Apple 2005 Review

 David Every wanted to look at the year in review (in regards to Apple) to reflect on predictions he had made.

At the beginning of 2005 I said I expected Apple’s stock to hit $110-$140 and then split within a year. Turns out I was wrong — Apple split, then went up to $70’s+ ($140 pre-split level). I’m pleased that my financial predictions were that dead-on. You can read the original article at: https://www.mymac.com/showarticle.php?id=1917.

Of course, even a broken clock is right twice a day. And one lucky hit doesn’t make me a financial analyst. Any long term predictions require luck as well as strategy. Analyst often focus on the minutiae to see how well a company is going to hit their next quarter predictions, while I’m looking more at the industry and company to try to figure out trends for the next year. So let’s look at Apple’s different operating segments (as they break them down), think about strategy, and look forward.

Computer Hardware

In the past, Apple was limited from bidding on many contracts that required “PC Compatibility” (x86 based computers) or running Windows. That ends this year. Apple is making the move to x86. What does this mean?

1) The x86 stuff is actually outperforming the PPC on most things non-scientific. Also at least some people or companies have been holding out, waiting for the introduction of the new machine. To the users, this is a big leap both technologically and psychologically. To the business, this means higher refresh than normal (larger short term sales).

2) There was the psychological barrier that if you were a PC user that bought a Mac, you’d be locked in. (And computers were expensive). Computers are coming down in price, which reduces the psychological barrier to entry to try a Mac (the MacMini effect). But soon if you don’t like MacOS, you can just put Windows on it (the x86 Mac effect). To business this means more customers, and with the superiority of the Mac OS, more short AND long term sales.

3) The Mac has been benefiting from the iPod effect; people buying Apple iPods also want Apple Computers. As Apple’s iPod sales have gone up 300% last year, we can expect carryover to the Macs. We won’t see 300% from this, but even if 1 in 20 iPod buyers thinks this way (5% capture), that means 1.1 million computer sales this last year, and around 3 million Macs next year, not counting cumulative effects.

Apple’s Mac hardware net sales grew at a rate of 27% last year or $1.4B. Apple went from roughly $5B (2004) to $6B (2005) sales, and in units they went up by 38% or 1.2M units, with a 7% decrease in unit cost; from 3.3M/year to 4.5M/year. The unit costs went down because of changes in the product mix (more lower end desktop units like MacMini instead of higher end laptops) and general price decreases in the whole industry. But manufacturing margins were pretty flat and Apple shifted more sales from retail to direct (increasing sales margins).

Now if we figure Macs are going from selling an additional 1.1M units to 3M units because of the iPod effect, we’re already at 6.5M units this next year (44% growth alone). Throw in lower prices, x86 and Windows, new contracts, major PowerBook and low end desktop refreshes, new Applications, and estimating 50-100% unit growth this next year is not out of the question. That means for 2006 we can guestimate that Apple will move about 7-9M Mac units, and with some more price decreases, that mean about $8-12B in gross sales. Not too shabby. This is before factoring in new segment busters, or totally new products or features. (Of which I expect at least one this year).

Mac Software/Services and Peripherals

Apple tracks their OS, Applications, AppleCare and AppleStore, as a separate line item. But it tracks pretty well with their Mac hardware sales; growing at about the same rate. Apple made about $1B in that area in 2005. Using our Mac unit forcast, that means we can estimate about $1.5-2B from this unit in 2006.

In truth, I suspect this number (percentage) is conservative. Apple is releasing more Applications, and enriching the ones they have, so in theory, penetration and profitability should increase with sales — but for a while, they may just put that back into R&D, so I’m going to play conservative and not factor in an increased penetration or operational efficiencies.

Apple also tracks their peripherals and other hardware separately. This “other” unit brought in about $1.1B, and it too tracks fairly well with hardware sales, but has a more modest growth slope. This may be more correlated to what products they introduce, rather than just how good Mac sales are doing. As such, rather than tie them to hardware growth, I’ll just use the current growth slope, and assume that by next year they’ll be selling about $1.3 – 1.5B in 2006.

The end result is these two units will likely go from bringing in $2.1B in 2005 (combined), to $3-3.5B in 2006.

Media/Gadget Hardware

Apple is the largest media gadget supplier. The iPod is a raging success. It has good interface, great design. Apple went from roughly $1.3B (2004) to $4.5B (2005) sales (248% growth), and in units from loosely 4.4M/year to 22.5/year. Apple is expected to sell over 10.5M units this quarter alone. That’s nearly half of last years total in one quarter (42M units if sales stay flat). So on the modest end of the forcast we’re talking 100% growth. If we stay at last years growth rate, we’re talking 115M units! And that’s if we don’t anticipate Apple figuring out ways to increase growth. Personally, I’ll be very conservative, and figure Apple is only going to sell 60M units (very modest growth over the current quarter).

Apple was selling the average iPod for $200 in 2005, which was down from nearly $300 the year before. But that was because of the introduction of the iPod shuffle. The Nano seems to be pushing those shuffle buyers back up the line, and the Video iPod’s may help there as well. So I don’t see much further errosion down. Even at an average selling price of $175, that means $10.5B in sales from iPods. That’s a fairly conservative estimate. I expect Apple to consider coming out with a device later in the year like a Phone or PDA iPod, which while wouldn’t move nearly as many units, could sell enough to increase average selling price, and keep Apple fresh and cutting edge.

Apple is changing their margins a bit, so there might be some thinning there. But they are also doing things to guarantee their supply chain, with investments and pre-buys into the memory they need for the Nano and Shuffles. This move is likely to stabilize their pricing, and put them in such a favorable position compared to competition, so it will be very hard to compete with iPods/Apple. Apple also has a pretty aggressive product refresh cycle on the iPods, and iPods are cheap enough that people don’t upgrade, they just buy new ones (driving up demand).

Media/Gadget Software

ITunes Music Store, and media distribution segment, Apple went from roughly $278M (2004) to $900M (2005) sales (223% growth). I couldn’t find unit sales, but it appears to be over 50M songs each month, and over a million videos per month and rising as they increase content library. If Apple increases capabilities of players and their computers, we can expect video sales to go up. For now, this number is nominal, even with the larger unit sales cost, and probably won’t be significant to the bottom line, but that’s just because Music sales are so huge for now. However, this will probably matter more in future years.

There is pressure from record labels to increase the price of some content, but the effects are unknown; increased and variable costs could mean more money and/or fewer sales. But still, if we assume the same growth rate, that means Apple will probably generate about $2.9B in gross sales. Apple doesn’t call out the margins, so we don’t know returns. But that’s still a measurable amount to their top-line, and exposure, even if we are unsure of the impact to the bottom one.

Apple is now one of the largest music retailers on the planet, and getting bigger, and expanding into video as well. This business is likely to keep growing at an extreme rate, because they have the software and hardware integrated in ways that make it hard to compete. All attempts by a company or companies have been dismal failures. The music alone isn’t a big deal to their bottom line, but it is critical to growth in the manufacture of the hardware (players), and market perception.

Sales (Forecast)

	2006	2005	2004
Mac Hardware (units)	8M	4.5M	3.3M
Mac Hardware (per-unit)	$1,100	$1,384	$1,496
Mac Hardware	$8.8B	$6.3B	$4.9B
Mac Software/Periph	$2.9B	$2.1B	$1.8B
Media Hardware (units)	60M	22.5M	4.4M
Media Hardware (per-unit)	$175	$202	$296
Media Hardware	$10.5	$4.5B	$1.3B
Media Software/Periph	$2.9B	$900M	$278M
Totals (gross sales)	$25.1B	$13.9B	$8.3B

 

Other

So what does all that mean? Mainly that Apple in gross sales could be double the size company next year as it is right now; assuming a slight decrease in the growth rate. This is also without any wildcards.

What are some of the wildcards? I’m not a rumor guy, I’m more an industry observer and business guy (that has heard the rumors), looking at what I’d do if I was Steve Jobs. But then I probably wouldn’t have pre-announced the move to Intel the way Steve did (which worked out fine), and I figured the industry was going to be able to reverse engineer the iPod and undercut them (which they couldn’t because of iTMS and iTunes and Music deals and memory deals/supply chain). So I’m obviously no Steve Jobs. Consider that Apple has people smarter than me, and lots of them — both to shoot these ideas down, and come up with better ones. Still, that being said, I could see Apple coming out with one or two new products among the following.

A real iPod phone; not that cheap and cheesy thing that Motorola created the ROKR. Cell phone companies offer subsidies on hardware, but have lots of annoying requirements like they don’t want you to be able to download pictures taken, or use songs as your ringtones. Apple could create a really good phone, with a really good interface, and all the features people really want, and just sell it without the subsidies, or possibly figure a way to negutiate with the carriers. If they do not, in a couple years 802.11x or other new technologies could change the Internet itself into a wireless anywhere kind of function, and the limitations of the cell phones will work against them, as people jump network providers/types. Not a huge impact in bottom line, but more converts and a lot of psychological impact.

Home media center; Mac Mini as media hub. Imagine the PVR/DVR, DVD player, Music JukeBox, Picture Player, iPod dock, WebTV, Streaming Media Player, all in one small device. This killer little turn key hub could move a lot of units. (I also question the gaming station option with a good video card and reasonable processor/RAM — but I suspect the cost increases would move this option downstream a year or three). Either way this would move a lot of units! This type of thing could be the next iPod in sales numbers. The question is where does it fit? Apple would sell it as a stand along turn-key device, more in the iPod or PVR realm (not as a computer), or leave it as a media computer to move more MacOS X boxes, and possible software that would come with it or be added. I favor the latter, but Steve has favored some closed appliance options in the past. Either way, this has huge impact if it becomes a reality.

I also suspect there will be some device in the portable version of the media center. Whether that is an ultra-portable media Mac, or a Video iPod on steroids, I’m unsure. I tend to favor the ultra-light Mac realm. Sort of a WinCE without having to run a different Operating System (all your apps run). But a device that lets you watch movies, play DVD’s, music, and is a computer. Others think Apple will just add dashboard to the iPod (and connectivity) and give it an optional bigger form factor. Either is a way to blur the lines, where a Mac and an iPod become more similar, thus get more cross-over. No need for a PDA as a slightly different finder mode, and Address Book, eMail, Safari, and all that, make the Mac into the ultimate PDA or sub-notebook (or sub-sub-notebook). With Apple’s industrial design, I’m sure they could do something cool and compelling.

In the software arena to really help Mac OS X, if I was Apple, I’d do one of two things. Work out with Intel a way that you could run Windows and Mac at the same time, or more with someone else, a way to release Windows porting API’s to Mac. If Apple either came out with a Win32 Library that did some/most of the Windows stuff, on top of OS X, or something that helped them port/translate, it could radically increase the number of Apps on the Mac. In the past, NeXT had the ability that if you made your Apps for the NeXT it could run on Windows (with their own library). There are lots of ways to do it, and risks with them all — but the goal is to reduce the barriers to entry to write more Mac software, which will increase sales even more. As marketshare goes up, Apple will gain Apps anyways. But with x86 working on Mac, some wrapper or remapper libraries or other things could really decrease the costs of making/supporting Macs, which would radically increase the number of Apps, thus sales.

So any of those options could make the projections I made conservative, or be at least the way they help achieve the sales. I’m not sure where they’d put each of those devices. And I’m sure Apple has their own ideas as well. But I expect at least one new thing this year.

Conclusion

People get squeamish about investing in stocks that are ‘hot’, because they think there isn’t any value. But value is based on growth. Let’s assume Apple is a little hot (overvalued) right now, with 118% growth (year over year), how long until the current price is considered a bargain? One month? What if they are hot then, are you going to delay again, waiting for it to come down? Each dollar you didn’t put in Apple this time last year would be worth $2.28 now. Last year, I tried to convince my brother to invest; he felt Apple was too hot at $70/share, so he waited. Later he bought at $49, after the split, and missed out on 22% growth. Still he made 42%, so isn’t complaining. And they say Real Estate is a good investment? I made more on my Apple stock than I made in salary. You kow, I’d be perfectly happy if Apple could just repeat last year. Even at half that, I’m plenty happy with the returns, and they slaughter just about any other investment I could make.

If I’m even close to my projections, and looking at price to sales, Apple’s stock would have to near double next year just to keep up. Less if you’re looking at earnings (thinning margins). Still, Apple has managed to keep good margins in the tightest areas; consumer electronics, thus there’s no reason to believe they can’t keep that trend. That’s without any new revolutionary products, breaking into new markets, or other things Apple is trying to do. Last year, just primed the pump to help them more this next year. iTunes and iPod is leading into more media types. Their stores are profitable and have only 5% penetration. Their websites are huge and profitable, they can start leveraging more with them. The Mac OS X and x86 transition is opening new markets. Video is coming big time. And so on. I see very little risk that Apple will be worth less next year at this time.

If you’re looking two years out, then the next year is probably better still. Microsoft is coming out with Vista, with almost 1/2 the features they initially promised. This is going to be a major headache and upgrade for Windows users and companies. Microsoft is also promising an update soon after Vista (could be a year or two behind) to deliver some of the features that they’ve had to drop to keep hitting the schedule they have already slipped. If users are migrating and paying heavy retraining costs (which they will), and with the fear and dislike of Microsoft, the risk is great for Microsoft. They have to every target just to keep close to Apple; and Apple has a new version of their Operating System targeted around the same time (which we don’t know the features of yet, and could be a major leap forward). The potential for Apple to make real market penetration in the PC arena is staggering. Apple just has to repeat their iPod recipe in the PC’s, tie them together more, or offer some better Windows integration than they already have, and it could be huge for Apple and the entire computer industry.

Remember a few years back when Steve Jobs said to Michael Dell, “we’re gunning for you”. Most people didn’t take it seriously. Dell was 5-10 times the size of Apple by most metrics. By next year, Apple’s market capitalization could be 50%+ bigger than Dell. The year after, at these growth rates, or slightly cooling, Apple’s sales will surpass Dell, as will profits (earnings). With Apple in multiple groth markets instead of more stagnant ones, and controlling their own destiny instead of being dependent on everyone else. The only problem is that saying that to Michael Dell, wasn’t thinking big enough. In 4 or 5 years, Apple could realistically have over 25% of the entire PC market, with their own OS, Applications, and controlling Music and Video distribution, and pushing into streaming media as well.

All investment has risk. I actually see Apple and this growth rate as pretty high risk. The whole world is paying attention and trying to figure out how to beat Apple and break the hold they have on media. But then people had been trying to do that with Microsoft for 20 years. Even if people do figure out a way to beat Apple, it will be hard to keep Apple from responding — so they’d be lucky to become a serious player in an Apple dominated segment. Apple’s evaluation is currently fairly high, based on their growth projections. If they start missing, they could get a short term pounding in the market. But longer term, they’re making the right moves, and may be under valued for where they could go. But who knows, things change quickly. Still, I’m bullish on Apple for the next two years — with this being a high risk year, and next year being a little higher still. But for now, I see a lot of things coming together at the right time for Apple, and Apple is running with it — and at this rate, they are going to be the success story of the generation.