Prudential: Apple to rise

Apple is likely to experience significant growth due to an early launch of Mac OS X Leopard alongside Adobe's March 27th release of Creative Suite 3, according to Prudential Equity Group. The firm upgraded Apple's stock to 'Overweight' from 'Neutral weight' based on an expected late March launch of Mac OS X 10.5 Leopard and Adobe's Creative Suite 3 -- 1-2 months ahead of Wall Street expectations. "We view this [as] a near-term catalyst for Mac sales," wrote Prudential analyst Jessie Tortora. "We view the company's long-term gross margin model of 28 percent to 30 percent as conservative and see margin upside over the next several quarters due to component cost declines and a richer product mix from sales of Leopard, Mac Pro, and MacBook Pro, and iPhone." New product ramps are likely for iPhone and a flash-based widescreen video iPod with new functionality -- such as Wi-Fi and GPS capability -- to drive growth in the second half of 2007, according to the firm, which also raised its price target for Apple shares from $100 to $105.

"Current valuation on [Apple's] stock appears attractive, trading at 22x on our fiscal year 2008 earnings-per-share estimate of $3.90," Tortora wrote in a research note obtained by MacNN.

March launch of Leopard, CS3, and Mac sales?

Prudential's recent checks lead the analyst to believe that Adobe's CS3 and Apple's Leopard operating system will launch simultaneously and at the end of March, roughly 1-2 months ahead of street expectations.

"We think this powerful one-two punch makes a great deal of sense, as it will likely unleash a flood of pent-up demand for both companies' products," Tortora said. "We view this as a near-term catalyst for Mac sales as we believe creative professionals and high-end consumers are holding out for these software releases before upgrading to the new Intel-based Macs."

Apple has historically experienced a significant increase in software sales for the following 2-3 quarters after releasing a new version of its operating system as the Mac installed base upgrades to the latest iteration. Tortora expects the late March release of Leopard to provide a boost to software revenues for at least the next two quarters.

The analyst points to the last Mac OS X release (Tiger) in April of 2005, which came roughly 18 months after the previous version. Tiger resulted in an increase in Apple's June quarter software revenue by around 45 percent quarter-over-quarter and around 65 percent year-over-year.

"We are modeling Leopard to boost software sales at slightly higher levels of 57 percent quarter-over-quarter and 75 percent year-over-year given the longer product cycle for its release (i.e. 24 month lag time) and larger installed base."

Apple already confirmed that Mac OS X Leopard will include 64-bit support, its Time Machine data backup system, Boot Camp, improvements to Spotlight, and enhancements to internet chat as well as Web conferencing and email tools. Leopard is also expected to contain several other features not yet disclosed, which could entice further customers who are considering upgrading this spring. Adding to the mix, Microsoft's recently released Windows Vista operating system -- which was the company's response to Apple's Leopard -- met with intense criticism after its debut.

"Given that Microsoft's Vista has not been very well received by the consumer, a successful Leopard launch could drive more consumers to shift form Windows based PCs to Macs," Tortora said.

Talks with Apple management and recent checks suggest that many prospective buyers for high-end Mac Pro and MacBook Pro systems are likely waiting to purchase high-end systems until Adobe releases its Creative Suite 3.

"We believe that the earlier than expected release of the software will result in upside to sales for these systems in the June quarter," the analyst noted. "These systems are more margin rich than the company average, and higher growth in this category would mean a richer product mix for the company, thus boosting overall company margin."

Apple may surprise with higher margin

Prudential analysts believe Apple's margin potential is being underestimated, and feel that the company's long-term gross margin model of 28-30 percent could prove conservative. Tortora sees an upside to Apple's margin over the next several quarters due to component cost declines and a richer product mix from sales of Mac OS X Leopard, Mac Pro systems, MacBook Pro notebooks, and the iPhone.

"We believe Apple will begin to see the benefit this quarter from accelerating component cost declines. Thus far in Q1, NAND flash, DRAM, displays, and notebook hard drives are experiencing the greatest price declines," Tortora wrote. "We expect this environment to persist through early Q3."

The firm expects Apple's iPod margin to see the largest gain as a result of flash memory prices declining around 35 percent sequentially so far in the quarter. Flash accounts for around 40-50 percent of the iPod nano and 35-30 percent of the iPod shuffle bill-of-materials (BOM), respectively. Mac margins are also expected to benefit from declining component costs in areas such as DRAM, panels, and notebook hard drives.

"Taken together, our BOM analysis and projected declines for each component through the remainder of the quarter, lead us to the conclusion that Apple could realize a total savings of 6.5 percent of COGS," Tortora said. "While in the short term we expect Apple's margin to rise due to these cost benefits, later in the year we expect Apple to reduce prices and/or increase product features in order to boost sales in the busier back-to-school and holiday season."

Apple's margin will likely see a boost from a richer mix of products -- including the release of Mac OS X Leopard as well as higher sales of Mac Pro and MacBook Pro systems -- driven by Leopard alongside Adobe's CS3 and followed by the launch of the iPhone. Leopard carries a significantly higher margin than Apple's average because the development work has already been done, and Mac Pro as well as MacBook Pro models reside at the higher end of the Mac line to command premium margins.

"We believe iPhone was priced at a premium to prevent the cannibalization of iPods and that it will initially carry the highest margin on any hardware product Apple sells. Taken together, we believe these product ramps [will] contribute favorably to Apple's overall corporate gross margin, which now stands at 31.2 percent."

New products may drive growth

Apple will likely experience significant growth in the second half of 2007 as a result of new products, including the iPhone and at least one addition to its iPod line, according to Prudential. The firm expects a flash-based widescreen video iPod with Wi-Fi and GPS (Global Positioning System) capability.

Apple is planning to sip its iPhone in the U.S. in June of this year, followed by Europe in the fourth quarter of 2007 and Asia in early 2008.

"We see great potential for Apple's entry into the cellular market, still, with many unknown aspects regarding customer acceptance of the phone, we prefer to be conservative with our estimates."

Tortora expects 1.5 million units in 2007 and 5 million units in 2008, vs. Apple's goal of 10 million units in 2008.

"We believe that even with these more conservative estimates, the iPhone ramp will have a significant impact on the company's bottom line given the product's higher margin. We are estimating iPhone to contribute earnings-per-share of $0.07 and $0.40 in fiscal year 2007 and fiscal year 2008, respectively."

The Cupertino-based company is also planning to unveil a new video iPod later this year that uses flash memory rather than a hard drive for storage, as well as a wider touch-screen similar to the one found in the iPhone. The new iPod is also likely to include Wi-Fi capability to transfer digital content wirelessly from Apple TV, and will include GPS functionality.

"With these exciting new features, we think Apple will position this new product at higher price points than its current video iPod ($249 for 30GB and $349 for 80GB), providing a boost to revenue growth," the analyst said. "Moreover, we see higher unit demand due to the substantial advantages flash memory brings including a thinner and lighter form-factor, longer battery life, and better durability."

Tortora points to how the introduction of the flash-based iPod nano boosted overall iPod sales in late 2005 as a case study, adding that the addition of GPS functionality could position the new iPod as the central hub for all digital content in cars, thus creating yet another market for Apple.

by MacNN Staff