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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Wednesday, April 23, 2008

A Look at Apple's iPod Business

Apple Inc, (nasd:AAPL)- This article focuses on Apple’s iPod business. The iPod has contributed significantly to Apple’s growth the past several years. However, iPod unit growth has been slowing, as nothing can grow forever. Apple has made some modifications to its iPod line which should help boost iPod demand. Apple announces Q2 results April 23rd, and unit sales growth as well as iPod ASP will be areas of focus.

Deceleration of iPod's sales growth is pointing to a market approaching saturation. Considering Apple has sold more than 140 million iPods, it’s not inconceivable to think that the PMP market is maturing. The iPod segment was Apple’s primary growth engine for FY05 and FY06 representing 58% of the dollar sales increase both years.

As iPod sales began to cool last year, Mac growth accelerated becoming the primary growth supplier. While investors aren’t expecting the iPod to be the chief source of growth going forward, sales still need to keep rising to not become a drag on Apple’s overall growth.

Apple will have to depend more heavily on the iPod customer base as a source for continued iPod demand. The introduction of the iPod Touch and the Shuffle’s reduced price point should help support iPod growth in the near-term. The Touch boosted iPod average selling price per unit in Q1. If Apple can continue to boost ASP, then the slowdown in unit volume growth will less adversely affect overall revenue.

iPod Sales:
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), and 35% (FY07).

It’s not a surprise that sales of iPods have been slowing. Since we live in a world of limited resources, growth cannot persist indefinitely. As iPod sales have grown to staggering heights, the Law of Large Numbers takes effect. To continue its FY07 31% unit growth rate, Apple would need to sell close to 70 million iPods in FY08, which is one-half the 140 million total sold over 6 years. At that growth rate, iPod sales would be 200 million FY12. It’s Highly unlikely that annual sales volume would ever achieve that level. Unit growth has been trending towards a rate in the teens, possibly single-digits.

Last quarter, Q1 2008, units increased 5%, compared to 50% growth in Q1 2007. Yr/Yr 2007 growth rates were 24% (Q4), 21% (Q3), and 17% (Q2).

Unit growth was 31% in FY07, compared to 75% (FY06), 409% (FY05), 371% (FY04), and 149% (FY03).

iPod unit sales only grew 5% (y/y) for Q1, 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 last quarter to $181/unit. You would have to go back 6 quarters to find a higher ASP. Boosting the ASP is a very positive sign in light of the slowdown in volume. Going forward, ASP will be the key metric to focus on.

Product Life Cycle:
iPod sales have mirrored the S-curve, which generally depicts the product life cycle. There are 5 stages in the PLC. Initially, sales growth is flat and then begins to increase in the introduction stage. The product enters the rapid growth stage, where sales increase at an accelerating rate. In the slowing growth stage, sales increase at a decreasing rate, finally to a point where sales turn flat as the product enters the maturity phase. Sales growth turns negative in the decline stage.

To avert the Decline (or mature) stage, product innovation is needed to rejuvenate sales growth. Introducing improved models with new features can sprout a new curve from sales growth reaccelerating. The S-curve then takes on a more scalloped shape.

To eliminate the seasonal effects, I have charted cumulative 4-quarter iPod sales. The resemblance to the de-facto S-curve is apparent.

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 140 million iPods sold and likely more than 200 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 sum, Apple can’t depend on new users to supply the sales volume as in previous years.

    The new Touch has the potential to 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.

  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 the largest source of potential sales. They outnumber competitors’ users and non-users likely to purchase a PMP in the near-term. Apple’s sales strategy will increasingly focus on selling more iPods to current owners since they represent the largest source of potential sales growth.

    Motivating current customers to buy a new iPod more frequently and/or buy multiple units are the primary methods for boosting sales among current iPod owners.

    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. 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 the replacement cycle for this type of product. New enhancements have to be so compelling to motivate the upgrade.

    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.

    Differentiation of the iPod model line encourages the purchase of multiple iPods. The introduction of the Touch and reduction in size and price of the Shuffle has reduced overlap of features. This may lead to iPod owners purchasing an additional model since the functionality is different.

iPod Product Line:
Primary attributes of iPod models:
Touch- PDA w/ internet & wide screen video
Classic- massive storage
Nano- video w/ size and price
Shuffle- size & price

One of Apple’s key strengths is innovation and the ability to improve its products in short time. This is evidenced by the 5 upgrades to the Classic model since originally introduced in late 2001. There have been 5 generations of the “Mini or 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.

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, Classic as repository to store all content, Nano (or more likely a Shuffle) for carrying a small device (during exercise).

The iPod 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 functionality. When third party applications arrive in June, the Touch will be revolutionized into an entirely new device as it will receive a massive boost in capabilities.

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. The Shuffle’s diminutive size, measuring 1 in x 1.5 in and weighing ½ oz, make it ideal for physical activity. Priced at $50, it’s attractive to current and non-current iPod owners.

iPod Outlook:
The Touch presents the opportunity for attracting new PMP users plus influencing current owners to “trade up” to a device at a higher ASP. 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.

Eventually, the iPhone will cannibalize a sizable amount of iPod sales, specifically the Touch. However, since a single carrier in the US offers the iPhone and only available in few foreign markets, the Touch provides most of the iPhone features to consumers who can’t feasibly buy an iPhone. This is especially beneficial for consumers who are locked in a wireless contract with a carrier other than AT&T, or for someone working at a business that doesn’t support iPhone. 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.

For the upcoming quarters, Investors should focus on the trend in unit volume in the context of ASP. If unit volume is sluggish, we want to see a high ASP. If ASP is weak, we will want to see very robust unit volume.

Wednesday, April 16, 2008

Apple's Q2 EPS Estimate Trend

Apple Inc. (nasd:AAPL) is scheduled to release earnings for Q2 2008 Wednesday, April 23rd. Below is some brief information on the historical trend of consensus estimates and reported earnings. This is a primer for a follow-up analysis I am currently working on- which I plan to publish within the next couple of days.

Data from Yahoo Finance reports 26 total estimates for Q2.
High Estimate: $1.18
Low Estimate: $ .94
Mean Estimate: $1.06

Q2 Previous Yr: $ .87
Apple Guidance: $ .94

Yr/Yr Growth:
Analyst Estimate:22%
Apple Guidance: 8%

The estimates have changed little in the last 60 days. Three months ago, the consensus stood at $1.09 until Apple announced its Q2 guidance of $.94 which caused analysts to trim their forecasts. Within the last month, the mean estimate ticked up one penny.

In February, there was a wave of negative reports: suggesting lower iPod shipments, weak iPhone and Macbook Air sales. The reports would support the lower than expected guidance, questioning whether Apple is really low-balling again this quarter.

In March, a flood of reports suggested iPod sales weren’t as dismal as previously thought. Also, there were indications that Mac sales were very strong. The iPhone SDK release renewed enthusiasm and a shortage at retail stores hinted at healthy sales. Even with positive industry data reports on Mac shipments, the consensus estimate only rose a penny.

I believe the consensus is a bit low, calling for 22% Yr/Yr EPS growth. I predict Mac sales are up more than 50% to over 2 million units. The general trend of Mac strength should be further bolstered by the new MacBook Air and upgrades to MacBook and MacBook Pros released during the 2nd quarter. The year-ago quarter saw no new introductions or upgrades to the Mac line. The Street is forecasting Mac unit sales of 1.9 million.

click to enlarge

Below is table of selected individual estimates reported by Zacks.

Table below depicts Apple’’s earnings history reported by quarter. Percentage changes are displayed for Yr/Yr change for individual quarter, Yr/Yr change for last 4 quarters, and sequential change for last 4 quarters.

Apple’s EPS announcement history- Estimate vs Actual and 1 day change in share price.
Last year, Apple beat Q2 estimates by 36% and shares rose 3.7%.

Stock price activity around announcement dates.

Wednesday, April 9, 2008

Festival of Stocks #83 @ Fat Pitch Financials

This week’s Festival of Stocks was held by George @ Fat Pitch Financials. I recommend checking out this week’s articles-  George did a great job selecting some terrific reads.

My article: EPS Revisions for S&P 500 Companies was included in this week’s edition.

Here are a few of my favorite articles from this week’s edition:

Fat Pitch Financials presents Official SEC XML Feeds.

College Analysts presents Selloff in Oracle (ORCL) Priming Tech to Rally

Dividend Growth Investor presents McGraw-Hill (MHP) Dividend Analysis.

The StockMasters presents EMC Corp: $1 away from a 52-week low, now what?

The Dividend Guy Blog presents Dividend Stock Wednesday: Target Corp (TGT:NYSE)

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

Friday, April 4, 2008

EPS Revisions for S&P 500 Companies

Here is a brief summary of data I collected from Yahoo Finance for companies in the S&P 500 Index.

EPS Estimates for the current fiscal year compared to estimates 90 days ago:
UP: 166 (33%)
DN: 306 (62%)
UNCH: 24 (5%)

In aggregate, current year estimates were revised down 4.7%.
The average upward revision was 4.2%
The average downward revision was 9.9%

Not much of a surprise as to which type of companies received the largest revisions: Energy & commodities-Up and Financials & consumer goods-Down.

Out of the 496 companies I could find estimates for (current & 90 days ago), 479 have positive EPS estimates and 17 negative, up from 11 negative estimates 90 days ago.

I eliminated the negative EPS companies when calculating the revisions to consensus estimates since percentage changes for negative values do not make sense. Therefore, the 9.9% figure for average down revision is slightly understated.

Back in February, when the market was trading at 13.7x estimates I theorized that investors were thinking estimates were too high and would be revised down, opposed to the market being relatively cheap. (see low multiples mean market cheap?) Currently, the S&P 500 is trading slightly higher than it was in February when I made those comments, yet according the data from the WSJ, the estimated P/E has risen to about 14.5x. It appears logical, the multiple has risen close to 6% and estimates have fallen close to 5%, and the market price level has increased a touch as well.

The question remains: “Are earnings estimates still too high?”

The S&P is still trading at low multiple considering that the 10-year currently yields 3.48%, and that multiples have generally been in the high teens for the past couple decades. So, does suggest more downward revisions? Well, if the investors were to think the economic slowdown will be brief and shallow, it would stand to reason that the S&P would be trading at a much higher multiple- reflecting the expectations of a strong rebound and higher future earnings.

Many do believe that the economy will strengthen considerably in the second half of this year and that earnings will return to double-digit growth rates. However, the S&P’s P/E multiple doesn’t convincingly confirm that sentiment. Perhaps another explanation exists.

A point I touched on in my February commentary was the increase to the equity risk premium, or ERP. Investors require a premium to hold risky equities over holding risk-free assets, such as Treasury Bills. The ERP over history has been 5.5-6.5%, but in recent times it has fallen to 2-4%, depending on which method used and which expert one asks.

In the last several months to almost a year, that risk premium has definitely increased. Using the price level of the S&P 500 index and expected earnings growth to calculate the ERP, the current implied ERP is somewhere around 5.5%. A higher ERP translates into lower price multiples. On the margin, when investors perceive increased risk to holding equities, they will pay less for $1 of EPS, hence a lower P/E multiple.

Investors have been less willing to pay up for equities. There has been an explosion of market volatility. Volatility is another way of saying uncertainty, which could be described as risk, actually it's the definition of risk.

Current conditions make the future impossible to predict. Times such as - when today was like yesterday, which was like the day before that, and so on, with static market and economic conditions, then it’s easier to assume that the future will be similar to the present. Volatility in the market is absent; investors perceive there to be less risk, hence P/E multiples are higher.

Currently, today is rarely anything like yesterday, and tomorrow is anyone’s guess. Will there be another big bank write-down? Which market will seize up next? We’ve had mortgages, auction-rate, muni’s, Libor, etc. Bear Sterns saw something like more than 10 billion in liquidity evaporate in the span of a day. It’s been an extremely uncertain and volatile period.

Getting back to the earnings estimates question- Does the market think estimates are not too high? That there will not be a rash of revisions? It’s hard to say. What isn’t hard to say is that even if investors think earnings forecasts are reasonable, they have a low degree of confidence (or certainty) that those estimates will prove accurate. Whether estimates are too high or not, or if a recession will be shallow or deep- actually may not be the question. Either way, investors are not willing to take that bet, instead they are paying low multiples for equities and buying low risk assets yielding negative returns (after factoring in inflation).

I have included tables for the 25 largest (pct) revisions- Up and Down



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Email: gmail-turley.muller
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