growth and boost margins. Alternatively, Apple could choose to lower prices abroad to stimulate product demand to drive volume. I believe many investors overlook the fact that Apple derives nearly half its revenue outside the U.S., thus don’t consider the considerable impact coming from a weaker USD.

The USD had been on a long-term weakening trend up until late 2008 when a string of financial institutions collapsed and panic ensued. This led to a massive influx into U.S. Treasuries, hence the USD. This caused a temporary rise in the USD as investors all over the world sought refuge in securities perceived to be the safest.

Around April/May 2009, money began shifting out of USD leading to the currency weakening. In effect, USD depreciation is a resumption of its previous long-term trend. However, this recent fall in the dollar comes with several new factors that support a long-term dollar decline.

1) Massive stimulus and bailouts

2) Budget deficits

3) Diversification away from USD

4) Weak dollar policy to boost exports and domestic manufacturing

I expect the dollar to continue it’s weakening trend and a return to levels pre-fall 2008. From October to about May, the USD rose considerably, before starting its slide mid-year. Apple generally hedges against currency fluctuations usually 3 to 6 months out, therefore the rise in the USD late-2008 likely didn’t much of an immediate impact. Eventually, the effect of the stronger dollar is felt as new hedges are set at less favorable exchange rates. Apple had warned on its earnings calls that a stronger USD would negatively impact gross margins, thus stated it a as factor for guiding GM lower. However, cheaper components, higher iPhone revenue recognition, increased supply chain efficiencies, and foreign currency hedging more than offset the temporary rise in the USD. Apple mentioned in its 2009 10-K filing that the stronger USD did have a negative impact on revenue growth abroad for the full year. When hedges expire, Apple can either raise prices to offset the stronger USD or elect to accept lower ASPs in USD terms. Even though the USD began to fall back in April/May, it’s likely Apple has yet to feel the full benefit of the dollar’s decline due to currency hedges still in effect.

The tables below compare product pricing from Apple’s online store for France, U.K., Canada, Australia, and Japan at most recent exchange rates versus rates in early 2009 when the USD was at its highs. Some of the pricing includes VAT, so the price differential between U.S. product prices and Euro zone is overstated, but the focus here is the difference between most recent prices (weak dollar) versus prices when the dollar was stronger during late 2008 - early 2009. In Europe, where Apple receives nearly 30% of its total revenues, prices have risen more that 20% in USD terms. In general, that would equate to a 6% increase in overall ASPs.

A weaker dollar does imply higher product costs since Apple sources components and manufacturing outside the U.S., namely Asia. However, the negative impact of a weaker dollar in terms of product costs is much less than the benefit of higher ASPs in USD terms. This is because: 1) costs are a smaller percentage of overall selling price 2) Apple enters into long-term supply agreements and also has significant leverage over suppliers 3) China’s currency is fixed to the USD as it prefers a weak currency to support exports.

In summary, Apple faced currency headwinds for much of FY09 which I expect will turn into tailwinds for FY10. This factor hasn’t been mentioned much in the investment community. A weak dollar will boost ASPs (in USD terms), hence international revenue growth as well as lift gross margins. Apple could also choose to take advantage of the weakening dollar by cutting prices where it sees elastic demand. Therefore, I expect GM will continue to show strength aiding in the growth of Apple’s bottom line.

Disclosure: Long AAPL.

Apple Inc (AAPL): Q4 2009 Estimates

2009-10-19T09:48:00.001-05:00

Apple (nasd:AAPL) reports its Q4 2009 results on Monday, October 19th. I am expecting revenue to increase 19% (Y/Y) to $9.374B and EPS to increase 25% to $1.57. I expect gross margin to rise sequentially to 36.7% from 36.3% reported in Q3.

Revenue growth will be driven by strength in the iPhone, iTunes, and software segments. Mac units sales will be up (Y/Y), but Mac ASPs will be down resulting in slightly lower Mac revenue (Y/Y). iPod revenue will be down 10% due to lower unit volume and ASPs.

Earnings growth will be driven by the higher sales mix of high-margin products such as iPhones and software.

Disclosure: Long AAPL

Apple Inc (AAPL): Current Valuation Still Reasonable

2009-08-11T17:43:00.011-05:00

Apple Inc. (nasd:AAPL) $162.83- Despite Apple shares rising more than 100% from its 2009 low of $78, the stock still appears to be attractively valued especially as a long-term holding. Using cash-flow and non-GAAP earnings, AAPL trades at less than 15x on a trailing 12-month basis. Since sales and cash flows were likely significantly depressed over that time period due to the sharp economic contraction, demand should improve considerably in the quarters ahead. Thus, forward multiples would be even lower given the anticipated rebound in sales and earnings growth.

The modest price multiple at which AAPL currently trades leads me to conclude that investors are: 1) Attributing the slowdown in Mac and iPod segments to a permanent secular decline, rather than temporary weakness consistent with economic contractions. 2) Ignoring/underappreciating the growth potential of the iPhone and products yet to be introduced.

Non-GAAP Earnings & Cash Flow:

Apple has reported $5.72 GAAP EPS for the past 4 quarters combined (ttm). However, over the same period, Apple has earned $9.23 in non-GAAP EPS (ttm). The non-GAAP figures are a better representation of Apple's earnings power since iPhone revenues are recognized in the period sold and not deferred over a 24 month time frame as is the case with GAAP EPS. The GAAP EPS numbers grossly understate Apple's profitability and cash-flow generation.

Looking at the difference between GAAP revenue and non-GAAP revenue for the past 4 quarters, GAAP revenue would be $7.7B higher, or 22.3% if Apple were not required to account for iPhone sales using the subscription method. Reported EPS (ttm) would have been $3.51, or 61.4% higher as well. The most noticeable difference is the effect iPhone sales have on profit margins. Since the iPhone carries the highest margin for Apple hardware, there is a dramatic impact on gross and net margins when subscription accounting is reversed. Gross margin rises from 35.5% to 39.6%, and net margin increases from 15.0% to 19.7%.

GAAP Revenue (ttm) has increased 12.2% compared to the prior trailing 4 quarters, yet non-GAAP sales increased 29.7%, more than double the rate of GAAP revenue growth. GAAP earnings growth (ttm) versus the prior 4 quarters was 11.7% ($5.72 vs. $5.12). However, non-GAAP EPS (ttm) increased 66.3% ($9.23 vs $5.55) compared to the same period for the prior year.

From June 2008 to June 2009, Apple's cash holdings increased $10.35B, from $20.77B to $31.12B. On a per share basis, cash/share increased $11.38, or 50% from $22.85/share (June 2008) to $34.24/share (June 2009). Apple generated $10.26B in free cash flow over the last 4 quarters, or $11.28/share.

It is clearly evident that the reported GAAP figures widely understates Apple's true performance. Therefore, investors should focus on the non-GAAP numbers and cash flow when evaluating Apple.

Valuation Metrics:

Even though stock values reflect future cash flows, we can examine Apple's performance over the last 4 quarters (ttm) to use as a conservative proxy since the recessionary backdrop has most likely depressed revenue and earnings. Apple's GAAP EPS (ttm) of $5.72 translates into a historical P/E (ttm) of 28.5x. That would appear to be quire a rich valuation, especially given the multiple compression that has occurred in the overall equity market. Or, at least, imply significant future growth.

However, investors should know that evaluating AAPL based on GAAP accounting is completely flawed. To compare apples to apples, investors must gauge Apple using its non-GAAP figures relative to peers/market. Apple uses subscription accounting methods to account for iPhone sales which spreads handset revenues over 24 months by accruing unrecognized revenue in a deferred revenue account that is stated on its balance sheet. Apple's non-GAAP EPS (ttm) is $9.23 which equates to a trailing P/E of 17.6x. That is a stark difference than the misleading GAAP P/E of 28.5x.

Considering that Apple has $34.24/share in cash & securities that could theoretically distributed to shareholders, Apple trades at even a lower multiple based on non-GAAP EPS ex cash. If we strip out $34.24 cash/share from AAPL's $162.83 share price, we are left with $128.59/share which essentially reflects the value of Apple's operating assets. In addition, interest income must be stripped out of earnings before calculating a P/E multiple due to the assumption that the cash stockpile would be distributed, hence no longer contributing interest income to EPS. For the trailing 4 quarters, Apple earned 33 cents per share (after-tax) in interest income. Apple is trading 14.4x ex-cash (ttm) based non-GAAP EPS ex-interest income of $8.90.

When there is a large disparity between interest yield (interest income/cash) and earnings yield (EPS/Price or 1/PE), the large cash balances can skew the value of the (non-cash) operating assets. When short-term rates were over 5% (pre-tax) and Apple traded at 20+ multiple, the earnings yield was roughly equivalent to the cash yield. Therefore, there was little or no difference between the standard P/E and P/E ex-cash & interest. Now that current short-term rates are near zero, Apple's cash holdings contribute very little income to total company earnings.

If Apple used its $31.1B for a stock buyback, it could reduce share count by 191M to 718M. Non-GAAP EPS (adjusted for interest income) would rise to $11.21 translating into a P/E (ttm) of 14.5x.

In the past year, Apple's cash position has increased by $10.35B or $11.38/share giving a P/CF (ttm) of 14.3x. Trailing free cash flow was slightly less at $10.26B giving a P/FCF (ttm) multiple of 14.4x. Removing the value of cash and interest income (from share price & FCF), the P/FCF multiple drops to 11.7x.

Recall that this valuation exercise has been based on historical earnings, not expected future earnings which is more appropriate since investors only care about future cash flows. However, I used trailing earnings since those figures are known while future earnings are not. I am confident that Apple's next 4 quarters will be better than its previous four. The economy has been in a deep recession for the past year, but has begun to improve. Apple has managed to withstand the downtown reasonably well; and with the success of the iPhone/App Store along with the possibility of new products, Apples growth should accelerate moving forward. Thus, I am reasonably confident that Apple's valuation multiples are even lower on a prospective basis.

Price Implied Expectations:

Trading for less 15x trailing earnings and ~12x expected earnings, AAPL on the surface appears cheap. Historically AAPL has traded at much higher valuations, yet expected growth was much higher too. In addition, investors are demanding a higher required rate of return on equities by paying lower price multiples. The increase in equity risk premium inherent in all stocks has led to the decline in P/E ratios. Investors perceive greater risks and are less sanguine about the long-run prospects of equity returns. This accounts for a portion of Apple's low valuation relative to its historical premium.

The primary reason why the investors are assigning a paltry price multiple is due to expected declines in Apple's growth rate. In my opinion, the current share price reflects the expectation of Mac growth commensurate with the industry average, declining iPod growth, and iPhone growth that will peak and rapidly decline to the industry average in a couple years. In short, Apple is priced as if its growth is quickly maturing, such as MSFT or DELL who both saw their margins compress as growth stalled. All firms eventually fall victim to the industry/firm life cycle. However, is this expectation likely for Apple's future? That is the key question.

I don't believe that overly optimistic or unrealistic expectations are priced-in AAPL shares. I believe the current outlook implied by the share price is conservative, but not entirely unlikely. The future of Apple's growth hinges on innovation and new products/services, as it does for most firms. Many firms are unsuccessful at being able to continue to innovate, staying relevant and avoiding being commoditized. In short, Apple's share price doesn't give much value to its ability to innovate and reignite growth. In my opinion, it's the belief whether or not Apple can continue to introduce products that wow consumers that determines if AAPL is over/under valued.

Apple's Record of Successful Innovation and Execution:

1) iPod's Dominant Market Share-

Apple's unit market share has exceeded 70% in the U.S. for years as it has successfully continued to ward off competition leaving carcasses by the wayside. Many powerful companies such as Dell, Sony, and Microsoft have attempted dethrone the iPod only to fall short or outright fail. Apple has been able to keep iPod prices relatively high as its revenue share of the U.S. PMP market is higher than 90%.

2) Apple's iTunes store is largest music retailer-

Tunes surpassed Best Buy and Wal-Mart to take the top spot is sales volume. Apple should increase its lead as bricks and mortar stores cutback on music selection due to high inventory cost and required floor space. Demand for physical music continues to decline as consumers shift to buying digital music online. Competitors have followed with online music download stores, yet they have made little dent in iTunes market share.

3) Retail stores generate highest revenue/sq.ft. and foot traffic-

It's quite indisputable that any retail strategy has been as successful as Apple's retail stores. Apple leads in performance metrics such as revenue/sq.ft. and visitors/store etc, but its retail strategy also has been extremely successful in promoting its brand and introducing customers to its products. Other computer makers' retail efforts have failed, such as Gateway and Dell. Many third-party computer and electronics resellers have also disappeared, such as CompUSA and Circuit City. It's quite evident that it's a very challenging environment to navigate. Apple continues to open new stores and is expanding considerably abroad.

4) Turn-around of Mac business and domination of premium segment:

Mac unit sales increased 38% in FY08 and 40% in FY07, which was more than 3x the PC industry as a whole outpacing the industry in 18 of the last 19 quarters. Even though Mac unit growth has slowed to single-digits, its share of the premium price segment has exploded. According to NPD, Macs made up 91% of sales for PCs priced $1000 and above for June 2009, up from 88% in May. This compares to 66% share Mac had in Early 2008. I believe Apple had about 40% share of the premium market in 2007. It is quite evident that Apple is the only PC manufacturer than can command a premium for its products.

5) Large and increasing share of smartphone market-

Even with the experience and industry footing incumbent mobile handset makers possessed, Apple was able to enter the market and quickly gain share. According to several surveys, the iPhone has the highest satisfaction rates by a considerable margin. Industry competition is very intense, yet Apple is the one to catch in the smartphone segment.

6) iTunes App Store-

One year after launching, the iTunes App Store offers 65K applications and has seen over 1.5B downloads. Other firms have followed with their own mobile app stores, yet haven't been able to duplicate nearly as much developer and consumer interest. Nintendo mentioned last quarter that Apple's App Store is impacting its handheld gaming business.

These remarkable achievements illustrate a common theme. Apple has been able to enter new product markets and become the leader that others must chase. Even though many competitors have attempted to duplicate Apple's strategy, most have had hardly much success, at least in terms of stealing business from Apple. A popular concern among Apple investors is that increasing competition from the number of firms following in Apple's footsteps. They believe that others will eventually catch Apple (iPhone, App Store, iTunes Music),hence its lead is only temporary. However, this has been a concern for ages and yet to come to fruition. That is not to say it won't happen as there is a real possibility that it will eventually. But given Apple's proven track record of disrupting, dominating, and defending its new endeavors, it's likely Apple will remain the innovative leader for sometime.

Apple's share price may reflect declining iPod growth and decelerating Mac growth, but it doesn't reflect potential new products which are a certainty. The success of those new products are less certain, but Apple makes products/services that complementary to its others, rather natural extensions. Basically, Apple products help drive sales of other products as well as increasing switching costs creating customer "lock-in."

Apple's products elicit the some of the highest customer satisfaction scores for their respective categories which has created immense loyalty and a powerful brand.

Conclusion:

On a non-GAAP basis ex-cash, Apple is trading at less than 15x trailing EPS. Considering the economy has been going through the worst economic downtown since the Great Depression, Apple's trailing earnings are depressed. As the economy turns up, earnings will normalize at a higher level. In addition, iPhone sales should continue to exhibit strong growth and drive free cash flow. Therefore, investors should be highly confident that future earnings will be considerably higher. On a forward earnings basis, AAPL's price multiple is 10-12x, a valuation representative of maturing growth. However, Apple has a long track record of innovation and using products to promote and attract consumers to its other offerings. Looking at the many remarkable achievements by Apple any the many stumbles by competitors, it can be argued that AAPL deserves a premium multiple, not a multiple reflective of ordinary growth.

Disclosure: Long AAPL

Apple Inc (AAPL): iPhone's Substantial Impact on Gross Margin

2009-07-29T05:00:00.000-05:00

Margins held steady Q/Q at 36.3% (down 10 bps) versus expectation of ~200 bps of margin contraction due to mounting headwinds.

Management issued Q4 GM guidance of 34%, 100 bps higher than Q3 33% GM guidance (which AAPL exceeded by 330 bps).

Considering the number of challenging cost environment Apple's Q3 performance and Q4 GM guidance are huge positives.

(1) Apple was able to maintain gross margins for Q3 and (2) According to Apple's guidance, I expect GM to hold in Q4.

The past two quarters have seen a significant lift in gross margins compared to the 3 periods prior (3Q08-1Q09) in which GM held steady at 34.7%. The rise in GM has be a major factor in the near doubling of the stock price since the January low. In the 2nd half of FY08, management started a chorus that it expects 30% GM for FY09. Even when GM turned out to be healthy for Q1 & Q2, Apple maintained its 30% GM outlook. This had many analysts and investors worried.

Last October, I reported Apple's FY09 Gross Margin Expectations Too Low arguing that GM will for FY09 will come in way above the 30% guidance. In January, I wrote Apple's FY09 EPS Estimate Too Low stating that the forecasted decline in FY09 EPS by analysts wasn't not going to happen and that earnings should increase by at least 5-10% versus FY08. (For the 3 quarters already reported for FY09, EPS is up ~8% versus the same 3 quarters for FY08.) The main thesis was gross margins would come in significantly above expectations mostly due to high margin iPhone revenue becoming a larger share of total sales.

1) Mitigated numerous factors pressuring margins.

- Transitioned entire notebook line.

- Cut prices across entire notebook line and/or added increased performance.

- Back to School promotion (Mac discounts plus free 8GB iPod touch).

- Revenue mix shifted towards lower margin Macs from weak business spending affecting the Mac Pro line.

- Component prices increased, coupled with higher commodity and energy prices.

Apple repositioned its entire notebook line, cutting prices significantly on Macbook air, and on 15" and 17" inch Macbook Pros. Apple also introduced 13" Macbook pros in place of the older aluminum body Macbooks. Macbook prices were cut anywhere from $100-$300. In addition, Apple kicked off its "Back to School" program that offers discounts on Macs plus a free iPod touch valued at $229. As a result, coupled with weak business spending, revenue was skewed towards the lower-margin models.

2) Guidance of 34% translates into GM likely coming in the 36%-38% range.

- Past 4 quarters GM has exceeded guidance by an average of 370 basis points.

- GM guidance has increased sequentially 3 quarters in a row. (2Q-32.5%, 3Q-33%, 4Q-34%)

Apple has routinely sandbagged on GM guidance by and average of 350 bps over the past 11 periods, and 370 bps for the last 4 quarters. In addition, over the past 10 quarters, when Apple has raised guidance sequentially, GM either rose or remained flat sequentially except for one instance. The scatter plot of change in guidance on x-axis versus change in actual GM on y-axis demonstrates managements accuracy in forecasting GM at least with respect to direction. Therefore, we can expect GM will up or at least flat in Q4 even in light of the challenging headwinds.

iPhone Contribution:

The profitability of the iPhone has played, and will pay a major roll in Apple's overall gross margins. Since Apple refuses to comment about product level margins, the iPhone's significance is often missed. Apple neglects to mention the iPhone angle due to the fact it doesn't want to discuss product level gross margins. The reasons for doing so are vast: firms desire to "cry poor" for the more money they rake in, the more money others will want to get a piece of. This extends to customers, carriers, suppliers, and competitors. Apple repeatedly exclaims it doesn't want to create an "umbrella" that would attract competitors to enter and undercut it. Therefore, much of the GM upside has been due to iPhone revenue being and increased percentage of total revenue, and since iPhone revenue is deferred, this trend will continue to intensify. I have been writing about this effect for nearly a year.

According to my Apple model, (which is i consider accurate being that its EPS variance has been 4 cents, 2 cents, 1 cent, and ZERO for the past 4 quarters) iPhone contributes an equal amount to EPS as does the Mac segment, and will surpass Mac's EPS contribution in the quarters going forward.

In Apple's 10-Q filings, it breaks out deferred revenue and deferred costs for iPhone and AppleTV reported on the balance sheet. Since AppleTV is a minute sliver of deferred revenue it is assumed that its impact on total deferred revenue (AppleTV + iPhone) is immaterial.

Looking at 4Q07, GM of deferred revenue (1- (deferred costs/deferred revenue)) is 27.5%. It was low since Apple received monthly revenue payments in place of an upfront subsidy as is the case today. 4Q08 comprised of the first quarter of subsidized 3G handsets, thus the bump in GM on the DR/DC on the balance sheet. Notice the non-current GM of 51.9% is 6.5% higher than the 45.3% GM of the current. This results from the non-current bucket comprising of a larger mix of 3G iPhones since much of the legacy (2.5G) iPhones have migrated to the current bucket.

Examining the trend, we can see that GM in the current bucket improves dramatically, at a much faster pace than the non-current bucket. This is due to the mix of new iPhones becoming a larger overall mix in the current bucket, whereas the non-current bucket is already majority of newer iPhone sales. The overall result is than GM are approaching near 60%, which I estimate iPhone GM is currently. This is evidenced by the rising GM Q/Q, especially in the non-current bucket which is impacted more by current sales.

My bottom-up iPhone gross margin estimate is 58.4% for the assumed mix, with the iPhone 3GS 32GB garnering the highest GM and the iPhone 3GS 16GB carrying the lowest of the 3 models.

The Bottom Line:

Deferred revenue as stated on the balance sheet has been increasing substantially. The gross margin attached to this deferred revenue has also increased significantly. Thus, going forward Apple will recognize higher iPhone revenue carrying a higher gross margin. As iPhone revenue as a percentage or share of total revenue increases, the impact of the higher iPhone GM on overall GM will intensify. This will assuage margin pressures Apple faces in other areas.

I wrote last year that the iPhone would cause Apple's overall GM to skyrocket, but I also posited another possibility. Apple would use iPhone GM to subsidize price cuts on other products to stimulate demand and ultimately avoiding an adverse impact on overall GM associated with such price reductions. As we just witnessed, Apple cut prices on its Mac line-up, and there hasn't appeared to be any noticeable impact on overall GM. Going forward, Apple is guiding Q4 GM to 34%, suggesting GM in the 36%-38% range, thus there doesn't appear that these price reductions will have a dramatic impact on its overall GM.

Apple Inc (AAPL): Examining the Prospects of a Low-Cost iPhone

2009-03-05T01:18:00.000-06:00

Apple Inc (nasd:AAPL) For some time, many have speculated about an arrival of a $99 iPhone. Some analysts expect a low-cost model with scaled back features, such as 2.5G instead of 3G, no GPS, and possibly a smaller form factor. While I believe a lower iPhone price point is possible, I don’t expect Apple to go backwards by removing features that reduce device functionality to achieve a lower-cost offering. The price of the handset is much less significant than the lifetime cost of the required $30/month data plan. Therefore, crippling device functionality to lower handset price makes no sense when the primary cost component is the data plan.

I believe if Apple were to pursue reducing the price of the iPhone to the consumer, it should first explore offering alternative pricing that doesn’t necessarily lower selling price and margins. Offering cheaper data plans that coincide with less usage would allow consumers to be able to pay according to usage, rather than being required to pay for unlimited when their usage is actually quite limited. Carriers would apply less subsidy and charge more for the handset, yet consumers would still save over the life of the contract. Carriers would still benefit from increased demand even though ARPU may not be quite as high. Carriers could capture the iPod touch demand that arrises from those who wish to avoid the required data plan.

Low-Cost Model With Less Features- Unlikely:
While unit demand increased dramatically from previous price reductions, ($599 - $399, $399 - $199), I don’t expect unit demand to be nearly as responsive to a $100 price reduction, from $199 to $99. At this price level, demand elasticity begins to evaporate, as consumers are less responsive to further price cuts. At $199, the iPhone is competitively priced, opposed to when it was priced out of the market at $599. The bulk of the pick-up in demand from cutting handset price has already been realized.

Reducing hardware cost is another challenge. Eliminating or scaling back certain features through cheaper or fewer components won’t significantly impact build costs. The obvious modifications that many have cited are removing GPS, 3G baseband, and installing less flash memory for media storage. These actions would likely only lower component cost by $15-$20. Additional cost reductions could be brought about with a smaller form factor, however the savings wouldn’t be great enough to offset the burdens it would create on the software development side.

Perhaps the most crucial aspect is it’s the cost of the service plan, not handset, that is the most costly. The iPhone requires signing a 2-year contract for the $30/month smartphone data plan. Over the life of the agreement, this amounts to $720. For those who currently have a $15/month data plan for a non-smartphone device, the incremental difference over 24 months is $360. However, AT&T offers a bundled unlimited text & data plan for non-smartphone devices for $30/month, instead of $35/month ($15 data + $20 text), which raises the monthly price difference to $20, or $480 over 2 year contract for those affected customers. AT&T subscribers who use a smartphone other than the iPhone wouldn’t pay more since the price of the data plan is the same as the iPhone.

Lowering the iPhone handset price by $100 accomplishes little in the sense of affordability due to the $720 24-month cost of the required data plan. I frequently track online discussion forums (such as AT&T iPhone support) as an informal survey tool. The amount of discussion regarding the iPhone handset price pales in comparison to the required data plan. People tend not to have any problem with the $199 price, but are very vocal about the recurring $30/month for the data plan. In fact, there have been a couple individuals who weren’t adverse to pay $399 since they weren’t eligible for an upgrade, but were inquiring if there were a way to circumvent the data plan requirement. There is little evidence suggesting a $100 price drop will have a profound impact due to the large number of consumers who find the data plan requirement inhibitory.

Reducing the data plan fee, or eliminating the requirement altogether, would have the most substantial impact on demand. The problem with this alternative is that Apple receives a ~$400 subsidy based the higher ARPU generated by the data plan. Therefore, if the iPhone ARPU were to decrease from reducing the price of the data plan, then the iPhone subsidy would decrease as well.

Assuming that hardware costs can be reduced by $50, and the subsidy falls to $200 from $400, gross margin would decline to 33% from 58%. In order for earnings to increase, unit volume would have to rise by a factor of 3.5x.

Assuming a more generous subsidy of $250, perhaps with required $10/month plan, gross margin would only fall to $43%, but volume would have to increase more than 2.3x.

A scenario where a $20/month data plan produces a $300 subsidy, gross margin would only drop 800 bps to 50%, and volume would only have to rise 75% to be cash flow neutral. However, consumers still face an incremental $480 increase from the data plan, which will limit the impact on demand.

Even if the economics of reducing hardware and service costs were to make sense, there are other issues. Crippling device functionality takes away from the user experience, which is the primary focus of Apple products. Substituting 2.5G would significantly worsen web browsing and video streaming.

The tests I have been conducting show iPhone 3G data speeds are currently 7-8x faster than 2.5G. In the months following the 3G iPhone release, speeds were only 2-3x faster than EDGE. Obviously, AT&T has made substantial progress in improving its network, which significantly enhances the iPhone user experience. With many competing devices beginning to offer 3G, a slower iPhone might damage consumer perception and lessen its appeal. The iPhone is designed for heavy internet usage, thus a much slower connection would dramatically lessen the iPhone experience. This move would probably only save $5-$10 in hardware costs.

Removing GPS would only save ~$5 in component costs as iSuppli lists the price of the GPS radio at $3.60, and the impact on user experience would be considerable. Many apps are designed around the user’s current location, which requires GPS to obtain an accurate position. The integration of location services with other iPhone features is a major factor that differentiates the iPhone from other devices. Therefore, without any real cost benefit, offering a model without GPS makes no sense.

Altering the form-factor is another alternative for reducing costs. A smaller device could reduce hardware costs to a degree, yet it would require a relatively large size reduction to meaningfully affect hardware cost. This would pose several challenges. Apps are developed for a specific display size, thus duplicate versions may be required to accommodate different displays. The challenge may be further exacerbated due to input commands being handled by the multi-touch display. Therefore, modification may be needed not just for output, but input as well. In addition, a smaller viewing area would reduce the user experience, and a smaller area for input commands may cause navigation to suffer. To achieve meaningful savings, the handset size would have to be reduced to a point at which the user experience would highly suffer.

I don’t believe there should be any change to the iPhone hardware since potential cost savings are rather insignificant. The only exception would be offering 2.5G models in markets where 3G is unavailable as long as it were accompanied by a cheaper data plan. This might help spur demand in non-3G markets where consumers must pay $30 for 3G service and aren’t even able to take advantage of the faster speed.

Possible Alternatives:
The best course of action would be to offer multiple data plan choices, and adjust the handset price accordingly by applying less subsidy. The consumer would have to pay more on the front-end, yet would save money over the 24 month agreement. A cheaper data plan results in less handset subsidy which would be absorbed by the consumer. Thus, it wouldn’t affect the economics of the iPhone with respect to Apple, yet it would provide flexibility for consumers. If a particular individual plans to use very little data, then he/she could select a cheaper plan with less data usage included. They would pay more for the handset, but would still save money over 2 years from the cheaper monthly cost of the data plan. The savings will come at the expense of AT&T, yet it’s not a real expense, rather the opportunity cost of not receiving $30/month for the unlimited data plan. However, this could be offset (or overcome) with sufficient increase in demand.

A scenario with a $10/month data plan would raise the handset price to $349, a $150 increase, but reduce lifetime service fees by $480. Including the price increase of the device, net savings over 24 months is $330. A second scenario with a $20/month plan for heavier data usage would increase the iPhone price $100, to $299, but lower service fees $240 over 2 years, resulting in net decrease of $140. If an individual pays the extra $100 for the cheaper $20/month plan, and later decides he/she needs the unlimited data plan, the carrier could offer a $25/month instead of $30/month since $100 was collected on the front-end. If one wanted to switch to a smaller data plan, then the handset discount could be recovered from lowering the monthly fee by less than the full amount.

There is one scenario of a low-cost model that I do think is a possibility. Bernstein Research’s Toni Sacconaghi has broached the idea of an “iPod phone” which makes a lot of sense. The premise is that music is moving onto many basic mobile phones which may pose a threat to iPod sales. The concept of a converged device means that users won’t prefer to carry both a phone and an iPod. For those who don’t want an advanced phone with internet capability, such as the iPhone, but want a media player combined with a basic mobile handset, an “iPod phone” would be a suitable match. Essentially, a iPod classic or nano could be married with a basic mobile device that wouldn’t require a data plan. Possibly, it may offer some “widgets” such as stocks and weather, but not email or internet browsing. The sole purpose would to counter iPod defection from those using their mobile phones more and more as a music player. I don’t foresee such a device anytime soon, however it remains a viable possibility down the road.

I do believe a $99 iPhone is inevitable. However, it wouldn’t be a “low cost” model, rather Apple could offer the current iPhone model for $99 in light of an introduction of new advanced models. I expect new iPhone models to arrive this summer, which will have faster processors, and advanced graphics chips that will allow multiple apps to run simultaneously and video capability. There has been an un substantiated rumor that AT&T might buy back iPhones since current 3G owners would be ineligible for a subsidy on a new iPhone model if one were to come this summer. These phones could be sold for $99 or less. AT&T has been running deals for $99 on refurbished iPhones.

Apple’s iPhone Vision:
Management has stated it doesn’t intend making an iPhone for everybody. Apple says it isn’t interested in selling the most units, but rather committed to being the leader in the market segment it prefers to serve. Comments from Apple contradict many pundits and analysts that claim the firm is limiting the iPhone’s potential by addressing such a small portion of the overall mobile handset market. However, Apple is a company that demonstrates patience. Steve Jobs once said rather than crossing a river to get to someplace else, Apple waits for the other side of the river to come to it. The smartphone market is growing considerably, thus there isn’t much reason to stoop down into the basic handset market that will be contracting.

Disclosure: Long AAPL

Apple Inc (AAPL): Snapshot- Apple's Cash Growth

2009-02-23T00:46:00.005-06:00

Apple Inc (nasd:AAPL) $91.21- Here's a quick snapshot of Apple's cash holdings over the past 9 quarters. In the case of Apple, it's extremely important to focus on cash flow opposed to accounting (GAAP) income due to the massive build of deferred revenue on its balance sheet. Total deferred revenue is $9.7B, $7.3B of which is iPhone related. Accounting EPS is often a poor gauge of a firm's actual earning power due to the many ways to legally (and illegally) inflate, obscure, or mislead actual performance. However, all one needs to do is follow the cash. The concept of investing is inserting cash into a vehicle that will return a larger cash amount back in the future. Cash flow, not earnings, best reflects a firm's investment prospects.

Apple's cash holdings swelled from $11.9B (Dec '06) to $28.1B (Dec '08), an increase of $16.2B. In terms of cash per share, Apple reported $31.20/share for Dec '08, and increase of $17.76 from the $13.44/share reported Dec '06. In the last 8 quarters, Y/Y cash growth has averaged north of 50% (per annum).

Just in the past 4 quarters, Apple's cash has ballooned $9.7B from $18.4B. Cash per share has increased more than $4 the past two periods, and last quarter (Dec 08), cash/share rose $10.71 from prior year quarter. What gives this cash holdings data meaning is the comparison to EPS. Apple's TTM EPS is $5.39, but TTM increase in cash/share is almost double, $10.71. Obviously, iPhone sales are responsible for the wide disparity.

Using price multiples as a valuation metric, Apple trades at 17x TTM EPS, but only 8.5x TTM cash/share. That's a massive difference, and many make the mistake of using PE ratios to compare Apple to its peers which is unreliable due to the EPS distortion caused by iPhone revenue referral.

Of course, the market is forward looking, as TTM ratios are less meaningful due to being historical-based metrics. However, the iPhone should continue to exhibit decent sales being a solid product in a growing market segment. This will cause the disparity between accounting EPS and cash flow to continue. Considering that Apple has historically traded at 40-50 TTM PE multiple, valuation is attractive on a long-term investment horizon. In my opinion, the short-term economic challenges are priced-in, but the long-term competitive advantage and earnings power is being ignored. That's the nature of the current mood of the market, and AAPL will probably go lower before it goes a whole lot higher. Eventually, when the economy shows signs of regaining its footing, and investors are comfortable owing stocks again, AAPL will go much, much higher. Downside risk is somewhat limited due to Apple's cash position and strong products that should at minimum, support valuations not terribly too much lower than the current share price.

Yet, risk still exists, and I would imagine shares stay range bound $75-$105. Apple's fundamentals provide strong support, but breaking through resistance above ~$105 and ~$115 will require sustained money flow from cash coming off the sidelines. Hence, participation by institutions and funds that have longer-term investment outlooks. Recently, Apple hasn't been able to sustain any sort of rally off positive news as traders have been quick to take profits, as well as selling/shorting into market weakness and rises of increased pessimism. If/when the equity investor were to return, Apple would be a popular choice at current levels.

More Financial Alchemist Analysis on AAPL

Disclosure: long AAPL

Authentidate (ADAT): Remote Patient Monitoring Presents Significant Opportunity

2009-02-05T21:36:00.005-06:00

Authentidate Holding Corp (ncm: ADAT) $0.27- Authentidate is attractively positioned to benefit from the expected flood of spending aimed at modernizing healthcare IT. Remote patient monitoring, also known as telehealth, is one area where Authentidate stands to capitalize due to its unique and superior product solution. Patient home monitoring is expected to be a $12 billion industry by 2012. ADAT will earn $120M in revenue if it achieves just 1% penetration. This compares to $6M in revenue Authentidate earned last fiscal year. There are a decent number of patient monitoring devices deployed currently, yet very few have actual “telemedicine” functionality, whereby a patient’s vitals are electronically transmitted to the healthcare provider coupled with any patient instructions subsequently relayed back to the patient. According to an InMedica study, there were less than 1 million telehealth subscribers in 2008, yet that number is expected to climb to over 55 million by 2016.

ADAT has 37 cents per share in cash, yet it is not currently profitable. Management expects to achieve cash flow breakeven in the near-term. Although ADAT has been putting up double-digit revenue growth, the slow pace of industry modernization has made achieving Authentidate’s potential elusive. I believe the new telehealth business aspect coupled with government spending and reform will accelerate the pace of revenue traction. My previous ADAT articles are here.

Company Description: (from ADAT 10-k):

Authentidate Holding Corp. (Authentidate or the company) is a worldwide provider of secure workflow management software and web- based services. Authentidate and its subsidiaries provide software applications and web-based services that address a variety of business needs for our customers, including increasing revenues, reducing costs, raising service levels, improving productivity, providing automated audit trails, enhancing compliance with regulatory requirements and reducing paper based processes. Our scalable offerings are primarily targeted at enterprises and office professionals and incorporate security technologies such as rules based electronic forms, intelligent routing and transaction management, electronic signing, content authentication, identity credentialing and verification and web and fax-based communication capabilities to electronically facilitate secure and trusted workflows. Authentidate currently operates its business in the United States and Germany with technology and service offerings that address emerging growth opportunities based on the regulatory and legal requirements specific to each market. In the United States the business is engaged in the development and sale of web-based services largely based on our Inscrybe™ platform and related capabilities. In the United States, we offer our patent pending content authentication technology in the form of the United States Postal Service ® Electronic Postmark ® (EPM). In Germany the business is engaged in the development and sale of software applications that provide electronic signature and time stamping capabilities for a variety of corporate processes including electronic billing and archiving solutions. Our web-based services and software applications are compliant with applicable digital signature rules and guidelines. We sell our web-based services and software applications through a direct sales effort and reseller arrangements. See USPS EPM.

Company & Industry Background:
Authentidate has struggled to gain revenue traction primarily due to the glacial pace of modernizing the IT infrastructure within the healthcare industry. The industry can be characterized as one with excessive “paper pushing” which swells the overall cost of healthcare. Evolving to an electronic document workflow paradigm would significantly reduce costs, errors, and turn-around times. The reason that healthcare has slow to move away from paper records and postal delivery is because the primary players haven’t been appropriately incentivized. HMOs experience the greatest benefits by reducing labor costs and working capital needs, yet those savings hinge on physicians converting to e-document platforms. Doctors have been hesitant to implement technology since the benefits to physicians haven’t been adequately communicated. In addition, physician thinking tends to be revenue-oriented, as opposed to cost oriented, generally solving high or increasing overhead costs with higher billings. Essentially, the thinking focuses on boosting revenue by “how do I charge more,” instead or focusing on boosting the bottom line by reducing expenses. Since patients, or rather customers, only pay a very small portion of their medical bills coupled with the absence fee comparisons and the inelastic nature of demand for healthcare treatment, medical practitioners have considerable pricing power. An individual’s cost for healthcare is pushed off on HMOs, insurance companies, and Medicare, which in turn spread those costs among its base of participants.

Instead of increasing efficiency and eliminating unnecessary costs, doctors can maintain profits with higher and/or additional fees that ultimately raise everyone’s cost of healthcare. As a result, HMOs and insurers have implemented fee caps for certain services and treatments, which essentially eliminates pricing power. However, some medical practitioners will choose not to accept specific types of medical coverage (or insurers chose not to cover specific physicians), or physicians will abandon treatments/services with unfavorable fee reimbursement caps. Even with restrictive fee caps, a physician could increase his/her bottom line from greater cost efficiency/productivity by migrating to an electronic document platform. Not only can overhead costs be reduced, time and other resources can be freed up and deployed for new revenue opportunities. Some doctors spend considerable time attending to office visits based primarily on paperwork issues for approvals and signatures, etc.

In my opinion, the catalyst for widespread migration to modern information technology is the Obama administration. For years, the government has been encouraging electronic medical records and electronic form remittals, but progress has been slow due to the reasons I outlined earlier. However, Mr. Obama’s goal is to have all medical records digitized in five years. According to the NE Journal of Medicine, only 4% of physicians use electronic health-records systems. The economic stimulus bill includes $20B for healthcare IT alone. Authentidate isn’t directly engaged indigitizing health records as it focuses more on the secure processing of electronic medical forms and signatures. However, as the industry migrates towards e-health records, it will become substantially easier for Authentidate to market its IT solutions. Mr. Obama understands the importance of technology and the benefits it provides; one has to look no further than President Obama’s fight to keep his Blackberry as evidence to his commitment to technology. Mr. Obama is also aware of the potential cost savings healthcare IT can deliver, and his ambition to make healthcare more affordable and available to all will require implementing IT solutions such as the ones offered by Authentidate.

Telehealth Monitoring:
According to a SUNY Fredonia 2008 study, the patient monitoring industry is expected to reach $12 billion by 2012. Authentidate entered into a joint venture with EncounterCare forming ExpressMD, which uses EncounterCare’s Electronic House Call patient monitoring appliance with Authentidate’s Inscrybe web-based software platform. The combination allows physicians to remotely monitor their patients’ vitals and adjust treatment accordingly. The benefits are immense. The patient receives higher quality care since the increased amount of data available provides better diagnosis and treatment. In addition, the monetary savings are substantial due to the reduction in doctor office/emergency room visits. Several studies have suggested telehealth monitoring can reduce healthcare related costs by at least 50%.

Patients visit their physician several times a month, or even a week, just to have their vitals taken. HMOs cap physicians billing at $137/month for this type of service. Thus, no matter how many times any one individual visits his/her physician’s office to have vitals taken, the attending doctor will take in no more than $137. This results in these types of visits using a disproportionate amount of a physician’s resources that aren’t proportionally monetarily compensated. In addition, it is estimated that the average monthly transportation billing for these types of patients is $527. Telehealth home monitoring reduces transportation costs by 80%. Due to the transportation cost savings, as well as other associated expense reductions, HMOs permit physicians to bill at $199/month if patient is on a telehealth home monitoring program.

Incentives for adopting remote patient monitoring exist for all major parties- patients, physicians, and insurance providers. Doctors can take in more revenue with less office visits. This frees up office space, time, and other resources for treating other patients, hence increased revenue opportunities. Thus, it’s not just the extra $62/month that doctors can generate with telehealth, it’s also the opportunity cost of lost revenue from office visits that can be recaptured with home monitoring.

Telehealth Monitoring Business Economics:
According to my sources familiar with the JV agreement, EncounterCare and Authentidate split the $30/month revenue (per device) 50-50. Authentidate earns an additional $8/month for services provided through its Inscrybe platform. This brings Authentidate’s revenue to $23/month. Yet, Authentidate can charge $50/month to third parties, such as pharmaceutical and medical research companies for access to data reporting. According to a source, a research group in Florida has implemented 2000 units thus far. Drug companies and researchers can measure the efficacy of their products being used in treatment, since patient vitals data can show the response to such treatment.

ExpressMD™ Solution (from company website):

The complete ExpressMD solution combines Electronic House Call™, an advanced in-home patient vital signs monitoring system with a web application that streamlines the practitioner’s job anywhere they have Internet or a Windows mobile communication device. The in-home portion includes the latest in simple-to-use monitor devices for unassisted patient vital signs measurement as well as question-and-answer mode for manual input. The self-contained home unit is perfectly suited for patients that require repeated assessment and reminders of their care plan schedule while practitioners can easily monitor patient progress remotely. Patients can review their own vital statistics history or even view and order products specific to their condition that support their care plan.

This proven system improves overall care outcomes for patients with chronic illnesses such as COPD, CHF and Diabetes. It delivers better continuity of care for elderly or special needs patients, as well as many others with chronic illnesses such as chronically ill pediatric patients. Patients using the ExpressMD in-home monitoring system have shown dramatic improvements in medication and therapy compliance. The overall effect produces significant reductions in the overall number of physician office visits, emergency room visits and hospital readmissions.

It provides intelligent routing to alert on-duty caregivers whenever patient vital signs are outside of the practitioner pre-set ranges. Parameters are set to automatically route to caregivers based on patient specific needs, payer preference and location. In addition, care providers can remotely access the system from Windows communications devices, delivering true portability of care management.

Some of the additional services available to the ExpressMD solution by adding Inscrybe™ Healthcare are: verification of physician and practitioner credentials allowing online input, review, update and electronic signature of medical documentation such as prior authorizations, care plans and physician orders. With this option, practitioners can customize a care plan for each patient based on their vital signs history that optimizes therapy results and improves patient quality of life. There is an online diagnosis and treatment library for physicians or practitioners. Additional services for physicians like the Care Plan Oversight module to support allowable reimbursement reporting and online entry of physician orders are also available.

ExpressMD Joint Venture Press Release (June 10, 2008):

The joint venture called ExpressMDTM Solutions will provide in-home patient vital signs monitoring systems and services to improve care for patients with chronic illnesses and reduce cost of care by delivering results to their health care providers via the Internet. ExpressMD Solutions will combine EncounterCare's Electronic House CallTM patient vital signs monitoring appliances with a specially designed web-based management and monitoring software module based on Authentidate's InscrybeTM Healthcare platform. ExpressMD Solutions will enable unattended measurement of patients' vital signs and related health information. Patients' data will then be securely sent electronically to each patient's health care provider for review. ExpressMD Solutions will be designed to aid wellness and preventative care, and deliver better continuity of care to specific patient segments such as the elderly, special needs or pediatric patients with chronic illnesses who require regular monitoring of serious medical conditions.

According to a January 2008 research study conducted at the State University of New York at Fredonia, the demand for patient monitoring systems in the primary healthcare sector in the United States is forecast to increase 5.9 percent per year to an estimated $12 billion market by 2012 based on expected contributions to positive therapeutic outcomes and efficiencies. Additionally, the study indicates that the market for self-monitoring activities will also expand as treatment for chronic care patients, especially patients with asthma, diabetes and heart disorders focuses on preventative care.

Using ExpressMD Solution's offerings health care providers will be able to easily view their specific patient's vital statistics and make adjustments to the patient's care plans via the Internet. ExpressMD Solution's easy to use patient monitoring system is intended to provide patients with increased peace of mind and improved condition outcomes through a combination of care plan schedule reminders and comprehensive disease management education on their in-home communication unit. The service will provide intelligent routing to alert on-duty caregivers whenever a patient's vital signs are outside of the practitioner's pre-set ranges.

Health care providers and health insurers also are expected to benefit by having additional tools to improve patient care, and reduce overall in-person and emergency room patient visits. "EncounterCare's expertise with in-home patient monitoring technologies and Authentidate's expertise in online healthcare systems and securely managing patients' documents has allowed us to shorten the development cycle and ready this solution for delivery in record time," said Ron Mills, CEO of EncounterCare Solutions, Inc. "The ExpressMD Solutions joint venture will allow Authentidate and EncounterCare to leverage existing portions of our respective healthcare products as well as existing healthcare industry relationships from both companies," said Ben Benjamin, President of Authentidate Holding Corp. "The telemedicine market is a large market that we believe will benefit from our document management capabilities. By entering this market through a joint venture, we will be able to strongly penetrate an emerging market, while expanding the use of our platform within the health care community.

ExpressMD Signs First Contract with Cyntrist:
On July 8th 2008, it was announced that Authentidate and EncounterCare had signed their first user contract with Cyntrist, for use in remote monitoring of Diabetes patients located through out the Southeastern U.S. The opportunity in the Diabetes space is colossal. In a recent study, the CDC reported that 24 million Americans (8% of population) are afflicted by Diabetes, a number which has increased by more than 3 million in just two years. The ExpressMD solution provides physicians with the ability to remotely monitor patients’ glucose levels, weight, etc. on a daily basis and adjust treatment as needed. Not only does this enhance the quality of patient care, it reduces the need for regular office visits, thus reducing the cost of medical care. The advantages are compelling, and with such a large addressable market, ADAT may benefit substantially.

Authentidate Outlook:
Using a conservative projection of the industry achieving $6B in 2012, Authentidate stands to capture at least 3%. This equates to roughly $200 million in annual revenue. Assuming 70% margins, EPS would be slightly less than $4.00 given the $105M+ tax-loss carry forward. Due to the degree of operating leverage in the revenue model, profit margins could be considerably higher, and expand with volume due to increasing returns to scale. Using the same margin assumptions, but a $12B market with 5% capture, ADAT would earn over $9.50 per share. The potential is staggering. However, just assuming a 1% capture of a $6B market would produce EPS of $1.00. Assigning a 15X multiple gives a $15.00 share price, or 55X current share price.

Conclusion:
The reason that ADAT shares trade at such a low price, below cash, is due to the lack of investor awareness of the massive revenue opportunities. As evidenced by the scant daily trading volume, and the lack of participation in online discussion forums and conference calls, very few investors follow ADAT. Many that did, abandoned ADAT years ago when the company was rapidly burning though cash without much promise of increasing revenues. Authentidate has been bringing its cash burn under control, down to $1.5M last quarter compared to cash burn of $4-5M per quarter in earlier periods. In the last two quarters, revenue growth for the U.S. business has averaged more than 50%. As the speed of IT adoption in the healthcare industry accelerates, revenue growth could increase to 5000%. As I have said in earlier articles, the Authentidate’s primary challenge has been the industry’s slow pace to modernize. The new administration along with increased spending and reform, will expedite this transformation. Health benefit providers are beginning to incentivize doctors to adopt cost saving solutions such as the ones offered by Authentidate. I believe it won’t be long before Authentidate’s offering gain meaningful traction.

Disclosure: Long ADAT

Apple's FY09 EPS Estimate Too Low

2009-01-10T18:16:00.009-06:00

Apple Inc (nasd: AAPL)- Apple’s FY09 EPS estimate continues to be revised downward and now stands at a $5.08, a level Apple should easily exceed. The consensus FY09 estimate represents a 5.2% decline from FY08 $5.36 EPS, although revenues are forecasted to increase 11.8%, or $3.8B to $36.3B. Thus, analysts are expecting significant margin compression. Specifically, the consensus estimates for EPS and revenue imply net margin will be 12.8% in FY09, a decline of 2.1% from 14.9% recorded in FY08.

It’s not that I don’t believe the recession will take a major toll on Apple, it will. Instead of achieving 35%-40% earnings growth likely to occur in a normal economy, Apple’s EPS should increase at least 5%-10% in FY09. Due to deferred revenue recognition and upward margin pressure, it’s very unlikely Apple’s earnings will decline, certainly not to the 20%-30% magnitude some analysts predict.

I believe there are two major factors being ignored with respect to FY09 estimates that suggest higher earnings. First, there are multiple factors in play that argue against margin deterioration. This includes lower product and overhead costs, and a more favorable sales mix towards high margin products. iPod revenue (as percentage of total sales) will be much lower in FY09 which is significant since iPod has the lowest margins. iPhone and software have the highest margins and will contribute a much larger portion of Apple’s total revenue.

Second, Apple will recognize a sizable amount of deferred revenue associated with high margin segments, such as iPhone and AppleCare. Also, Apple’s $25B cash position will produce a decent amount of income. Thus, without even having to make a single sale, Apple should still produce $2.67/share in incremental after-tax income.

Assuming 19M iPhone unit sales, incremental taxed EPS for iPhone segment would be $2.99/share. Combining deferred revenue, interest income, and iPhone sales; I estimate incremental EPS will be $4.04. Apple would only have to earn $1.04/share in its other segments to meet the FY09 consensus.

According to Yahoo Finance, the lowest estimate for FY09 is $3.70 (High- $6.00). I have been seeing many estimates being revised down to the mid-to-low $4 range. In my opinion, these estimates are ridiculously low. Canaccord Adams puts FY09 EPS @ $3.70 (31% decline) with an $80 price target and Morgan Stanley’s FY09 estimate is $4.37 (18.5% decline) with price target of $95.

PROFIT MARGIN OUTLOOK:
I recently did a detailed analysis of Apple’s profit margin outlook and concluded that FY09 gross margin expectations are too low. I highlight some of my main points below.

-Favorable Cost Environment:
All of the factors listed below should lead to lower costs, hence higher margins. At the least, provide margin stability by eliminating upward pressure on costs. Considering most of FY08 was marked by a commodity bubble and $100-plus crude, FY09 should be a much more favorable cost environment.

1) Raw Material / Component Prices
2) Energy- Transportation / Overhead
3) Occupancy / Labor (stable)
4) Marketing
5) Scale Benefits & Shared Costs

-Margin Expansion From Increased iPhone Revenue:
The primary driver for higher margins for FY09 is iPhone revenue. The iPhone generates substantially higher margins than the Mac and iPod segments. Due to the subscription accounting whereby iPhone sales are recognized over 8 quarters, the margin effects were minor for FY08 since only $1.84 Billion of iPhone revenue was recognized. This equates to roughly 5.7% of Apple’s total FY08 revenue.

Most analysts and myself included, expect iPhone revenue to come in above $7B for FY09. Not only will the iPhone supply more than 20% of Apple’s total sales (FY09), the subsidy payment agreement of the new 3G model translates into even higher margins compared to the legacy iPhone. I calculated that the gross margin of the new 3G model was 55% in 4Q08.

If Apple recognized iPhone revenue in the period sold, instead of deferring, 4Q08 gross margin would have been 39% compared to GAAP 34.7%, net margin would have been 20.9% vs. 14.4%, and EPS $2.69 vs. $1.26. As deferred revenue continues to pile up on the balance sheet, the portion recognized in current quarterly revenue will continue to increase each quarter.

-Other Margin Drivers:
There are several other factors that could aid profitability this year. First, software revenue, which has huge margins, will be much higher in FY09. Apple is releasing new iWork and iLife editions, and it’s expected to release Mac OSX 10.6 “Snow Leopard” this year. MobileMe also carries high margins, yet even though revenue won’t be much, the yr/yr incremental will be sizable. Second, Apple will incur and recognize more of its high margin AppleCare revenue.

Looking at operational expenses, such as SG&A and R&D, these items should fall on a percentage basis (of total sales) due to leverage effects if sales continue to increase as expected. Looking at the table one can see the trend in declining operating expense and rising profit margins.

The other side of the margin equation is selling price. Margin compression can still occur even while costs are decreasing if selling prices drop more. Apple’s brand is unique and it products command premium prices. Apple’s products are highly differentiated which eliminates price competition. I don’t expect Apple to make drastic price reductions. I recently explained why Macs sell at premium ASPs.

SALES OUTLOOK:
The Street is expecting sales to increase 11.8%, or $3.8B to $36.3B (FY09) vs. $32.5B (FY08). By default, Apple’s sales will increase $3.5B from recognizing 4.85B in current deferred revenue. Apple will also take in around $400 million from iPhone carrier payments and $650 million in investment income. Thus, even with out making a single sale in FY09, Apple will still post nearly $6B in revenue.

Total FY09 iPhone revenue will likely increase by at least $5B, implying Apple’s other revenue is expected to decline if consensus sales growth is $4B. Most analysts expect iPod revenue to drop significantly, coupled with either a slight increase/decrease in Mac sales. I see iPod unit sales declining 25%-30%, but iPod revenue only dropping 15%-20% due to the shift towards the higher ASP touch model.

-iPhone:
According to my estimates, Apple will report iPhone FY09 sales of $7.0B, $3.1B originating from new sales, and 3.9B from recognition of deferred revenue and carrier payments. This assumes Apple sells 19M units. With 56% gross margins, iPhone will contribute $2.99 in EPS. Hence, all other segments only need to earn $2.09/shr to meet the Street’s estimate.

I estimate only 60 cents of $5.36 FY08 EPS is associated with iPhone, which leaves $4.76 from all other segments. This means FY09 non-iPhone EPS could decline 55% or $2.67 to $2.09 and match the $5.08 consensus if iPhone can pull in $2.99/share.

-Mac:
With new MacBooks released in Q1, and new desktops expected in Q2/Q3, FY09 Mac sales should continue to grow despite the weak economy. MacBook hasn’t seen a redesign since being released in 2006. This has provided little reason to replace/upgrade. Looking at unit sales growth, it is evident that the product line had become very tired and in need of a refresh as growth began to lag desktops. There are probably 5M MacBooks that may be replaced in the coming year.

Mac revenue has grown roughly 40% for the past two years, and under favorable economic conditions, I would expect growth to continue if not exceed that pace. Given the harsh economic conditions, I expect single-digit unit growth for FY09.

-Pod:
Unit sales will probably see a sharp decline in FY09 due to the economic landscape and product saturation. The iPod touch model will be popular causing unit sales to exceed forecasts. In addition, the touch will boost ASPs, which will soften the decline in dollar sales.

-Music & Software/Services:
Music segment revenue increased 34% to $3.34B in FY08. Music sales will continue to demonstrate strong growth due to the direct placement of the iTunes music store on the iPhone and iPod touch allowing purchases/downloads in seconds over cellular and Wi-Fi network connections. The iTunes App store could add up to one billion in additional sales this year.

Software sales could get a billion dollar boost from iWork ’09, iLife ’09, Snow Leopard, and MobileMe plus other titles. Typically software delivers high profit margins, thus these software introductions should offer margin support.

CONCLUSION:
When considering the amount of high margin deferred revenue and interest income Apple will recognize this year coupled with multiple drivers lending margin support, it’s unlikely Apple’s earnings will fall in FY09. Apple won’t earn $7 to $8 in EPS possible in a favorable economic climate, but EPS won’t decline as analysts predict.

Apple already has $2.67 in incremental EPS in the bag. Including my estimates for new iPhone sales, the incremental EPS effect is $4.04. Considering SG&A and R&D expense, I estimate that EPS from deferred revenue recognition, interest income, and iPhone sales will be $3.43. Adding Mac, iPod, and all other segments, EPS will easily top the $5.08 concensus.

Disclosure: Long AAPL

Apple Inc (AAPL): Taking a Look at Mac Pricing

2008-12-19T18:24:00.004-06:00

MAC DEMAND CONCERNS:
For past couple months, Wall Street’s concern du-jour for Apple has been Mac demand. No PC/consumer electronics firm is immune to this economic downturn, but many analysts believe there is substantial downside risk for Mac sales. Analysts claim the contracting economy is causing changes to the complexion of industry demand that could have further negative implications for the Mac segment. Specifically, the slowdown in consumer spending will cause industry demand to contract, and within the computer industry, demand will shift away from Mac to lower-priced PCs. This double-blow presents a considerable threat that Mac sales will come in way below expectations. Some argue the popularity of netbooks and other low-price PCs present a major challenge for Apple since Macs’ price points encompass the high-end of the spectrum. Thus, Apple lacks a low-price offering within the price range where demand has been and will continue to be strong.

Given the pullback in spending and the shift to lower-priced PCs, analysts have been calling for Apple to introduce a cheaper Mac to become more competitive. Many were expecting just that when Apple unveiled its new MacBooks last October. Missing from the event were price reductions. The legacy white plastic, low-end MacBook received a $100 price cut ($1099 $999), but the mid-range model’s price ($1299) was unchanged, and the high-end MacBook price increased $100 ($1499 -> $1599). This was a disappointment for those who were expecting price cuts of $200-$300, at minimum.

There was ample speculation for Apple’s Black Friday discounts. Most analysts/journalists were predicting larger than usual discounts, 15% compared with Apple’s typical discounts of 5%-10% from previous years. However, Apple offered modest discounts that were inline with its previous Black Friday promotions. Some were disappointed, notably Shaw Wu of Kaufman Brothers: “We would have hoped that with its nearly $25 billion net cash position and very favorable component pricing environment, that Apple would have taken slightly more aggressive action on pricing given that consumers are still hurting from the tough credit environment.” Ben Reitzes of Barclay’s Capital says “like to see Apple get more aggressive in terms of pricing.” The crux of the matter is that if Apple believed steeper discounts would significantly lift demand then it would have cut prices more aggressively.

Aside from the Mac Mini and legacy plastic MacBook (October price reduced to $999), Apple doesn’t offer a sub-$1,000 model. In September, Kathyrn Huberty at Morgan Stanley cut her price target on Apple citing slowing global PC sales. The next Monday, Huberty cuts her rating on Apple, and slashes her price target to $115 from $178 based on the concern that “PC unit growth is decelerating and the remaining source of growth is increasingly in the sub-$1000 market where Apple does not play.”

According to NPD, Apple had 66% market share for the above $1000 price category, and 14% overall. In an August 2008 NPD study, Apple’s market share for the past 12 months in the above $1500 price segment was 69%, up from 41% in the August 2007 survey.

Huberty points out that revenue for the premium segment has been declining (y/y) every month since the winter, and that the sub-$1K market’s revenue has been growing. She concludes that consumer demand is shifting to the low-end, where Apple does not have a presence. In addition, Huberty claims Apple is at risk because it’s highly exposed to the premium-end, where demand has been falling. However, Mac unit sales grew nearly 40% for 2008, and its share in the premium segment almost doubled. Mac sales have been growing roughly 3x the market.

Therefore, it’s Windows PC demand that is shifting to the lower-end.

If the overall industry is trending to lower price points, how does Huberty reconcile the sub-trend of increasing Mac demand, which is mostly confined to the premium segment? If Mac demand runs counter to the premium segment’s overall trend, one can’t make the assertion that there’s a strong correlation. There is a convincing relationship between ASP and growth for the industry, but not for Macs. The PC industry is comprised almost entirely of Windows PCs, thus demand for Windows machines determines industry demand. In short, Macs and Windows PCs are not similar product offerings. Some analysts, notably Huberty, appear to conflate the two. Macs are Windows machines, for one can install Windows OS on Mac hardware and use it just as if it were a Dell or HP. But, PCs such as Dell and HP can’t run Mac OS.

MAC VS WINDOWS HARDWARE:
The reason why demand has shifted towards cheaper PCs is because of substitution. A $1500 Windows PC may not be noticeably different from an $800 machine for most users. With economic fears engulfing the consumer, a less expensive PC still can do everything that a higher-end PC does, albeit with less performance. However, many consumers are not heavy users where such a difference would be detected. Even so, for most users, less performance can be tolerated. Therefore, the question is “What more do I get from spending more? What I am sacrificing by spending less?” For many, the answer is “nothing.” In short, there isn’t much difference. The consumer isn’t going to pay more if he/she doesn’t have to, especially in a tough economy.

Windows machines increasingly compete on price, and price alone. PCs have become commodities; there is little, if any differentiation among hardware manufacturers, especially desktops. Essentially, the sole proprietary aspect of a Windows machine is the brand name; most of the hardware components are sourced from 3rd party manufacturers. Whether it’s Dell, Gateway, HP, or Sony hardware makes little-to-no difference.

I understand why consumers aren’t paying-up for Windows PCs. How are HP, Dell, Acer, Toshiba, etc different from each other if they all use Intel chips, run Windows, and have many other of the same components? Consumers don’t see the value in paying a higher price for a Windows PC versus another. For a significant portion of consumers the main purpose of owning a computer is internet/email access, as well as ability to create documents. Any computer accommodates those needs, thus for many, price is the most relevant attribute. I believe this is the driving force behind netbook popularity. Many consumers desire a computer capable of performing basic tasks, such as email, internet, etc. Netbook CPUs are low-powered, and are not suitable for heavier usage, such as graphic intense games or spreadsheets containing complex formulas.

Consumers perceive less differentiation among Windows hardware, thus they are more likely to select whichever brand offers the best price for the desired configuration. Consumers are not necessarily shifting to cheaper PCs solely based on price. Consumers trade down because there isn’t sufficient value-added to justify paying a higher price.

Conversely, there is a stark difference between spending less for a Windows PC (or any amount) opposed to buying the higher-priced Mac. Mac OS X and the associated user experience are significantly different from Windows. Hardware isn’t the differentiating factor; it’s the OS. PCs are not substitutes for Macs. People who desire Macs have to spend more, but those who don’t care for Macs don’t have to pay the high prices due to the availability of less expensive Windows machines. Consumers desiring Windows OS don’t purchase Macs to exclusively run Windows since it would be a waste of money. Consumers purchase Macs for the value-added benefits supplied.

The robust growth in Mac sales demonstrates that consumers are willing to pay more for Macs. Mac’s 70% share of the premium segment suggests that Macs are essentially the only computers for which consumers are willing to pay up. Windows PCs can’t compete in the premium segment against Apple. Premium Windows PCs can’t even compete against lower-priced Windows PCs. Since Macs run Windows (many say Windows runs best on Macs), PCs don’t provide any value-added benefits over Mac. Thus, to create value to the consumer, PC hardware firms cut prices to make their machines relatively attractive. Since the Mac offers Windows OS plus Mac OS, it provides additional benefits that command a premium price.

PC prices have come down a great deal, and continue to fall. However, Mac ASPs have been relatively flat since 2003 (~$1500). It should come as no surprise that Apple’s GM has risen from 26% to 35%, while Hewlett-Packard and Dell have seen their margins shrink. Where are these analysts getting the notion that cheap netbooks will pressure Mac sales when notebook prices have been relatively cheaper for years?

APPLE’S MAC SALES STRATEGY:
The two main reasons why consumers buy a Windows PC instead of a Mac are 1) Unaware of added benefits 2) Aware of added benefits, but assign little value preferring a low benefit package at cheapest price, i.e. price-sensitive. For many, they choose a Windows machine because it’s cheaper. Consumers would pay more if they believed the incremental value added exceeded the incremental cost. Many are unaware/unfamiliar of the incremental value the Mac provides, thus Apple’s primary goal is to inform consumers most likely to perceive added-value.

The primary challenge facing Mac growth is educating the market about Mac benefits. Due to Apple’s tiny market share, its growth potential is massive. At the start of the decade, Apple’s share was roughly 1%-2% and will likely reach 10% by decade-end. The major catalysts to share growth have been the iPod, iPhone, and Apple’s retail store strategy, which have increased Mac curiosity and awareness. For the past couple years, Apple has been reporting that more than 50% of retail Mac sales are to new Mac users. This is no surprise since Mac sales have outpaced the industry by a factory of three (3x).

Remember that Apple’s share of the computer market has been in the low single digits throughout time, only in the last several years did Mac sales takeoff. Therefore, most haven’t used or possibly seen a Mac in the wild. With little or no Mac experience, an individual would have difficultly to justifying the higher price. In addition, consumers don’t actively seek to acquire more information on products that are relatively more expensive. One has to spend more time and effort learning about a product that costs more and ultimately may not be suitable or worth the price. Therefore, expensive, less-known products experience greater difficulty in making the short-list of a consumers consideration set for a given purchase decision. Apple believes its Macintosh provides a superior computing experience. There is evidence supporting that claim as Apple earns the highest satisfaction ratings and gets the best reviews from industry pundits. So, it’s more about informing consumers that its product is the best than it is making its product the best.

Apple leverages the popularity of its iPod and iPhone to heighten attention for Mac. These gadgets arouse curiosity and interest about the Mac, as well as driving traffic to its stores where consumers can experience Macs first-hand.

MAC PRICING STRATEGY:
Since Macs are highly differentiated and offer features/benefits unique to its brand, Apple is afforded significant pricing power. Apple believes since it offers a premium product it should charge a premium price. Exploding demand for Macs seen in the past several years demonstrates that consumers justify paying a higher price (relative to PCs) for the extra value/benefits unique to Apple. Apple believes that there are many potential consumers that would share the same opinion if they were more knowledgeable about Macs.

Cutting prices does little to advance product knowledge for the uninformed consumer. Macs would still be pricier, and the consumer still wouldn’t know why. Thus, reducing Mac prices wouldn’t boost substantially boost demand. Many analysts miss this point. Amazon’s best selling notebooks are all within the $350 - $600 price range. If Apple cut the price on the $1299 MacBook to $1000 or even $800, it’s still more expensive than the more popular, cheaper notebooks. The $999 legacy white plastic MacBook has been less popular at Amazon than the $1299 new aluminum MacBook. There is a bifurcation in the computer market- 1) consumers seeking lowest price 2) consumers seeking value-added. The former are buying netbooks and the latter are buying Macs. If price were as significant an issue as analysts claim, then the $999 MacBook (actually $910) wouldn’t be ranked #15 behind the $1299 MacBook ranked #7.

I believe it’s not the size of the price differential versus the amount of added benefits that is in question. To clarify, it’s not that consumers don’t believe that the higher price of Macs aren’t justified by their unique features, it’s that consumers aren’t aware or don’t care for Mac features. Those who are price-sensitive and seek bare-bones machines are a waste of Apple’s time to pursue.

Apple would have offered larger discounts (as analysts were predicting) on Macs for its Black Friday sale if it thought lower prices would materially affect demand. Unit sales wouldn’t increase very much, but dollar revenue would decline (lower ASPs) when customers are willing to pay the higher prices.

Apple still has an abundance of potential consumers willing to pay premium prices for a computer that Apple has not yet penetrated. It is these consumers that Apple is chasing, the mid to high income demographic, which are less price-sensitive and receptive to a product that offers value-added benefits. Generally, these consumers understand that “one has to pay more to get more,” and that if a product is cheap, “then it’s cheap for a reason.” In addition, sometimes saving some bucks might result in owning a product that is unsatisfactory, or possibly worthless. In these circumstances, one often is forced to make another purchase since the original product was a dud. Thus spending the extra cash, on the margin, makes the most economical sense. In essence, by spending more, one may be actually be paying less considering the long-term costs and product life.

On the 4Q08 conference call (from Seeking Alpha), Steve Jobs remarked: “There are some customers which we choose not to serve. We don’t know how to make a $500 computer that’s not a piece of junk, and our DNA will not let us ship that. But we can continue to deliver greater and greater value to those customers that we choose to serve and there’s a lot of them. And we’ve seen great success by focusing on certain segments of the market and not trying to be everything to everybody. So I think you can expect us to stick with that winning strategy and continuing to try to add more and more value to those products in those customer bases we choose to serve.”

APPLE’S CHALLENGES:
The economic turmoil presents a significant challenge for Apple. As I mentioned previously, it’s not consumers that normally would buy a Mac trading down as some analysts suggest. Consumers either want the added benefits Macs provide, or they desire the basic functionality of Windows OS PCs. If one wants a Mac, then there are no other alternatives; Macs can’t be substituted by Windows PCs opposed to the substitutability of cheaper Windows PCs for more expensive Windows PCs.

The recession won’t cause cheap Windows PCs to take sales away from Macs, instead it will slow the rate that Macs take share from PCs. The higher-end consumer that Apple targets is less sensitive to the economic cycle, yet not immune. Consumers are less receptive to learning about/trying out unfamiliar products, as their mood to spend is subdued. During periods of rising asset prices, the wealth effect reduces the threshold for capturing a consumer’s attention and subsequently closing a sale.

I eventually expect Apple to address the popularity of the netbook segment by introducing a computing device in a tablet form. I imagine it will be something similar to the iPod Touch, yet with more power and viewing area. It will offer the same functions that consumers look for in a netbook, yet the form factor will be different.

CONCLUSION:
The popularity of low-priced PCs stems from the lack of added value for pricier Windows computers, rather than the inability/unwillingness to spend more for a computer. Lower prices are driven by the intense competition among Windows PC manufacturers whereby the primary differentiating factor is price opposed to other value-added benefits. The fact that Mac demand growth (which sell at higher entry price points) has been much higher than the industry indicates that Macs don’t compete on price, but rather features/benefits.

It’s incorrect to assert that Mac sales growth is vulnerable to netbooks or cheap PCs. The real challenge facing Apple in this rough economy is attracting new users and enticing current users to upgrade/replace. New models, the expansion of the retail store footprint, the halo effect from iPod/iPhone, and positive word of mouth are the primary driver in sustaining Apple’s Mac sales.

Disclosure: Long AAPL

Calculating Gross Margin for Apple's iPhone (4Q08)

2008-11-17T20:57:00.006-06:00

APPLE INC (nasd:AAPL) According to my calculations, deferred revenue booked from Q4 iPhone sales carries a 55.5% gross margin. Gross margin on the deferred revenue (DR) booked from the first generation model averages about 29%. The average gross margin for total booked DR is 47.8%.

I derived this number from the “deferred expense under subscription accounting“ that Apple disclosed in its annual filing (10-K) in conjunction with the deferred revenue (under subscription accounting) also reported. I used some rather extensive math to come up with the 55.5% number which I discuss below.

Apple’s ”Non-GAAP“ figures it provided for Q4 implies that 3G iPhone GM was 47.8%. According to the 10-K, GM for iPhone deferred revenue not yet recognized in income is also 47.8%. Coincidence? Not likely. Since the deferred revenue carried on the balance sheet includes both the original and 3G models, that GM should differ from the GM implied by Q4 Non-GAAP numbers that solely comprise of 3G unit sales. We know that the GM on the 3G model is much higher than the first model.

So why is the GM according to Apple’s Non-GAAP figures the same as the GM derived from the 10-K? Apple included estimated future warranty expenses in the adjusted cost-of-goods sold (COGS), which inflates Non-GAAP COGS and understates GM. The amount of estimated expense is at Apple’s discretion. In my opinion, Apple overstated the Non-GAAP COGS adjustment for the sake of conservatism, but also to obscure the true iPhone GM. Normally, under GAAP accounting (subscription), Apple recognizes iPhone warranty expenses as incurred. However, Apple added its estimates for future warranty liability into the COGS adjustment, and I believe management was very conservative.

The gross margin on the iPhones sold in Q4 that will be recognized over the coming seven quarters is 55.5%. There will be some warranty expense incurred, yet I expect it to be relatively small. It’s likely that most of the warranty liability is incurred during the period sold. If a unit is defective, the problem usually surfaces shortly after it’s purchased.

I estimate the normalized gross margin is even higher, possibly north of 60%. Thus, iPhones sold in 1Q09 and beyond will carry higher GMs, assuming ASPs remain constant. iPhone GMs for Q4 were abnormally compressed due to elevated shipping costs, adapter recall, and other various expenses related to the global introduction of the new 3G model.

Gross Margin- Non-GAAP Reported Q4:
For the first time, Apple provided adjusted figures showing the actual iPhone sales/income earned in the quarter. Until Q4, Apple always gave the GAAP numbers that uses subscription accounting for iPhone sales. Instead of recognizing the actual revenue earned for the quarter, it is spread over 24 months and amortized on a straight-line basis. Using normal accounting methods, total revenue would have been 3.787B higher, or 11.682B. Cost of goods sold (COGS) increases 1.975B to 7.161B. Overall gross margins improve from 34.7% (GAAP) to 39.0%, which equates to a 47.8% GM for the iPhone adjustment ([revenue adjustment - COGS adjustment] / revenue adjustment).

However, the 47.8% figure is not the true iPhone GM. First, the adjustments include AppleTV sales, yet that amount is believed to be quite small relative to the iPhone, thus the effect is probably very minimal. Second, and most important, is that Apple included the estimated warranty costs for over its full life in the COGS adjustment.

iPhone Gross Margin- Deferred Revenue/Costs Reported in 10-K:
Without knowing the amount of deferred iPhone cost booked in a quarter, it’s impossible to calculate iPhone gross margins. Apple’s quarterly filings discloses the iPhone portion of deferred revenue which is reported was a liability on the balance sheet, but Apple never broke out the iPhone related deferred costs that is included in an asset account. The actual amount of iphone revenue earned in a quarter can be determined by adding the change in DR account (+) the amount of iPhone revenue recognized in income. To find the actual product costs, we need the change in deferred costs. In its annual filing, Apple disclosed the amount of iPhone related deferred cost on the books at the end of Q4, but we don’t know the Q3 number.

Using the DR & DC at year-end, an average GM (of all iPhone sales) can be found. At year-end, Apple had $5.78B in DR and $3.02B in DC on its books, which translates into a 47.8% gross margin for all the iPhone sales still be amortized. Since Apple gives the figures for current (less than 1yr) and long-term accounts, we can gain additional insight into iPhone margins. For the iPhone sales that will be recognized within a year, the average GM is 45.1%, and for the non-current portion, the GM is 51.9%.

The reason for the 7% difference is due to 3G sales, which carries a much higher margin than the original iPhone. Almost all the non-current DR & DC is related to the 3G, since iPhones sold in 4Q07 & 1Q08 have moved from the non-current to current bucket. Only a small portion of Q2 sales would be left in non-current, and Q3 sales were low, thus the figures classified as non-current are almost entirely associated with 3G sales. The actual percentage of 3G models can be estimated from the change in DR from Q/Q compared to the actual ending balance. Current DR increased 2.129B to 3.518B, which means 60.5% of current DR is from 3G. Long-term DR increased 1.63B to 2.62B, but the actual amount of 3G classified as non-current is higher because of the portion of legacy iPhone revenue recognized for the quarter. I estimate that 320M of DR was recognized in Q4. Roughly 86% of non-current DR is from 3G sales.

Actual 3G iPhone Gross Margin Calculation:
With the figures for (1) average GM for both current and long-term [45.1% / 51.9%], and (2) the percentage of units which are 3Gs for both classifications [61% / 86%], I solved for the “true” 3G iPhone gross margin by setting up 3 simultaneous equations. The goal is to find the GM number (for both the 3G units and the legacy units) that produces the same combined gross margin for all three classifications (current, non-current, total). As I mentioned above, I solved for the percentages or “weights” of each model represented in the amount of deferred revenue reported on Apple’s balance sheet. Using those weights, the solution I found was 3G gross margin of 55.1% and 29.2% GM for the original model units. When the 3G & legacy gross margins are multiplied by the percentage weights for all three classifications (Total, Current, Non-Current), the products equal the same gross margin extracted from Apple’s 10-K.

(1) Total deferred: 47.8(all)= .71(MGN[3G]) + .29(MGN[2.5G])
(2) Current Deferred: 45.1(all) = .61(MGN[3G]) + .39(MGN[2.5G])
(3) Non-Current Deferred: 51.9(all) = .86(MGN[3G]) + .14(MGN[2.5G])

Conclusion:
If my math is correct, the gross margin on the DR booked from 3G iPhones sold in Q4 (Sep 08) is 55.5%. This means over the next seven quarters, Q4 iPhone sales that will be recognized in current earnings contribute 55.5% GM. Yet, gross margins on units sold going forward will materially exceed the 55.5% generated on Q4 sales.

The rationale for thinking the normalized GM will be higher is due to excess product expense related to the roll-out. Shipping costs were abnormally inflated due to pressures created by supply shortages. The elevated expenses were due to more shipments of smaller lot sizes expedited at quicker delivery times. In short, distribution costs weren’t optimized, yet it’s better to spend a little more to make a sale, than to try to contain costs and forego a sale. For example, iPhones ordered through AT&T direct fulfillment were being delivered individually by FedEx. In addition, Apple stores were receiving smaller shipments but more frequently, on an as-needed basis, so that some stores don’t get too much stock leaving others short. Now that demand and supply factors are in balance, Apple is able to reduce distribution expense by shipping larger lot amounts, less regularly at non-expedited speeds.

Another item inflating product costs was the power adapter recall. Not only does this cause material costs to increase, shipping and packaging costs were likely unfavorably impacted as well.

Going forward, I foresee rising margins resulting from efficiency gains in distribution along with lower product costs resulting from falling component prices and scale benefits. Another item of note, the end of September Apple began selling unlocked iPhones online to Hong-Kong for roughly $685/$799 (free shipping). These prices are quite higher than what Apple receives on other iPhone sales. It’s possible that Apple can do decent volume through the Hong-Kong channel given the propensity for iPhones to find their way into grey markets, such as China, Thailand, Vietnam and others. It’s interesting that Apple decided to sell unlocked, open carrier iPhones only to Hong-Kong which makes one wonder if this is a direct response to the stubbornness of Chinese carriers.

Massive iPhone margins provide Apple with the ability to reduce selling price and still earn a generous profit. Apple has a key advantage over other mobile handset makers that don’t have nearly as high GMs. I expect Apple to eventually lower iPhone prices, but given the iPhone’s superior value proposition, a price cut shouldn’t be needed for some time. However, that doesn’t preclude Apple from doing so just to make competitors life difficult.

Apple could use the colossal iPhone margins to subsidize price reductions on other products if needed. Given the difficult economic environment, this is a very beneficial arrow for Apple to have in its quiver to draw upon.

Disclosure: Long AAPL

Analyzing Apple's iPod Business

2008-11-06T23:34:00.006-06:00

Apple Inc. (nasd:AAPL)- Slowing iPod sales growth has been one of the chief concerns among AAPL investors because the iPod has historically been a major contributor to Apple’s overall revenue growth. The concern stems from the belief that the PMP market is becoming saturated. With 175 million iPod units sold, finding new customers is becoming more difficult. However, the iPod is becoming less of a revenue contributor, hence Apple is less dependent on the iPod for its sales growth. Andy Zaky, a highly accurate AAPL analyst addressed the iPod’s shrinking importance with regards to Apple’s corporate revenues. In addition, If Apple reported iPhone sales as part of the iPod segment, this wouldn’t be much of a concern, because the iPhone would have reaccelerated sales growth in the iPod segment. I recently discussed that scenario. Yet, Apple reports the iPhone separately. Therefore, this analysis focuses on the traditional iPod product line and its growth outlook.

Historically, Apple has used price reductions to fuel unit volume. The demand elasticity allowed the increase in unit sales to outweigh the decrease in ASP, resulting in higher dollar revenue. In a more saturated environment, demand becomes less elastic Unit growth has been slowing: 6% (FY08) vs. 35% (FY07), but iPod dollar revenue grew 10% in FY08 compared to 8% in FY07. Apple was able to increase iPod ASP to $167 (FY08) from $161 (FY07) with the introduction of the Touch. Even as the PMP market has neared saturation, Apple has reformulated its iPod product line which will motivate upgrades to iPod models carrying higher ASPs. Therefore, Apple’s current iPod product line strategy focuses on appealing to non-PMP users, as well as motivating current users to upgrade to higher ASP models. Apple has also positioned the iPod product line so that it’s practical for a user to own multiple iPod models to serve different purposes.

iPod Sales- Historical Overview:

iPods were the primary growth engine for FY05 and FY06, responsible for roughly 58% of Apple’s total revenue growth for both years. In FY07, iPod segment generated only 14% of overall sales growth. As a percentage of total revenue, iPod accounted for 33% (FY05), 40% (FY06), 35% (FY07) and 28% (FY08). 

The iPod is becoming less significant for revenue growth due to the success of the Mac and iPhone segments. Apple’s revenue grew 35% in FY08 and 24% in FY07, yet the iPod was the slowest growing segment both years. In the last quarter (4Q08), iPod sales were only 21% of total revenue, and less than 15% not using iPhone subscription accounting. Thus, concerns about flagging iPod sales detrimentally impacting Apple’s overall business are stretched since the iPod is becoming less of a contributor. On a non-GAAP basis, the largest revenue contributing segments are the iPhone and Mac, which are the also the fastest growers.

Historically, Apple has introduced new iPod models at high prices then gradually lowered prices. Unit volume accelerates at lower price points, but the decrease in ASP results in less dollar sales growth. The reverse is true when Apple introduces models at high ASPs, which offsets the effect of lower unit volume on dollar revenue. In a saturated market, demand elasticity evaporates as unit volume is not responsive to lower prices. The focus shifts to motivating current users to upgrade to new-featured models at higher price points. A common belief is that Apple has sold so many iPods, that there isn’t anyone left that doesn’t already own one. In a sense, that’s almost literally true. Those that would enjoy such a device, likely have already bought one. Figuratively speaking, the low hanging fruit has been picked. Therefore, Apple needs to keep introducing new models with advanced features that will entice user upgrades and appeal to new consumers lying beyond the PMP market. Apple has accomplished this with the Touch.

iPod’s first two years on sale, ASPs averaged around $350. Then in Q404 (Sept) Apple cut iPod prices $100 and demand increased considerably. In Q205, Apple priced the “Mini” iPod model @ $199 along with launching the shuffle. This resulted in ASP dropping to $191 in Q2 from $264 in Q1. Unit sales exploded even exceeding the previous period which was a holiday quarter. ASP trended down over the next couple quarters until Q106 when the video iPod was released. ASP rose to $207. ASPs gradually fell over the subsequent 8 quarters, sustaining unit volume growth.

In FY07, unit sales growth was 31%, but revenue growth was only 8%. In 1Q08, Apple introduced the Touch model which carried a significantly higher ASP. This resulted in FY08 iPod revenue growth of 10% on top of 6.2% unit growth. That’s right, iPod revenue growth was higher in FY08 compared to FY07. Thus, even though unit volume has slowed materially, dollar revenue growth has actually increased. I think that point is often missed from investors and the media primarily focusing on unit sales.

iPod unit sales only grew 5% (y/y) for 1Q08, but dollar sales increased by 17% due to a higher average selling price (ASP). After 8 consecutive quarters of declining ASP, the Touch reversed that trend as ASP rose to $181/unit in 1Q08. You would have to go back 6 quarters to find a higher ASP. We have seen a decline in ASP since Q1 mainly due to the price cut for iPod Shuffles, which management stated has had a very positive effect on volume.

In the September quarter (Q4), ASP fell to $150, primarily due to the back-to-school promotion. I surmise that ASP might have been $20-$25 higher otherwise. Going forward, I expect the recent trend of declining ASPs to reverse. ASPs will rise due to the sales mix skewing towards the Touch model. The July opening of iTunes App store, along with the September’s introduction of the 2nd generation Touch model at reduced prices, will substantially boost demand.

The purple shaded area of the sales table highlights the periods where ASPs dropped stimulating unit sales growth. It’s also apparent that revenue growth slowed due to the lower ASPs. The green area shows the periods where ASPs increased significantly; unit sales stalled, but revenue growth accelerated due to the higher ASPs.

The graph below depicts unit volume at various ASPs; the basic demand curve. Due to seasonality effects, data points are plotted according to quarter. Elasticity of demand is quite visible as quantity demanded is barely responsive in the $400 to $250 price range, then turns very elastic from the $250 to $150 price range as the demand curve flattens.

iPod Product Line: 

Primary Attributes: 

Touch- PDA, internet/email, wide screen video, games, other software (applications)  

Classic- massive storage 

Nano- video w/ size and price 

Shuffle- size & price

Touch: (iPhone) is the purest form of a converged device with its broad array of applications. It’s a perfect “all-in-one” device that’s small/light enough to be carried on one’s person. A converged device doesn’t totally eliminate the need for multiple devices. Instead, it reinforces the importance of having dedicated devices to accomplish specific needs. I know many consumers myself included) that have an iPhone and multiple iPod models to serve different purposes. A recent LA Times article reports that some iPhone users are also buying a Touch just for gaming purposes.

Classic: Primary feature is its massive storage capacity. It can serve as the chief repository for all one’s media as well as a dedicated media player. I connect my classic to my home stereo system which plays music throughout the house. Substituting my iPhone (or Touch) involves limitations. First, the capacity is much less, but most important, it ties up the device which means I am unable to use the other features.

Shuffle: This is perfect for outdoor and/or physical activity. This model is quite durable and very difficult to damage. Even if one manages to destroy his/her shuffle, then he/she is only out $50. Contrast this with other iPods which are more easily damaged and cost much more to replace. Thus, I’m not too inclined to jog or lift weights with my iPhone. Plus, the Shuffle’s diminutive size, measuring 1 in x 1.5 in and weighing ½ oz, makes it ideal for physical activity. At $50 for 1GB, the Shuffle is very reasonably priced. This expands its appeal to those who are less enthusiastic about music to spend very much on a PMP. For instance, some listen to a basic FM radio Walkman while working in the yard or exercising since they are not particular about which songs they hear. A Sony Sports Walkman (with arm band) runs $44 at Best Buy, thus the Shuffle is price-competitive.

Nano: This has been the most popular iPod due to its attractive price and the improvements in storage capacity. I expect a significant portion of the Nano sales will migrate to the Touch model since Touch prices have come down. Originally, the cheapest Nano was $150, and the cheapest Touch was twice as much, $300. In September, the 8GB Touch was reduced to $230. At $150 one can buy a 8GB Nano, or for $50 more upgrade capacity to 16GB. From the consumer perspective, it may make sense to pay 33% more in price for 100% more in memory. Common thinking is that one might later regret not getting the higher capacity model. However, that has become a less pertinent issue due to increased capacity offered in the base model. 8GB could be sufficient for many people, whereas 4GB was not. Yet, for $80 more one can buy a 8GB Touch which is a quasi-mini computer. Thus, when evaluated from the perspective of- $50 buys more storage, and $80 buys a conglomeration of added functionality, it makes much more sense to buy a Touch now that its price has fallen from $300 to $230. Bottom line, if one is going to spend that much money for a Nano, why not spend a little more money and get many more features? I believe a number of consumers will share the same line of thinking and will be “pulled up” to a higher ASP purchase.

iPod- Product Line Evolution:
One of Apple’s key strengths is innovation and the ability to improve its products in short time. This is evidenced by the 6 upgrades to the Classic model since originally introduced in late 2001. There have been 6 generations of the “Mini/Nano” model since 2004. The advances in functionality have been very significant, all one has to do is compare the Touch to an early iPod model, or just compare the current Classic model to an early generation.

The iPod’s expansive evolution from its roots as basic music player. Early models included remedial PDA features such as contacts, calendar, and notes, yet entries/edits such the once ubiquitous Palm Pilot. adds virtually full internet functionality and email when connected to WiFi. This summer, the App store was launched offering thousands of applications, many are free. This is a radical change which makes the Touch more like a mobile PC. Throw in a cellular radio and the Touch becomes and iPhone. In essence, the iPhone is just a mutation of an iPod, and the Touch is somewhere in between, with the Classic and Nano models still retaining the original iPod characteristics.

The first iPod models only differed in capacity. In 2004, a smaller model “Mini” was added at a significantly lower price point. Being just music players (later video added), consumers would choose an iPod based on desired capacity and price. Most likely, that would be the only model he/she would need/want. The introduction of the Touch changes that scenario with its PDA and web browsing attributes and games.

The iPod took a giant leap with the Touch. The display is much larger than other iPods and includes touch screen navigation. Touch iPods also include WiFi, users can access the web, e-mail, and utilize the widgets to grab updated weather, stock prices, maps, as well as watching YouTube Videos. It also has PDA applications, such as calendar and notes, as do other iPods, but the Touch’s qwerty keyboard significantly enhances functionality.  

The evolution of the iPod line creates a higher possibility that an iPod owner would want more than one model. For example: Touch for PDA/internet & gaming, Classic as repository to store all content and as a de-facto stereo component, and a Shuffle for use during physical activities.  

The iPod’s potential market is expanded by the Touch’s new capabilities, which may attract new consumers who had little interest buying a device strictly for music and video. Current iPod owners may buy a Touch for its PDA and web browsing features. The App Store has literally revolutionized the device’s potential, as gaming is becoming a prominent attraction.
 
iPod Growth Strategies: 

Sales can only come from 3 sources: 1) Non-users of product category 2) Competitors’ customers 3) Firm’s current customers. Saturation occurs when the market can no longer expand from the addition of non-category users. Often, a industry shake-out occurs from firms switching focus from attracting new category users, to stealing competitors users. Weak firms are pushed out of the industry and a competitive equilibrium results. Capturing sales from competitors’ users becomes increasingly difficult. A much greater focus is then placed on extracting more sales from current customers. A firm can revolutionize a mature product (making current obsolete) to start a new life cycle.  

3 Sources for Increasing Sales: 

1. Non-Users- Don’t use product category: Attract new users  

The number of consumers, who don’t own a PMP but potentially would buy one, is dwindling. If a consumer hasn’t purchased a PMP by now, the likelihood of purchasing one in the future is relatively low. With 174 million iPods sold and nearly 250 million total PMPs sold, it’s increasingly difficult to keep expanding the market to new users. Yet the market will continue to expand, albeit at a much slower rate.  

In short, Apple can’t completely rely on new users to supply the sales volume as in previous years. Apple has been addressing this issue by reformulating its product line.  

The Touch will expand the market since it’s not exclusively a music/video player. For those with little interest in music, then the web browsing, e-mail, and PDA features may be attractive. With the copious software available from the iTunes app store, it’s not hard to imagine some Touch owners not even using the music player. Considering gaming capabilities, the Touch is akin to handheld gaming devices, I, and many of you, know them as “Game Boys” even though today’s devices have advanced light years.

The Shuffle’s reduced price (under $50) makes it appealing to physically active individuals that desire to listen to music while exercising, but not very particular about listening to music at other times.  

2. Other’s Users- use competitors’ products: Increase market share  

Apple’s iPod has more than 70% of the unit share of the PMP market. That number has held steady for past several years. With such a large share, Apple has already taken business from its competitors, thus less remaining to take now.  

The iPod has roughly 90% of the market’s dollar, thus competing devices are the most part cheaper and target more price sensitive consumers. Apple just recently cut iPod Shuffle prices from $79 to $49 making iPods more competitive among lower-priced devices. I expect Apple may slightly increase its market share, but not to an extent large enough to boost sales growth significantly. 

3. Current Users- iPod owners: influence to buy multiple devices / buy new device more frequently  

iPod owners represent a large source of potential sales. They outnumber competitors’ users and possibly non-users likely to purchase a PMP in the near-term. A focus of Apple’s sales strategy is selling more iPods to current owners since they represent a colossal source of potential sales growth. 

 Increasing sales from current customers Apple must motivate the user to buy a new iPod more frequently (replacement cycle) and/or buy multiple units.   

PMP devices aren’t similar to printer ink, where more usage leads to more sales. Since usage doesn’t cause product consumption, the replacement cycle is longer. Speeding up the replacement cycle is more difficult than other products whereby it’s advised to “change every 3,000 miles” or “lather, rinse, and repeat” and “best if used by x date.”  Device enhancements from adding new features and expanded capabilities speed up the replacement cycle. Hence, the replacement cycle becomes an upgrade cycle. A number of iPod owners buy a new generation model because of better features even when their current device works fine. Innovation is key driver in generating more sales from current users. New enhancements have to be compelling to motivate the upgrade.

The heart and soul of the iPod line has been the Classic, later supplanted by the Nano. Apple’s new Nano generation adds new features, such as the accelerometer, which will stimulate the replacement cycle.   

Stimulating users to purchase multiple units is a challenge for this type of product. There is little need to have more than one PMP device since a user can only listen to one device at a time. Since devices are highly portable, there isn’t a need to buy multiple devices for use at different locations, unlike a TV perhaps. The challenge is to differentiate the product line by form and functionality.  

Differentiation of the iPod model line encourages the purchase of multiple iPods vis a vis owning different models. The mini-PC/gaming functionality of the Touch, the reduction in size and price of the Shuffle, and massive storage of the Classic reduces the overlap of features. Thus, there exists a reason to own more than a single iPod model since the functionalities differ. An individual might own a Classic for storage, a Touch for internet/email and gaming, and a Shuffle for physical activity.
 
iPod Outlook:
Given the recent evaporation of global economic activity, iPod sales are likely to be the most effected Apple business segment. Due to iPod’s commanding market share coupled with its “lifestyle staple“ nature, Thus, iPods will continue to be in demand. A sluggish economy may reduce demand in the near-term, but it creates pent-up demand which will be realized with an up-turn in the economy.

It’s hard to argue that the iPod market is not becoming saturated, as Apple has sold over 174 million units. However, the Touch with 3rd-party applications opens the device to new consumer segments. Originally, the iPod only appealed to those consumers who desired a PMP (personal music player). The Touch offers much more than just a music player. It’s a gaming device, as well as a email and internet browser, and a personal organizer, and much more. With the advent of the iTunes App store, the potential for the Touch’s functionality is virtually boundless.

The Touch presents the opportunity for attracting non-PMP users plus coaxing iPod owners to “trade up” to a device at a higher ASP. I didn't think the original Touch offered much value at the relatively high price points along with lacking 3rd party software capabilities. Now with the recent price reduction and iTunes App store launch, the Touch has gained significant potential. Initial demand of the 2nd generation Touch model released in September appears to be quite strong. There were widespread supply shortages during September and early October, and the Touch has continually been the #1 PMP seller at Amazon.com as well as a top 5 bestseller in the electronics category. The iPod sales mix will begin to skew towards the Touch boosting ASP. This will offset any slowing/negative unit growth effects on dollar sales.

The iPhone cannibalizes Touch sales, and probably the reverse is true as well. The magnitude of sales impact on one another is hard to know. I think the Touch provides a powerful gateway to the iPhone. Why carry two devices? The Touch provides an avenue to capture consumers who unwilling/unable to buy an iPhone. For instance, consumers may be locked in a wireless service contract, or use a different phone due to business purposes, may not live in wireless service area, or just don’t use a mobile phone. The Touch lets them become acquainted with a device similar to the iPhone, and when conditions permit, enhances the likelihood that they will purchase an iPhone. I am basing that assumption on the high rates of customer satisfaction.

Even though the Touch performs the same functions as other iPod models, it may not be the best choice for specific applications. This opens the door for consumers to own more than just one iPod model. The Classic can replace the CD player component for a home stereo system. The shuffle is ideal for outdoor/physical activities. The Shuffle should appeal to price sensitive consumers who previously weren’t willing to pay the high prices for iPods. These two factors should strengthen demand in light of a maturing market.  

DISCLOSURE: Long AAPL

Taking an Alternative Perspective on Apple's iPod Growth

2008-11-03T21:38:00.004-06:00

Apple Inc. (nasd:AAPL)- Analysts and the media have regularly cited slowing iPod sales as a major headwind for Apple shares. The iPod has been a major force in Apple’s total sales growth since it has been such a large percentage of Apple’s overall revenue. A common claim is that the iPod has been so successful, that everyone has one. A seemingly positive statement, some choose to take a negative point of view. For example, “ It’s not good for future growth because Apple is running out of new people to sell iPods to. Basically everyone who wants an iPod, already has one. While there will be sales resulting from the replacement cycle, it certainly won’t generate the magnitude of growth exhibited in the past. Therefore, iPod sales will significantly deteriorate.”

Apple has sold almost 175M iPods, and imagine if Apple created a new iPod that motivated iPod owners to upgrade, as well as appealing to non-iPod consumers. One can say Apple did, the iPhone. Apple reports iPhone sales in a separate segment apart from iPod, and it accounts for iPhone revenue using a subscription method that distorts actual performance due to spreading revenue over a 24 month period. If we were to combine iPhone sales, using traditional accounting, with the iPod segment, then we would get an entirely different picture. That wouldn’t change any of the overall numbers, but it would change the perception that iPod growth is rapidly slowing.

iPod Growth:
iPods were the primary growth engine for FY05 and FY06, responsible for roughly 58% of Apple’s total revenue growth for both years. In FY07, iPod segment generated only 14% of overall sales growth as iPod sales only increased 8% compared to 69% in FY06. Actually, revenue growth for the iPod segment ticked up in FY08, growing 10%.

Some cite market saturation as the major factor that will lead to a slowdown in iPod demand. Given iPod’s large revenue contribution along with having been the primary growth engine, critics predict a rough road ahead for Apple. As a percentage of total revenue, iPod accounted for 33% (FY05), 40% (FY06), 35% (FY07) and 28% (FY08). However, the iPod is becoming less significant for revenue growth due to the success of the Mac and iPhone segments. Yes, times have changed. It still seems that many have yet to catch on.

Apple’s revenue grew 35% in FY08 and 24% in FY07, yet the iPod was the slowest growing segment both years. In the last quarter (4Q08), iPod sales were only 21% of total revenue, and less than 15% not using iPhone subscription accounting. Thus, concerns about flagging iPod sales detrimentally impacting Apple’s overall business are stretched since the iPod is becoming less of a contributor. On a non-GAAP basis, the largest revenue contributing segments are the iPhone and Mac, which are the also the fastest growers.

Andy Zaky from Bullish Cross is a leading expert on Apple. Zaky recently wrote an excellent analysis regarding Apple’s dwindling reliance on iPod to fuel overall growth. He argues that too many are focusing on the slowing growth of the iPod segment and that they are misinformed as to the real impact any slowdown would have on Apple’s revenue growth.

Zaky writes: “Investors, the media and the analysts have consistently overstated Apple's dependence on the iPod for future revenue and earnings growth. In Q1 2008, the street, choosing to disregard iPhone and Mac revenue as being at the core of Apple's primary driver of future revenue growth, only focused on how iPod unit sales grew at a meager pace of 5% YoY.”

Zaky adds: “Even today, analysts and the media continue to question whether Apple could succeed in a recessionary environment due largely to the perceived uncertainty as to whether iPod sales can continue to grow in 2009. Several members of the media, including analysts and fund managers who don't cover technology stocks, continue to refer to Apple as the "iPod maker" or simply a "gadget maker" indicating that Apple's core business is derived from iPod sales.”

Viewing From an Alternative Perspective- iPod + iPhone Combined:
Arguably, The iPhone is just and extension of the iPod product line. Steve Jobs said “It’s the best iPod we’ve ever made.” The iPod segment has expanded with the Mini, Nano, Shuffle, and Classic model introductions. The iPhone is more/less a Touch with a cellular radio. Yet, one is an iPod and the other is an iPhone, at least judging by how Apple breaks out sales by product segment in its financial releases.

Until last quarter, whether Apple included iPhone revenue in the iPod segment, or reported it separately, there wouldn’t be much of a noticeable difference on the surface. This is because iPhone unit sales have been quite modest relative to iPod, and iPhone revenue is distorted from the subscription accounting that amortizes sales over 24 months. Management repeatedly said that iPhone wasn’t a significant portion of revenue. Very true using subscription accounting, 3% (Q1), 5% (Q2) 6% (Q3), 10% (Q4). Yet, the GAAP accounting treatment isn’t an accurate reflection of Apple’s business performance.

What if we took a different perspective and adjusted iPhone revenue to reflect the total amount earned in each period instead of the distorted subscription basis? And, what would it look like if iPod and iPhone were combined into a single reported segment?

Apple very easily could have decided to report iPhone sales as a part of the iPod segment, as well as using normal accounting. It’s all a matter of choice, the real figures stay the same. We probably wouldn’t still hear misguided comments such as “iPhone sales may be growing but it’s a very small revenue contributor. iPod is a huge revenue contributor and its sales are slowing.”

Without subscription accounting couple with combining iPhone sales with iPod, revenue dollar growth (Y/Y) for combined would be: 41% vs. 4% (4Q07), 47% vs. 17% (1Q08), 59% vs. 8% (2Q08), 26% vs, 7% (3Q08), and 184% vs. 3% (4Q08). With the iPhone’s $199 price tag and Apple’s plans to be in over 70 countries by the end of the year, we should expect to see growth figures like the 184% (4Q08) going forward. See the tables below.

Conclusion:
From a combined iPod & iPhone perspective, we wouldn’t hear these misplaced concerns of an iPod slowdown. Instead, it could be characterized as “Apple tackled the issue of slowing iPod growth by introducing a new iPod with cell phone functionality which has re-ignited sales growth in the iPod segment.” “Apple could sell another 175M iPods as users upgrade to the iPod cell phone.”

Disclosure: Long Apple

Apple's FY09 Gross Margin Expectations Too Low

2008-10-28T20:13:00.009-06:00

Apple Inc (nasd: AAPL) - Apple’s FY09 gross margin should well-exceed management’s guidance of 30%. There are multiple factors that will support FY09 gross margins. 1) As iPhone’s revenue contribution to total company sales increases, overall gross margins will rise since the iPhone carries a very high GM. 2) There will be a more favorable component price environment created by plunging commodity and energy prices. 3) As production volume rises for the iPhone and MacBooks, scale effects and cost efficiencies will benefit drive down product costs. 4) Higher revenues supply leverage by spreading fixed costs across a higher revenue base.

Apple’s guidance is way too conservative; yet considering the economic landscape, management is exercising prudence. This cushion should help Apple exceed earnings expectations even if the economy adversely affects its business. With gross margin expectations so low, Apple’s revenue growth could turn out worse than expected and still match/beat EPS estimates. Alternatively, Apple could use the gross margin cushion for lowering prices to boost demand if warranted.

Market Reaction to Lowered Guidance:
On the Q3 2008 earnings call back in July, Apple guided Q4(Dec) gross margin down to 31.5% which concerned investors after reporting a healthy 34.8% for Q3 (June). Much more troubling was the 30% GM guidance for FY09, down significantly from FY07 average of 34.2% and 34.1% average for FY08’s first 3 quarters. Apple’s shares had an ugly reaction. The weak GM guidance was shocking surprise for Wall Street. Management didn’t provide a clear explanation for the reduced GM guidance. The general perception in the investment community was that Apple was planning to drastically lower its prices which was seen has having negative implications. The popular belief was that Apple must have started to see a dramatic slowdown in demand at higher price points. A few examples being mentioned- competition will intensify, other firms will introduce alternative products at much lower prices, consumers won’t be able to afford or willing to pay premium prices. Many dismissed the possibility that Apple could be providing overly conservative guidance. In addition, many were overlooking the possibility that Apple would only cut prices and accept a lower gross margin because there would be a positive impact on the bottom line.

Gross Margin Guidance Historical Overview:
Management developed the reputation for repeatedly low-balling its gross margin estimates. For the 5 quarters- 1Q07 to 1Q08, Apple exceeded its gross margin guidance by an average of 14.1%. Yet, that trend ended for 2Q08 & 3Q08, when Apple only beat GM guidance by 2.8% & 5.5%, respectively (4.1% avg). Therefore, when Apple provided that week guidance for Q4 on the July call, investors reacted very negatively since the guidance for Q2 & Q3 had been relatively accurate.

In 3Q08 (June) Apple reported its gross margin was 34.8%, which exceeded guidance by about 180 basis points. Management stated that several factors contributed to better than expected margins. First, the one-time true-up of contract manufacturer deferred margin added 70 bps. Second, the remaining 110 basis points resulted primarily from lower commodity prices, a more favorable product mix with respect to margins, and the leverage effect of higher-than-expected revenue.

For the reduced gross margin guidance for Q4, Apple gave three primary factors for the expected sequential GM decline. 1) The full quarter impact of the back-to-school promotion 2) A future product transition 3) The one-time true-up of contract manufacturer deferred margin realized in Q3 (June).

Q4 2008 Gross Margin Exceeds Expectations:
Apple beat management’s GM estimates by a sizable margin (320 bps): 34.7% actual vs. 31.5% guidance. I was surprised because I had been expecting GM to come in at 32% with a possible upside of 50-100 bps. I expected the back-to-school promotion would have a larger impact on overall margin.

Apple offered students a full price rebate for 8GB iPod Touch ($299) purchased along with a Mac. The iPod sale is recorded, and then once it’s rebated, the sales price is applied as a reduction to sales for both iPod and Mac, in proportion of the iPod and Mac sale. This probably results in about 80% of the rebate being applied to Mac revenue and 20% to iPod revenue. This noticeably impacted Macbook ASP which fell $93 sequentially, from $1,440 in Q3 down to $1,347 for Q4. The decline year/year was $69.

The iPod ASP fell to $150, its lowest ever. However, the sequential decline was only $2 and $9 year/year. In September, Apple introduced new iPods carrying lower price tags. The 16GB & 32GB Touch dropped $100, and the 8GB model saw a $70 reduction. Even though the lowered prices only prevailed for roughly 3 weeks of the quarter, Apple shipped a good number of units into the channel before quarter-end to alleviate the wide-spread shortage Thus, the amount of units sold with the new pricing was larger than what one would expect given the short length of time.

4Q08 Gross Margin Analysis:
Management stated that improved component pricing was primarily responsible for GM exceeding guidance. I believe that component pricing will only get more favorable and should even have a more robust impact going forward. It’s likely that most products sold in Q4 contained inputs procured months back at higher prices, especially given Apple uses FIFO accounting method. In the coming quarters, components will have be acquired at significantly cheaper prices, and those price will likely continue to fall.

Apple said that higher carrier payments on legacy iPhones was a secondary factor contributing to higher-than-expected GM. This is perplexing. No 2.5G iPhone units were sold in the September quarter. Only 717K units were sold in the June quarter; the majority of sales likely occurred during the early half since supply was virtually gone by the end of May. In addition, a decent number of the June quarter sales were unlocked and exported. Therefore, the number of units generating carrier payments would have not materially increased in the September qtr versus the June qtr. Thus, if anything, payment revenue would be slightly better than flat. Yet, total revenue increased by $431M which would have diluted the impact on gross margin.

Actually, the population of first generation iPhones with revenue payments decreased in Q4. With no additional 2.5G units were sold during the period, the number fell since 2.5G units were replaced with 3G models. My understanding is that this would curtail the carrier payments on those units. I estimate over 3M units had attached carrier payments and by end of Q4, 500K to 1M legacy iPhones were replaced by 3G. Unless there is some huge one-time payout, or a similar agreement, payments from wireless providers should have decreased. Due to the massive subsidy being paid by AT&T on 3G models coupled with the fact that legacy iPhone customers could upgrade without penalty, It seems very unlikely that there would be any such payments that would materially affect GM. Another interpretation is that management expected higher fallout of original iPhones carrying shared revenue payments, thus the actual revenue decline was less than expected.

I believe robust sales of the new 3G model (that resulted in a near doubling of recognized Q4 iPhone revenue) had a meaningful impact.

Due to massive 3G iPhone unit sales, revenue recognized in Q4 almost doubled sequentially. iPhone revenue reported in Q2 & Q3 amounted to roughly 5% of total sales. Yet, Q4 iPhone revenue constituted over 10% of total sales. With iPhone margins around 50%, the impact is noticeable. Assuming GM for non-iPhone segments was 33.1% and iPhone GM was 49%, Q4 GM would have been 33.9%, or 80 bps lower is iPhone was 5% of total sales instead of 10%.

Gross Margin Outlook Q1 2009:
Gross margins might see a slight to moderate decline sequentially in the December quarter due to the reduced prices for iPods and the higher manufacturing cost associated with the new generation of MacBooks. Apple guided GM to 30%-31%; taking the midpoint of 30.5%, GM would decline 420 bps Q/Q. That’s a significant decrease which is tough to grasp because of the multiple factors that should benefit gross margin.

Positives-
1) There will not be the negative impact of the back-to-school promotion.
2) Commodity and energy prices continue to fall, and the drop-off in component demand is improving Apple’s product cost. I don’t foresee this trend reversing in the near-term.
3) Q1 iPhone revenue will increase (larger % of total sales) providing further GM support since iPhone margins are much higher than overall company GM.

Unknown-
1) How much higher production costs are for the MacBooks.
2) How conservative the guidance is.

Given the mix of favorable factors at play, product costs for new MacBooks would have to be very large to counteract the upward margin pressure AND drive GM down 420 bps. That doesn’t appear likely.

Financial Alchemist FY09 GM Outlook:
In addition to the items discussed above, the primary GM driver in FY09 will be the iPhone.

Using regular accounting, whereby all revenue/expense are recognized in period incurred, the 4Q08 GM was 39% compared to 34.7% reported using the subscription method. The non-GAAP figures Apple provided take out iPhone amortized revenue/product cost reported under GAAP, then adds total revenue/product expense for the units shipped during the quarter. This highlights the huge disconnect between accounting earnings and cash earnings. The subscription method, whereby revenues and product expense are amortized over 24 month period, causes the reported GAAP numbers to be highly misleading.

iPhone revenue would have increased by 3.79B, from 806M to 4.59B. This represents nearly 40% of total revenue. Granted, this includes AppleTV revenue, but its contribution is believed to be insignificant.

Also impressive is the leverage effect- operating margin is 27.9% vs 18.3% under GAAP. Apple expenses associated operating costs as incurred, and defers the product cost and revenue. This weighs on operating margin because only a portion of the revenue related to the expense is recognized. Theoretically, this benefits margins in the next period since the deferred revenue to be recognized will have had its associated SG&A fully expensed in the prior period. However, SG&A costs are necessary to operate the business, thus there will be new non-product expenses arising in every period. As deferred revenue builds, the amount recognized increases by quarter offsetting the related operating expenses. Selling and advertising costs associated with the iPhone should be the highest in the months following the launch. This creates a favorable situation where recognized revenue is rising coupled with falling non-product costs.

First: With subscription accounting, operating margins should improve as the amount of revenue recognized flowing from deferred revenue increases. Second: Overall gross margins will rise as the high-margin iPhone revenue becomes a greater percentage of total sales. Thus, going forward, the iPhone should lift margins.

I believe the low GM guidance for FY09 is overly conservative. The iPhone GM is likely higher than 50%. Q4 GM was 39% sales in the period fully recognized. We can see the upward trend. Thus, GM somewhere else has to sharply decline. The new MacBooks are likely to create some pressure, but how much? Hard to say until we get Q1 numbers. Even so, those costs should moderate with increasing production volume along with lower component prices.

Apple could also trade margin for volume if demand elasticity appears to be favorable. Hence, keep GM in low 30’s by using iPhone margin to subsidize price reductions on other products to drive volume. Apple consumers are not very price sensitive, therefore something Apple is not likely to do. Considering the economic backdrop, it’s not a bad alternative to have on the table.

Conclusion:
FY09 gross margins will come in way above management’s guidance of 30%. The iPhone, with it’s staggering margins, will become a larger contributer to overall revenue, thus it will drive GM higher. Management is being excessively conservative, and the ultra-low GM guidance provides a cushion in the event that Apple’s business considerably deteriorates. A more favorable commodity and component price environment will also lend support to margins. As management stated, costs from the iPod and MacBook transition should also decreases from volume manufacturing and cost engineering as the firm moves along the cost curve. AAPL shares are pricing in lower margins as analysts are looking for FY09 EPS to be flat versus FY08. Even in a tough economic environment, I foresee better results.

Disclosure: Long Apple

Apple to Surpass its iPhone Sales Goal of 10M in CY08

2008-10-06T04:03:00.007-05:00

This article was a collaborative effort with:

Andy Zaky from Bullish Cross

Based on the tremendous efforts by members at Mac Observer’s AFB and Investor Village's AAPL Sanity Board member howlongtoretire to track IMEI iPhone numbers, Apple has drastically surpassed analyst’ Q4 iPhone sales estimates, and reached its goal of selling 10 million iPhones in 2008. The consensus estimates for iPhone sales figures for Apple’s Q4 (calendar Q3) were calling for approximately 4 million units. It now appears that Apple has sold at least 7 to 7.5 million iPhones in Q4—that’s nearly 80% above consensus. Apple has far surpassed even Gene Munster’s bullish estimates of 5 million iPhone sales in Q4 according to the data.

At MacWorld 2007, when Apple was trading at the same price it is today, Steve Jobs and Apple set a bold goal of selling 10 million iPhones in 2008. Despite Apple’s consistent reassurances of meeting its goal, bearish analysts repeatedly raised irrational concerns about whether Apple could reach such lofty sales figures. In January, Bernstein Research analyst Toni Sacconaghi, an analyst who rarely comments on Apple, started the “missing iPhones controversy” which led to a herd of naive analysts to reduce their iPhone sales estimates to numbers that fell well below Apple’s 10 million iPhone goal for 2008. Sacconaghi forecasted that Apple would only sell 7.9 million iPhones in the period. This obviously put considerable pricing pressure on shares of Apple in February.

Kathryn Huberty of Morgan Stanley, arguably one of the worst analysts covering Apple, estimated that Apple would only sell 9.3 million iPhones for the year. Apple now appears to be on track to sell nearly double that number. Yet, Huberty and Sacconaghi aren’t the only ones. Keith Bachman of BMO Capital also jumped on the bashing Apple bandwagon in February when he estimated that Apple would only sell 8.5 million iPhones in 2008. Scott Craig of Bank of America also maintained bearish iPhone estimates in February with an 8 million iPhone sales target. Several other analysts followed suit and were obviously dead wrong. One would think these analysts would have learned from their mistakes, yet to no avail we see similar behavior from many of these very same analysts today.

IMEI Number Tracking by Mac Observer’s AFB

An IMEI number or an International Mobile Equipment Identity number is a unique 15 digit code assigned to each individual iPhone found on the back of the box in which an iPhone is packaged. Within this 15 digit code are two 6-digit numerical sequences crucial to determining the number of iPhones being produced. One 6 digit number, known as the TAC, or Type Allocation Code, signifies a particular build or set of iPhones being manufactured. The second 6 digit number is unique to each individual iPhone produced in that particular series—so that 1 million iPhones can be registered to a specific TAC. In other words, one six digit code, known as the TAC, signifies a set of iPhones being produced whereas the other six digit code signifies each individual iPhone within the TAC set.

Members at the Apple Finance Board at Mac Observer have been collecting IMEI numbers from new 3G iPhones sold during the period, and have been maintaining a spreadsheet of iPhone IMEI data points along with the purchase date, model, and production week. By early September, Apple was on its 8^th TAC, meaning that 8 million 3G iPhones had already been manufactured. The actual number of handsets sold versus manufactured depends on a variety of factors including the amount of inventory Apple carries in its retail chain, defects that were destroyed, defects that were sold and then exchanged, display models etc.

However, the latest IMEI data point collected by AFB was 9,190,680—an 8GB Black iPhone recorded as manufactured on September 29 and sold on October 5. This suggests that even if a whopping 1.5 million iPhones of the total IMEI registered devices are unsold as of today, an unlikely assumption, it would still put 3G iPhone sales at 7.6 million units and 2008 iPhone sales at over 10 million units. Coming into the quarter, Apple had already sold 2.42 million iPhones. Thus, 7.6 million 3G iPhones sold puts Apple above 10 million units for the year.

Net Applications OS Market Share:

The Net App OS share measurements based on web usage data lends further support to the IMEI tracking conclusions. In the weeks leading up to the 3G launch, iPhone OS share was rather consistent hovering at 16 bps. During this period, the population of iPhones remained static at 6 million units because inventory dried up weeks before. The share readings began to rise sharply subsequent to the 3G introduction. Due to the volatility and noise present in the data over the quarter, it’s not possible to make granular assessments. However, for the last few weeks of the September quarter, iPhone OS was averaging 34 bps. This suggests iPhone units increased by 6.75M. A small portion of legacy iPhones were replaced by 3G models resulting in those sales having no effect OS market share readings. Sales into the channel are not represented in the Net Applications measurement since the device is yet to reach the end-consumer. This data together with the IMEI Number Tracking by the AFB highly suggests that Apple more than likely sold at least 7 million iPhones in Q4 and that Apple has surpassed its 10 million iPhone target.

See my previous commentary: iPhone Q4 Sales Estimates

Disclosure: Both Authors are Long Apple

Q4 Sales Estimates for Apple's 3G iPhone

2008-09-11T17:12:00.006-05:00

Apple Inc. (nasd:AAPL) $152.65- Apple introduced the new 3G iPhone model on July 11, and sales thus far look to be impressive. Using the OS market share data from Net Applications and the IMEI tracking data from the Mac Observer’s Apple Finance Board, iPhone sales appear to have approached 6 million units since launch. By the end of this quarter (Q4), I predict iPhone sales will reach 7-8 million. Most estimates on the Street are calling for unit sales to come in under 5 million units. Perhaps the most important aspect is the effect on cash earnings. Since Apple spreads iPhone revenue over 8 quarters, reported EPS will see little effect. However, cash earnings should increase more than $2.00.

SUMMARY:

I estimate Apple has sold roughly 6 million 3G iPhones with 3 weeks still left in the quarter. Q4 sales could hit 7 million, or more, with the aid of a couple factors.

1) July 11th, Apple introduced new model at 189 Apple stores and 2,000+ AT&T locations in the US, and internationally in more than 20 countries.

2) August 22nd, another twenty-plus countries launched.

3) September 7th, iPhone went on sale at Nearly 1,000 BestBuy stores.

Supply dried up at all points of sale after the first weekend. Apple stores received the bulk of new shipments as AT&T and foreign providers were strained for several weeks. About mid-August, the production ramp and demand levels showed signs of equalizing. It wasn’t until late August that AT&T stores began to have on-hand inventory since running out on the initial launch. Apple records iPhone sales when shipped to carriers opposed to Apple retail stores, which are recorded when sold to the end-user. As demand is starting to normalize along with Apple’s retail store inventory stabilizing, focus will shift to supplying the channel. This comprises of AT&T stores, foreign carriers from both the July and August launches, and BestBuy. With 6 million likely sold thus far, sales should surpass 7 million by the end of the quarter from replenishing the channel and consumer sales.

NET APPLICATIONS OS MARKET SHARE MODEL:

Net Applications estimates OS market share from internet usage data. Since the 2G iPhone supply dried up in May and June, the installed base essentially remained static at 6.12 million units during that time. As measured by Net Applications, iPhone OS share remained steady at around 16.5 bps for those two months. That equates to roughly 370 units per basis point of market share. Using the share data since the 3G launch, unit sales of the new iPhone model can be estimated.

There appears to be some aberrations in the Net Application survey data as the huge spike in mid-August would suggest. The spike causes the sales estimates to accelerate rapidly and then flatten. If the share data were more normalized, weekly sales estimates would be smoother. Thus, the weekly estimates are volatile, and likely not accurate. Yet, the data probably does give a decent estimation of cumulative sales since the launch.

Here are a several thoughts regarding the spike in web usage seen the week beginning August 8:

1) Certainly the weekly run rate has slowed, as with any new product launch, but definitely not to the degree that the OS share data depicts. Larger proportion of early sales (1st 30 days) versus late sales (2nd 30-days) whereby internet usage is highest right after purchase and fades. Thus, early iPhone purchases caused pronounced acceleration and when usage faded, late iPhones with heavy usage don’t offset the early decline since it’s a smaller portion.

2) There is cannibalization of 2.5G iPhones from upgrades. Original iPhones that become inactive from new 3G purchases won’t increase market share measurements. Of course, some legacy iPhones are sold or passed on.

3) Up until early August, supply was sporadic at Apple retail outlets, and virtually non-existant at AT&T and international carriers. A good number of orders were placed at AT&T outlets, but customers had to wait for their shipments to arrive. It’s possible than many customers who placed orders in July received them at the beginning of August when supply firmed, leading to higher web usage.

AFB IMEI NUMBER TRACKING MODEL:

Members at the AFB board have been collecting IMEI numbers and recording those in a Google spreadsheet. The theory is that the IMEI numbers follow a consecutive sequence, and tracking them can reveal the number of units produced so far. The highest IMEI number submitted so far points to 5.604 million from a iPhone purchased on August 30. Fortune’s Elmer-DeWitt wrote about this approach September 1st. This model corroborates the Net Application data and my calculations, suggesting unit sales have approached 6 million.

STREET Q4 ESTIMATES:

These are the latest estimates that I have been able to find, however they may have been revised since.

Piper Jaffray- 4.5M

Credit Suisse- 4.2M

Pacific Crest- 3.5M

Financial Alchemist- 7-8M

CONCLUSION:

Apple’s 3G iPhone appears to be selling ahead of Street estimates which may provide an opportunity for upside surprise when Apple reports Q4 results in October. Even though demand has cooled from launch day, Apple has to supply the channel which suffered an inventory drought for over a month after the 3G model was released. Domestically, iPhone shipments will go being going to over 2000 AT&T outlets and nearly 1000 BestBuy locations. Abroad, some 50 countries will have their inventories replenished. This should give a boost to iPhone sales as the quarter comes to a close.

Looking at the OS market share data, the focus should be on cumulative units, as opposed to weekly change. I believe that some aberrations in the measurement may have lead to that abnormal spike seen at the beginning of August. This causes the subsequent weekly changes to show a pronounced slowdown which is likely exaggerated. We also must remember that some 3G models replace legacy iPhones which will not increase market share numbers, thus won’t account for new 3G unit sales.

The number to watch will be cash flow when Apple reports. The iPhone has the potential to significantly boost cash earnings. I discussed this implication back at the end of July- Apple’s Cash Earnings. On a cash earnings basis, Apple is very cheap at current levels.

Disclosure: none

Understanding Valuation Multiples with Respect to Cash

2008-08-25T18:01:00.007-05:00

A common mistake I see people make refers to how a firm’s cash stockpile is treated in the valuation process. Specifically, Investors err when they subtract cash from market value before calculating an earnings multiple that includes interest income. P/E multiples are calculated using EPS, or net income per share. This figure includes interest income that is generated from a firm’s cash investments. It’s incorrect to make assertions regarding P/E ratios based on cash/share values. For instance, $100 share price & $5 EPS, and has $20 cash/share, the firm’s P/E is 20x. End of story. No adjustments are to be made, nor should the $20 cash/share have any bearing/relevancy in that scenario. It’s true and only P/E multiple is 20x. The common mistake is to adjust the share price by the cash/share and then divide earnings. Hence: 100-20= 80/5 = 16x. If the $20 cash/share earns 5%, then it contributes $1 to EPS. If cash were eliminated from the calculation, it needs to be done on both sides. EPS would then be $4 not $5, and $80/$4 is 20x. Multiple doesn’t change because the value of the cash was captured in the share price as well as the EPS. Therefore, cash/share doesn’t have any effect on P/E multiples and shouldn’t be part of P/E analysis.

EQUITY VALUE MULTIPLES:

Let’s take Apple (nasd:AAPL) for example: Price = $172.55, Cash/Share = $23.45, FY09 EPS Estimate = $6.06. The forward P/E is 28.5x. The incorrect computation is to subtract cash from the share price before dividing by expected EPS: $172.55 - $23.45= $149.10 / $6.06 = 24.6x. The rationale people give for making this mistake is that one share of Apple represents $23.45 of cash and a business that generates $6.06 in EPS, thus an investor can purchase the earnings stream for $149.10.

Here’s the issue- the cash balance contributes to earnings in the way of interest income. Without the cash stockpile, EPS would be lower. One must not assume that Apple’s FY09 EPS will be $6.06 without interest income, thus a higher multiple should not be assigned on the basis of its high cash/share. In FY07, Apple earned $647 million in interest from its cash holdings, which totaled $15.4 billion at year-end. In per-share terms, interest income contributed roughly 51 cents to Apple’s reported FY07 EPS of $3.93. Apple’s P/E multiple based on FY07 EPS is 43.9x. Without interest income, EPS falls from $3.93 to $3.42, and subtracting cash from share price, Apple’s historical P/E is 43.6x. That’s roughly the same as the multiple calculated with cash included in both price and EPS. The common mistake is not subtracting out interest income from EPS while taking cash out of the share price. Therefore, it’s incorrect to subtract cash from one figure without taking it out from the other figure as well.

Since P/E ratios represent income that includes interest income, the conversation of cash/share is inappropriate, as it has no bearing on value, nor multiples in that regard. It’s incorrect to assert that a firm’s P/E multiple is actually lower because it has a relatively high cash/share, and that one should consider cash/share in tandem with P/E ratio. The cash/share is accounted for in the P/E ratio because it’s a part of the “E” or earnings, which includes interest income. The cash balance is the present value of future interest income, thus the two are the same.

ENTERPRISE VALUE MULTIPLES:

In instances where EBIT or EBITDA figure (Earnings before Interest, Taxes, Depreciation, Amortization) is used in a price multiple, then cash holdings should be considered since interest income (expense) is not captured. Thus, a P/EBITDA multiple makes an incorrect comparison since cash & debt aren’t included in the value of the denominator but are in the share price, or market value of the equity. To properly compare EBITDA, one should use enterprise value, or EV, in place of share price, or P. EV is the market value of the equity plus value of debt minus cash. Therefore, the multiple becomes EV/EBITDA. Cash holdings are excluded from the value figure, numerator, as well as excluded from earnings stream, EBITDA, in the denominator.

CONCLUSION:

To calculate multiples correctly, one shouldn’t include components in the numerator without also including in the denominator. If one is computing P/E multiple, then cash/debt needs to be ignored because those values are captured in the EPS. If one is computing EBITDA based multiples, then EV instead of P, is the correct input for the numerator. Since EBITDA doesn’t account for interest income/expense, then it would be much higher for a debt-laden firm. If share price, P, were used instead of EV, then the numerator would be too low resulting in too low of a multiple. Adding debt to arrive at EV, increases the numerator to coincide with the exclusion of interest expense increasing the denominator as well.

Apple vs Google: Detailed Comparison

2008-08-19T06:32:00.006-05:00

I have been coming across many comparisons between Apple (nasd: AAPL) and Google (nasd: GOOG) lately, especially given that Apple’s market cap surpassed Google’s last week. A recent example is Felix Salmon, who doesn’t think Apple should be worth more than Google as he argues in “Apple vs Google.” Mark Krieger compares Apple to Google and concludes Apple’s valuation is lofty and due for a pullback. The authors do make some great, valid points, yet their conclusion is ultimately flawed due to the failure of comparing on a free cash flow basis. Cash flow, not accounting earnings, determines an asset’s value. For the matter of an Apple-Google comparison, there are significant differences in free cash flow production, hence return on invested capital (ROIC).

I present the following analysis of the similarities/differences between the two firms.

The primary issue I take, is the common fallacy of valuation comparisons using price-earnings multiples. Last month, I wrote a rather detailed analysis about the disconnect between Apple’s reported earnings and its cash flow (Investors Overlooking Cash Earnings). This gap will widen as iPhone sales accelerate. The iPhone accounting treatment calls for its revenue to be recognized over 8 quarters, yet Apple receives cash in the full sale amount when they occur. A very astute Apple analyst, Andy Zaky, whom I highly respect, echoed my viewpoint in his recent commentary- “Apple Should Be Valued on a P/FCF Basis.” Zaky reported that many are making the mistake of comparing Apple to Google based on reported earnings multiples, which he states is inappropriate. Zaky couldn’t be more correct in that assertion. Andy Zaky and myself are not alone in thinking that the P/E as a value metric for Apple is misguided. Stephen Coleman of Daedalus Capital wrote “The price earnings multiple (P/E) is an increasingly useless metric when valuing Apple’s stock price. The reason why is that Apple now uses subscription accounting”

In summary, Apple and Google can’t be compared on a P/E basis because of the differences of accounting treatment and capital spending levels that affect free cash flow. Reported income doesn’t accurately present either firms real story. To better assess and compare Apple and Google, one must examine each firm’s cash earnings, thus P/FCF is a much more suitable metric for comparison.

Price Multiple Comparisons- Apple vs Google:

The first table illustrates the differences between P/E and P/FCF based comparisons. First, let’s compare the cash flow multiples. According to Morningstar, Apple is trading at 25.6x trailing free cash flow compared to Google’s P/FCF of 38.6x. Google’s P/FCF ratio is more than 50% higher than Apple’s, and that’s on a trailing basis. Consider that Apple will probably sell close to as many iPhones in this quarter, as it did in the past year in total. Also, factor in dozens of new countries that the iPhone will soon be offered, as well as increased exposure through Best Buy outlets. iPhone sales are certain to increase free cash flow relative to reported EPS due to the 24 month revenue deferral. As I mentioned in my July analysis, I wouldn't be surprised is Apple could generate more that $10 FCF/shr next fiscal year. Hence, Apple’s free cash flow is poised to increase dramatically. In contrast, Google’s free cash flow growth will likely match EPS growth, if even that. Google’s has high capital spending needs, and even much higher if considering cash spent on acquisitions. A more detailed analysis on the matter will be presented later.

Evaluating P/E multiples: Apple trades at a higher forward P/E- 28.9x vs 20.6x based on expected FY09 EPS. On the surface, this appears to be backwards, since Googles earnings are expected to increase 23% versus Apple’s 16%, it would seem Google should be afforded the higher P/E multiple. Thus, GOOG would appear to be of better value superficially. However, a closer examination reveals that Apple’s multiple isn’t unreasonable, rather uninformative. There are several justifications for Apple’s higher P/E multiple.

First, Apple’s FY09 estimates are most likely too low. Apple has significantly exceeded the consensus estimates for many quarters going back. 16% EPS growth is not inline with Mac sales growth which has been north of 40%. This spills over into hardware and software sales growth which has been growing roughly 30-40% Yr/Yr in recent periods. Music sales has been north of 30%. More iPhones will continue to support that growth. iPod sales have been one area of concern, yet FY08 iPod revenue growth has been stronger than FY07, and with the expected introduction of new iPod models, iPod growth should not significantly falter.

The key issue has been the reduced margin guidance. I believe there are two possibilities: 1) Management is being overly conservative 2) Apple is undertaking a more aggressive strategy. Neither of the two are unfavorable. According to Andy Zaky’s research at Bullish Cross, Apple has a long history of sandbagging on its margin guidance which has enabled Apple to consistently beat EPS numbers. Generally, Apple only exceeds revenue estimates by a slight to moderate margin, yet its EPS continues to come in by a much higher amount. Therefore, it’s very possible that management is being overly conservative. The other possibility is that Apple is actually being candid, but not necessarily a cause for concern. Management alluded to a “new product transition” and I also detected a latent overtone of possibly more competitive pricing. Apple wouldn’t sacrifice margin unless it were to more than offset the ensuing profit reduction with increased sales volume. Why would it? Apple doesn’t have to shrink its margins voluntarily. Historically, it hasn't had to defend market share with price promotion. Thus, Apple may be looking to measurably expand its share with more completive pricing. In short, I don’t expect the lowered margin guidance to negatively impact earnings growth.

Second, FY09 EPS would be significantly higher if Apple didn’t account for iPhone sales using subscription guidelines. This is a key issue many others are missing or just choosing to ignore. Most analysts expect Apple to sell more than 20 million iPhones next year, which may amount to 10 billion in revenue, yet it will be reported over a 2-year period even though resulting cash flow will be received on the front-end. At minimum, under traditional accounting methods, Apple’s FY09 EPS would be at least $1 higher than current estimates. I stress “at least.” That would push Apple’s FY09 growth back above 30%.

Google’s Revenue Demand Outlook:

Google’s main source of revenues is online advertising, notably paid-search. Google dominates as it garners an overwhelming share of search traffic and paid-search ad dollars. Google’s sales growth rate has been decelerating for a couple reasons. First, the “Law of Large Numbers” is beginning to take affect. It’s much easier to increase sales 50% from a revenue base of 1 billion than it is from $10 billion. No growth stock is immune from this inevitable constraint. Second, more importantly, Google is exhausting its growth avenues in paid-search.

The three paths for a firm to increase sales are 1) Market Growth- non-users become new users 2) Increase Market Share- steal current users from competitors. 3) Up-Sell Own Customers- entice current customers to purchase more or pay higher prices.

Google’s rapid growth has originated from the online advertising industry growth, coupled with market share gains within that industry. Generally, as the industry life cycle evolves, firms initially focus on capturing growth as the market expands and attempt to avoid clashing with other industry participants. When industry growth ebbs, firms then look to take share from weak competitors for sustaining sales growth. When low-hanging fruit has been harvested, a firm may attempt to raise prices if it has monopoly power (differentiated product) which assuages customer defection.

What has been Google’s major focus recently? Raising prices. Customers bid on key search terms providing price formation as PPC, or price per click, the amount an advertiser is charged each time a consumer clicks on the sponsored search result. Google has been working on improving quality, hence relevancy of its paid search ads displayed. The goal is to reduce the “bounce rate” which is when a user clicks an advertised link and subsequently navigates off the destination web page without navigating any deeper on the landing site. The advertiser still incurs charges for the traffic sent to its site, however it didn’t produce any value. In theory, the higher number of clicks leading to a sale should be more valuable, thus command higher prices. If Google’s major effort is enhancing ad search value, what does that imply about its other avenues for growth? It basically confirms what is logically apparent. Internet advertising market growth is decelerating as it traverses the path towards saturation. Google’s market share growth has also been decelerating. Both areas are still growing, albeit, at slower rates. The outlook for market share growth is limited. Google already commands an overwhelming majority giving it less room to expand. It has taken so much of the market there is not much more left to take. There will always be room for niche players that provide value by offering an alternative to Google. Yahoo is moving in that direction as it continues to lose share, joining the likes of Ask, MSN, etc. but will be off limits to Google for anti-trust reasons.

This new focus provides clear evidence that Google can’t solely rely on industry growth and share gains to support continued sales growth. Google also needs to find new growth sources aside from online advertising. This is a primary focus as evidenced by the heavy capital spending, research & development, hiring, and new acquisitions. It’s quite nebulous as to how this will all take shape, yet there’s a very good chance that Google will be the pioneer in new market spaces once they evolve.

There is no question that Google will continue to turnout impressive growth, as it’s the leader in a space that should continue to demonstrate above-average growth. And, there are all the other growth opportunities that Google faces. Given its technological leadership and market position, Google has the advantage going into emerging product spaces. The key question in my mind continues to be “Google’s growth- At what cost?” How much of this capital spending and R&D will pay off? How about acquisitions? Can Google get those to add value, specifically YouTube and DoubleClick? Or, will Google destroy shareholder value from investing in areas that fail to produce desired returns? For me, these are the most pressing issues.

Many say that Google is a one-trick pony, and a pony not getting younger at that. Another characterization is Google is Janus-faced: part cash cow,a piggy-bank that will continue to get fatter, coupled with the side that milks the cash cow in efforts to add to its cattle herd. In order for Google’s stock price to move higher, investors will need to see evidence that Google’s spending and investing activities are worthwhile. I published an analysis of Google on March 18, 2008 when shares were trading below $440. I concluded from my analysis and valuation modeling that Google’s fair value was $537. I think that fair value estimate roughly still remains intact today, yet I haven’t done the needed in-depth analysis to ascribe a high degree of confidence to it. My thinking is I would be a buyer under $500 and a seller above $550, absent of any new developments.

Apple’s Revenue Demand Outlook:

Apple’s Mac computers only account for single digit share of the PC market. That share has been increasing at breakneck speed, and there hasn’t been any indications that the trend won’t continue. With the capability of running Windows OS on Mac hardware, the transition barrier has been drastically reduced. Apple’s small market share provides vast room for sales growth. Same could be said about the iPhone. The iPod business may be approaching a saturation point, as I recently evaluated. , however Apple is likely to introduce new models that may lift growth. There is no telling what new products Apple will come up with. They will likely be natural extensions or complements to existing offerings which will allow Apple to leverage its installed base. This is essentially what we have been witnessing as the “halo” effect.

Apple has also not appeared to be as economically sensitive as Google. Mobile phones and computers have become daily needs, whereas online advertising is not. When the economy weakens, consumers will not spend as much or as often on phones and computers, yet the first item axed from corporate budgets is advertising spend.

Apple’s demand outlook is strong, and it generates strong free cash flow due to low capital investment needs and working capital. My view is that Apple’s cash flow prospects are not entirely reflected in its share price causing the stock to be undervalued. Considering how little incremental investment is required to support sales growth, Apple is great company. Assets such as brand equity and human capital aren't reflected on the balance sheet, yet those are critical value-generating assets. With the additional cash flow I expect the iPhone to deliver next year, I believe AAPL will surpass $250 in 2009.

Profit Margins:

Another difference many point out is profit margins. Google has higher net margins than Apple 25% vs 15% (ttm), yet there is a major caveat that shouldn’t be ignored. Net income reported is not the amount of cash that is available to shareholders. Free cash flow is, since it’s net of capital expenditures and other investments using internal cash. The FCF margin (FCF/Sales) is roughly identical for both firms, about 20% in the trailing 12 months. Google’s capex as a percentage of sales is much higher than Apple’s. Additionally, Google has spent large sums of cash on acquisitions recently which I didn't include in the FCF margin calculation reported above. In the last 12 months, Google spent over $4 billion acquiring businesses, or 20.5% of total sales. In FY06, cash acquisitions were 3.8% of sales, and 5.5% for FY07. Therefore, Google may have a higher net margin, yet it must spend heavily on capital assets and acquisitions which results in less remaining cash that could be distributed to shareholders.

Another notable fact: Apple’s net margin has risen from 10.3% FY06, to 14.6% FY07, and is 14.9% in the last four quarters. Google’s net margin has declined, 29% FY06 to 25.3% FY07, and to 24.6% in the trailing four periods.

Capital Investment Requirements:

Apple’s capital expenditures were 2.9% of revenues for the last 12 months according to Morningstar. This has been drifting lower as capex/revenues was 3.4% in FY06, and 3.1% in FY07. Google’s capex requirements are significantly higher as it has averaged north of 14% of revenues for the past year. As mentioned previously, Google has also used cash to acquire businesses which pushes cash investments as percentage of sales above 20%, to be exact 35% for the preceding 12 months. This illuminates the stark difference between Apple and Google many fail to consider.

Operating Expenditures:

Google spends heavily on research and development as evidenced by 12.9% of sales in last 12 months. This has ticked up from 12.8% in FY07 and 11.6% in FY06. Apple’s R&D is much more modest, 3.3% TTM, 3.3% FY07, 3.7% FY06. Google spends nearly 4x as % revenues than Apple, and Google’s R&D has been increasing while Apple’s R&D has been falling/stabilizing

Apple’s selling,general, and administrative expense (SG&A), the technical word for overhead, has been falling as a percentage of overall sales. In contrast, Google’s SG&A expense is higher (%sales) and has been trending in the opposite direction, up. This can partially be attributed to the massive increase in Google’s head count as well as additions to its sales function. The idea behind an internet company is that there are economies of scale, incremental revenue dollars incur lower costs, not higher costs, as sales are spread over fixed cost base. This hasn’t proved to be the case with Google, nor Amazon for that matter. Yet, the caveat is that these two have experienced rapid growth, and are spending in attempts to generate more.

Since Apple’s product categories/markets are more defined, it’s able to spend at a more measured pace to support growth. Being of a more traditional business model, Apple is able to spread overhead expense over higher sales volumes, in effect leveraging its cost structure to boost margins.

Conclusion:

Google spends heavily on capex, acquisitions, R&D, and new hires in attempts to sustain its robust growth. Google’s paid-search business probably won’t be able to sustain above 30% revenue growth for too much longer. It’s likely that growth will gradually fall into the upper to mid-teens where it will stabilize. Google is positioned to capitalize on an immense number of growth opportunities as they are presented. It’s in the driver seat, yet there is some risk Google may spend frivolously on efforts that never come to fruition. Yet, there’s also the potential of huge rewards that cold result from Google’s heavy investing translating into a market leader in new spaces. Google’s new sources or growth are not entirely clear at the moment, opposed to Apple’s growth sources being more defined.

Apple has plenty of room for growth due to its low share of PC and mobile handset market. Apple has built substantial momentum in capturing more share in both markets. Apple has low R&D and capital spending requirements, Margins have been improving, as the desired effects of scale and operating leverage come into play.

Google’s margins are falling as expenses increase, the opposite effects of leverage. This implies that there is an increasing incremental cost of generating an additional dollar of revenue. Thus, in my mind, this suggest Google is hitting headwinds as it has picked the low-hanging fruit.

Apple and Google can’t be compared on a P/E basis because of the differences of accounting treatment and capital spending which affects free cash flow. Reported income doesn’t accurately present either firms real story. To better assess and compare Apple and Google, one must examine each firm’s cash earnings, thus P/FCF is a much more suitable metric for comparison.

Disclosure: None

Apple Inc (AAPL): Are Investors Overlooking Cash Earnings?

2008-07-30T10:27:00.005-05:00

Apple Inc (nasd:AAPL) $157.08: I believe investors have become overly fixated on Apple’s expected accounting income, while ignoring Apple’s impressive free cash flow generating ability. Free cash flow, not earnings reported in the accounting statements, determines the true value of a firm. AAPL’s high margins coupled with minimal capital investment needs, enables it to produce robust free cash flow. Another issue is the iPhone accounting treatment, which conceals the true magnitude of its cash generation. According to my estimations, the 3G model’s cash flow per unit is higher than its predecessor. In addition, Apple receives these cash flows much sooner compared to the old model. Not only will Apple sell many more 3G models, the per-unit impact on cash earnings will be much greater. Therefore, when shifting focus to cash earnings, as opposed to accounting earnings, AAPL looks attractive at current levels.

Earnings Expectations:
At the Q3 earnings call, Apple guided well below expectations for Q4, and gave a weak gross margin forecast for FY09. Shares took a hit and prompted Wall Street analysts to reduce their 4Q08 and FY09 estimates. Consensus estimates for FY08 & FY09 are $5.20 & $6.05, respectively. Early this year, the FY09 estimate was ~$6.50, then drifted lower to ~ $6.35 where it hovered for several months. Since Apple announced its margin guidance, the consensus FY09 EPS estimate has plunged to $6.05.

Apple shares currently trade @ 27x FY09 EPS, with expected annual growth of 16%. A 27x multiple for 16% growth isn’t exactly cheap. However, evaluating Apple on an EPS-multiple basis is misleading due to Apple’s iPhone accounting treatment. Considering Apple’s cash flow/share, the stock looks attractive.

Wall Street estimates are for accounting income- what Apple is expected to report, not what Apple will actually earn. Cash flow is the true metric that matters, not accounting earnings. Accounting earnings are a product of a firm’s finance department, and cash earnings are a product of customer behavior. Thus, one shouldn’t place too much emphasis on accounting income and quarterly estimates.

The amount of cash flow available for distribution to owners determines intrinsic value. Accounting income and cash flow are not the same, and often accounting income is a poor proxy for distributable income, hence intrinsic equity value.

Evolution of Market Expectations:
The 3G iPhone developments- new markets, new revenue model, lower price points, and new features, etc didn’t seem to affect AAPL shares much. However, concerns over Steve Jobs’s health and guidance have pressured shares. iPhone demand has been relentless since the launch as stores struggle to keep supplied. Analysts have raised their forecasts for unit sales, yet earnings estimates have only changed slightly (before CC).

Earlier this year, investors and analysts were questioning whether Apple would achieve its stated sales goal of 10 million units in CY08. Some began to think the iPhone was going to turn out to be a disappointment, and that expectations were certainly excessive. However, iPhone sales projections rose significantly with the June announcement. Many analysts raised estimates to more than 20 million for 2009. Yet, there was then the question of reduced profitability due to the reduced price points. Originally, the thinking was that volume could certainly expand but the effect on the bottom line would be subdued due to shrinking margins. Yet, it was soon agreed that margins won’t be significantly impacted due to the larger-that-originally expected subsidy payment. Instead of receiving a cut of monthly carrier payments over 24 months, Apple will receive an upfront lump-sum payment that is likely equivalent.

So, we have a massive increase for iPhone sales expectations with profitability remaining somewhat intact, yet AAPL shares react moderately and analysts only revise estimates slightly higher. Ostensibly, earnings estimates didn’t change significantly due to the iPhone accounting treatment that spreads revenue over 24 months. Thus, iPhone sales won’t really impact the income statement until a much higher run-rate persists for many quarters so that revenue recognition has had time to catch-up.

Shares reacted little to the June announcement, until somebody pointed out that Jobs looked unhealthy causing the stock to tank. Shares later recovered only to get slammed again after the Q3 earnings call when management refused to elaborate on Job’s health condition. Panic over Job’s health has abated, but concerns regarding Apple’s gross margin guidance and susceptibility to a weakened consumer still linger.

3G Produces More Cash Flow & Sooner:
The transition from shared payments from carriers to an upfront subsidy payment increases Apple’s intrinsic value.

Apple’s cash flow will increase from receiving an upfront, one-time payment opposed to recurring monthly payments. Originally, when an iPhone was sold, Apple only received cash associated with the handset sale, revenue which probably averaged around $430-$440. Apple then would receive $15/mo (guesstimate) for the next 24 months, $360 in total payments, or PV of $319 @ 12% discount rate. Present value of total CF is ~$750/unit, However, this isn’t a very realistic assumption to model. Actual revenue/unit is significantly less due to several reasons.

First, not all units receive full 24 months of payments due to iPhones being lost, stolen, broken, etc. Monthly payments are then attributed to the replacement unit and the original device no longer generates monthly revenue payments. AT&T shares revenue per iPhone customer (activated device), not for each device sold. Thus, Apple has sold two handsets yet only collects $15/mo, or theoretically $7.50 per device.

Second, not all iPhones sold were activated with a participating carrier (unlocked), so a significant percentage of legacy iPhones (maybe 40%-50%) don’t receive carrier payments. Unlocking has actually been beneficial because is has allowed Apple to sell units that it would have never sold, and it has generated product exposure in foreign markets. Yet, for the sake of modeling, and for cash flow comparison between the former and current revenue models, we can’t assume that the average monthly payment is $15 across all units.

Third, many units will be replaced with 3G iPhones before the full 24 months elapses. 2.5G iPhone owners that upgrade to the subsidized 3G model contribute maybe 12 months (or less) worth of payments. Piper Jaffray’s survey on launch day found 38% of 3G buyers were current iPhone owners.
Just for the sake of illustration, assume 50% of iPhones are unlocked (or lost/broken), and one-half of the other 50% upgrade to the 3G model after 12 months. This leaves 25% with 24 months of revenue payments At $15/month shared carrier payment, the average unit revenue/month is $5.63, or $135 over 24 months. Assuming ASP of $430, total revenue/unit is $565 (not accounting for time value of money). Therefore, it’s unrealistic to assume that the legacy iPhone revenue model was bringing in $790/unit ($430 + $15 x 24m)

With the subsidy payment model, there isn’t any uncertainty as to what the actual realized revenue/unit will be, since all payments occur on the front-end. Sales thus far have been skewed towards the 16GB model, which AT&T is offering for $299 with a 24-month contract, or $699 for no commitment. Similar arrangements exist in foreign markets, and the pricing works out to be roughly equivalent on a currency translation basis. So, AAPL could be capturing over $600/unit, a more conservative figure would be $550 or $500. Thus, Apple is likely receiving revenue per unit commensurate to the 2.5G iPhone.

A major point that I feel is overlooked relates to the timing of cash flows. For example, consider the following illustrative assumptions. Apple receives $600 upfront on the 3G opposed to $450 upfront and $150 in total cash payments spread over 24 months for the 2.5G. The accounting will look the same for both models since total revenue/unit is equivalent, and in both cases is recognized over 24 months resulting in revenue of $75 per quarter. Even though both scenarios appear to be similar from an accounting standpoint, the cash flows are different. All cash flow from the 3G hits at the time of the sale, where as just a portion of 2.5G cash flow occurs on the front-end.

To summarize my points:
1) 3G iPhone realized revenue/unit is higher- not every 2.5G iPhone generates shared carrier revenue, and not all units that have attached payments will survive the full 24 months.
2) Time Value of Money- Apple receives 3G iPhone revenue upfront, whereas the previous model entailed deferred revenue payments. Not only is there the opportunity cost of forgone investment alternatives, the cash payments are uncertain.
3) 3G model’s production cost is estimated to be about $55 less that the original model.
4) Demand, demand, demand. More markets, more features, cheaper price. The first iPhone took more than two months to sell 1 million units, which the 3G iPhone surpassed its first weekend.

The new 3G iPhone and revenue model will dramatically boost Apple’s cash flow that should result in a higher valuation. Not only is demand substantially stronger for the 3G model, but the actual revenue/unit realized will be higher, and the cash flow will occur sooner.

iPhone Impact:
If Apple sells 20 million iPhones next year assuming: $500 ASP, 50% gross margin. 30% tax rate, it will generate incremental cash flow of $3.90/share. Assuming that Apple sells 5 million in each quarter, the accounting treatment would only recognize $1.23/share for 2009. Cash earnings are more than 3x higher than reported earnings. Using more aggressive assumptions: $600 ASP, $250 COGS, the iPhone would produce $5.50 CF/share. Subscription accounting would only report $1.72/share.

The assumptions I am modeling for FY09: 20 million units, $350 subsidy, 65% 16GB ($299) & 35% 8GB ($199) = $614 ASP, $233 production cost, 30% tax rate. This calculates out to 5.32B in after-tax cash flow, or $5.92/share.

Apple’s FCF/share (ttm) is roughly $6.84, a price multiple of 23x. In contrast, Apple trades 31x EPS (ttm). I estimate that $1.10 of the $6.84 CF/share is iPhone related, thus FCF/share associated with all other segments is $5.74. With a 25% growth rate, non-iPhone CF increases to $7.18/share in FY09, and adding $5.92 from iPhone, CF for FY09 totals $13.10/share. This figure equates to a price multiple of 12x, and as mentioned previously, Apple is trading 27x FY09 EPS estimate of $6.05.

This is more or less a “back of the envelope” exercise, but the purpose is to illustrate the vast difference between Apple’s cash flow and accounting EPS due to iPhone revenue recognition.

Apple’s Free Cash Flow-
Apple is an impressive free cash flow generator. The primary components of free cash flow are 1) NOPAT- net operating profit after-tax 2) Working-capital requirements 3) Investment in fixed assets (capex).

Apple’s has negative working-capital requirements due to rapid inventory turns. AAPL turns its inventory about every 7 days, or 50x a year. Apple’s collection period for outstanding receivables is slightly more than 20 days, yet it doesn’t pay its suppliers for roughly 90 days. Thus, Apple doesn’t need to sink additional cash into working capital as sales increase since it’s funded through trade credit. This would allow more cash to be distributed to shareholders since it doesn’t need to be retained to fund operations.

Apple’s capital investment needs are quite modest. FY07 capex was $735 million and $893 million for the last 4 quarters. This equates to roughly 3% of revenues, and when depreciation is taken out, net investment is approximately 1.7% of total sales. A sizable portion of Apple’s capital investment relates to retail store growth. Apple’s stores produce extremely high revenue per square foot, as well as attracting consumers unfamiliar with the Apple brand. Retail stores perform a marking function for Apple due their appeal that generates substantial foot traffic. The stores are also ideal for cross-selling Macs to consumers who have come to purchase an iPhone or iPod. Thus, Apple’s retail store strategy has proven to be a very worthwhile investment.

Much of Apple’s assets are intangible, thus not reported on the balance sheet. Intellectual capital and brand equity are just two examples. Relatively speaking, Apple doesn’t have to spend heavily on developing these assets. Apple’s marking spend is 2% of revenue as it enjoys doses of free advertising from the media and word-of-mouth from satisfied users. Apple’s research and development expense is just slightly more that 3% of sales. In comparison, R&D for Yahoo ~16%, Google ~13%, and Amazon ~ 6%.

Conclusion:
In summary, EPS (ttm) is $5.11 or 15% net margin, and free cash flow as a percentage of revenue is 20%. As iPhone sales increase, these two metrics will diverge further, yet the focus should be on cash flow. It’s widely accepted that the iPhone has a much higher gross margin than the overall Apple business, yet due to subscription accounting, the iPhone’s impact on overall gross margin is very minimal. Thus, panic over the gross margin forecasts is misguided because on a cash basis, gross margins would be much higher. Investors should then place less weight on Wall Street earnings estimates. Therefore, when evaluating Apple on its prospective cash flows, shares look attractive under $160.

Disclosure: None

Authentidate (ADAT): Exploding Demand for Shares

2008-07-27T18:11:00.004-05:00

Authentidate Holding Corp. (Nasdaq: ADAT) $0.78- Authentidate has been on a tear recently with shares up 189% from an all-time low of $0.27 reached on July 7. In May, I wrote about ADAT when it was trading at $0.43 and recommended the stock since I believed it was undervalued. Since its trading low, daily volume has averaged 108k for the subsequent 14 trading sessions. For the 14 sessions prior to its low, ADAT’s average daily volume was 17k. Hence, there has been strong demand for ADAT shares. This trend bodes well for continued share price appreciation.

I think there are a couple factors responsible for the recent rally. First, ADAT is a good value with $0.53 cash/share and is expected to reach cash flow breakeven in the next 2-3 quarters. Second, ADAT recently announced a new joint venture with EncounterCare Solutions, Inc. (OTC PK: ECSL that represents its entry into a new market vertical. This new segment offers a significant opportunity for revenue growth and profitability.

ExpressMD Joint Venture Press Release (June 10, 2008):

The joint venture called ExpressMD^TM Solutions will provide in-home patient vital signs monitoring systems and services to improve care for patients with chronic illnesses and reduce cost of care by delivering results to their health care providers via the Internet. ExpressMD Solutions will combine EncounterCare's Electronic House Call^TM patient vital signs monitoring appliances with a specially designed web-based management and monitoring software module based on Authentidate's Inscrybe^TM Healthcare platform. ExpressMD Solutions will enable unattended measurement of patients' vital signs and related health information. Patients' data will then be securely sent electronically to each patient's health care provider for review. ExpressMD Solutions will be designed to aid wellness and preventative care, and deliver better continuity of care to specific patient segments such as the elderly, special needs or pediatric patients with chronic illnesses who require regular monitoring of serious medical conditions.

According to a January 2008 research study conducted at the State University of New York at Fredonia, the demand for patient monitoring systems in the primary healthcare sector in the United States is forecast to increase 5.9 percent per year to an estimated $12 billion market by 2012 based on expected contributions to positive therapeutic outcomes and efficiencies. Additionally, the study indicates that the market for self-monitoring activities will also expand as treatment for chronic care patients, especially patients with asthma, diabetes and heart disorders focuses on preventative care.

Using ExpressMD Solution's offerings health care providers will be able to easily view their specific patient's vital statistics and make adjustments to the patient's care plans via the Internet. ExpressMD Solution's easy to use patient monitoring system is intended to provide patients with increased peace of mind and improved condition outcomes through a combination of care plan schedule reminders and comprehensive disease management education on their in-home communication unit. The service will provide intelligent routing to alert on-duty caregivers whenever a patient's vital signs are outside of the practitioner's pre-set ranges.

Health care providers and health insurers also are expected to benefit by having additional tools to improve patient care, and reduce overall in-person and emergency room patient visits.  "EncounterCare's expertise with in-home patient monitoring technologies and Authentidate's expertise in online healthcare systems and securely managing patients' documents has allowed us to shorten the development cycle and ready this solution for delivery in record time," said Ron Mills, CEO of EncounterCare Solutions, Inc.  "The ExpressMD Solutions joint venture will allow Authentidate and EncounterCare to leverage existing portions of our respective healthcare products as well as existing healthcare industry relationships from both companies," said Ben Benjamin, President of Authentidate Holding Corp. "The telemedicine market is a large market that we believe will benefit from our document management capabilities. By entering this market through a joint venture, we will be able to strongly penetrate an emerging market, while expanding the use of our platform within the health care community.

ExpressMD Signs First Contract with Cyntrist:

On July 8^th, it was announced that Authentidate and EncounterCare had signed their first user contract with Cyntrist, for use in remote monitoring of Diabetes patients located through out the Southeastern U.S. The opportunity in the Diabetes space is colossal. In a recent study, the CDC reported that 24 million Americans (8% of population) are afflicted by Diabetes, a number which has increased by more than 3 million in just two years. The ExpressMD solution provides physicians with the ability to remotely monitor patients’ glucose levels, weight, etc. on a daily basis and adjust treatment as needed. Not only does this enhance the quality of patient care, it reduces the need for regular office visits, thus reducing the cost of medical care. The advantages are compelling, and with such a large addressable market, ADAT may benefit substantially.

Conclusion:

The recent news comes after Authentidate management had stated that they believed cash flow break-even could be attained by CQ1 2009. The implication was that existing business was likely sufficient to attain that goal, for it was an issue of customers ramping up implementation. Now, with these recent developments regarding the ExpressMD joint venture, Authentidate’s prospects have become even brighter.

A Look at the 3G iPhone's Profitability

2008-07-15T18:19:00.003-05:00

Apple’s 3G iPhone appears to be quite profitable. The fully subsidized price from AT&T is $199/$299 for the 8GB/16GB models, respectively- requiring a 2-year contract. If a current AT&T customer has recently purchased a discounted phone, then the price may increase up to $399/$499, depending how much subsidy AT&T needs to recover on the old phone. Without a 2-year contract from AT&T, the iPhone will cost $599/699.

The actual amount Apple receives per iPhone is uncertain. Wall Street analysts estimate AT&T is paying a $300-$350 subsidy. The AT&T pricing scheme suggests the subsidy may be as high as $400 per unit.

Even though $200 is the industry standard for smart phone subsidies, there are many reasons that support the higher estimates.

1) AT&T is increasing data plan by $10/mo and no longer offering 200 free text messages. Most iPhone plans will increase by $15/mo. This equates to a $360 increase over the life of the contract.
2) AT&T’s average revenue per user (ARPU) is roughly $50/mo, where the iPhone ARPU is north of $90/mo. Thus, iPhone users generate $960 more per 24-month contract.

Therefore, a $350 subsidy is quite reasonable and perhaps conservative. Using this assumption, Apple receives $550/$650 from AT&T.

A recent estimate by iSuppli puts the production cost at $173 for the 8GB unit. The 16GB model adds only $16 more to cost; yet it sells for $100 more than the 8GB device. Gross profit for the 8GB model is $376 at a selling price of $550. The 16GB model has a gross profit of $460 selling at $650. The gross margins calculate to 68% and 71% for the 8GB/16GB, respectively.
The 16GB adds $84 in incremental gross profit, or nearly a $1/share per 10 million units. Thus, the model mix can significantly impact the income statement.

Initial data suggests that consumers are favoring the 16GB model. This is very positive since the $16GB produces $100 more in revenue and has a higher gross margin.

According to the retail store availability information on Apple’s website, the 16GB model has been dramatically outselling the 8GB model. However, one problem is the supply of 8GB versus 16GB is unclear. Early Saturday, Apple’s website reported 20 stores sold-out of 8GB, versus 28 stores sold-out of 16GB-white and 53 for the 16GB-black. This indicates significantly higher demand for the 16GB models.

It’s also likely that Apple had a larger stock of 16GB devices due to higher demand for larger capacity historically. In addition, it’s less advantageous to carry to little stock of the higher-priced model since running out of the 8GB may persuade a consumer to trade up to the 16GB. Conversely, higher supply of 16GB models prevents losing potential sales of the higher-priced model when a stock-out forces one to purchase the cheaper model.

A survey by Piper Jaffray of 283 line waiters this weekend reported that 66% planned to purchase the 16GB model. This ratio of 2:1 would support the data gleaned from Apple’s website regarding iPhone availability.

Regions Financial (RF): Due for a Bounce?

2008-06-18T23:36:00.005-05:00

Regions Financial (nyse:RF) has plummeted to $11.40 from its July 2007 levels of $32. For most of 2008, RF traded in the $18-22 range, but since May, RF has been on a pronounced downtrend. It’s also important to note, that the regional banking group as a whole, has been extremely weak for the past several weeks. Regions fell 7.4% on Tuesday, June 17th, and then fell 10.4% on Wednesday. In the last 30 days, RF has plummeted 45%. Also under pressure are Suntrust (STI), Key Corp (KEY), Fifth Third (FITB), BB&T (BBT), and Wachovia (WB). Looking at the table, most of the 3 & 6 month cumulative losses occurred just in the last month.

The obvious question- is the selling overdone? Regions may be due for a bounce. The two key possibilities that must be examined are 1) Has indiscriminate selling of the regional bank industry unfairly punished RF shares? 2) Does the market know that disappointing news from RF is imminent- or consensus EPS estimate revisions?

Regarding the first possibility- if shares have been unfairly crushed, then answer is simple: RF should be bought. In order to ascertain if RF’s situation differs from the rest of its peers, the second possibility needs to be examined.

It’s tough to predict negative news announcements and earnings misses. However, it’s rather apparent that investors have been pricing in these events. Thus, the balance of risks appears favorable. If earnings come in below the consensus, or if the dividend is cut etc., it’s likely that much, if not all, are already reflected in the share price. Therefore, disappointing news wouldn’t adversely affect RF’s stock price. If news turns out to be better than expected, then RF should rally. Hence, the potential upside exceeds the risk to the downside; this creates a favorable risk-return tradeoff

Asset Quality:
Regions Financial doesn’t have any sub-prime exposure. It did have a sub-prime origination business- EquiFirst, but those mortgages were sold servicing-released and not retained on the books. Regions sold EquiFirst to Barclays back in 2007. In addition, Regions isn’t exposed to non-traditional mortgages such as option ARMs or loans with teaser rates. Regions primary concern is its $11.5 billion construction loan portfolio with $447 million in non-performing loans. Regions hasn’t had to take any major write-downs, and earnings have held up in the past several quarters relative to peers.

Earnings Expectations:
Analysts are forecasting EPS of 48 cents for the June quarter, which is down from 54 cents 90 days ago. For FY08, the consensus estimate is $1.95, down from $2.14 three months ago, but has been steady for the past month. Regions is trading 5.8x this year’s EPS estimate. This is quite low given RF’s 12.8x 5-year average and industry average of 13.5x. This might suggest that investors expect Regions to earn half of the current consensus, or 97 cents for FY08.

The trailing 12m dividend is $1.50, a yield of 13.2%. The stock price definitely reflects a cut or elimination. A 5% dividend yield at the current share price would be 57 cents. Assuming a 60% payout ratio, EPS would need to total at least 95 cents over the next 4 quarters.

It appears that analysts haven’t revised RF estimates down to reflect current market expectations. Why do investors think estimates are too high? It’s likely concerns center on Regions construction lending portfolio as it has been deteriorating. 3.5B of the 6.2B residential homebuilder segment consists of vacant lot and land, which could experience high losses. Regions management states that they are moving aggressively to manage losses in this portfolio.

Regions recorded a loan loss provision of 181 million for 1Q08, down from 358 million in 4Q07. It’s likely that Q2’s provision will have to return to at least 400 million. Even so, RF has been reducing costs through last year’s merger with AmSouth. In the march quarter, merger cost saves totaled 127 million, and management expects total cost saves of 700 million by year-end 2008. In addition, Regions Financial also owns Morgan Keegan, a strong brokerage firm, which will help diversify revenue streams during this downturn.

Short Interest:
RF’s short interest surged 13.1 million shares (27%) during the last period reported (May 15-30). This represents about 9% of the outstanding share float with cover ratio of 6.3 days. Since the last report, short interest has likely increased further given the declining share price. Short interest represents future share demand as shorts must buy shares to cover their positions.

Option investors are betting on further share declines in RF shares. On Wednesday, trading in Regions Financial's options surges to eight times the normal daily volume, as investors bought 48,000 puts and 8,000 calls. Activity was heavy in the July $10 puts, trading at 95 cents and will be in the money if RF slides below $9.05 before July 18.

It’s quite evident that investors are negative on RF. This positive aspect is that weak sellers are folding there hands and negative expectations are being priced-in. With so many investors negative, the supply of sellers begins to dry up, as the supply of future buyers increases. If future developments are not a dire as expected, then RF should see a nice bounce as short-sellers scramble to cover positions.

Conclusion:
Capital ratios are decent- Tier 1 capital ratio is 7.3% and Total capital ratio is 11.1%. These are well above the minimum requirements of 4% and 8%. Regions book value / share is $28.82 resulting in a P/BV of 0.4x.

Thus, the selling of RF shares has been warranted, but has it been overdone? Or, is there more selling to come? Regions revenue streams are diversified with its banking, brokerage, and insurance businesses. Regions is also aggressively improving its cost structure through its merger cost reduction plan. The combination of these factors should help offset, to a degree, future write-downs and loan losses. RF has adequate capital ratios, thus I don’t foresee a major equity capital raising.

I believe current share prices can withstand a 50% reduction to earnings and the dividend, as these possibilities are priced-in. Thus, I think, with a considerable amount of negative news already discounted, there is significant upside potential. Hence, the balance of risks is favorable possibly making RF due for a bounce.

What Can Push Apple's Shares Higher?

2008-06-11T21:17:00.006-05:00

Apple Inc (nasd:AAPL)- Apple has surged to $180 from $120 where it was trading back in February. Of course, Apple was trading near $200 at the end of December 2007, but sentiment turned and Apple’s shares plummeted January through March before reversing, and staging a rally in April. Shares have been stuck in the $180’s since May. The pivotal question becomes: “what can/will push shares higher?”

Apple’s stock may have gotten ahead of itself at the end of last year (2007), when it hit $200. Analysts were bullish and nearly all had a price target above $200. Then January arrived, Apple provided weak guidance and the Street flipped out. Sentiment quickly turned negative, and heavy selling drove Apple lower. A couple analyst downgraded the stock, and most revised their price targets lower to the $150-175 range. As industry data reports showing potential robust Mac sales became available in March, Apple shares began to recover. Apple announced earnings in April that showed strong Mac sales. This further quelled apprehension and eliminated the overly pessimistic attitude on Wall Street. As the chart illustrates, price targets were revised upward. In short, I believe Apple shares collapsed due to worries that they were overvalued, then information subsequently supported those high share prices, thus Apple’s stock returned to that level.

Apple has been stuck in the $180s since the beginning of May. Nothing has been able to power shares beyond the current range. There have been several analysts raising price targets. However, the effect on Apple’s share price has been insignificant. Apple announced the July arrival of its new 3G iPhone, yet Apple shares were still unsuccessful in breaking out into the $190s.

Apple has announced the expansion of iPhone countries from 5 to 70, as well as a much lower price point of $199. However, EPS estimates for FY09 have only slightly budged.

According to the EPS revisions table, most recent changes to the consensus estimates have been downward.

In my opinion, I think the catalyst for a move higher will be upward revisions to EPS estimates. I don’t think they currently account for the immense sales potential of the new iPhone, as well as the momentum in the demand for Macs. Albeit, Apple is giving up the monthly subscription revenue payments from AT&T, thus the increase in volume will becoming at a lower margin. This might possibly be why Apple’s shares have failed to respond more positively. There are a couple things to consider. First, there have been estimates that the new phone’s manufacturing cost is half of the current iPhone. Second, the MobileMe service at $100 per year adds revenue potential associated with the new iPhone. Sales of iPhone applications from Apple’s App store is another avenue to boost revenue. Most importantly, iPhone sales will expose the Apple brand to many who lack experience, and ultimately boost Mac sales.

I think we will gain more clarity in July, when the new iPhone hits stores and Apple releases Q3 results. It’s likely, until then, there won’t be many developments capable of really moving the stock, other than possible EPS estimate revisions.

Apple isn’t cheap trading at 35x FY08 consensus EPS estimates and 28x FY09. Apple may actually be cheaper if you believe those estimates are too low. I think the estimates are likely too low, thus Apple would be trading at slightly lower multiples. I think Apple could be bought on any weakness or pullbacks, since Apple’s share price reflects the fundamentals as opposed to pure sentiment, as it did last fall and this winter.

Disclosure: none

Consumer Spending Outlook

2008-06-09T21:03:00.004-05:00

Current economic conditions are challenging, especially for the consumer. Given a multitude of factors, I am skeptical of the popular belief that GDP growth will pick up significantly in the second half. I expect GDP growth will remain flat to sluggish well into 2009. I can’t foresee significant economic growth returning until the consumer regains strength. Historically, roughly three-quarters of GDP is related to consumer consumption, thus economic growth hinges on the health of the consumer. I have highlighted the primary elements affecting consumption.

Consumption is a function of monetary inflows (spending capacity) minus compulsory monetary outflows with respect to the level of willingness to spend net inflows. A consumer’s spending capacity is a combination of wages, investment income and access to borrowed funds. Compulsory expenditures are basic necessities, such as food, housing, energy, clothing, health & education, and taxes. After purchases for non-discretionary goods and services are satisfied, a consumer can choose to either spend or save the remaining money. The decision to save vs. spend depends on consumer sentiment and outlook on the economy.

Since we are focusing on GDP growth, we must evaluate at the margin, how current conditions have changed from those previous. There are multiple factors responsible for overall consumption. I can’t think of any major factors positively affecting spending other than the tax rebates. Most factors are neutral or unfavorable, with a major factor- home equity borrowing, being very negative. In this decade, GDP growth was largely dependant on equity withdrawals, which significantly boosted consumption. This is my key concern- the demise of the housing market and the evaporation of home equity. Since 2000, GDP without equity withdrawals would have never surpassed 1.25%.

Consumers have a reduced capacity to spend and face higher costs for essential goods/services, which leaves less money available for discretionary spending. Due to weak consumer confidence, disposable income will likely go more towards saving and debt reduction than being spent.

Consumption:
Wages + Investment Income + Borrowed Funds + Sentiment
- Taxes
- Mortgage/rent payment
- Compulsory Spending
= Disposable Income

CONSUMER SPENDING CAPACITY:
Wages:
I expect slow consumer wage growth due to the increasing supply of labor. Labor demand is weak as evidenced by the monthly decreases in payrolls we have been witnessing this year. When the economy is shedding jobs, then the unemployment rate rises (all else equal). Wage growth primary occurs when employers have to compete for labor in a tight market. When labor is abundant, there is less need to offer higher wages to attract and retain labor. In addition, corporations are trying to preserve earnings by controlling costs, thus there is less impetus to increase workers’ wages. Instead, companies will be looking to boost productivity. This is likely a reason we have been seeing strength in the technology sector.

In aggregate, job losses means there is lost income that otherwise would be spent, adding to total consumption.

Investment Income:
Investment income should continue to be soft. Financial firms, such a banks, generally pay large dividends. A large number have recently reduced or cut their dividend. Interest income from savings accounts and bonds has decreased due to falling interest rates. Income can also come from capital gains on investments and real estate. The stock market has been volatile, and one would have to go back to 2006 levels for gains on S&P500. Thus, in general, there are probably less profits that can be taken from an investor’s stock holdings. The second half of the ‘90s GDP growth was bolstered by a surging stock market.

Falling home values mean potential capital gains have fallen as well. Unless the house was purchased more than several years ago, there will not likely be any gain on sale.

Available Credit:
The most crucial aspect of consumer spending is ability to borrow funds. The major sources of borrowing are mortgage cash-outs, home equity lines of credit, and credit cards. In this decade, consumer spending was driven by home equity withdrawals. At the beginning, rates fell to historic lows resulting in mortgage refinances. Monthly payments were reduced along with equity withdrawals. During the middle years, home values appreciated significantly causing home equity levels to rise contemporaneously. The robust gains in home equity, coupled with easy credit that allowed high LTV, enabled consumers to use their homes as a major source of funds.

Recently home values have been plummeting which is causing reductions in home equity levels. 16% of homeowners with a mortgage have zero or negative equity. Moody’s expects that number to increase to 25% by June 2009. Average level of equity for a US home is 46%, which is the lowest level since the 40’s. At the beginning of the decade, home equity was nearly 60%, and hovered in the mid to low 50’s until 2007 when in broke below 50% as home values began to decline. Considering inflation-adjusted home values rose 70% from 2000 to 2006, one would expect equity levels to rise as well. Of course, cash-out equity refinancing must be considered. Thus, value created from home appreciation was withdrawn and consumed. Lax credit standards and loans allowing higher LTV (loan to value) also contributed.

With equity levels at historic lows, the amount of equity available to be withdrawn and spent is relatively minimal. This is compounded by the reduction of LTV ratio that banks will lend.

Foreclosures will add to the already bloated housing supply, which stands at 11 months. Demand for housing is weak due to tightened credit and reduced investor appetite for mortgages. These factors will continue to pressure home prices, and without appreciation, equity withdrawals will not increase.

Consumers pulled back on their borrowing during the first quarter, slowing the growth in their new debt to a 3.5% annual rate, less than a third of the growth rate seen two years ago and the slowest growth since 1992. New mortgage debt was particularly weak, growing just 3%, the slowest increase since 1970. Home-equity loans fell by $7.3 billion, the first decline since 2001.

COMPULSORY SPENDING:
With rising inflation, essential goods are becoming more expensive which leaves less funds available to spend on other goods and services. Even though spending on essential goods/services contributes to GDP, it can reduce discretionary spending leading to weakness and job loss in those areas. Inflation is rising in areas where demand is inelastic, such as food and energy. The dollar has been declining making imported goods more expensive. Not only does this reduce spending in other areas, it takes money from the domestic economy to be recycled in foreign markets.

Food Inflation:
Food prices have been rising to very high levels. The primary reason is due to a significant increase in demand coming from emerging markets where standards of living have drastically improved. Since nutrition is a top priority, consumers spend will first spend on food until satisfying that requirement, before challenging expenditures to other areas. Thus, huge demand increases will occur from those with the highest propensity to purchase food, which are those who are undernourished. In many countries, people are able to eat 2 to 3 meals a day instead of just 1 or 2.

The cost of food production has risen due to higher fuel and fertilizer costs. In order for farmers to produce a crop, the price must be high enough to cover costs or they will choose not to supply it. Essentially costs are passed on to the consumer if producers don’t incorrectly forecast demand resulting in excess supply.

Ethanol production has led to increased corn acreage, which has affected other food prices. Since more land has been devoted to corn, land available for producing other grains has decreased, hence reduced supply. Higher grain prices have translated into higher feed costs for livestock farmers, which drives up prices of meats.

Higher Energy Costs:
The price of oil has skyrocketed over the past two years. Price of gas has about doubled. Heating oil and natural gas prices have risen too. Transportation costs generally spread throughout all areas of the economy causing rising prices. Transportation for an individual, such as driving, has become much more expensive and there isn’t much that can be done to significantly alleviate the increased costs. Heating a home has become more costly as it’s another area where demand can’t be reduced much to offset rising costs.

Rising Cost of Imports:
Americans import many of their goods. The weakening of the dollar means that foreign goods become more expensive. China has been a major source for inexpensive goods, especially since its currency has been very undervalued for a longtime. With inflation is China skyrocketing and pressure to revalue the Yuan, the dollar has been weakening against the Chinese currency and will likely continue for some time. A significant factor in keeping inflation low has been cheap Chinese imports.

SENTIMENT:
The mood of the consumer is important in determining whether they will spend or save/pay down debt. The current economic landscape plays an important role. If consumers are optimistic about the economy, then they will save less, increase debt levels, and spend more. The wealth effect is equally important. Rising asset values make the consumer feel more wealthy, thus increasing discretionary spending budgets.

The net worth of U.S. households and nonprofits dropped at an annual rate of 11.3% in the first quarter to $55.97 trillion. It was the biggest drop in wealth since late 2002. Net worth had grown by more than $20 trillion from 2002 through the end of 2007, as home values and the stock market boomed.

Consumer confidence has plummeted. Home values, the consumer’s largest asset, are dropping. Consumer debt levels are high (nothing new). With these factors, consumers are less sanguine about spending and will be more reserved. They will likely take on less debt and save more.

CONCLUSION:
As I outlined above, there are multiple challenges facing the American consumer. The pivotal question is: “what will energize the consumer?” Historically, home equity borrowing has been the primary source, yet it will be some time before this is a material source for consumer funds. The consumer is also facing higher costs on staple goods and bleak employment outlook. Consumption has been by far, the largest component of GDP. Thus, I expect GDP growth to be tepid and consumer discretionary stocks to struggle. There is a bright spot- exports, the weak dollar is causing exports to surge. This is especially important because foreign funds pour into the American economy and are recycled domestically.

Festival of Stocks #90 @ Circle of Competence

2008-05-29T12:08:00.002-05:00

This week’s 90th edition of the Festival of Stocks is at Circle of Competence. Be sure to check out this week’s articles!

My article Authentidate Remains Undervalued was included in this week’s edition.

I recommend taking a look at some of the posts on Circle of Competence. It’s a new blog launched by Jeff Annello a couple months ago, and he has written some terrific material in short time. Mr. Annello focuses on Value Investing and its icons, such as Warren Buffett.

You can catch up on past editions by visiting the Festival of Stocks homepage. There you can also find out how to submit an article for next week’s Festival or learn about how you can volunteer to host an edition of the Festival of Stocks on your own blog.