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

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

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

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

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Authentidate (ADAT): Remote Patient Monitoring Presents Significant Opportunity

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

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Apple's FY09 EPS Estimate Too Low

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

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

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

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

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

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Analyzing Apple's iPod Business

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

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Taking an Alternative Perspective on Apple's iPod Growth

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

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Apple's FY09 Gross Margin Expectations Too Low

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

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

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

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Q4 Sales Estimates for Apple's 3G iPhone

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

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Understanding Valuation Multiples with Respect to Cash

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. 

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