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

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

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

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.